On January 2, 2013, the President signed the American Taxpayer Relief Act of 2012 (the “Act”) into law. The Act mostly brought us back from the fiscal cliff for the federal estate and gift tax laws. Below is a summary of some of the more important provisions of the Act and of certain additional changes in the estate and gift tax laws that are effective in 2013.
The Act continues the estate tax exemption of $5 million, indexed for inflation (from 2011). With the inflation adjustment, the 2013 exemption is $5.25 million. At this level, a married couple may shield up to $10.5 miliion from federal estate tax. The Act also provides for a maximum estate tax rate of 40%.
If we had fallen over the fiscal cliff, the estate tax exemption was scheduled to decrease to $1 million, and the maximum estate tax rate was scheduled to increase to 55%.
In addition, there have been changes in the inheritance tax laws of many states for 2013. For example, in Illinois, the exemption for 2013 has increased to $4 million (from $3.5 million in 2012). In New York, the exemption for 2013 is $1 million (unchanged from 2012). In Hawaii, the exemption for 2013 is $5.25 million (the same as the federal estate tax exemption and unchanged from 2012). California, Georgia, and Florida continue to have no inheritance tax in 2013. These variations from state to state and the discrepancies between the US and the state exemptions require careful attention in every estate plan.
PLANNING NOTE 1:
Many people have been waiting to update their estate plans because of the uncertainty over the estate and GST tax exemptions. These exemptions directly impact how much property may be left to grandchildren and more remote descendants and whether the taxes would interfere with the desired gifts to collateral relatives and charity. Since we now have certainty as to the estate and GST tax exemptions, clients should review and update their estate plans.
The Act also continues the gift tax exemption of $5 million, also indexed for inflation ($5.25 million for 2013). Under the Act, a married couple may make lifetime gifts having a value up to $10.5 million without incurring any federal gift tax. The Act also provides for a maximum gift tax rate of 40%.
If we had fallen over the cliff, the gift tax exemption was scheduled to decrease to $1 million, and the maximum gift tax rate was scheduled to increase to 55%.
The Act provides that the federal estate and gift taxes continue to be unified and have the same exemption amounts and tax rates. This means the exemption at death is reduced by any exemption previously used for lifetime gifts.
In addition, the gift tax annual exclusion amount for 2013 has increased to $14,000. The annual exclusion amount is indexed for inflation and was $13,000 for 2012.
PLANNING NOTE 2:
Many people made large gifts at the end of 2012 to use the $5.12 million gift tax exemption ($10.24 million for a married couple) before the exemption fell back to $1 million. The focus on the possible drop in the exemption, which did not occur, may have diverted attention from an equally compelling reason to make gifts rather than hold assets until death — all income and growth on gifted assets also avoid any future gift or estate tax. At a 7% compounded growth rate, a $5 million gift grows to $10 millionin about 10 years and none of that is subject to estate or gift tax. If that $5 million is not given away, a large portion of the growth and income will be subject to gift or estate tax.
Generation-Skipping Transfer (“GST”) Tax
The GST tax is a tax assessed on transfers during lifetime or at death to or for the benefit of grandchildren or more remote descendants. It is in addition to any gift or estate tax that may apply.
The Act also continues the GST tax exemption at $5 million, also indexed for inflation ($5.25 million for 2013). Under the Act, a married couple may shield up to $10.5 million from GST tax during their lifetime and at death. The Act also provides for a maximum GST tax rate of 40%.
The GST tax exemption in 2012 was $5.12 million, and the maximum GST tax rate was 35%. The GST tax exemption was scheduled to decrease to $1 million, and the maximum GST tax rate was scheduled to increase to 55%.
The Act extends spousal “portability” which allows the executor of a deceased spouse to elect to give that spouse’s unused federal estate and gift tax exemption to the surviving spouse. Prior to the Act, portability was available only to the estate of a deceased spouse who died in 2011 or 2012 and was scheduled to “sunset” or be eliminated in 2013. Please note that portability does not extend to the GST tax exemption or to state estate or gift tax exemptions.
PLANNING NOTE 3:
A common planning technique for married couples is the so-called A-B plan which involves use of a Family Trust to hold the exempt amount of the first spouse to die. The Family Trust is typically designed so that the surviving spouse has access to the trust funds, but they are not taxed as part of the surviving spouse’s estate. Portability makes use of a Family Trust less compelling because the assets can instead be given outright to the surviving spouse who now, because of portability, will also be able to use the deceased spouse’s exemption to shelter those assets from tax at the death of the surviving spouse. But, a Family Trust still has multiple advantages over an outright gift:
- Growth and income on assets in the Family Trust are also exempt from estate tax — growth and income on outright gifts will not be exempt.
- Portability does not apply to the GST exemption. In contrast, a Family Trust (including all income and growth) can be made exempt from the GST tax.
- Family Trusts provide iron clad asset protection and also can be designed so that, at the death of the surviving spouse, the remaining assets must pass to descendants.
Deduction for State Death Taxes
The Act extends the deduction of state death taxes for federal estate tax purposes.
If we had fallen off the cliff, this deduction was scheduled to be eliminated in 2013 and replaced with a full tax credit. Prior to 2005, a full or partial tax credit for state death taxes was allowed for federal estate tax purposes.
PLANNING NOTE 4:
Prior to 2005, state estate taxes were credited, dollar for dollar, against the U.S. estate tax, so state estate tax laws were not a big consideration in choice of a state of residence. The extension of the “deduction” regime means that a dollar of state estate tax will reduce U.S. estate tax by only 40 cents. Since many state estate tax rates can reach 16%, the cost of living in a high estate tax state can be very high — increasing overall death taxes from 40% to close to 50%. Yet some states have no estate tax. This, along with many other issues, including income tax rates, should be considered when selecting a state of residence.
Other Estate and Gift Tax Provisions
The Act also extends certain other estate and gift tax provisions including: qualified conservation easements, qualified family-owned business interests, the installment payment of estate tax for closely-held businesses, the continued step-up in income tax basis at the death of a taxpayer, and the repeal of the 5% surtax on estates larger than $10 million.
Tax Planning Opportunities
The Act does not restrict or eliminate certain tax planning opportunities, including grantor retained annuity trusts (“GRATs”), the use of valuation discounts, and sales to grantor trusts. In particular, the Act does not restrict the use of GRATs and sales to grantor trusts, which are highly effective techniques to transfer wealth at little or no gift tax cost. Please note, however, that these techniques may be restricted or eliminated by law at any time. The Obama Administration has suggested several significant restrictions, and many observers suspect those changes may be part of the budget deal that will be addressed this Spring. Discounts for family businesses and family partnerships are also on the Obama Administration list.
Tax on Net Investment Income
The Act also imposes a new tax on unearned income of individuals, estate and trusts. The tax is generally levied on income from interest, dividends, annuities, royalties, rents, and capital gains and is subject to the individual estimated tax payment rules.
For an estate or trust, after a small exempt amount, the tax is 3.8% on this unearned income.
The rules regarding the new 3.8% tax are complicated. The tax does not apply to charitable trusts. In addition, the tax should not apply to simple trusts, or a trust that is required to currently distribute all of the trust income, or grantor trusts.
Income Tax Provisions
The Act also significantly changes individual and business income tax laws. Please see the summary which describes some of these more important provisions here.
The Act generally extends the most important provisions of existing federal estate and gift tax laws and keeps exemptions at pre-existing levels. The estate and gift tax rates increase to 40% from the 2012 rate of 35%. But more changes may be forthcoming. Taxpayers should not delay consulting with their advisors concerning tax planning opportunities, particularly given the current low interest rate environment which is conducive to many techniques still available — at least for now.