Much has been written about the possible expiration of the Bush tax cuts, which were to sunset on December 31, 2010. The tax and estate planning community has been struggling to understand the possible changes to the tax code, and particularly the estate tax exemption, for the years following 2010, in their efforts to assist clients in planning for their estate tax liabilities, gifting options, and charitable intentions. Luckily, on Friday, December 17th, President Obama signed the $858 billion H.R. 4853—The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, better known as the “Middle Class Tax Relief Act of 2010,” into law. In this week’s column, I will discuss the provisions of this Act, and what they mean for taxpayers and for estate planning.
The two most important concerns that people had about the Bush-era tax cuts expiring were the increase in tax rates, particularly for high income earners, and the uncertainty surrounding the limits on the transfer of wealth at death. Fortunately the new Act addresses both of these issues, along with capital gains, dividend taxes, and a host of other important taxation issues.
First and foremost, the Act extends the Bush tax cuts for tax years 2011 and 2012, holding the top tax bracket at 35%. For capital gains, the top rate for federal taxes on long-term gains will remain at 15%. The current rate of 15% on “qualified” dividends will also remain at 15% for 2011 and 2012 (the federal capital gains rate would have returned to 20% and dividends would have been taxes as ordinary income, at ordinary income tax rates, if the Bush tax cuts had expired).
Be careful here – “qualified” dividends can be tricky. Basically, the key issue is that, if the company takes a tax deduction on the dividends paid, then the investor will not get the favorable 15% tax rate. In essence, if the company is deducting the dividend payment, they are treating it as an interest expense and not a true dividend, and therefore the dividend would not be qualified for the lower tax rate for the investor. (Check with your tax advisor or investment advisor if you are unsure whether or not your dividends are qualified.)
For 2011 and 2012, the estate tax limit, according to the Act, is $5 million (per individual ($10 million for couples) and will be indexed for inflation starting in 2012). Estates in excess of this $5 million limit will be taxed at a top rate of 35% for 2011 and 2012. (Theoretically, without the Act, the exemption amount would have returned to only $1 million, and the top tax rate on estates would have returned to 55%.)
The new estate tax rules are retroactive to the beginning of 2010. According to Paul Graziano, a Partner with Allen & Kimbell, and an estate planning expert; “For decedents dying in 2010, the executor will have an election to treat the estate under estate tax repeal with limited basis adjustment, or to use a $5 million exemption with the full basis adjustment as was the case prior to 2010.”
The cost basis adjustment is a critical issue because it will impact the potential future tax liability of the person inheriting the estate. For those dying in 2010, even though there was no estate tax, there was also no step-up in cost basis, so assets inherited from estates of decedents who died in 2010 would also inherit the cost basis of the assets. This means that these assets could have very low costs bases, particularly for assets purchased many years prior, which in turn means that the future tax liability for those inheriting these assets, when they sell the assets, could be substantial.
What happens if in January, 2011 a taxpayer makes gifts that use the full $5 million applicable exclusion amount, and then the tax law is changed again, but this time to lower the exclusion amount and/or to increase the gift and estate tax rates? The short answer, according to attorney Bill Staley of Staley Law, is that under current law the taxpayer would lose the benefit of the high exclusion and the low gift tax rates, but not until the taxpayer died and his or her estate tax was due. If the taxpayer made more taxable gifts after the law was changed, he or she might have less lifetime credit (that is, the applicable exclusion amount) left, or might not have any, to apply to the new gifts.
If the 2010 law sunsets at the end of 2012 (as scheduled without more legislation), a taxpayer who used the full $5 million applicable exclusion amount for gifts in 2011 and 2012 will not be required to pay gift tax on the gifts over the $1 million applicable exclusion amount that will apply after 2012. If the current gift tax rates and applicable exclusion amount is changed by legislation, it is not possible to predict how gifts in prior years would be treated. However, it does not seem consistent with constitutional principles to impose a tax in 2013 on a gift that was not taxable when it was made in 2011 or 2012. Clearly Congress has not thought of everything with the Act, leaving estate planners with ongoing challenges.
Staley also advises; “The gift of an asset moves two things out of the donor’s estate: (1) the post-gift appreciation in the value of the asset and (2) the post-gift, after-income-tax income on the asset. Even if gift tax is due, the gift is more efficient because there is no transfer tax on the cash used to pay gift tax, whereas the cash used to pay estate tax is itself subject to estate tax.”
Starting in 2011, any unused exemption amount that remains from the estate of one’s deceased spouse may be applied to the surviving spouse’s estate to be used upon his or her death (providing the second death occurs before 2013). In other words, the exemption of the first spouse to die is portable to the second spouse, as long as that second spouse dies before the start of 2013.
For gifts in 2011 and 2012, the gift tax will remain at 35% for both years, with a unified lifetime gift and estate tax exemption of $5 million (adjusted for inflation starting in 2012). The GST rate will be set at zero percent for 2010 and will be 35% for 2011 and 2012, with a $5 million lifetime exemption. Starting in 2011, donors may apply any unused exemption from their last deceased spouse to gifts made during their lifetime (provided the first spouse dies after 2010 and the second dies before 2013). (Please note: Portability does not apply to the GST and it must be elected on the first-to-die spouse’s estate tax return.)
Phil Palmquist, CPA and Partner of Hocking Denton Palmquist adds; “The Act also provides a “Patch” for the Alternative Minimum Tax (AMT) for 2010 and 2011.” The two-year patch, which is retroactive to the beginning of 2010, keeps the AMT exemption at (or near) 2009 levels, through 2011. For tax year 2010, the AMT threshold will be bumped up slightly to $47,450 for individuals and $72,450 for couples filing jointly. For 2011, the bar will rise to $48,450 for individuals and $74,450 for couples. Taxpayers will be also be permitted to apply non-refundable credits –credits that reduce a filer's tax bill –to their tax liability under either the AMT or the regular tax code.
According to the Act, there will be a 2% reduction in Social Security taxes (on the first $106,800 in wages earned), which also applied to self0employment taxes. Taxpayers aged 70 ½ or older can still make tax-free distributions to charities from their IRA accounts of up to $100,000 per taxpayer, per tax year, in both 2010, and 2011. For businesses, there is a provision which allows a 100% write-off of qualifying equipment and machinery purchased and placed into service from September 9, 2010 through 2011.
For many, the uncertainty surrounding the sunsetting of the Bush tax cuts likely forced major changes to estates, especially during 2010. Although the Act provides a band-aid of sorts for estate and tax planning, the reality is that we will face similar challenges in 2012, since the provisions of the Act will end, and so far, Congress has not provided a long-term solution. However, we can safely assume that tax rates, at least for highest income earners, will increase in the future. At least we have two more years to plan for it!