Want to Reduce Your Estate Tax? Plan Now to Take Advantage of Recent Legislative Changes

Uncertainty complicates planning. Sometimes, if we’re lucky, it also generates windows of opportunity.

Last December’s Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Tax Relief Act) changed the rules for gifting and estate planning. It temporarily extended a number of expiring tax provisions while also establishing new, albeit temporary, provisions.

The result is a new opportunity for gifting and estate planning.

However, because the Tax Relief Act’s provisions expire after 2012, you only have two years to take advantage of new strategies that can significantly reduce your taxable estate.

Under federal tax law, the value of your assets (above a legislatively determined exemption amount) is generally subject to estate tax at your death. In addition, the income generated by your estate after your death is subject to federal income tax.

The result is an obvious incentive to reduce the size of your taxable estate during your lifetime through gifting, philanthropy, or a combination of the two.

The recent Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (Tax Relief Act) changed the rules for gifting and estate planning-for a two-year period. Unless Congress acts, the advantageous rates and other tax provisions are slated to expire at the end of 2012.

General Tax Rules for Gifting
The federal government taxes the value of the money or other property that you gift to another person, subject to a number of exclusions and exemptions.

The Internal Revenue Service defines a gift as “any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.”

Although most gifts are subject to federal gift tax, there are exceptions, such as charitable giving, gifts to your spouse or to a political organization for its own use, and the medical or tuition payments you make on someone’s behalf directly to a health care provider or educational institution.

If you make a taxable gift during the year, you must report it to the IRS on Form 709 and pay any taxes due by April 15th of the following year. However, the gift is not reportable by the person who receives it and the amount of the gift is not considered taxable income to the recipient.

Annual Gift Tax Exclusion
The federal tax rules provide for an annual gift exclusion, representing the maximum amount of money or other property that you can give-per year, per recipient-before you are subject to federal gift taxes. (Most states, including Washington, do not have a state gift tax.)

For 2011, the inflation-adjusted annual exclusion amount is $13,000, which is unchanged from 2010.

If you’re married, you and your spouse can each gift up to $13,000 per recipient, per year without using any of your lifetime gift exemption-for a maximum combined tax-free gift of $26,000 per recipient, per year. You also have the option to treat any gift made by you or your spouse from separate property as if it was made half by you and half by your spouse, referred to as gift splitting.

Lifetime Gift Tax Exemption
The tax rules also establish a lifetime gift exemption, representing the amount of money or other property that you can gift during your lifetime without incurring a gift tax. It’s important to note that any nontaxable gifts that you make as a result of the annual gift tax exclusion do not reduce your lifetime exemption amount.

For 2011 and 2012, the Tax Relief Act increases the lifetime exemption amount to $5 million, up from $1 million in 2010. The exemption amount is scheduled to return to $1 million in 2013.

Impact of the Tax Relief Act on Estate and Gift Taxation
The Tax Relief Act established beneficial tax rules affecting the federal gift tax, generation-skipping tax and estate tax. However, it also extended the period of uncertainty that has governed estate tax planning for the last few years, as its provisions apply only to 2011 and 2012.

Unless Congress acts, higher rates and lower exemption amounts return in 2013, generating a sense of urgency for enhancing existing estate and gifting plans to take advantage of the new opportunities.

Under the provisions of the Tax Relief Act, the federal tax rates and exemption amounts for gift, generating-skipping and estate taxes are unified for the next two years. The practical consequence of unification is that the amount you gift under the lifetime gift tax exemption reduces the amount of your exemption for estate and generation-skipping taxes.

The Tax Relief Act also created portability of the estate tax exemption for spouses in 2011 and 2012. In other words, the unused portion of the exemption for the first spouse to die passes to the surviving spouse, increasing his or her estate tax exemption.

Important Planning Opportunities
There are a number of actions you can take over the next two years to take advantage of the new two-year window for enhanced gifting afforded by provisions of the Tax Relief Act. However, because of the complexity of the federal gifting and estate tax rules-and the need to coordinate gifting with your overall estate plan-it’s crucial that you discuss your situation with your tax advisor at Bader Martin before taking action.

Perhaps the simplest and most obvious strategy to reduce your taxable estate under the new rules is additional gifting. If you’ve maxed out your lifetime gifting at $1 million under the previous rules, you can gift an additional $4 million during the next two years without incurring any gift tax liability. If you’re married, your spouse can also gift an additional $4 million-potentially reducing your taxable estate by $8 million. Selecting appropriate assets to gift is critical.

You can also ensure that you and your spouse maximize your gifting each year under the annual gift tax exclusion, as these gifts do not reduce your lifetime giving opportunity. Depending on the number of people who receive these tax-free gifts, the amount by which you reduce your taxable estate each year can be significant.

In light of these changes and the new portability of the estate tax exemption between spouses that is available in 2011 and 2012, it’s important to consider necessary updates to your estate plan documents.

Although the State of Washington has no gift tax, it does have its own estate tax, with an exemption of only $2 million and a top tax rate of 19 percent. No matter what happens to the federal estate tax, Washington residents need to consider the state’s estate tax in their planning.

There are additional tax planning opportunities arising from what the Tax Relief Act was anticipated to address, but did not. Planning techniques such as the use of family limited partnerships, grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts (IDGTs)* can help you leverage your lifetime gifting exemption through the use of value freezes and valuation discounts. However, these techniques have been the target of much IRS scrutiny. As a result, they may be impacted-or even eliminated-by future legislation, so timing is critical.

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* These planning techniques will be discussed in more detail in a future article