2011 Estate Tax Update—Including How AB Trusts are Affected

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In December 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 into law. More commonly known as the “Tax Relief Act,” this legislation includes provisions regarding the federal estate, gift, and generation skipping transfer (GST) taxes (the latter is the tax that applies to gifts and bequests to grandchildren whose parents are still alive).

Read on for a brief summary of the changes, but remember that every estate plan requires individual attention based on the individual’s particular circumstances and should be reviewed whenever there are changes in the tax law.

New Exemption Limit and Tax Rate

The new law has brought the estate, gift, and GST taxes together so that each individual has a $5 million exemption limit (to be adjusted for inflation in 2012). That is, an individual may use the $5 million exemption by giving gifts during life, bequests after death, or a combination thereof. The new tax rate for all types of gifts or bequests is 35%.

For comparison purposes, in 2009, exemptions were $3.5 million for estates and GST and $1 million for gifts with the tax rate at 45% for all; in 2010, there were no estate or GST taxes, but the gift tax remained intact with an exemption of $1 million and a maximum tax rate of 35%.

Portability

Another important provision of the new law provides the option of “portability” of exemptions between spouses, which means that a married couple (at least for the next two years) has the possibility of a maximum exemption of $10 million. This would happen if a surviving spouse claims the unused portion of a deceased spouse’s exemption (up to $5 million) in addition to his or her own. Note that the estate of the first spouse to die must still file an estate tax return even if there is no estate tax due.

What Portability Means for AB Trusts

An AB trust is an estate planning tool used to maximize federal exemptions from estate tax as well as the amount of property given to beneficiaries at death, while ensuring the surviving spouse is still in good financial shape for the rest of his or her life. The concept of portability may have a substantial impact on many AB Trusts currently in existence.

Under the current law with its $5 million exemption, an AB trust may not be necessary or even advisable for some couples, particularly those with smaller estates; that is, the new law does much of the work of an AB trust without the need of having anything special set up—and in fact, the AB trust could create income tax concerns, especially those involving the stepped-up basis and capital gains tax.

The AB Trust and Capital Gains Tax

Under well-established tax rules, a beneficiary receives an asset at its current value, or with a “step-up” in basis, instead of at its value at the time the decedent had acquired it. This is advantageous for the beneficiary because if he then sells the asset, he would only have to pay capital gains tax on the difference between the stepped-up basis and sale price as opposed to the difference between the value when the decedent had acquired it and the sale price. The tax savings can be tremendous because of this stepped-up basis.

In order for the beneficiary to receive the stepped-up basis, though, the asset must be passed via the decedent’s estate. When dealing with AB trusts, however, assets in the “B” trust (set up to pass to beneficiaries estate-tax free) are not included in the decedent’s estate; therefore, the beneficiaries lose that stepped-up basis.

Before the most recent revision of the tax rules, AB trust holders accepted this loss of the stepped-up basis because capital gains taxes at 15% were still more favorable than estate tax rates; accordingly, the loss of the step up in basis wasn’t such a big deal financially for most estates. Now, however, since married couples can exclude up to $10 million through “portability,” those with smaller estates could very well find themselves losing not only the stepped-up basis but also any estate tax savings because they wouldn’t have been responsible for estate taxes anyway, having been able to exempt up to $10 million as a couple.

That said, one situation in which an AB trust may still be a good idea is if spouses have different beneficiaries lined up—for example, one spouse wishes to leave assets to children from a prior marriage.

In general, with the recent tax changes, all AB trusts should be reviewed to determine whether they are still advantageous to the estates in question.

Nothing Lasts Forever

There is one huge caveat to all the preceding information: unless Congress takes action, in 2013, the tax rates and exemptions will return to their pre-2001 statuses, i.e., a unified exemption for estate and gift taxes at $1 million and a GST exemption of $1 million (indexed for inflation) with a tax rate of 55% for all three. Just as importantly, the portability provision would expire as well.

As of now, there is simply no way to know what the estate and gift tax landscape will look like in two years. Accordingly, this continues to be an area of law to keep your eye on, especially as the 2012 presidential campaign heats up.