REPORT ON ESTATE AND GIFT TAX
PROVISIONS OF 2010 TAX RELIEF ACT

On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the "Tax Relief Act") was enacted into law. The Tax Relief Act has numerous provisions affecting income taxes, including increases in alternative minimum tax exemption amounts, an extension of cuts in income and capital gains tax rates enacted during the Bush administration and an extension of the deduction for state and local sales taxes. The new law also significantly changes federal estate and gift tax law. The discussion set out below reviews many provisions of the new law that will have an impact on estate and gift tax planning.

To appreciate the significance of the Tax Relief Act for estate planning, it is necessary to understand how the act affects the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") that amended the laws governing estate tax, gift tax and generation-skipping transfer ("GST") tax. The EGTRRA provisions changing estate, gift and GST tax ("transfer tax") laws were scheduled to expire as of December 31, 2010. As discussed below, the Tax Relief Act postpones the expiration of EGTRRA's transfer tax provisions for two years, reinstating many of those provisions and amending others.

EGTRRA reduced the highest marginal estate and gift tax rate to 50% for gifts made, and decedents dying, in 2002. The act lowered the highest marginal estate and gift tax rate 1% annually for the next 5 years, which reduced the rate from 49% for 2003 to 45% for 2007, and maintained the rate at 45% for 2008 and 2009. EGTRRA repealed estate taxes for individuals dying in 2010 and reduced the gift tax rate to 35% for gifts made in 2010.

EGTRRA also made adjustments to the amount of assets that an individual could transfer free of federal estate and gift tax. For many years, federal law has allowed a credit (the "unified credit") against estate and gift taxes on transfers of an individual's property. The unified credit offsets taxes on gifts made during an individual's lifetime and transfers occurring at his or her death. The term "exclusion amount" refers to the amount of assets that an individual can transfer free of estate and gift tax by applying the unified credit. The unified credit effectively exempts from estate and gift tax an individual's transfers of assets as long as the total value of the assets transferred does not exceed the exclusion amount.

EGTRRA bifurcated the estate tax exclusion amount and the gift tax exclusion amount while increasing the exclusion amount for both estate and gift tax purposes. Under EGTRRA, the exclusion amount for gift tax purposes increased to $1,000,000 for estates of gifts made in 2002 and remained at that amount for gifts made between 2003 and 2010. EGTRRA increased the exclusion amount for estate tax purposes to (1) $1,000,000 for persons dying in 2002, (2) $1,500,000, for persons dying in 2004 and 2005, (3) $2,000,000 for persons dying in 2006, 2007 and 2008, and (4) $3,500,000 for person dying in 2009.

EGTRRA changed the rules for determining the basis of assets acquired from a decedent, for decedents dying in 2010. Under federal law, a person who acquired an asset from a decedent dying before 2010 generally received a stepped-up basis, i.e., a basis for the asset equal to the asset's fair market value at the decedent's death. EGTRRA added new rules, codified in Internal Revenue Code ("IRC") Section 1022, that prescribed a modified carryover basis system for assets acquired from decedents dying in 2010. Under the general rule of IRC Section 1022, when an individual acquired an asset from a decedent dying in 2010, his or her basis in the asset would generally equal the lesser of the decedent's basis in the asset and the asset's fair market value at the decedent's death. Exceptions to the general rule of IRC Section 1022 allowed an executor to increase the bases of assets passing from a decedent by up to $1,300,000 in general and to apply an additional increase to the basis of a decedent's assets passing to the surviving spouse of up to $3,000,000, subject to a provision limiting the basis of any asset to the asset's fair market value at the decedent's death.

EGTRRA made numerous other modifications to federal estate and gift tax law. Among other changes, the act made exclusions for conservation easements more widely available, replaced the state death tax credit with a deduction for state death taxes paid, increased the range of circumstances in which estates would be allowed to pay estate taxes in installments and repealed the rule allowing a deduction for a decedent's qualified family owned business interest.

EGTRRA also modified the rules governing GST taxes. For example, the act expanded the scope of automatic allocations of GST exemption so that the automatic allocation applied to any "indirect skip," defined as a transfer, other than a direct skip, that was made to a GST trust, i.e., a trust falling within one of the categories specified in IRC Section 2632(c). EGTRRA also permitted a trustee of a trust with an inclusion ratio of less than one to divide the trust into two trusts, one with an inclusion ratio of zero and the other with an inclusion ratio of one, provided that specified conditions were met.

Because the transfer tax provisions of EGTRRA were scheduled to expire on December 31, 2010, the transfer tax laws as in effect before EGTRRA were set to spring back into effect as of January 1, 2011. For example, with the sunset of EGTRRA, the exclusion amount for estate and gift tax purposes would have become $1,000,000 on January 1, 2011.

Reinstatement of EGTRRA

The Tax Relief Act temporarily reinstates and amends EGTRRA, providing that the estate and gift tax rules of EGTRRA in effect on December 31, 2009, as amended by the Tax Relief Act, will generally remain in effect. In restoring the rules in effect on December 31, 2009, the Tax Relief Act generally overturns the one year repeal of estate taxes, which reinstates the estate tax for the estates of persons who died in 2010. As discussed below, however, the new law permits executors of decedents dying in 2010 to elect to avoid estate tax by applying the rule repealing estate tax for 2010.

Rate and Exclusion Amount

The Tax Relief Act reduces the estate tax rate that was in effect on December 31, 2009, providing that the estate tax rate is 35%, effective as of January 1, 2010. The act also increases the exclusion amount for estate tax purposes to (1) $5,000,000 for decedents dying in 2010 and 2011 and (2) $5,000,000, as indexed for inflation, beginning in 2012.

The Tax Relief Act does not change the basic rules applicable to gifts made in 2010, retaining the gift tax rate of 35% and the applicable exclusion amount of $1,000,000 for gifts made in 2010. Under the new law, the gift tax rate will remain at 35% for 2011 and 2012. Beginning in 2011, the gift tax exclusion amount becomes equal to the estate tax exclusion, i.e., $5,000,000 in 2011 and $5,000,000 indexed for inflation thereafter.

Basis

The new law essentially eliminates the modified carryover basis rules set forth in IRC Section 1022. Under the new law, persons who acquire property from a decedent dying after December 31, 2009 will obtain a basis in the property under the same rules that applied for decedents dying before 2010. Accordingly, when an asset passes from a decedent dying after 2009, the asset's basis in the hands of the person acquiring it will generally equal the asset's fair market value on the date of death.

Election

The Tax Relief Act gives an executor of an estate of a decedent dying in 2010 the option of electing to make the estate subject to the federal estate tax rules as in effect before enactment of the Tax Relief Act, i.e., the rules of EGTRRA that eliminated estate tax and imposed modified carryover basis rules for decedents dying in 2010. As a general rule, if an executor of a decedent's estate makes such an election, the estate would not be subject to estate tax and the modified carryover basis rules of IRC Section 1022 would apply in determining the basis of assets passing from the decedent. When the taxable estate of a decedent dying in 2010 substantially exceeds the exclusion amount of $5,000,000, an election by the executor to make the estate tax inapplicable to the estate will normally be advantageous.

Portability

In addition to increasing the applicable exclusion amount, the Tax Relief Act includes a portability provision that generally makes it possible for the unused exclusion amount of a deceased spouse to be carried over to his or her surviving spouse. The amount of a deceased spouse's exclusion that can be used by the surviving spouse is referred to as the "deceased spousal exclusion amount." The new law defines the deceased spousal exclusion amount for a surviving spouse as equal to the lesser of (1) the exclusion amount in effect for the year of the surviving spouse's death and (2) the unused exclusion amount of the last deceased spouse of the surviving spouse. Thus, if the surviving spouse has survived more than one spouse, the surviving spouse may only use the unused exclusion amount of his or her spouse who died most recently. A surviving spouse is entitled to use a deceased spousal exclusion amount for transfers made during the surviving spouse's lifetime or at his or her death. The new law requires an election by the executor of the deceased spouse's estate as a condition to allowing the surviving spouse to use the deceased spousal exclusion amount. The executor of the deceased spouse's estate must make the election on a timely filed estate tax return for the deceased spouse's estate.

To illustrate, assume that a woman survives her husband, who died in 2011 and used $1,000,000 of his $5,000,000 exclusion amount. If the widow were to die in 2012 without making any taxable gifts, her exclusion amount would be $9,000,000, i.e., the sum of $5,000,000 (her exclusion amount) and $4,000,000 (the exclusion amount that carries over from her deceased husband).

Sunset of the Transfer Tax Provisions

As indicated above, the transfer tax provisions of EGTRRA, as modified by the Tax Relief Act, are temporary, including, but not limited to, the increase in the exclusion amount, the reduction in the tax rates, the portability provision, the substitution of the state death tax deduction for the state death tax credit, the repeal of the deduction for qualified family business interests and the modifications to the GST tax rules. The provisions of EGTRRA applicable to estate, gift and GST tax had been scheduled to expire on December 31, 2010. The Tax Relief Act postpones the expiration of those provisions of EGTRRA, as amended by the Tax Relief Act, until December 31, 2012, with the result that the laws governing transfer taxes in effect before EGTRRA are scheduled to come back into effect on January 1, 2013.

Planning Implications

Designing estate tax planning strategies before 2011 was often complex due to the lack of predictability in the estate tax law that resulted from the numerous changes in the exclusion amount and the scheduled expiration of EGTRRA on December 31, 2010. Estate tax planning will probably remain complex after passage of the Tax Relief Act, given the scheduled expiration of the act's transfer tax provisions on December 31, 2012.

Estate planners will face decisions about what estate tax planning strategies should be utilized in light of the changes to the law made by the Tax Relief Act. One issue to be addressed relates to the advisability of continuing to advise married clients to use a credit shelter trust, which has frequently been recommended as a technique to minimize federal estate taxes. Assets held in a credit shelter trust created under the will or trust of the first spouse to die were not included in the surviving spouse's estate for federal estate tax purposes. As a result, the surviving spouse's estate would generally not be subject to estate tax if his or her taxable estate, comprised of separate assets held outside of the credit shelter trust, did not exceed the exclusion amount. Provisions of a credit shelter trust typically permitted the trustee to make trust funds available to the surviving spouse, subject to limitations designed to prevent inclusion of the trust assets in the estate of the surviving spouse.

Will and trust agreements employed various methods for determining the amount of assets that would be used to fund a credit shelter trust. Some documents created a gift to the credit shelter trust through a formula that provided for distributing to the trust the largest amount that could pass to the trust free of estate tax. Other wills and trust documents included a provision that made a gift to the credit shelter trust of a specified percentage of the residue of the estate or trust. Another method provided for a gift of the residue of the estate or trust to the surviving spouse and further provided that assets disclaimed by the surviving spouse would pass into a credit shelter trust.

Designing estate plans without using credit shelter trusts might be viewed as appropriate for more couples under the new law than it was under prior law for two reasons. First, the need for a credit shelter trust could be considered unnecessary in more situations because of the increase in the exclusion amount. Second, some individuals may expect that the portability provision permitting a surviving spouse to utilize the deceased spouse's unused exclusion will allow a married couple to use both spouses' exclusion amounts without creating a credit shelter trust.

Despite the new portability provision and the increase in the exclusion amount, however, certain factors could make it desirable in many cases to continue incorporating a credit shelter trust into a will or trust, either by including a gift to a credit shelter trust or by including a gift to the surviving spouse and providing for a credit shelter trust to hold any assets disclaimed by the spouse. As an initial matter, basing an estate plan on the portability provision or the $5,000,000 exclusion amount could be considered problematic because those provisions may not remain in effect after December 31, 2012. In addition, assuming that Congress extends the portability provision, an individual who survives his or her spouse will lose the right to use the deceased spouse's exclusion amount if the deceased spouse did not establish a credit shelter trust and the surviving spouse remarries and outlives the new spouse. Another advantage of a credit shelter trust is that any appreciation in the value of a spouse's assets that occurs after his or her death escapes estate taxation if the assets are placed in a credit shelter trust but not if the assets pass outright to the surviving spouse. Finally, an individual may want to use a credit shelter trust to hold assets for his or her surviving spouse for objectives unrelated to estate taxation, such as protecting the assets from creditors of the surviving spouse or controlling the distribution of the assets at the time of the surviving spouse's death.

The Tax Relief Act creates new opportunities to make gifts for individuals who have substantial estates. Because the Tax Relief Act increases the gift tax exclusion amount to $5,000,000, it is possible for individuals to begin making taxable gifts in excess of $1,000,000 without incurring an obligation to pay federal gift tax. Individuals interested in making significant gifts may consider using one or more of the several arrangements that have been employed in structuring gifts to family members. Techniques that are frequently used in implementing plans that involve gifts of substantial assets include, but are not limited to, (1) gifts of interests in limited partnerships and limited liability companies, (2) transfers of assets to grantor retained annuity trusts, (3) gifts of undivided interests in real estate, (4) transfers of cash to irrevocable life insurance trusts to pay premiums on insurance policies held in trust and (5) sales of assets to grantor trusts.