January 3, 2011
Tax Relief Act of 2010
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January 3, 2011
Re: 2011 Tax Update
Dear Clients and Colleagues:
This letter provides you with a summary of the Tax Relief Act of 2010 (the “Act”) which was passed into law on December 17, 2010, as well as planning techniques that should be considered in order to take advantage of the benefits under the Act.
In addition to providing significant income tax benefits to all taxpayers, the Act temporarily increases estate tax exemptions and drastically increases gifting exemptions creating an unprecedented environment for high net worth individuals to remove significant wealth from their estates through gift techniques. The Act is only effective until the end of 2012, however, and without a further act of Congress, the unfavorable 2001 estate and gift tax laws are set to return.
2011 and 2012 deaths
The Act provides a temporary two-year “patch” to the burdensome $1 million, 55% estate tax rate that was set to return in 2011. For deaths in 2011 and 2012, the Act increases the estate tax exemption to $5 million, per spouse, and reduces the estate tax rate to a maximum of 35%. All property in one’s estate (and the community property interests of a surviving spouse) receive a full “stepped up” basis in the hands of beneficiaries equal to the value of the property as of date of death.
Also new for 2011 and 2012, the $5 million estate tax exemption is now “portable” between spouses. Under the portability provisions, any part of the $5 million exemption that is not used at the first spouse’s death may be applied at the second spouse’s death (in addition to the second’s spouse’s $5 million exemption) provided both spouses die before 2013. Important: in order for the excess exemption to be used, the executor of the first spouse’s estate must file a federal estate tax return, regardless of the size of the estate, and make the appropriate elections.
As stated above, the estate tax is set to return in 2013 at a $1 million, 55% rate. Nevertheless, as explained below, gifting that is completed prior to 2013 will effectively “lock in” the 35% rate.
For estates of individuals who died in 2010, the Act gives the representative of the estate the option to use either (a) the “new” regime ($5 million exemption / 35% rate / full stepped up basis), or (b) the “old” regime (no estate tax / limited stepped up basis). If no election is made, the default rule is estate tax under the new regime (which might require the filing of a federal estate tax return).
Generally, the election to be taxed under the old regime will only benefit large estates that have a relatively high income tax basis in the estate assets. The reason is that under the old regime, there is no estate tax for estates of persons passing away in 2010, regardless of the size of the estate. The tradeoff, however, is that the estate assets only receive a $1.3 million additional stepped up basis in the hands of beneficiaries (and/or a further $3.0 million additional stepped up basis which is available only to assets passing to a surviving spouse or owned as community property with a surviving spouse).
Thus, estates that exceed the $5 million threshold must consider whether electing to pay no estate tax is worth foregoing the full stepped up basis under the new regime. For estates under $5 million, there is no estate tax under either regime; therefore, the new regime is generally more beneficial since the estate assets receive a full stepped up basis.
If you are the trustee of a trust or personal representative of an estate of a person who has died in 2010, please contact us in order to determine which regime is most beneficial under your particular circumstances.
Gift and Generation Skipping Transfer Taxes
2011 and 2012
The new Act creates an unprecedented environment for lifetime gifting.
The reason is that until the end of 2012, the lifetime gift tax exemption is increased from $1 million to $5 million, per spouse, reduced by any prior taxable gifts made during one’s lifetime. This means that each individual may transfer up to $5 million, outright or in trust, without having to pay any gift tax. The effect of making such gifts is the permanent removal of any and all appreciation on the gifted amounts from one’s taxable estate. The benefits of this are even more pronounced if estate taxes increase after 2012.
Moreover, for lifetime aggregate gifts that exceed the $5 million exemption, the gift tax is imposed at an all-time low rate of 35%. There is an advantage to paying the gift tax – if the estate tax rate increases after 2012, you will have effectively locked in the 35% rate on assets gifted that would otherwise have been taxed at death at the higher estate tax rates.
Even more generous is that the Act also increases the generation skipping transfer tax (GST tax) exemption to $5 million for gifts to grandchildren. Thus, through proper planning, up to $10 million of assets (and the future appreciation on those assets) may be removed not only from a married couple’s taxable estate, but also the taxable estates of their children and grandchildren. In our opinion, this is perhaps the largest tax planning benefit created under the Act for wealthy individuals – and one that should be carefully considered.
You may remember that there was uncertainty in 2010 with respect to setting up a trust for grandchildren. Although there was no GST tax for 2010, the question was whether distributions in later years might become subject to the GST tax. The Act gives us a favorable answer: there is no GST tax in 2010, and any future distributions from GST trusts established in 2010 will be free from GST tax.
A grantor retained annuity trust (GRAT) is a planning technique which allows for the tax-free transfer of significant wealth to the younger generation without creating any significant downside risk. The reason is that if the trust assets outperform the IRS “7520 benchmark rate” in effect at the creation of the GRAT (currently 2.40% for GRATs executed in January 2011), the excess remainder at the termination of the GRAT passes to beneficiaries tax-free; however, if the assets underperform or if the grantor dies within the GRAT term, the assets simply revert back to the grantor or his estate.
Although there have been nearly a dozen attempts by Congress to quash them in the past year, GRATs remain unaffected by the new Act. Nevertheless, individuals looking to utilize this technique should act with a sense of urgency for two reasons. First, the 7520 benchmark rate which was previously at an all-time low (1.80% in December 2010) just increased to 2.40% for January 2011; this is likely not to be the last increase (rates change monthly), and the larger the benchmark rate at the creation of the GRAT, the less value which passes tax-free to the younger generation at the end of the GRAT. Second, it is expected that Congress will continue to aggressively pursue legislation to permanently curtail the benefits of GRATs.
Gift/Sales to IDGTs
Due to the significant increase in the lifetime gift tax exemption, there is even more incentive for high net worth individuals to use a sale to an intentionally defective grantor trust (IDGT) to reduce the size of one’s taxable estate over the next two years.
This technique works particularly well with real estate investments that produce a solid cash flow. The general structure of an installment sale to an IDGT is that the grantor sells assets to a trust established for children and/or grandchildren in consideration for a promissory note that is payable from the trust to the grantor over a number of years. Due to the “defective” nature of the IDGT for income tax purposes, no capital gains taxes are due on the sale. The result of the technique is that the grantor retains a cash flow that is similar to his/her cash flow prior to the sale, while permanently shifting to the IDGT (and out of the grantor’s taxable estate) any post-sale appreciation on the property sold.
The next two years is a great time for larger estates to implement this technique in order to leverage the $5 million gift tax exemption. This is because the downside of the IDGT technique is that it requires a taxable “seed” gift equal to between 10 and 20 percent of the value of the transferred property. Historically, only $1 million of gift tax exemption has been available, so this technique was not appropriate for significant wealth transfers. Over the next two years, however, the gift tax exemption is increased to $5 million. Therefore, until 2013, IDGTs can be used to leverage roughly five times as much assets as before.
In addition to the gift and estate tax benefits, the Act also extends the “Bush-era” income tax cuts for all taxpayers. Same as 2010, the top ordinary income tax rate remains at 35%, and the top rate for long-term capital gains and qualified dividends remains at 15%. The alternative minimum tax (AMT) brackets remain at approximately the same as 2009 rates for both 2010 and 2011.
The Act also provides a few additional income tax benefits including the following highlights. First, Social Security taxes are reduced by 2%. Second, there is an extension of the section 1202 “100% gain exclusion” for investments made in qualified small businesses that are held for longer than 5 years (this generous provision was previously only available for investments made between September 27, 2010, and the end of 2010; under the Act, this is extended until the end of 2011.) Third, individuals who are 70 ½ and older may make up to $100,000 of distributions to charities from their IRAs, per year, for both 2010 and 2011. This is a very efficient way to make a charitable deduction, and the Act even permits individuals to make a retroactive distribution for tax year 2010, if it is made by the end of January 2011.
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Again, we cannot stress the significance of this Act enough, nor the importance of acting quickly in order to take advantage of the tax benefits offered under the Act. We recommend that all estate plans be reviewed to analyze the effect of these temporary law changes.
If you have any questions or would like to discuss any of the above in more detail, please feel free to contact one of our estate planning attorneys listed below:
|SAN JOSE OFFICE||PALO ALTO OFFICE|
|Jim Quillinanfirstname.lastname@example.org||Peter LaBoskeyemail@example.com|
|Jennifer Cunneenfirstname.lastname@example.org||Charles Packeremail@example.com|
|John Hopkinsfirstname.lastname@example.org||Darin Donovanemail@example.com|
|Bruce Robertsfirstname.lastname@example.org||Laurie Lookemail@example.com|
|Don Shererfirstname.lastname@example.org||Diane Fongemail@example.com|
|Jonathon Morrisonfirstname.lastname@example.org||Richard Schachtiliemail@example.com|
Circular 230 Notice
Recently adopted Internal Revenue Service regulations generally provide that, for the purpose of avoiding federal tax penalties, a taxpayer may rely only on formal written advice meeting specific requirements. Any tax advice in this message does not meet those requirements. Accordingly, any such tax advice is not intended or written to be used, and it cannot be used, for the purpose of avoiding federal tax penalties that may be imposed or for the purpose of promoting, marketing or recommending to another party any tax-related matters.