I was positive at the end of 2009 that Congress would do something to prevent the estate tax from going away. They didn't, and the estate tax was repealed. However, the repeal was temporary. The estate tax only went away for a year. It was all set to spring back in the form it would have taken had Congress not trifled with estate tax repeal back in 2001. We were looking down the barrel of a 55% estate tax on the value of everything a decedent owned in excess of $1 million. As 2010 wound down, it was looking like Congress was going to sit on its hands again, and I was pretty sure that estate tax relief would happen, if at all, in 2011. Once again, I was wrong.
President Obama and the Republicans in the U.S. Senate hammered out a compromise that would bring the estate tax back in a kinder, gentler form than would otherwise have been the case. Somehow the House Democrats were cajoled into adopting the Senate bill, and just this afternoon, the President signed the bill into law. There is a catch, however, and that is that the new estate tax rules are temporary. Congress will have to act again within the next two years in order to make them permanent. If Congress doesn't act, we go back to the 2002 incarnation described above. So what are the new temporary rules? Here are some highlights:
1. Bigger Exclusion – The Senate Republicans were able to negotiate a $5 million exclusion. This means that each individual who dies in 2011 or 2012 will be able to pass on $5 million worth of assets without estate tax liability. If a husband and wife both die in that same time frame, they will be able to pass on a total of $10 million worth of assets estate tax free.
2. Lower Tax Rate – Score another one for the Senate Republicans, who were able to negotiate a 35% tax rate. So every dollar over $5 million ($10 million for a married couple) will be taxed at 35%. Nothing to sneeze at, but still worth finding ways to minimize for people with larger estates.
3. Portability – Prior law set an estate tax trap for married couples who owned joint assets. When the first spouse expired, all of the joint assets passed to the surviving spouse, and they passed tax free because of the unlimited marital deduction. This seemed pretty good until the surviving spouse died with an estate in excess of what the survivor could pass tax free. Then there would be tax that could have been avoided only if the spouses had split their assets between them and separately titled them in their individual names or their separate revocable trusts.
Let's say a couple owned $2 million worth of assets, and both spouses died in years when the exclusion amount was $1 million and the tax rate was 55%. When the first spouse died, there was no tax, but the tax was only postponed by the marital deduction; it was not eliminated. When the second spouse died, only the second spouse's $1 million exclusion amount passed tax free. The excess was taxed at 55%. So, with a $2 million estate, $550,000 had to be paid to the IRS within 9 months. Had the couple split their assets between their separate revocable living trusts, then the trust of the first spouse to die could avail itself of the $1 million exclusion, and it could and allow the surviving spouse to benefit from the deceased spouse's assets–but not have them piled on top of the surviving spouse's assets later on for estate tax purposes.
When the second spouse died, his or her exclusion would shelter the rest of the assets from estate tax, and the $550,000 that went to the IRS in the joint ownership scenario would go to the kids. Under the new "portability" rules, the spouses would not need to split their assets for estate tax purposes (though there may be other good reasons for doing so). The second spouse to die will get to use the unused portion of the exclusion of the first spouse to die.
Portability may be a good thing for an estate that is not planned on a sophisticated level, but it is a poor substitute for good planning. Those who rely on portability as an estate tax planning tool may miss out on some important opportunities.
4. Unified Once Again – Prior to the 2001 tax act, the estate and gift taxes were "unified." What that meant was that there was one overall exclusion amount that applied to both lifetime gifts and transfers at death. Back when the exclusion was $1 million, it meant that each of us could make up to $1 million worth of tax free lifetime gifts, and then whatever was left of the exclusion could be applied against transfers at death.
The 2001 Tax Act did away with the unified approach. The gift tax exclusion stayed at $1 million from 2002 up to (and including) 2010. In the meantime, the estate tax exclusion escalated from $1 million in 2002 to $3.5 million in 2009, and then the estate tax went away in 2010. If a person gave away $500,000 and subsequently died prior to 2010, there would have been no gift tax to pay, but the person's estate tax exclusion would be reduced by $500,000. If the person had given away more than $1 million, there would have been gift tax to pay, and his or her estate tax exclusion would have been reduced by the full $1 million. Unification simplifies some death tax planning, but some States (including my beloved home State of Hawaii), in an act of frustration with Congress' inaction, have nullified the simplification by creating their own estate tax systems that do not tie in well with the federal estate tax rules.
The new estate tax rules may tempt you to think that estate planning isn't really all that important anymore. If planning to avoid the estate tax is the only thing that is important to you, you may be right. On the other hand, you should know by now not to get too comfortable with the temporary fixes that Congress increasingly uses to patch up our national problems. The new estate tax rules are good for two years, but then all bets are off.
More importantly, effective estate planning involves making sure that you are in control of your estate, that it will be administered by your hand-picked decision-makers when you are not able to manage it, and that your assets ultimately go where you want them to go. The estate tax is only one problem that comprehensive estate plans solve, and the non-estate tax problems have not gone away. If anything, they have been brought out of the shadow of the estate tax, and more of us will now focus on the issues that will really make a difference to us and our loved ones.