Important Details On New Estate, Gift, and GST Rules End Of 2010 And Forward

[ 2 ] December 22, 2010 |

New Estate, Gift, and GST Rules Could Be a Tough Act To Follow
Note: The Alert has been updated to include additional year-end planning considerations, as well as GST planning considerations.

On Friday, December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the Act). With varying effective dates discussed below, the Act reinstates through 2012 the estate and generation-skipping transfer (GST) taxes with exemptions of $5 million each and a maximum rate of 35%. The Act also increases the gift tax exemption from the current $1 million to $5 million, thereby reunifying the gift tax with the estate tax exemptions. The gift tax rate will also be 35%.

As noted in a prior Alert (see Tax Alert 2010-1561), absent this legislative action, as of January 2011, gift, estate and GST tax exemptions would have been limited to $1 million, respectively, at maximum rates of 55%. The Act also includes a provision for portability of the gift and estate exemptions (but not the GST tax exemption) between spouses. It also reinstates the concept of “stepped-up” basis for assets inherited from a decedent, replacing the carryover basis regime that has been in effect for 2010.

(A separate Alert discusses the extension of the Bush income tax cuts and resulting year-end tax planning considerations for individual taxpayers. Another Alert outlines the extension through 2010 and 2011 of multiple tax provisions of interest to individuals that had previously expired at the end of 2009.)

Generally, the $5 million estate and GST exemptions will be effective for 2010. The gift tax exemption will remain at $1 million for 2010, increasing to the reunified $5 million level in 2011. The gift tax rate, which has been 35% in 2010, will remain at that level for 2011 and 2012 and thereafter. While the estate tax will apply for estates of decedents who die in 2010, the executor will be able to elect whether to apply the estate tax and stepped-up basis regime or the rules that had been in place for 2010 (i.e., no estate tax but the modified carryover basis regime). The former will actually be the default. The latter will have to be elected.

Presumably, estates below the $5 million level would accept the default provision in order to get a step-up in basis without paying estate tax. Finally, although the GST tax will apply in 2010, the rate will be 0% for that year.

The Act particularly lays to rest the fear that Congress would reinstate the gift, estate, and GST tax rules on an unfavorable and retroactive basis. While there is some retroactivity as described above, it is generally a positive for those taxpayers who would be affected by it. Meanwhile, the Act did not mention and therefore left intact two of the most useful wealth transfer tools available to taxpayers today, i.e., Grantor Retained Annuity Trusts (GRATs) and valuation discounts. Except in larger estates, the former may no longer be as necessary given the increase in the gift tax exemption. The latter, however, will simply add more positive leverage to transfers of closely-held businesses and other entities, including by way of GRATs.

As noted, the relief and benefits afforded by the higher exemptions and lower rates under the Act are temporary. After 2012, the gift, estate and GST tax laws will revert to what had been scheduled for 2011.

From an administrative perspective, the Act extended the due date for filing estate tax returns for decedents dying in 2010 (prior to the date of enactment), GST tax returns for generation-skipping transfers made in 2010 before the date of enactment and for making disclaimers to no earlier than the date that is nine months after the date of the enactment of the Act.


The implications of the Act are as broad and far-reaching, as they are facts-and-circumstances dependent. With that in mind, we will consider the implications of the Act from three perspectives. First and foremost, we will simply list some planning steps that taxpayers should consider before year-end. Second, we will consider some things that taxpayers are well advised to understand about their current estate plans and, if necessary, revisit in light of what the Act does and does not do. Third, we will survey some of the planning opportunities afforded by the Act, whether those are opportunities to address troublesome aspects of planning already in place or to do incremental wealth transfer planning over the next two years.

Planning Steps To Consider Before Year-End

While we will address each of these items in more detail below, taxpayers may want to consider taking these steps before December 31, 2010:

1. Make so-called “direct skip” transfers to grandchildren or, if more appropriate, to generation-skipping trusts for the exclusive benefit of grandchildren and more remote descendants. Note that for GST tax purposes, taxpayers can transfer unlimited amounts to grandchildren or to such trusts in 2010 without triggering GST tax. However, any transfer above $1 million (or above a taxpayer’s remaining gift tax exemption) will trigger gift tax at the 35% rate.

2. With the GST tax rate for 2010 set at 0%, consider opportunities for making GST tax-free distributions to grandchildren from trusts that were not otherwise protected from application of the GST tax (so-called ‘non-exempt trusts”) or for terminating those trusts in 2010 and distributing assets to grandchildren or to trusts for their benefit, free of GST tax.

3. GRATs (and the valuation discounts often used to reduce the gift tax value of property transferred by GRATs) are still available in 2010 and will be available after 2010. There is no longer any legislative reason to get a GRAT done by year-end. However, any taxpayers who were ready to implement a GRAT in 2010 should monitor the Section 7520 “hurdle” rate for GRATs for January 2011. If there is a significant uptick in that rate, such taxpayers might just as soon complete the transaction by December 31 at the lower Section 7520 rate.

Revisiting Existing Plans or Please Note the Signs About “No Jumping to Conclusions”

Despite the considerable planning opportunities available through 2012, we’ll take some poetic license with an ancient adage to suggest that on the flipside of those opportunities are some traps that, if not avoided, could create unintended crises for taxpayers’ survivors and dependents.

As a fundamental matter, the Act significantly increases the amount of property a taxpayer can give away tax-free during lifetime or leave tax-free at death. That’s all it does. It doesn’t repeal death or loss of capacity or the personal and financial stresses and anxieties associated with either. In short, it does not repeal or even suspend temporarily the need for a clear, thoughtfully designed plan that provides first a structure for living dependently in case of loss of capacity and then a structure that provides appropriate protection and resources for that individual’s survivors.

The point is that the flip side of the opportunities created by the Act is the danger that taxpayers who have long been given the impression that estate planning means estate tax planning, might now think that if their estates are under $5 million (or $10 million for couples), they won’t have to bother with and incur the expense of “estate planning.” They won’t have to heed their advisor’s advice to bring a decade-old set of documents current or get a complete plan done in the first place. Unfortunately, the cost of that misimpression could be, well, incalculable.

Therefore, we urge taxpayers who have not done their planning to do so. The notion that there will be no estate tax on what could eventually pass to the children is likely to be of little solace to a surviving spouse who is left with a lot of ambiguity and little structure for management of what could be considerable sums otherwise “left” to him or her.

Even those taxpayers with relatively current (and au courant) estate plans should revisit their plans to be sure they understand and are still comfortable with how those plans will “work” if they die between now and 2013. Perhaps the most important feature of existing plans that should be revisited is the amount that would pass to a so-called “credit shelter” or “bypass” trust at the death of a spouse. These trusts, which are used to take full advantage of a spouse’s estate tax exemption, typically provide income and discretionary distributions of principal to the deceased’s surviving spouse. The amount that goes into these trusts is typically determined by a formula that puts the maximum possible amount into the trust without generating federal estate tax in the deceased spouse’s estate. Assets in excess of the remaining exemption either pass to the surviving spouse outright or remain in a form of trust that will qualify for the estate tax marital deduction.

The advantage of the bypass trust is that its assets will not be included in the surviving spouse’s estate at his or her death, regardless of the amount in that trust at that time. In 2009, a fully funded bypass trust would have been allocated $3.5 million. In 2011, it will be allocated $5 million! We suggest that taxpayers, especially the spouses who are the likely beneficiaries of those bypass trusts, revisit these plans and reassess their comfort level with the full $5 million going into trusts that effectively trade off their direct access to the trusts’ assets for the sake of saving estate taxes at their deaths.

New Planning Opportunities

Aside from the obvious fact that for the next two years anyway, taxpayers can give or bequeath so much more on a tax-free basis than ever before, the Act offers an array of opportunities to either shore up or fine tune existing planning vehicles or start afresh on significant wealth transfer. We will consider first the implications of the Act on planning between spouses. Then we will consider planning for wealth transfer to the next generations.

Portability of Exemptions

The Act provides that when a spouse passes away after 2010, the surviving spouse can add to his or her own $5 million exemption, whatever amount of exemption the deceased had not used during his or her lifetime. The deceased’s estate will have to file an estate tax return in order to effectuate this benefit. What’s more, the Act provides that it’s only the last, meaning “most recent deceased” spouse whose exemption is portable in this fashion. Apparently, the government thought that tacking several spouses’ exemptions would be tacky. The portability extends to the gift tax exemption in that, after 2010, the surviving spouse will be able to use his or her deceased’s spouse’s exemption for lifetime transfers as well as at the survivor’s death. Portability does not apply to the GST exemption.

A surviving spouse who received the benefit of his or her late spouse’s remaining exemption will not lose that benefit just because he or she remarries. The problem, however, is that if the person whom the survivor marries should predecease him or her, then the second spouse becomes the “most recent deceased” and, depending on the situation, exemption could be gained or lost.

While creative types could well turn portability into a subplot for soap operas or crime shows, the primary question for planners and taxpayers will be whether portability obviates the need for bypass trusts (so long as the estate of the deceased spouse files a return and makes the necessary election). As we noted, use of the bypass trust was mandated when the spouses wanted to ensure that the full (remaining) amount of the deceased spouse’s exemption and the growth thereon would not be taxed in the surviving spouse’s estate when it passed to the next generation. If the deceased left everything to his or her surviving spouse, there would be no tax because of the marital deduction but the deceased would “waste” his or her exemption. With portability, there would still be no tax, but the deceased’s exemption would not be wasted. However, there is much to consider, because while portability represents relative simplicity vis a vis the perceived complexity of the bypass trust, the latter offers the traditional benefits of a trust, such as creditor protection, and the ability to avoid some of the technical foibles of the portability provision, such as that noted about remarriage and death of the “new” spouse. Use of the bypass trust will also help preserve the GST exemption of the first spouse to die.

Life Insurance Planning The Act raises a host of questions about life insurance that taxpayers might have to provide liquidity for estate taxes. At first blush, the combination of a higher exemption and lower tax rate suggests that some taxpayers will no longer need the coverage or will be able to reduce the amount of coverage they currently maintain. At second blush, however, dropping or culling that coverage could be premature (and ill-advised) if the temporary nature of the Act’s favorable provisions proves to be just that … temporary. While sharply decreasing the exemption and/or increasing the rate in 2013 seems unlikely to some, enactment of the Act itself by this president and this Congress was just as unlikely. In other words, stuff happens. Therefore, it follows that a taxpayer/insured who drops or reduces his or her insurance coverage over the next couple of years could rue the day if (1) the estate tax reemerges in 2013 with a much wider net and (2) the underwriters are no longer favorably impressed by the taxpayer’s medical reports.

The better course might be to stay the course for a while so that the taxpayer doesn’t get bush-whacked after 2012. That said, if the policy itself has a flexible premium structure, the taxpayer could choose to reduce the premiums to the minimum required to support the death benefit until the future is clarified or, at least, until the next “temporary” set of rules puts things in limbo long enough for the taxpayer to consider that things are “permanent.”

Another question is whether a taxpayer whose estate is less than $5 million (or $10 million on a combined basis) and is now considering use of an irrevocable life insurance trust (ILIT) should establish one. Actually, the question probably applies to any taxpayer whose estate is greater than $5 million (or $10 million combined) but believes that, with attribution to The Who, if the children can receive the first $5 million (or $10 million) free of estate tax, then the kids should be alright. These taxpayers may well choose to defer establishing the ILIT until things are clarified or until the next temporary hiatus is effectively permanent as far as they are concerned.

The Act’s implications on life insurance planning extend well beyond whether to maintain the coverage or establish an ILIT. The greatly increased gift and GST tax exemptions as of 2011 and the 35% gift tax rate offer taxpayers (more than) welcome opportunities to resuscitate some existing insurance arrangements. Many policies now owned by ILITs are calling for higher premiums to support their death benefits, originally planned premiums to be paid far longer than originally anticipated, or both.

Taxpayer/grantors of these ILITs are unhappily facing the prospect of significant taxable gifts or GST transfers to get enough cash into the ILITs to support these policies. In many cases, these policies are subject to collateral assignment split-dollar arrangements that were supposed to reduce the tax cost of the premiums on ILIT-owned policies but now threaten to do just the opposite. These taxpayers have been told for some time that they should fund their ILITs with more cash to avert policy lapse or the splitting asunder of the split-dollar arrangement. But even when the cash flow itself was not an issue for a taxpayer/grantor, the fact that the gift would attract a substantial gift and, when applicable, GST tax, or would have to be structured not as a gift but as an interest-bearing loan to the ILIT, made such ILIT funding a non-starter. And so, a bad problem only became worse.

As of 2011, however, the increase in the gift and GST tax exemptions to $5 million and a continuation of the relatively low 35% rate on any excess transferred put this kind of ILIT funding into a whole new light. Therefore, taxpayers who identify with this set of facts and circumstances should consult with their advisors and agents to explore the tax economics of such restorative funding.

On a more positive, proactive note, the increased gift and GST tax exemptions open opportunities for tax-free funding of ILIT-owned policies to create very long-term “family banks” that provide income and capital for successive generations on a transfer tax-free basis.

Gifts, Either in Their Own Right or as Components of Other Wealth Transfer Techniques

While there is no reason to defer a gift in 2010 that will not attract gift tax (even after a challenge to the valuation of the gift), gifts in excess of that amount will obviously be more efficient in 2011.
The increased gift tax exemption can now become the key to a “multiplier effect” for wealth transfer planning. For example, intra-family loans and installment sales to defective trusts are very popular, tax effective techniques for transferring wealth. But conservative practice generally calls for those grantor trusts to be “seeded’ with a gift of cash or other property in order to lend commercial credence to the transaction. When large enough, these seed gifts can attract gift (and, where applicable, GST tax) unless the grantor/lender/sellers have enough remaining exemption to cover the gifts. Often, they don’t. The significant increase in both the gift and GST tax exemptions will either pave the way for much larger transactions or will provide welcome cushion against such risks as valuation adjustments.

Another opportunity presented by the Act is for the beneficiary of a marital trust that will be taxed at his or her death to take a significant distribution and give it to his or her children at a higher gift tax exemption and a lower rate than could well be available if that beneficiary passes away after 2012. This opportunity could be expanded and coordinated with GST tax planning.

Charitable Giving — Is the Glass Half Full or … ?

As many commentators have foretold over the past few years when the estate tax was in play, one possible loser under the Act is charity. With much higher gift and estate tax exemptions, some taxpayers will no longer turn to various charitable techniques to transfer wealth to their children during their lifetimes or at their deaths. For that matter, continuation of the 15% tax rate on capital gains will remain a deterrent to the use of charitable remainder trusts to diversify low basis, highly appreciated assets.

However, wealthy taxpayers who are charitably inclined may find that the $5 million gift and GST tax exemptions afford them considerably greater flexibility to fashion charitable remainder and lead trusts in a variety of circumstances, while now they are constrained in their choice of the non-charitable beneficiary or the term and/or payout of the charitable interest.

A Special Focus on Generation-Skipping
When one considers that the GST tax, along with its gift and estate tax siblings, could have been reinstated at a $1 million threshold and a 55% rate, the new $5 million exemption represents a truly fertile ground of opportunity. As we already noted, the significant increase in gift and GST tax exemptions will afford welcome relief for taxpayers who need to restore the economic viability of their generation-skipping trusts. Certainly, on a more pro-active basis, the higher exemptions simply create that much more room to make sizeable new transfers to such generation-skipping vehicles as classic dynasty trusts.

The 0% GST tax rate for 2010 confirms additional opportunities for making GST tax-free distributions to grandchildren from trusts that were not otherwise protected from application of the GST tax (so-called ‘non-exempt trusts”) or for terminating those trusts in 2010 and distributing assets to grandchildren or to trusts for their benefit, free of GST tax.

For now, however, meaning for the rest of 2010, the most positive thing that the Act does is to remove the uncertainty about the tax implications of transfers to certain generation-skipping trusts. Taxpayers and their advisors have been quite comfortable with the notion that, absent retroactive reinstatement of the GST tax, transfers in 2010 made directly to grandchildren or great-grandchildren and not in trust would be GST tax-free, regardless of the amount of the transfer. True, the transfers could trigger gift tax, but they would not attract GST tax.

What has been uncertain and therefore problematic is whether a taxpayer’s 2010 gift to trusts for the exclusive benefit of his or her grandchildren would not only be GST tax-free in 2010, but also GST tax-free when the trust makes distributions to the grandchildren or to trusts for their benefit in later years. The Act confirms that such transfers would be GST tax-free, both upon funding the trust in 2010 and when distributions to grandchildren are made in later years.

The absence of the GST tax in 2010 has also presented issues for taxpayer/grantors of generation-skipping ILITs who, prior to 2010, had been allocating GST tax exemption to their premium gifts to the ILITs. By allocating GST tax exemption to the transfers to the trusts, these taxpayers could eliminate (or at least reduce) the GST tax on the eventual proceeds of the insurance policies. In 2010, however, there has been no GST tax exemption to allocate. Yet, many policies require cash premiums nonetheless. The absence of an allocable exemption became problematic because taxpayers could not assume that a transfer (of cash for premium) made in 2010 without allocation of exemption could be covered by an allocation of exemption in 2011. Now that the Act applies the GST tax in 2010 and provides a $5 million exemption (and a 0% rate), taxpayers should be able to allocate exemption to their premium gifts in 2010.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice or opinion provided by Ernst & Young LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Ernst & Young LLP or other tax professional prior to taking any action based upon this information. Ernst & Young LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

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