American Taxpayer Relief Act – Estate and Gift Tax Provisions

As has been widely reported, we averted the “fiscal cliff” doomsday scenario by our fingernails when the Senate passed the American Taxpayer Relief Act of 2012 (ATRA) in the wee hours of the morning on January 1, 2013; the House adopted the same legislation later the same night. The President signed the bill into law on January 2nd.

My commentary takes a broader look at the most important estate and transfer tax provisions of the new legislation.

No more “sunsetting” of the sunset provisions! The most significant part of the estate and transfer tax portion of ATRA is that the beneficial estate, gift, and GST provisions of the past two years have been made permanent. For many observers, this was most unexpected—and, as a result, most welcomed. From now on, the lifetime estate, gift and GST transfer tax exemptions will remain permanently at $5,000,000 ($10,000,000 for a married couple) as indexed for inflation. Observe the power of indexing:  starting in 2011, the exemption began at $5,000,000; in 2012, the indexed amount rose to $5,120,000 and in 2013 it is expected to be close to $5,250,000. This will allow individuals who have already reached their maximum lifetime exemption to make additional incremental tax-free gifts in 2013 and beyond.

The provisions of the new legislation apply to estates of decedents dying after December 31, 2012 and to gifts and generation-skipping transfers made after December 31, 2012. Truly a trifecta for estate planners – the highest exemptions in history, made permanent and indexed for inflation, and forever unified with gift and GST transfers! But as we know from our system of sausage-making, nothing is permanent or lasts forever.

As it turned out, estate taxes ended up being the major sticking point in getting ATRA passed. The Republicans wanted the $5,000,000 exclusion made permanent but had to compromise by increasing the federal estate and gift tax rate from 35% to 40%. This was done by reinstating two additional tax brackets:  $500,000 to $750,000 taxed at 37% and $750,000 to $1,000,000 taxed at 39%. Everything above $1,000,000 is taxed at 40%. Practically speaking, this is meaningless, because no estates or gifts will be taxed unless they exceed $5,000,000 as indexed anyway. Remember that even at 40% the now-permanent tax rate is still lower than the 45% rate that was in effect as recently as 2009.

Even though the federal estate tax exemption is comfortably high (eliminating 98% of U.S. decedents’ estates) don’t forget that the Oregon and Washington equivalent exemptions are much, much lower. Specifically, Oregon’s exemption remains at only $1,000,000 and the Washington amount is double that at $2,000,000. Note that neither of these amounts are currently indexed for inflation, either. This means that gift and estate tax planning remain very important considerations since the maximum estate tax rates are 16% and 19% for Oregon and Washington, respectively.

With passage of ATRA, “portability” also became permanent. Introduced into law for the first time in 2011, the concept of portability permits a married couple to fully utilize its combined $10,000,000 lifetime exemption as indexed by letting the surviving spouse claim any unused portion of the deceased spouse’s exemption (referred to in the law as “exclusion”). With this provision now permanent, the surviving spouse no longer has a time limit to decide how best to use the increased exemption both during life through increased gifting and at death by protecting more of the estate from taxation. One slight but important (and generous) technical modification in the new legislation is as follows: If a surviving spouse remarries having claimed a decedent spouse’s unused exclusion, and then predeceases the second spouse, that surviving second spouse is entitled to claim the decedent spouse’s unused exclusion plus any unused amount from the previous decedent spouse.

Some comments about portability. It is elective, so in order to claim a decedent spouse’s unused exclusion a federal estate tax return (Form 706) must be timely filed showing a calculation of the unused exclusion amount. This would be the case even though the estate might otherwise be non-taxable. In addition, portability has not been adopted by Oregon and Washington, so there won’t be any state estate tax savings. Finally, while portability can be a simple and cheap form of estate tax planning, it is no substitute for more sophisticated credit-shelter and marital trust planning strategies, which offer much more flexibility, protection and permanency.

Just as a new top-tier 39.6% tax bracket was added for wealthy individuals, the same 39.6% top tax bracket was added for “wealthy” trusts that have taxable income above only $11,950 as indexed in 2013. In addition, trusts are also subject to the new 3.8% Medicare surtax, which would apply to the lesser of undistributed net investment income (NII) or the excess of the trust’s AGI over $11,950 in 2013. Thus, a trust’s undistributed NII (such as interest, dividends, capital gains, passive income, etc.) can be taxed at 43.4%, the combination of these two rates.   Many irrevocable trusts could face this higher-tax trap starting in 2013 because the $11,950 threshold is so low. Trustees can minimize if not eliminate the application of the 3.8% Medicare surtax by restructuring investment choices and carefully reviewing the composition of beneficiary distributions.

What did ATRA not do in the estate planning area?  For now, anyway, it left unchanged all the same sophisticated estate tax planning and wealth-shifting strategies that existed before although they remain in the crosshairs of the administration’s “Green Book” recommendations. So planners can still avail themselves of such techniques as GRAT’s, which have no minimum term limitations, intentionally defective grantor trusts, intra-family installment sales, or other intra-family transfers that take advantage of entity-level valuation discounts.

In the end, it is nice to have permanency and certainty in the estate planning process once again. Let’s hope it last a while!