April 5, 2011

Notice to Clients and Friends
Summarizing the Estate, Gift and Generation-Skipping Provisions
of the Tax Relief, Unemployment Insurance Reauthorization, and
Job Creation Act of 2010

On December 17th, President Obama signed into law the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.” In addition to temporarily extending the income tax cuts under the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) which would have expired on January 1, 2011, the Act provides temporary extensions of and modifications to the estate, gift and generation-skipping transfer tax provisions, retroactive to January 1, 2010. The Act also extends the sunset provision of EGTRRA to December 31, 2012; in other words, as of January 1, 2013, absent further action by Congress, the estate, gift and generation-skipping provisions revert to the law in effect prior to EGTRRA. That the Act is a “Senate Amendment to House Amendment to Senate Amendment” is indicative of the political wrangling that occurred and is likely to occur again prior to the end of 2012 – a Presidential election year.

This Notice is to summarize the provisions of the new law pertaining to estates, gifts, and generation-skipping transfers, applicable to estates of persons dying and transfers made during the tax years 2010, 2011, and 2012.

If you should have any questions about these changes to the tax laws, and how they might impact your existing estate plan, or an estate of which you are an executor or beneficiary, please call to schedule an appointment. While this Notice is intended to alert you to changes in the law, it is not intended to suggest that you take any action without first consulting with me, or another tax advisor of your choosing, about your specific situation.

The Estate Tax:
The federal estate tax is reinstated, and carryover basis is repealed, retroactive to estates of persons dying after December 31, 2009. The estate tax “applicable exclusion amount” (or exemption) for 2010 and 2011 is $5 million, and the maximum tax rate is 35%. Beginning after 2011 (in other words, for 2012), the $5 million exemption is indexed for inflation.

• For estates of persons who died in 2010, the executor can elect to have the law in effect under EGTRRA apply. EGTRRA repealed the estate tax for 2010, and replaced the automatic step-up in basis of assets of the deceased to fair market value as of date of death with a “modified” carryover basis (with up to $1.3 million of basis step-up, and an additional $3 million for assets passing to a surviving spouse, as allocated by the executor). Presumably, Congress provided this election to pre-empt litigation over the constitutionality of a retroactive estate tax. The election is NOT available with respect to the generation-skipping transfer tax, which applies regardless of whether an election is made with respect to the federal estate tax (see below).
• The applicability of an estate tax with a $5 million exemption and automatic step-up in basis is the “default” provision; absent an election, the estate tax retroactively applies to estates of persons dying in 2010, and the basis in the hands of the estate’s beneficiaries will be the fair market value at date of death.
  
• Any estate tax returns required to be filed will be due 9 months from the date of enactment, in other words, September 17, 2011. The time for making a disclaimer is similarly extended; however, state law may not provide a corresponding extension of time. A disclaimer, in order to be valid under federal law, must be valid under state law. Thus, a beneficiary of an estate of a person dying prior to April 17, 2010 may be precluded from making a valid disclaimer, if he/she had not already done so.
  
• Absent action by Congress, the estate tax exemption reverts to $1 million, with a maximum rate of 55%, for estates of persons dying January 1, 2013 and after.
  
  

The Gift Tax:
The gift tax exemption for 2010 remains at $1 million, with a maximum tax rate of 35%. For the tax years 2011 and 2012, the estate and gift tax exemptions are re-unified, with a $5 million exemption applicable in 2011, and a $5 million exemption, indexed for inflation, applicable in 2012. The exemption amount reverts to $1 million in 2013.

The Generation-Skipping Transfer Tax:
The generation-skipping transfer tax is reinstated retroactive to January 1, 2010, and, although the exemption amount for 2010 is $5 million, the tax rate for 2010 is zero percent. For 2011 and 2012, the exemption is $5 million with a tax rate of 35%. Beginning in 2012, the exemption will be indexed for inflation. The exemption amount reverts to $1 million, indexed for inflation, in 2013, with a 55% rate.

• Several advantageous provisions of EGTRRA, such as automatic allocation of GST tax exemption, are extended through 2012.
• There is a limited opportunity (through the end of 2010) to make taxable gifts to grandchildren or certain trusts (“direct skips”) without paying a generation-skipping transfer tax.
  
  

Spousal Portability:
The Act adopts “spousal portability”, or the ability of a surviving spouse to use the unused exemption amount of a predeceased spouse. This has been proposed and discussed for some time, but this is the first time this provision has appeared in the law. For example, if husband dies in 2011 with an estate of $3 million, his wife can elect to use his unused exemption of $2 million, in addition to whatever exemption is available to her, on her death, or to make lifetime gifts.

• The election must be made on a timely filed federal estate tax return (Form 706), even if an estate tax return is not otherwise required to be filed.
• The election is available only for estates of persons dying in 2011 and 2012.
• Even if the surviving spouse dies after 2012, the unused exemption of the predeceased spouse for 2011 and 2012 will be available, so long as the election was made, if spousal portability is extended by Congress. Therefore, an estate tax return should be filed and the election made in all cases in which there is unused exemption in 2011 and 2012, and a surviving spouse.
  
  

In Summary:
Once again, the tax “relief” is temporary, and the status of the federal estate, gift, and generation-skipping taxes after 2012 is uncertain. The exemptions are currently $5 million (with the exception of the gift tax exemption, which remains at $1 million for 2010), with a top rate of 35%. Under the temporary estate tax relief provisions, the estate, gift, and generation-skipping taxes are scheduled to reappear in 2013 at 2002 levels (with a $1 million exemption and rates of up to 55%). Therefore, any estate plans should be reviewed with respect to what would happen with a $5 million exemption, and a $1 million exemption, and then in the event of an ultimate repeal of the estate tax in 2013. A “formula” plan passing the amount that can pass free of federal estate tax to a “family” or “credit shelter” trust, or directly to children, will now result in $5 million in assets passing to the family or credit shelter trust, or to children, and may leave none passing to a spouse. Plans that were based on the amount passing free of both Connecticut and federal estate taxes will now pass $3.5 million to the “credit shelter” trust or gift.

If your estate plan consists of a “disclaimer” trust or a “single QTIP” trust for the surviving spouse, some flexibility in dealing with differing exemption amounts is built into the plan. Your spouse, or your executor, can determine whether to disclaim, or make a marital deduction election, based on the state and federal exemption amounts in effect at the time of your death.

You should not rely on “spousal portability” in simplifying your estate plan and leaving all your assets to your spouse. It is unknown whether spousal portability will continue beyond 2012. Also, spousal portability does not apply to the generation-skipping transfer tax exemption. The unused exemption of a predeceased spouse is not indexed for inflation. Any appreciation in assets that would otherwise have passed to a credit-shelter trust will not be available in the case of a spouse’s unused exemption. Finally, there are reasons beyond tax planning to leave assets in a credit-shelter or family trust: asset management and investment; protecting assets for ultimate beneficiaries, such as children of a prior marriage; and providing for protection and management in the event of disability, incapacity, re-marriage, divorce or bankruptcy of a spouse or other beneficiary.

Substantial gifts (for those who can afford to make them) should be considered during 2011 and 2012 while the gift (and generation-skipping) exemptions are $5 million. Use of a deceased spouse’s unused exemption can be used by a surviving spouse to make gifts, in addition to the survivor’s own exemption amount.

The Connecticut Estate (and Gift) Taxes:
Keep in mind that the exemption from Connecticut estate (and gift) taxes remains at $3.5 million, with a maximum tax rate of 12%.

• Although many believe that the intention of the Connecticut legislature in enacting an “independent” QTIP (marital trust) election was to enable executors to elect separate martial deductions for federal and Connecticut purposes, the Connecticut Department of Revenue has declared that any election made for federal purposes will be binding for state law purposes. Therefore, for estates of over $3.5 million, an executor (or a spouse, in the event of a disclaimer plan) will have to elect whether to pay state estate taxes to shelter a greater amount on the death of the second spouse from federal estate tax. It may be advantageous to take advantage of a $5 million federal estate and gift tax exemption, and to pay a state estate tax of up to 12% on the difference, in order to shield assets from federal tax on the death of the survivor, if the opportunity arises.
• The Connecticut gift tax exemption is also $3.5 million. Therefore, there may be a limited opportunity to make gifts free of both state and federal gift tax up to $3.5 million, or to make gifts in excess of $3.5 million and to pay state gift tax, in 2011 and 2012. Gift taxes paid (provided that gifts were made prior to 3 years from death) will be excluded from the gross estate on death. Appreciation on assets given during lifetime will also be excluded from the gross estate on death.
• Other states may have lower exemption amounts, but no gift taxes. Consider whether it makes sense to make gifts of out-of-state real estate so as to avoid paying state estate taxes on the property at death.
• The deduction against the federal estate tax for state estate taxes paid is extended through 2012. For 2013 and beyond, the deduction disappears, and the state death tax credit is re-instated. States (such as Florida) that still have a “soak-up” tax will then, once again, impose a state estate tax on federally taxable estates.
• You should know that the Governor’s budget proposal includes a reduction in the lifetime estate and gift tax exemption to $2 million, retroactive to January 1, 2011, if enacted.
  
  

Extension of the Charitable IRA Rollover:
The Act extends the availability of the charitable IRA rollover for 2010 and 2011 (the requirements are summarized in the Pension Protection Act notice, on my website at www.cottonhilllaw.com). The Act permits distributions through January 31, 2011 to be treated as if made in 2010.

Please be aware that this information is intended to be general and does not constitute tax advice.
Circular 230 Notice: None of the information contained herein is intended to be used,
nor can it be used, for the purpose of avoiding US tax penalties.