At this time last year, we announced the surprising failure of Congress to act in 2009 to prevent the repeal of estate and generation-skipping transfer (“GST”) taxes effective January 1, 2010.  Early in 2010, there were predictions that Congress would act quickly to retroactively reinstate those taxes, but as the year dragged on, such reinstatement became less and less likely.  An even greater concern loomed on the horizon, for if Congress continued to do nothing in 2010, both estate and GST taxes would automatically come roaring back in 2011 with only a $1,000,000 estate tax exemption (and a slightly higher GST exemption, because it was indexed for inflation) and a top tax bracket of 55%.  Finally, in a flurry of activity at the 11th hour, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (for simplicity referred to herein as the “2010 Tax Relief Act”), and President Obama signed it into law on December 17, 2010.

The enactment of the 2010 Tax Relief Act came as a complete surprise to most estate planners.  The liberality of the provisions relating to estate, gift and GST taxes was completely unexpected from this lame duck Congress.  Here is a summary of the most important provisions:

1. Estate Taxes – have been retroactively reinstated to be effective throughout 2010 and beyond, but with four major changes:

a. A significantly increased estate tax exemption of $5,000,000 (applicable to decedents dying in 2010-2012);
b. A significantly reduced estate tax rate of 35% (applicable to decedents dying in 2010-2012);
c. An option for each 2010 decedent’s estate to either remain subject to the revised estate tax regime with a stepped-up basis in the decedent’s assets, or “elect out” of the estate tax regime and pay no estate taxes, but become subject to a modified carry-over basis regime (applicable to decedents dying in 2010 only); and
d. An option for a surviving spouse’s estate to take advantage of the unused portion of the estate tax exemption of his or her last predeceased spouse, which would otherwise have been wasted (applicable to spouses dying in 2011-2012).  This new provision is commonly called “portability” of the predeceased spouse’s exemption.

2. GST Taxes – have been retroactively reinstated to be effective throughout 2010 and beyond, but with three major changes:

a. A significantly increased GST tax exemption of $5,000,000, but without any portability option (applicable to GST transfers occurring in 2010-2012);
b. A zero tax rate for generation-skipping transfers occurring in 2010; and
c. A significantly reduced GST tax rate of 35% for taxable transfers occurring in 2011 and 2012.

3. Gift Taxes – had not been repealed in 2010, and the 2010 Tax Relief Act did nothing to change the gift tax rules applicable to last year.  Those rules, that became effective on January 1, 2010, included a $1,000,000 gift tax exemption and a 35% gift tax rate.  However, beginning in 2011, the rules have been changed by the 2010 Tax Relief Act as follows:

a. The gift tax and the estate tax have been reunified, so that the new $5,000,000 exemption also applies to lifetime gifts made during 2011 and 2012.
b. The 35% gift tax rate continues to apply in 2011 and 2012.
c. The gift tax annual exclusion is unchanged ($13,000 per person per calendar year for gifts of present interests in property during 2010 and 2011, and potentially adjusted for inflation in 2012).

4. GRATs and Discounts Unaffected – Two important things that the 2010 Tax Relief Act did not do:

a. There was much speculation that Congress would eliminate the strategy of using “zeroed-out GRATs” (Grantor Retained Annuity Trusts) by requiring a minimum 10-year term, but that provision was conspicuously absent from the Act.
b. Likewise, there was fear that Congress would pass legislation limiting or prohibiting discounts in the valuation of certain closely-held entities, but no such provision was included in the Act.

The 2010 Tax Relief Act is very good news for the taxpayer.  Unfortunately, the good news is scheduled to last for only two years, 2011 and 2012.  Unless Congress takes action by the end of 2012, the laws that were in effect in 2001 will be revived on January 1, 2013 (generally a $1,000,000 exemption and a highest transfer tax bracket of 55%).

Potential Dangers

These extraordinary changes in the laws governing gift, estate and GST taxes may present dangers to taxpayers whose existing estate plans were drafted with the old laws in mind, especially married couples.  With the $5,000,000 exemption being much higher than expected, some married taxpayers may feel that they have overfunded a credit shelter trust for the children and underfunded a marital trust for the spouse.  The increased exemption and the added option of “portability” will tempt married couples to simplify their estate plans by devising all assets to the spouse without creating any kind of credit shelter trust, since the surviving spouse will have two exemptions available.  Unfortunately, if Congress fails to act and “portability” is repealed in 2013, then such simplification will have been a mistake.  Current estate plans should maintain as much flexibility as possible to accommodate the possibilities that Congress may extend the law, change the law, or take no action at all, reviving 2001 law.

Potential Opportunities

While some dangers do exist, for many taxpayers, the 2010 Tax Relief Act presents some extraordinary opportunities:

1. Gift the remainder of one’s gift tax exemption (now up to $5,000,000, or $10,000,000 if one’s spouse joins in the gift) and remove all future appreciation on the gifted property from one’s estate, even if the exemption is reduced in some later year.
2. Make taxable gifts at the 35% bracket rather than the 55% bracket if 2001 law is reinstated in 2013.
3. Irrevocably create dynasty trusts for $5,000,000 of assets ($10,000,000, if the spouse joins in the transfer) for the benefit of grandchildren and lower generations, while the GST exemption remains at that level.
4. Create zeroed-out GRATs before Congress makes good on its promise to eliminate them.
5. Leverage gifts through the use of discounts in the values of closely-held entities before Congress acts to eliminate them.

Most of these opportunities will disappear if Congress takes no action to extend the provisions of the 2010 Tax Relief Act beyond 2012.  We strongly encourage all recipients of this Alert to review their existing estate plans to make sure that the plans will still carry out their wishes in this new environment and to give serious thought to the opportunities to take advantage of these new tax laws before they are changed or automatically repealed.  Please contact us if there are any questions about these matters.