In January 2013, the American Taxpayer Relief Act of 2012 was enacted, establishing a “permanent” $5 million exemption for Federal estate tax, gift tax, and generation of skipping tax purposes. Because the Act provides for indexing of the exemption, the Federal estate tax exemption is $5.25 million this year. The new law also makes permanent the portability rules dealing with the spousal exemption, thereby closing a significant gap in the estate planning process.
Previously, upon the death of the first spouse to die, we would consider the size of that spouse’s net taxable estate, apply the appropriate amount of estate tax exemption, and, if there was any remaining unused estate tax exemption, it would be lost.
For example, if the wife died with a net estate of $2.5 million, which was passing into an otherwise taxable bypass trust, then $2.5 million of the Federal estate exemption would be applied on her return, leaving zero tax liability, but also leaving $2.75 million of unused estate tax exemption. The portability rules provide that if upon the wife’s death only $2.5 million of her exemption is utilized, then the remaining $2.75 million of the estate tax exemption is carried over to her surviving spouse to be used as part of his estate.
If the surviving spouse dies with an estate of $8 million, we would first apply his $5.25 million exemption to his estate, and then could apply the carried over $2.75 million of the estate exemption, leaving his estate with a zero tax liability.
Essentially, the law has reduced the need to worry about how the various assets are titled between the husband and wife, because any unused exemption of the first will be carried over to the second. This is a very broad brush explanation of the fairly complex portability rules and a more detailed discussion is beyond the scope of this article.
The current law sets the maximum estate tax rate at 40 percent. While considerably less than the maximum rate of 1997-2001 (55 percent) and even less than the maximum rate as recently as 2009 (45 percent), it is still an increase from 2011-2012 (35 percent).
How “permanent” are the exemption amounts for estate tax, gift tax, and generation skipping tax purpose? And how “permanent” is the maximum tax rate applicable to the estate, gift, and generation skipping tax computations?
Since 1997, the Federal estate tax exemption has increased 11 times, from $600,000 to $5.25 million. The maximum tax rate has decreased from 55 percent to 35 percent, and then increased to 40 percent, changing eight times in 16 years. The gift tax and generation skipping transfer tax exemptions have increased seven times in 16 years.
How “permanent” are the various benchmarks? President Obama’s April 2013 budget proposal included the following recommendations:
- Reduce the estate tax exemption and general skipping tax exemptions to $3.5 million, the amounts from 2009. These levels would become effective in 2018.
- Reduce the gift tax exemption to $1 million, the amount from 2009. This level would become effective in 2018.
- The maximum tax rate (for gift, estate, and generation skipping tax purpose) would increase from the current 40 percent level to 45 percent, effective in 2018.
How “permanent” are the permanent levels and rates set forth in the American Taxpayer Relief Act of 2012? Based on the record of changes to the various exemption levels and rates over the past 16 years, as well as Present Obama’s recent budget proposal, the estate and gift tax scenario is only as permanent as the next congressional session.
Other possible changes to the “permanent” estate tax structure are as follows:
- The disappearance of discounts in computing the value of a closely held business. Currently, the value of an interest in a closely held business can be discounted in computing its value for either gifting purpose or estate tax purposes. This discount can be based on a lack of marketability of an interest in the business or due to the fact that only a minority interest is held. The White House has previously called for limiting or eliminating such discounts, at least as they relate to family members.
- A person inheriting an IRA may take the distributions over his/her life expectancy, thereby minimizing the tax bite in any particular year. Under the President’s budget proposal, most beneficiaries (other than a surviving spouse) would be required to fully withdraw an inherited IRA over a five-year period. This could significantly increase the overall income tax liability and reduce the ability to pass wealth on to the next generation.
Yale M. Ginsburg is a member with Adelberg, Rudow, Dorf & Hendler, LLC, who practices in estate planning and administration, and general tax planning.