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Estate Planning: Tax Revisions of the 2010 Tax Relief Act

After much deliberation, delay and political in-fighting, Congress passed and the President signed into law the 2010 Tax Relief Act in December 2010 which updated the federal estate tax structure that had expired in January of last year. In doing so, Congress has made significant changes in the manner in which the federal estate and gift tax applies to most estates, and these changes may significantly affect how your estate will be taxed at death.

Overview of the New Law
First, it must be noted that the 2010 Tax Relief Act provides only temporary relief. Technically, it applies only for estates where the taxpayer dies in calendar year 2011 or 2012. However, having finally leaped this political hurdle, most pundits believe that this new structure will survive for the long term.

Under prior law, enacted in 2001 under the guise of estate tax repeal, Congress slowly increased the federal estate tax exemption from $1,000,000 in 2001 to $3,500,000 in 2009, and the top estate tax rate was reduced from 55% to 45%. Prior law also provided that for calendar year 2010, both the estate tax and the gift tax were repealed.  However, due to budgetary concerns, this was a one-year repeal – for calendar 2010 only, and the estate tax rules applicable to calendar 2001 were scheduled to be revived in 2011 (meaning an exemption of only $1 million and a 55% tax rate).

Under the Tax Relief Act of 2010, for calendar years 2011 and 2012, the estate tax exemption rises to $5,000,000 (with an additional inflation adjustment for 2012), and the top tax rate declines to 35%. But as noted, these changes technically apply only for persons dying in calendar 2011 and 2012, and the exemption amounts and tax rates would revert to 2001 levels after 2012, unless Congress takes further action to make them permanent.

New Portability Feature
The federal estate tax exemption amounts apply to each individual, that is both spouses are entitled to take advantage of the now $5 million exemption. This means that together, married couples are able to shelter from federal estate tax assets totaling up to $10,000,000. Under prior law, lawyers commonly employed a somewhat complicated technique to ensure that both exemptions were utilized. For example, if a couple had a combined estate worth $10 million, and the first spouse to die left everything to the surviving spouse, then on the second death there was a potential for amounts in excess of the $5 million exemption amount to be taxed in the estate of the survivor. Effectively, the first spouse’s exemption amount was left unused.

Consequently, lawyers would commonly use what was known as the “A B trust” to ensure that the exemptions of both spouses were utilized. The essence of this device was that on the first death, two trusts were created, an exemption trust and a survivor’s trust, and the estate was carved up between them – with the deceased spouse’s assets passing into the exemption trust, and the survivor’s assets being funneled into the survivor’s trust. To make a long and complicated story short, for federal estate tax purposes, even though the survivor was entitled to use the assets funded into the exemption trust, the survivor wasn’t deemed the owner of those assets, and on the second death, those assets weren’t taxed in the survivor’s estate.  Instead, they were considered taxable upon the first spouse’s death, but that spouse’s exemption shielded them from any estate tax. The effect was that the entire estate could be passed to the next generation without any federal estate tax being assessed.

The 2010 Tax Relief Act provides a simpler and more elegant solution to this dilemma. Under the new rules, any portion of the exemption of the first spouse that isn’t used upon his/her death now carries over and can be used by the surviving spouse, in addition to his/her own exemption. This is commonly referred to as portability. In concept, it reaches the same result as the tried-and-true (but more procedurally complicated) A-B trust approach.

Unfortunately, just like the increased exemption amounts, portability also expires for calendar years following 2012.  Moreover, the simplicity of the concept of portability is not without its own complications in application – for example, there are scenarios that still remain to be clarified, such as how to apply portability in situations involving remarriage.

What does this mean for you and for me? Here’s how the changes will likely affect us:

• The increase in the estate tax exemption should mean that fewer people become subject to the federal estate tax, at least for the short term. For the long term, we still have to wait and see what permanent solution Congress ultimately passes.

• In most cases, we should be able to greatly simplify estate plans (wills and trusts) for many if not most people. While the old-standard A-B trusts won’t necessarily become a thing of the past, for smaller to modest sized estates, portability should do the trick (assuming it is made a permanent feature), and trusts and wills can be drafted with much less complexity.

If you have an existing family trust plan in place, now would probably be a good time to have it reviewed and updated as it can probably be greatly simplified. If you have nothing yet in place, now would be the time to consider starting an estate plan of your own.

— Joseph F. Look is an estate planning attorney and partner at Schley Look Guthrie & Locker LLP in Santa Barbara. He spoke recently on the topic of Recent Estate and Gift Tax Law Changes at a free estate planning seminar co-sponsored by Visiting Nurse & Hospice Care and Santa Ynez Valley Cottage Hospital Foundation. For copies of his more detailed presentation, please contact Pat Snyder at VNHC’s Gift Planning Office, 805.690.6282 or .(JavaScript must be enabled to view this email address).

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