Significant recent developments in estate planning.

• Author: Ransome, Justin
• Position: Part 1

This two-part article examines developments in estate, gift, and generation-skipping tax planning and compliance between June 2010 and May 2011. It discusses legislative developments, the outlook on estate tax reform, cases and rulings, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (Tax Relief Act), (1) and the annual inflation adjustments for 2011 relevant to estate and gift tax. Part I discusses estate tax reform, cases and rulings, the Tax Relief Act, and other estate tax developments. Part II, in the October issue, will cover gift tax, generation-skipping transfer tax, and trust developments.

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Estate Tax Reform

On December 17, 2010, President Barack Obama signed into law the Tax Relief Act, which includes extensions of 2001 and 2003 income tax cuts, individual alternative minimum tax relief, estate tax relief, unemployment relief, and certain other temporary tax provisions. Most of the provisions in the Tax Relief Act are temporary, and the transfer tax provisions expire on December 31, 2012.

In general, the Tax Relief Act reunifies the gift and estate tax; increases the gift and estate tax exemption amount to $5 million; provides for a top gift, estate, and generation-skipping transfer (GST) tax rate of 35%; provides an election for estates of decedents dying in 2010 to choose to apply the estate tax law applicable in 2010 prior to the enactment of the Tax Relief Act; allows portability between spouses of their estate tax exemption amounts; and preserves the taxpayer-favorable GST tax rules contained in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). (2) (See the exhibit.)

Gift Tax

Top rate: The Tax Relief Act resets the gift tax rate schedule to mirror the estate tax rate schedule with a top rate of 35%. This provision was effective on January 1,2011.

Exemption amount: The exemption amount for both gift and estate tax was the same, or unified, prior to EGTRRA. Under EGTRRA, gift and estate taxes were decoupled as the estate tax exemption amount steadily increased over several years, while the gift tax exemption amount remained at $1 million. The Tax Relief Act reunifies the gift and estate tax exemption amounts by amending Sec. 2505 to provide that the gift tax exemption is the same as the estate tax exemption. This provision was effective on January 1, 2011, at which time the estate tax exemption amount was $5 million.

Generation - Skipping Estate Tax Gift Tax Transfer Tax Exemption Top Exemption Top Exemption Rate Rate Rate 2009 $3,500,000 45% $1,000,000 45% $3,500,000 45% 2010 $5,000,000* 35%* $1,000,000 35% $5,000,000 0% 2011-12 $5,000,000 35% $5,000,000 35% $5,000,000 35% [dagger] [dagger] [dagger] (portable) 2013 $1,000,000 55% $1,000,000 55% $1,000,000 55% [dagger] Estate Tax

Repeal of carryover basis: The Tax Relief Act repeals the provisions in EGTRRA that had repealed the estate tax in 2010 and provided for modified carryover basis. This provision was effective on January 1, 2010. Thus, as discussed below, any person dying in 2010 with an estate in excess of $5 million was subject to estate tax at 35%.

The Tax Relief Act, however, gives the estate of a person dying in 2010 an election to apply the law as if the act had not repealed the provisions in EGTRRA. This provision allows the estates of decedents in 2010 to elect to have no estate tax imposed but also requires the use of carryover basis. Treasury is delegated the authority to determine the time and manner in which the election is to be made.

The Tax Relief Act essentially retroactively reinstates the estate tax to apply to estates of decedents dying in 2010. In general, if a person died in 2010 and the estate was less than $5 million, the estate does not owe estate tax and receives a step-up in basis of the assets in the estate to their fair market value (FMV) at the date of the decedent's death. If a person died in 2010 and the estate was in excess of $5 million, the estate may want to elect to apply the law in effect before enactment of the act. If it makes the election, the estate does not pay estate tax and applies the carryover basis rules set forth in EGTRRA.

The lateness of the passage of the Tax Relief Act provides additional time for the estates of decedents who died in 2010 (before December 17, 2010) to file an estate tax return, pay estate tax, or make a qualified disclaimer. The additional time is nine months from the date of enactment, December 17, 2010.

Top rate: The Tax Relief Act sets the top estate tax rate at 35%. The lower rates, however, continue to be in effect for the first $500,000 of an estate and are used in the calculation of the estate tax for an estate in excess of $5 million (i.e., above the estate tax exemption amount).

Exemption amount: The Tax Relief Act sets the estate tax exemption amount (otherwise referred to as the applicable exclusion amount) at $5 million, and this amount is indexed for inflation in $10,000 increments after 2011. This provision was effective on January 1,2010.

Portability: The Tax Relief Act provides for portability of the estate tax exemption amount between spouses. This allows a surviving spouse to utilize the unused estate tax exemption amount of the first-to-die spouse. For a surviving spouse to use the deceased spouse's unused estate tax exemption amount, the executor of the deceased spouse's estate must file an estate tax return that computes the unused estate tax exemption amount and makes an election on the return that allows the surviving spouse to use the deceased spouse's unused estate tax exemption amount. This provision is effective if the first spouse dies on or after January 1, 2011, and the second spouse dies or makes gifts before January 1, 2013.

GST Tax

Reinstatement of GST tax: The Tax Relief Act repeals the provisions of EGTRRA that had repealed the GST tax for 2010. This provision was effective on January 1, 2010. Thus, GST tax applies to GSTs (i.e., direct skips, taxable terminations, or taxable distributions) that occurred in 2010. However, for GSTs that occurred in 2010, the applicable rate under Sec. 2641(a) is zero.

The Tax Relief Act essentially retroactively reinstates the GST tax to apply to GSTs occurring in 2010. Thus, if a donor transferred $10 million to a trust for the benefit of grandchildren (i.e., skip persons), the transfer was a direct skip and has GST tax consequences. However, the applicable rate to apply to the GST is zero, and no GST tax would be due.

Direct skips have GST exemption automatically allocated to them, and an election out of these automatic allocation rules needed to be made on timely filed gift tax returns for 2010 to preserve GST exemption for future years. If this election out is made, the trust has an inclusion ratio of one.

Example: On December 1, 2010, G transferred $ 10 million to a trust for the benefit of her grandchildren and greatgrandchildren. She elected on her Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, not to allocate GST exemption to the transfer. The GST tax that G paid on the direct skip is zero, because the applicable rate is zero. The trust, however, is not exempt from GST tax because it has an inclusion ratio of one. Under the "move down" rule in Sec. 2653(a), G is assigned to the generation above the highest generation in the trust -i.e., to the generation of the parents of the grandchildren. Distributions from the trust to grandchildren will not be subject to GST tax because, under Sec. 2653(a), they are only one generation below G's generational assignment. However, transfers to great-grandchildren will be subject to GST tax because they are two generations below G's generational assignment. Because of the lateness of the passage of the Tax Relief Act, it also provides additional time for persons who made GSTs prior to the date of enactment to file a return for GST tax purposes. The additional time is nine months from the date of enactment. Thus, for taxable distributions or taxable terminations occurring between January 1,2010, and December 16, 2010, the due date for Forms 706-GS(T), Generation-Skipping Transfer Tax Return for 2010 Terminations, 706-GS(D), Generation-Skipping Transfer Tax Return for 2010 Distributions, and 706-GS(D-l), Notification of Distribution from a Generation-Skipping Trust, is September 19,2011. For taxable distributions or taxable terminations occurring on or after December 17, 2010, the due date for those forms was April 18,2011.

Top rate/exemption amount: Sec. 2641 sets the GST tax rate at the highest estate tax rate. The top estate tax rate under the Tax Relief Act is 35%, so the GST tax rate is 35%. Sec. 2631(c) sets the GST exemption amount at the estate tax exemption amount. The estate...