Planning for Uncertainty: Changes in Federal Estate and Gift Taxes

Federal law permits the transfer of $5 million without payment of U.S. taxes on estates, generation-skipping transfers or gifts. This exemption amount, as well as the tax rates on transfers exceeding the limit, have been the subject of debate for more than a decade. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 provides temporary certainty on these issues.

The exemption amount for federal estate and gift taxes remained largely static between 1987 and 2001, with a unified exemption amount of $675,000 in 2001. Tax cuts passed in 2001 incrementally increased the estate and GST tax exemption throughout the next decade, culminating in a $3.5 million estate and GST tax exemption in 2009. There was a one-year total repeal of the estate and GST tax in 2010. The lifetime gift-tax exemption increased to $1 million in 2002 but remained at that level through 2010.

Had Congress not acted before Dec. 31, the Bush-era tax cuts would have disappeared on that date, and the estate and GST tax exemptions would have been reinstated and reduced to roughly $1 million. The 2010 act prevented a dramatic return to the pre-2001 tax-law structure and set forth a substantive regime of tax implications of transfers made in 2010, 2011 and 2012. The relief is temporary, however, and unless Congress acts before Dec. 31, 2012, the law will revert to pre-2001 levels on Jan. 1, 2013.

Before that date, individuals may make total noncharitable gifts up to $5 million during their lifetimes without incurring federal gift tax. (North Carolina does not have a state gift tax.) Lifetime transfers above $5 million are taxed at a rate of 35 percent. In addition to this $5 million lifetime exemption, each individual may transfer up to $13,000 per year to an unlimited number of recipients. These "annual exclusion" gifts were also permitted under previous law.

The estate of a person dying in 2011 or 2012 is subject to federal estate tax on the amount exceeding $5 million (less the value of lifetime gifts that used a portion of the decedent's $5 million exemption for such gifts). The value of assets exceeding the exemption is taxed at 35 percent. In addition, North Carolina imposes a state estate tax at a rate of up to 16 percent on assets exceeding the exemption amount. This increased exemption amount means only a small number of estates — about 5,000 per year — will incur any estate tax. 

Finally, generation-skipping transfers to grandchildren and later descendants are tax-free if they don't exceed $5 million. Transfers above $5 million are taxed at 35 percent. North Carolina imposes a GST tax, which will be imposed in addition to the applicable estate or gift-tax liability, if any, on the generation-skipping transfer. Perhaps most significantly, effective for estates of people dying after Dec. 31, the 2010 act allows the executor to transfer any unused estate-tax exemption to the surviving spouse.

Previously, use of a "credit shelter" or "bypass" trust established during life was required to take full advantage of both spouses' exemption amounts. The estate-tax exemption is now portable between spouses who die in 2011 and 2012. It's important to note, however, the $5 million GST tax exemption is not portable.

While portability provides an attractive new option for estate planning, certain disadvantages -- including the fact it may not exist after Dec. 31, 2012 -- mean it's not appropriate for all estate plans. As with any estate-planning technique, portability is one of many strategies that must be considered in light of each individual's circumstances.

While the 2010 act leaves the future of federal transfer taxes unsettled, it does provide new estate-planning opportunities. The increased gift-tax exemption permits families to take greater advantage of lifetime wealth-transfer strategies. They include the use of trusts and family limited partnerships to transfer substantial wealth to younger generations. Further, the increased estate-tax exemption and portability are significant changes in federal estate-tax law that will impact many estate plans.

These recent developments in federal transfer taxation serve as an excellent opportunity for families to revisit -- or create -- their estate plans with an attorney specializing in the field.