January 4, 2013
Authored by: Stephanie Moll and Kim Civins
Unless you have been living on a tropical island with no television, cell service, or internet for the past few days, you have probably heard that the Federal government passed a new law this week, averting the “fiscal cliff” by the skin of their teeth (well, at least with respect to tax reform, it remains to be seen what will happen with spending cuts). While there are many portions of the “American Taxpayer Relief Act of 2012” (the “2012 Act”) that may apply to you (for example, see our prior post on the effects of the 2012 Act on charitable gifting), our focus now is on how the new law affects your estate planning.
The New Law
Since 2001, the transfer tax laws have been in a state of flux, with ever-changing exemptions, rates, expirations and sunsets. Now, for the first time in over a decade, the 2012 Act finally makes “permanent” the estate, gift, and generation-skipping transfer tax laws. (I put the word permanent in quotation marks, because nothing prevents Congress from passing a new law tomorrow, which could change everything again.)
Under the 2012 Act, every American citizen now has estate, gift, and generation-skipping transfer tax exemptions of $5,000,000, which number will be increased each year for inflation as necessary. In 2012, the exemption was $5,120,000. There is speculation that the exemption for 2013 will be increased to $5,250,000, but there is no official word from the IRS on this point. This is an extension of the law that has been in effect since late 2010, rather than a change in the law. Any lifetime gifts, or transfers at death, that exceed the exemption amount will now be taxed at a rate of 40%, as opposed to the 35% tax rate that was in effect in 2010-2012 and the maximum 55% rate that was scheduled to go into effect on January 1 if the 2012 Act had not been passed.
In addition, the 2012 Act has made portability permanent. This means that a surviving spouse’s gift and estate tax exemption would be the total of her exemption and her predeceased spouse’s unused exemption. This concept was introduced in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. For years, estate planning practitioners had encouraged Congress to pass a bill authorizing portability of a married couple’s gift and estate tax exemption. However, because the 2010 Act was set to expire at the end of 2012, the estate planning community was still left in a state of limbo because it was unclear whether portability would apply after 2012.
What does the 2012 Act mean for you?
This means that, either during your life or at your death, you can transfer up to $5,000,000 (as adjusted for inflation) without having to pay any estate, gift, or generation-skipping transfer taxes. If your spouse predeceases you and doesn’t use all of his $5,000,000 exemption, you can also add his exemption to yours for purposes of making gifts or transferring assets at death. It is important to note, however, that planning your estate around the concept of portability is still not the best planning for several reasons, including that portability of exemptions is not inflation-adjusted (meaning the amount of exemption transferring to the surviving spouse locks in at the first spouse’s death and does not adjust for inflation in subsequent years) and does not apply to generation-skipping transfer tax exemptions.
Did I Make Gifts in 2011 and 2012 For Nothing?
In 2011 and 2012, estate planning practitioners set their sights on how to help their clients take advantage of the historically high gift tax exemption before it potentially dropped back to the $1,000,000 exemption. Even thought the exemption did not drop to $1,000,000 on January 1, don’t think that your planning was for nothing. There are many benefits to making lifetime gifts that still apply.
First and foremost, you get to see your beneficiaries enjoy the gifts you have given while you are still alive, which you would not be able to do if you waited to make gifts at your death.
If that’s not enough, you have also succeeded in getting the appreciation from the assets you transferred out of your estate now, so that the appreciation will not be subject to tax at your death. For example, if you gifted $5,000,000 worth of company stock to your children and that stock grows to $7,000,000 by your death, you have passed an extra $2,000,000 to your children without paying any estate or gift tax on that amount. If you’ve made these gifts to generation-skipping trusts, you have also succeeded in passing this appreciation on to further descendants without the imposition of any transfer tax, allowing the assets to continue to grow exponentially.
Finally, frequently these gifts were made to “grantor” trusts which requires you, the grantor, to pay the income taxes incurred by the trust, and neither the trust nor the beneficiaries pay income taxes. Every time the grantor pays the trust’s income taxes, this amounts to another tax-free gift to the trust. This concept of tax burn, as some call it, provides its own valuable estate and gift tax opportunity, as obviously, the income taxes must be paid by someone, better by those whose estates are large enough to require estate and gift tax planning.