“The only things certain in life are death and taxes” said Benjamin Franklin. His insight remains fully applicable three centuries later. Death taxes, levied by both state and federal governments, combine these two certainties into harsh reality. When your parent or other benefactor dies, you face both.
Death taxes and their cousin gift taxes apply to transfers of property which are made for less than fair value and are not otherwise exempt from taxation. The Federal Government has both a gift tax for donative transfers made during lifetime, and an estate tax for donative transfers that occur after death. It also imposes a “generation skipping tax” on transfers to grandchildren and later descendants.
Pennsylvania has an inheritance tax that applies to transfers after death and to those made within one year “in contemplation of death.” Pennsylvania has no gift tax.
The recently enacted Fiscal Cliff tax deal, the American Taxpayer Relief Act of 2012 (ATRA), makes some changes to the federal estate and gift tax rules, but in the most part gives “permanent” status to the rules that existed in 2012. Here is an overview of the current state of the federal gift and estate tax rules.
Overview of 2013 Estate and Gift Tax Rules
40% Maximum Rate. ATRA establishes a maximum tax rate of 40% for taxable gifts and estates. This is an increase from the 35% maximum that existed in 2012.
Exclusion Amount. A unified credit of $2,045,800 (for 2013) is available with respect to taxable transfers by lifetime gift or at death. This credit effectively exempts a total of $5.25 million* (for 2013) in cumulative lifetime and post-mortem taxable transfers from the gift tax and the estate tax. This large “exclusion amount” will continue to be adjusted each year for inflation. This means that, unless the law is changed in the future, only a small minority of taxpayers should ever be subject to federal estate or gift taxes.
Portability. To the extent that the first spouse to die has not used up his or her exemption at death, the unused exemption can generally be claimed by the surviving spouse. ATRA makes this exemption “portability” a permanent feature of the estate tax law. It provides the surviving spouse with the opportunity to have a larger exclusion amount upon his or her death. See my article IRS publishesregulations on portability of estate and gift tax exclusion for more on portability.
It’s important to note that an estate tax return must be filed at the death of the first spouse in order to make the portability election. Otherwise, the unused exemption amount will not pass to the surviving spouse.
Gift Taxes. The rates for gift taxes remain unified with the estate tax rates. This means that there is a 40% maximum rate on gifts in excess of the donor’s $5.25 million (in 2013) lifetime exemption.
In addition, a donor can give up to $14,000 (in 2013) each year to any number of individuals without gift tax consequences. This is called the “annual exclusion” amount. Gifts made each year which are in excess of the annual exclusion amount must be reported to the IRS. These “taxable” gifts are deducted from the donor’s lifetime exemption. When the exemption is used up, the donor (or estate) will owe gift or estate tax on the excess.
Example 1: John has three children. He gives each child $14,000 in 2013 (a total of $42,000). John does not have to report these gifts and has not used up any of his gift and estate tax exclusion.
Example 2: John gives his son $40,000 in 2013. He has made a “taxable” gift that must be reported to the IRS. The gift uses up $26,000 of John’s gift and estate tax exclusion.
Generation Skipping Tax. The generation-skipping transfer (GST) tax is an additional tax on the transfer of property from a grandparent to a grandchild (or later generations). The tax is also assessed on property passed to unrelated individuals more than 37.5 years younger that the person making the transfer.
ATRA makes no changes to the GST tax. The exclusion amount is $5.25 million in 2013. Note that the portability rules do not apply to GST transfers.
Step-up in Basis for Inherited Assets. ATRA makes no changes in regard to rule governing the step-up (or step-down) in basis for inherited property. This rule means that the recipient's tax basis for inherited property is the property's fair market value at the decedent's date of death rather than the decedent's cost basis. As a result it can sometimes be more advantageous for a transferee to receive appreciated property via inheritance rather than by lifetime gift. [With lifetime gifts, the recipient’s tax basis is usually the same as it would have been in the hands of the donor ("carryover" basis.)]
The step-up in basis on inherited property can substantially reduce the income taxes due on the sale of an asset by the recipient.
No Change to Some Popular Estate Planning Techniques. ATRA did not address a number of perceived estate planning “loopholes” which the Obama Administration had targeted for closure. These strategies, such as limiting property valuation discounts and the use of grantor trusts, continue to be available for the time being.
See my article Obama Budget Proposes to Close Estate and Gift Tax Loopholes for more about these controversial planning techniques.
Are These Estate Tax Changes Permanent?
The years from 2001 to 2012 were an age of great uncertainty for taxpayers and their estate planning professionals. The estate and gift tax rules were temporary and subject to “sunset.” As a result, building flexibility into wills and trusts in order to deal with future changes in the law was a key aspect of estate planning.
One of the most important aspects of ATRA is its removal of the sunset – which means that the 2013 rates and rules are made “permanent.” But taxpayers need to recognize the contingent nature of that permanency. The new laws are permanent only until Congress and the President agree to change them.
As the political winds continue to blow towards deficit reduction, the estate and gift tax laws may be soon revisited. Building flexibility into your estate plan still makes sense. And taxpayers who want to take advantage of popular estate planning strategies like valuation discounts and grantor trusts may wish to get their planning in place soon.
Implications of ATRA for Your Estate Plan
Here are my thoughts on some of the implications of ATRA that might be important for your estate plan.
Fewer People are Subject to Federal Estate and Gift taxes. Under the law prior to ATRA the estate and gift tax exemption was set to revert to $1 million dollars. As a result, anyone who anticipated dying with an estate in excess of that amount needed to build federal estate tax planning into their planning. Now, with an exclusion amount of over $5 million dollars, indexed for inflation, it seems that many fewer people will have to try to plan around these federal taxes.
This is a Good Time to Review your Estate Plan. When the exclusion was set to revert to $1 million per individual, many couples with estates of between $1 million and $10 million included provisions in their estate planning documents that set up so-called bypass (or credit shelter) trusts. These trusts were structured to use the exclusion amount of the first spouse to die. With the exclusion now “permanent” at over $10 million, and spousal portability, these couples may want to review their existing plans to see if those trusts are still appropriate.
Those couples who are certain that their combined estates will be under a total of $10 million may decide to do away with the bypass trusts that are part of their current plans. However, couples should recognize that the benefits of their bypass trust planning may go beyond tax savings.
These trusts can offer many potential advantages including: the protection of assets for children of a first marriage from loss due to a 2nd marriage of the surviving spouse (something I've seen happen many times); protection from creditors; removal of asset appreciation from the taxable estate of the surviving spouse; and professional management. Trusts (for example, disclaimer bypass trusts**) can provide flexibility in the event of future reductions in the exclusion amount or other changes in the law. And for those with estates that may someday exceed $5 million, trusts can help ensure that a married couple gets the full use of both of their estate tax exclusions. Portability can be easily lost after the death of the first spouse due to the failure to elect it or as a result of remarriage of the surviving spouse.
State Death Taxes Remain Important. ATRA does not address state death taxes. In Pennsylvania those inheritance taxes rates are 4.5% on children and up to 15% on others. In some cases these state taxes can be deferred or even eliminated through planning. Talk with your elder law and estate planning lawyer.
Portability is not Automatic. For married couples, the exclusion portability provisions of the law are not available to the surviving spouse unless it is properly claimed. When your husband or wife dies, you need to talk with a lawyer who is knowledgeable about this aspect of the law to determine whether portability should be claimed. At present, a federal estate tax return (Form 706) has to be filed to pass the deceased spouse’s unused exemption to the survivor. This will involve some time and expense, and you will need to consider whether filing the return makes sense for you.
Planning for Larger Estates. Some individuals and couples still have estates large enough to be subject to federal estate, gift, and generation skipping taxes. With the current tax rate of 40%, if you fit into this category your planning will be of critical importance to your heirs. Here are a couple of planning ideas.
- Consider taking advantage of grantor trusts and other perceived “loopholes” now while they are still available.
- Lifetime gifts, using the annual exclusion or your lifetime exclusion or both, can produce large tax savings. Annual exclusion gifts can reduce your taxable estate by significant amounts especially if there are multiple recipients. Even gifts using your lifetime exclusion can remove future appreciation from your estate and can avoid state inheritance tax. Of course, you want to consider the potential loss of step-up in basis on gifted property. And always be careful not to give away what you may need during the rest of your life.
- For married couples bypass trusts still make sense for both tax and non-tax reasons.
- When your spouse dies, be sure that the executor or other personal representative of his or her estate takes the steps needed to elect portability of the unused estate and gift tax exclusion.
*Source: Overview Of The Federal Tax System As In Effect For 2013, Joint Committee on Taxation, January 8, 2013, https://www.jct.gov/publications.html?func=startdown&id=4498.
**With a disclaimer bypass trust you leave everything to your spouse outright, but give her the right to disclaim all or part of the inheritance and have it go into a bypass trust instead. Her decision can be based on the law and her circumstances at that time.