Major Change in Recent Estate Tax Legislation

As we reported on our Blog in December, Congress enacted new estate tax legislation in late 2010 that makes radical changes to the estate tax law that would have gone into effect on January 1, 2011. Under the old law, each person dying after December 31, 2010, would be entitled to a $1 million estate tax exemption, and any assets that he owned in excess of $1 million would be taxed at a maximum rate of 55%. Under the new legislation, taxpayers dying in 2011 and 2012 will be entitled to a $5 million exemption, and any assets in excess of $5 million would be taxed at a maximum rate of 35%.

It is easy to see that the new legislation contains two major changes. First, the estate tax exemption amount is increased from $1 million to $5 million per person in the United States. Second, the maximum tax rate imposed on the assets someone owns in excess of the exemption amount is reduced from 55% to 35%. These changes, undoubtedly, stand to save families substantial sums when family members die.

While these changes have been discussed widely in the media, another important change was enacted in the 2010 legislation that marks a dramatic shift in estate tax law. The new legislation contains a “portability” provision that allows the estate tax exemption of one spouse to be carried over upon their death and added to the surviving spouse’s exemption. Thereafter when the second spouse dies, he or she can utilize both exemptions to leave their children $10 million instead of $5 million.

For example: Jack died in January 2011 at the age of 85. He and his wife, Jane, owned combined assets valued at $9 million on the date of Jack’s death. Jane’s health is not good. She is not expected to live longer than another 6 months beyond Jack’s death. Her Will leaves all of her assets to the couple’s 3 children.

Under the prior version of the estate tax law, when Jack died leaving all of his assets outright to Jane, they lost Jack’s $5 million exemption. Consequently, upon Jane’s later death, when she left all $9 million to the 3 children, Jane’s estate could utilize her $5 million exemption but would have to pay taxes on the remaining $4 million. With a maximum tax rate of 35%, their children would end up paying over $1 million in taxes.

However, with the new portability provision, when Jack died leaving his assets to Jane, he can also leave her his $5 million exemption. As a result, when Jane later dies, she would be able to combine her $5 million exemption with Jack’s $5 million exemption to leave their children up to $10 million tax-free. Accordingly, upon Jane’s death, the couple’s entire $9 million would pass tax-free to the children.

The portability option is a substantial change in estate tax law, and it stands to provide a significant advantage to many clients. However, the new law contains several pitfalls in this portability provision. It also creates some new problems in putting together estate tax planning options. For more information about these pitfalls and challenges in estate planning, please contact us to discuss them more fully.