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February 2011
By: Stuart H. Sorkin, Esq.
Michael P. Bentzen, Esq.
T he following is a brief review of the applicable gift and estate tax law. Unless otherwise stated herein, reference to “estate tax” refers to the laws of the United States.
I. The Federal Gift and Estate Tax Background.
A. Summary of Federal Estate Tax. On December 17, 2010 President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (hereinafter referred to as the “Act”). The Act provides a temporary reduction in estate taxes for persons who die prior to December 31, 2012 by significantly increasing the amount of the unified credit against estate and gift taxes, as described below (“unified credit”), to $5,000,000 with a maximum estate tax rate of 35%. However, unless Congress enacts new estate tax legislation prior to December 31, 2012, the estate tax will revert to a lower unified credit of $1,000,000 and the estate tax will range between 18% to 55%, which were the estate tax rates in effect prior to 2001.
Estates of decedents who died between January 1, 2010 and December 31, 2010, now have an option to (i) elect use of the Act’s increased unified credit of $5,000,000 with a maximum tax rate of 35% on estates over $5,000,000 and receive a stepped up basis on the decedent’s assets (see description below), or (ii) pay no estate tax regardless of the size of a decedent’s estate but only receive a limited step-up in basis on the decedent’s assets. Estates of decedent’s dying between January 1, 2011 and December 31, 2012, will be subject to the Act’s unified Credit of $5,000,000, the 35% estate tax rate on estates over $5,000,000 and receive a stepped-up basis on the decedent’s assets.
The unified credit in effect through December 31, 2010 allows an individual to make gifts or bequests to any person up to $5,000,000 free of estate and gift taxes, but if the estate exceeds $5,000,000 the excess will be subject to estate and gift taxes at a 35% rate. When a person dies his/her total taxable lifetime gifts (gifts in excess of the annual gift exclusion described below) are added to his/her gross estate to compute the estate tax, if any. The same gift tax rates apply to estate taxes; however, a tax credit is given based on prior gift taxes paid. This is why estate and gift taxes are referred to as an unified tax regime. However, under prior estate tax law, from December 31, 2003 the gift tax credit was limited to $1,000,000 even though the unified credit for estate tax purposes rose to $3,500,000. The Act revives the unification of the estate and gift tax unified credit. As described further below, gift tax planning is a significant part of estate planning because gifts that do not trigger gift taxes reduce the size of a person’s estate thereby reducing future estate taxes.
i. The Return of the Stepped-Up Basis. The Act reinstates the stepped-up basis rules that were in effect prior to January 1, 2010. This means that the assets in an estate receive a new income tax basis equal to the fair market value of the assets on the date of the decedent’s death, or on an alternate valuation date (an estate may elect to utilize the fair market value of the estate’s assets on the six month anniversary date of a decedent’s death). This means that the beneficiaries of an estate will receive assets from the estate with an income tax basis as of the date of the decedent’s death value (unless an alternative valuation date is chosen by the estate). Accordingly, a beneficiary of an estate will pay income taxes on any inherited assets sold by the beneficiary based on the difference in value of the assets between the date of death value and the sales price.
ii. Gifts/Bequests Between Spouses. All gifts and bequests by one United States citizen to his/her spouse are exempt from estate and gift tax by virtue of an unlimited marital deduction. In addition, each spouse is entitled to the unified credit. Under the Act for 2011 and 2012 a surviving spouse may elect to take advantage of the unused unified credit of his/her predeceased spouse, but a decreased spousal exclusion amount would only be available to the surviving spouse if an election is timely made on the estate tax return. Accordingly, for 2011 and 2012, if the combined taxable estates are less than $10,000,000 the estates are not subject to estate taxes. However, unless Congress enacts new estate tax legislation for 2013 and beyond, then the combined estates will be subject to estate taxes if they exceed $2,000,000. Furthermore, under the estate tax law that would be in effect after 2013, there is no right to utilize the unified credit of a predeceased spouse, therefore, an outright gift or bequest of one’s entire estate (no matter how large) to his or her surviving United States citizen spouse would qualify for the marital deduction and incur no estate tax; however, such a bequest effectively wastes the unified credit of the deceased spouse, increases the taxable estate of the surviving spouse, and merely defers payment of potentially substantial estate taxes as estate tax rates that may be significantly higher due to the increased size of the survivor’s estate.
iii. Annual Gift Tax Exclusion. The Act left unchanged the provisions that allow each taxpayer an annual gift tax exclusion of $13,000 ($26,000 for a joint gift by spouses) for gifts of a present interest to any person, without limitation as to the number of persons receiving such gifts and without the imposition of gift taxes. Spouses can “split” their gifts, meaning that a spouse, who does not own an assets, can join in a gift by his/her spouse in order to permit use of a $26,000 annual exclusion per each donee (for example, a couple with three children could give each child $26,000 and receive a total exclusion of $78,000 annually). Note that the annual exclusion is indexed for inflation in 2011, but the indexing will only apply in $1,000 increments. Additionally, gift taxes do not apply to amounts paid directly to qualified educational organizations for tuition on behalf of another individual or directly to a provider of medical care for another’s medical care.
B. Differences between Federal Estate Tax and Federal Income Tax. Federal estate taxes apply to assets conveyed at death – remember the stepped up basis discussion above? The issue of Federal income tax typically applies in cases of gifts of assets made during the lifetime of the donor. There likely is a significant difference between Federal estate tax and Federal income tax consequences as to highly appreciated assets. The recipient of a lifetime gift takes the gift at the cost basis of the donor as of the time of the gift. On a sale of an asset, the beneficiary (estate of gift) will pay income taxes on any gain, i.e., the difference between the seller’s donor’s basis and the value on the date of sale. Gain is currently taxed at more favorable capital gains rates if an asset is held for at least one year. A good exception is in the case of selling a primary residence where the first $250,000 of gain ($500,000 in the case of a married couple) is entirely excluded from tax.
In sharp contrast, the recipient of a legacy received after the donor’s death takes the legacy with a tax basis of its market value on the date of death, known as a “stepped up basis,” and the donor’s estate is subject to estate tax with the legacy valued at this stepped up basis. In effect, the donor’s estate is subject to estate tax on the appreciated value between the donor’s basis and the date of death value, and the recipient pays no income tax on such pre-death appreciation. Thus, once estate taxes, if any, are settled, if the recipient sells the legacy for its stepped up basis amount, the recipient would pay no income taxes.
These differences present some obvious tax planning opportunities in selecting how and when to pass particular assets. All things being equal, it is often worth considering passage of highly appreciated assets (as distinguished from unappreciated assets, such as money market funds) after death to take advantage of the stepped up basis. However, a large estate (subject to a high marginal estate tax rate) of an individual who is elderly or is likely to die in the near future could well realize significant tax savings by selling highly appreciated property, even to the heirs, and paying the much lower capital gains tax rate. In the case of a primary residence, the situation is not as clear, because the first $250,000 of gain ($500,000 in the case of a married couple) is entirely excluded from tax. CAUTION: While exploiting the differences between estate tax and income tax treatment of highly appreciated assets can save very significant taxes, a determination of the most beneficial scenario for gifting or bequeathing highly appreciated assets cannot be made without running projections and making assumptions as to the future market value of assets and as to how long the prospective donors are likely to live.
C. Special Considerations Relating to Life Insurance Policies. Most people understand the basic income tax implications of purchasing life insurance: The benefits payable under the policy are subject to income taxation if the policy premiums were deducted as a business expense (e.g., a key employee policy or an employer provided policy) and are not subject to income tax where the premiums were paid using after tax income (e.g., an individual’s personal insurance policy not paid for by the employer). However, many people are unpleasantly surprised to learn that the death benefit payable under a life insurance policy, whether or not subject to income taxation, is included in the taxable estate of the policy owner. For Federal estate or gift tax purposes, the party able to name the beneficiaries and otherwise direct disposition or assignment of the death benefit payable under an insurance policy is regarded as its owner.
D. Generation Skipping Tax. Federal generation skipping tax (“GST”) applies when a donor conveys in excess of a stated dollar limitation (“GST Limitation”) to a generation beyond the next living generation, for example, skipping over living children in favor of grandchildren, etc. (known as a “generation skip”). Again, this may be affected by any new estate tax legislation; however, the dollar limitation for the GST Limitation has historically been the same dollar amount as the unified credit against estate taxes (i.e., $3,500.000 in 2009 and $1,000,000 in 2011). In effect, this means that fully utilizing the GST Limitation transfers by means of a generation skip (e.g., to grandchildren, etc.) passes without the estate(s) of the skipped generation (e.g., children) ever being exposed to imposition of any estate or gift tax on such a transfer. As to amounts above the GST Limitation, the GST essentially recaptures these prospective savings immediately.
Where a large estate is involved, or where there is a substantial problem with leaving assets outright to a child, such as the potential for divorce or other difficulties, it often makes a lot of sense to establish a GST trust because it saves the Federal estate tax consequences that would accrue to the estates of the next generation on passing assets to their descendants. All assets transferred to a GST trust are generally protected from creditors, including a spouse in the case of a divorce, and provide a safety net of assets available to your heirs.
E. The Special Needs Trust/Discretionary Trust. A Special Needs Trust provides, in summary, that no payments from this type of trust will be made if any person other than the Trustee shall have the right to direct payment on behalf of the disabled child. If a disabled child receives any portion of a Special Needs Trust, such disbursement shall be made solely by the Trustee, and not by any other person, agency or public authori¬ty, administrative or judicial, regardless of the capacity in which any other such person or entity is asked or seeks to act. This type of trust is specifically allowed in Maryland pursuant to the Maryland Discretionary Trust Act. The Trustee is required to take into account the disabled child’s present and future general welfare, other income or resources available to him, or which may be applied for his benefit, including public or private programs and benefits for which he may be eligible, and the effect of payments from a Special Needs Trust on the disabled child’s eligibility for public or private programs and benefits. Furthermore, the Trustee shall first inquire into the availability of other public or private resources and funds. It is intended that this type of trust supplement, rather than substitute for or supplant, benefits available to a disabled child from public or private programs available to her/him. The term "supplement" refers to services that shall be deemed qualitatively or quantitatively superior to services to which such disabled might be limited under public or private programs for which she/he is eligible. We customarily include provisions in estate planning documents which convert any trust for the benefit of the surviving spouse, any of your children or grandchildren into a Special Needs Trust if any of them should become disabled.
II. Local Inheritance Taxes. Prior to the 2001 Tax Act, most states and the District of Columbia imposed an estate tax, sometimes called a “sponge tax,” that piggybacks on top of the Federal tax scheme discussed above. Planning is not required for local inheritance taxes that are structured as sponge taxes, because they are imposed to the limit under Federal law so that the estate receives a dollar for dollar credit against Federal estate taxes for state estate taxes in the nature of sponge taxes. Therefore, from your point of view, it really doesn’t matter if, for example, your estate pays $100,000 of Federal estate taxes or $78,000 of Federal taxes plus $22,000 of a local sponge tax that is credited against the Federal tax. Virginia has temporarily repealed its estate tax for persons who die prior to December 31, 2010. At this point in time it is unclear what Virginia estate taxes will be after that date because the repeal is tied to any changes to the Federal estate tax.
Maryland had a sponge tax, but modified it unfavorably in light of the revenue reduction foreseen in light of the 2001 Tax Act. The old Maryland estate tax gave full credit for federal estate taxes, meaning that if you were exempt from federal tax you would be exempt from Maryland estate tax, and if you paid federal tax, some of it would go to Maryland and you would get a dollar for dollar credit. This, alas, is no longer true. Maryland now taxes any estate larger than $1,000,000. The amount of Maryland estate tax that isn't subject to federal tax credit will grow over the years. While this is probably not sufficient reason to rule out living in Maryland, you may want to consider it.
Maryland also imposes an inheritance tax. The Maryland inheritance tax exempts the first $1,000 of property and imposes an additional 10% inheritance tax, over and above federal estate tax, on non-immediate family beneficiaries. Legacies to descendants and immediate family members are exempt from this tax. Certain other exemptions also exist; including gifts to IRS qualified charities, and various relatively narrow items as for proceeds of holocaust settlements. The Maryland inheritance tax may, in certain circumstances, be avoided by using a revocable living trust, provided the assets are titled in the trust for at least two (2) years prior to the death of the owner.
States and District of Columbia inheritance or estate taxes, including non-sponge type taxes, are imposed only to the extent property exists that can be considered held within each particular state. Where the domicile of an asset is at issue, there are generally ways, beyond the scope of this letter, to allocate tax liability, pro rata, between states with competing claims so that double taxation is avoided.
© 2010 Hughes & Bentzen, PLLC.
THIS ARTICLE IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND MAY NOT BE RELIED UPON AS LEGAL ADVICE. FOR SUCH ADVICE, PLEASE CONTACT YOUR ATTORNEY.
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