2012 Tax Act

After months of negotiating, Congress and the President finally reached an agreement regarding income taxes and Federal spending. The new laws are contained in a bill known as the “American Taxpayer Relief Act of 2012” (the “2012 Tax Act”). The 2012 Tax Act also addressed estate, gift, and generation skipping transfer taxes, and those changes are the subject of this letter.

1. Estate Tax Exemption, Rate of Tax, and Indexing For Inflation.

The 2012 Tax Act permanently increased the estate tax exemption to $5,000,000 per person, and importantly, the exemption is now indexed for inflation. With that indexing, the exemption for 2013 is equal to $5,250,000, and it will continue to increase each year. To the extent a decedent’s estate exceeds the exemption available in the year of death, the excess will be taxed at 40%. This rate of tax is higher than the 35% which was due on taxable estates in 2011 and 2012, but it is far lower than the 55% rate of tax which was imposed for many years prior to the Bush tax cuts.

2. Portability.

The 2012 Tax Act also made “portability” a permanent part of the estate tax system. Portability, which was originally introduced into law in 2010, is a way for married taxpayers to save estate taxes. Before 2010, if a spouse with a taxable estate died without proper estate planning and left his or her estate outright to the surviving spouse, that deceased spouse’s ability to shelter property from estate taxes after both spouses died was lost (absent a disclaimer of the inheritance by the surviving spouse, something most surviving spouses have no interest in doing). Even though the bequest to the surviving spouse did not generate any estate taxes due to the “unlimited marital deduction,” it meant the surviving spouse was left with all the property, but with only one person’s exemption from estate taxes. The exemption of the first spouse to die was therefore lost if no “bypass” trust was created. Now when a spouse leaves property directly to the surviving spouse, the surviving spouse can add the deceased spouse’s unused exemption amount (referred to as the “DSUE Amount”) to his or her own $5,250,000 exemption, thereby potentially doubling the amount that can be given away or left tax-free at death.

These new estate tax provisions may make planning less complicated for some clients, but there are still good reasons to create a bypass trust at the first spouse’s death. For example, if an estate is left to a trust, any appreciation that accrues to the trust property between the two spouses’ deaths will be removed from the surviving spouse’s estate. The DSUE amount is a fixed number, and it does not adjust for inflation. For example, if a couple has a $10,500,000 combined estate when the husband dies, and the wife’s estate subsequently grows to $15,000,000 prior to her death, she would be able to add only $5,250,000 to her exemption even though her husband’s half had grown to $7,500,000. This disadvantage is mitigated though because property owned outright by a surviving spouse receives a stepped-up cost basis upon the surviving spouse’s death, whereas assets in the trust will not. Even so, estate tax rates have historically been at least double that of capital gains tax rates (in 2013, the estate tax rate is 40% and the long-term capital gains rate is 20%), so in most cases, it will be best to use a trust rather than rely on portability.

Importantly, trusts offer creditor and divorce protection, two benefits that can be very important to many surviving spouses. Further, the portability laws provide that you can only claim the unused exemption from your last deceased spouse. If the surviving spouse in the above example remarries a wealthy man who dies shortly thereafter leaving his large estate to his own children, he will have no DSUE Amount for his wife to claim since he will have used up all of his exemption. The surviving spouse would lose her first husband’s DSUE Amount and have none to claim from her newly deceased husband. So, for some widows without a bypass trust, there’s the very real possibility that extra unplanned taxes might be owed if a new spouse dies first. Also, because a surviving spouse is usually not permitted to pass trust property to a new spouse or other beneficiaries, a trust has the added benefit of preserving the trust property for the children or other beneficiaries of the spouse who dies first.

3. Gift and GST Taxes, Rate of Tax, and Indexing For Inflation.

The 2012 Tax Act also made permanent changes to the gift tax and to the generation skipping transfer (“GST”) tax. Gift taxes apply to transfers made during lifetime that are in excess of any available exclusions and exemptions. GST taxes generally apply to transfers made to grandchildren, great-grandchildren and certain other persons and trusts.

Just like the estate tax, the available lifetime exemption from both the gift and GST tax has been increased to $5,250,000 per person. Transfers that exceed this limit will be taxed at the same 40% rate that applies to the estate tax. This $5,250,000 exemption is also indexed for inflation and will be increasing along with the estate tax exemption in future years. Importantly, if a surviving spouse has unused exemption from a spouse who died (the DSUE Amount), that carry-over amount can be added to the $5,250,000 gift tax exemption, thus increasing the amount the surviving spouse can give away during his or her lifetime. With such large exemptions now available, there are far more planning options available to people who want to make gifts while they are alive, whether in trust or outright to their children or others.

Most people are not concerned with gift and GST taxes because of the annual exclusion. This is the amount that can be given to any person each year without using up any part of the lifetime exemption from gift and GST taxes. The annual exclusion in 2013 is now equal to $14,000, up from $13,000 last year. The annual exclusion allows any person to give any other person as much as $14,000 per calendar year without reducing the available lifetime exemption. The annual exclusion is indexed for inflation, and it increases from time to time in $1,000 increments.

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