Estate Tax Reform 2010 — Is It Over Yet?

DECEMBER 20, 2010 VOLUME 17 NUMBER 39
The ink is not yet dry on Congress’s tax and unemployment insurance compromise. Signed just last week by President Obama, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 has now become law. It continues previous income tax breaks for everyone, regardless of wealth. It extends unemployment insurance coverage for an additional 13 months. It also rewrites the estate tax — it does not simply carry forward the estate tax rules adopted a decade ago.

Under the new law no estate tax will be due on estates of less than $5 million. Since there is no Arizona state estate tax, that means that only the wealthiest Arizonans (or those with significant assets in other states which do impose an estate tax) need to be concerned about estate tax rules at all. It should mean that estate planning just got easier, more predictable and lower-risk for nearly all of our clients.

It should mean that, but it may not. There are a number of details to watch out for, including:

  • If you are married and your estate plan was initially prepared a decade or more ago, you might well have a two-trust arrangement. Sometimes described by the shorthand “A/B trust” designation, such an arrangement can actually now increase the total tax paid by your heirs. How could that happen? If a separate trust is created and funded at the first spouse’s death, assets assigned to that trust will not get a stepped-up basis on the death of the second spouse. Under the new law you can get an equivalent estate tax result and still preserve the 100% step-up in income tax basis at the second spouse’s death.
  • If a loved one died during 2010, the heirs get to choose which tax regimen to adopt — either the no-tax choice originally in place for 2010 or the $5 million exemption now adopted. Since the $5 million option includes full stepped-up basis (the original 2010 structure limited the step-up to $1.3 million for unmarried decedents), it may actually be beneficial to opt for the new taxable-estate option. Hard to figure out? Yes. The good news: you have until September, 2011, to decide which option is better.
  • The $5 million exemption is now “portable.” That means that if your spouse dies without having planned to use the exemption, it is still available to you. In other words, a couple effectively gets $10 million in estate tax exemption without having to prepare any planning documents. One small caveat: if the surviving spouse remarries and their new spouse predeceases, they lose the original unused exemption amount (but still get to use any unused exemption from the second spouse). It looks like Congress has (perhaps unwittingly) created a new marriage-discouraging provision for seniors — or at least for wealthy seniors.
  • For a decade we have been saying that the most important estate tax principle would be certainty. If you are pretty sure you know what the estate tax will look like for the next five years or so, you can plan accordingly. Unfortunately, Congress and the Administration have given us only two years of certainty — and much of the certainty we have is that the issue will be politically charged and intensely debated for much of that two-year period. In fact, Vice President Biden told a national television audience Sunday morning (on NBC’s Meet the Press) that “scaling back … the estate tax for the very wealthy” would be a top priority for the Administration over the next two years.
  • The new law also increases the level at which both gift taxes and “generation-skipping” taxes are an issue. Both of those also set at the $5 million level for the next two years. If either or both returns to lower levels after 2012, that could mean an important planning issue for very wealthy individuals in the meantime. Should gifts be made now, just in case? Should gifts be made to grandchildren and later generations, just in case? Expect to see more about those issues in coming months.
  • Paradoxically, the new rules could mean that more people (at least more wealthy decedents) should be filing estate tax returns — even though no estate taxes are due. Penalties for failure to file are higher, the importance to surviving spouses has increased and the stakes involved have generally gone up.

Does all of that sound like the issues are resolved? No — but the plain fact remains that a tiny minority of Americans are wealthy enough to be worried about any of these issues. How do you know if you need to worry? Take this quick four-question quiz:

  1. Is your entire estate (including life insurance, IRAs and retirement accounts) worth less than about $2 million? Whatever happens in the next two years, it is pretty unlikely that the estate tax level is going to return to a number below about $3.5 million (the favorite number kicked around by Democrats during debates over the past year).
  2. Are you married? If so, you can double the estate value in the previous question.
  3. Do you live in Arizona (or another state with no estate tax)? There are only about a dozen states where state estate tax is important — Arizona is not one of them.
  4. Are you middle-aged or older? If so, are you comfortable assuming that your net worth will not dramatically increase in the next few years?

Depending on your answers, your estate planning choices are likely to be simplified. You should check to see whether you now have estate planning provisions that are no longer needed. You should also check whether your non-tax planning issues have been addressed. Do your documents name the right person to act as trustee, health care agent, personal representative and financial agent? Do they leave your assets to the people (and organizations) and in the proportions that you want? Do they refer to events, locations or items that are no longer relevant?

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5 Responses

  1. I am not sure you are correct on point no. 3 with respect to portability that the ten million exemption does not disappear upon another marriage of the surviving spouse but the surviving spouse’s exemption is set to whatever the portability exemption was from the last predeceased spouse. So if the surviving spouse A had 7 million exemption (5 for spouse and 2 unused) from the previous marriage and then got remarried and the new spouse B died with 5 million exemption (because it was all used up and only surviving spouse’s 5 million exemption remained) then the surviving spouse was stuck with only their exemption and lost the 2 million exemption from their first marriage. Of course, this all depends on if surviving spouse A filed an estate tax otherwise it doesn’t matter because they failed to perserve their exemption by not filing an estate tax return.

  2. Chris:

    You’re right. In my haste to simplify a complicated system, I simplified it into inaccuracy. I have corrected the text to eliminate the error. This is a complicated issue to explain, and it is still new to all of us. Thank you, Chris, for helping clarify.

    Robert Fleming

  3. Bill Kulsrud

     /  January 19, 2011

    Does the portability rule eliminate the need for a two trust plan altogether? Is there any reason to continue the “credit” trust? You provide an excellent reason for not funding the credit trust (since those assets would not get a step-up in basis to their fair market value upon the death of the surviving spouse) so it seems that credit trust is dead. Is there any reason not to continue the marital trust (e.g., a QTIP or general power of appointment trust)? Thanks.

  4. Really good question, Bill. We think it’s too early to eliminate two-trust arrangements yet, but mostly because the tax law is once again set to switch back in two years. Assuming Congress gets it together enough to come up with a solution that is at least semi-permanent, and that it includes the portability provision (probably good assumptions, but let’s not count on them yet) it may be time to review the decision. So wait a year or so.

    In the meantime, existing credit shelter trusts can’t just be eliminated. If one spouse has died and a credit shelter trust has already been created (or was supposed to be created because of the terms of the deceased spouse’s will or trust), then the surviving spouse should talk to a lawyer with considerable estate planning and trust administration experience.

    QTIP trusts are another question altogether, as your post indicates. Best to talk with your estate planning attorney about that issue.

    While one apparent goal of Congress was to make planning easier, they have failed so far. Sorry to answer that you need more legal advice, but that is probably the case for the next two years. After that, we’ll have to wait to see.

  5. Bill K.

     /  January 23, 2011

    Thanks for the response. After doing some more reading, one practitioner suggests the credit trust would still be a good place to transfer assets that will appreciate such that they could be taxed in the survivor’s estate. Of course, they lose the step-up. Also, using the credit trust ensures that the assets are transferred to the desired heirs.

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