At long last, in its first action to avoid the Fiscal Cliff, Congress has enacted a new tax act (The American Taxpayer Relief Act of 2012).
From a US (but not Massachusetts) gift tax and estate tax perspective the Bush-era tax cuts were made permanent. The most important of these is the permanent extension of what has commonly been thought of as a $5,250,000 estate tax “exemption”. Estates with as much as $5,250,000 of assets may no longer have to even file US estate tax returns, and estates with more than $5,250,000 of assets may be able to shelter from estate tax as much as $5,250,000 of assets that are not protected by various estate tax deductions (for example, by the marital deduction, the charitable contributions deduction, or the state estate tax deduction). And, the “exemption” is indexed for future inflation.
Similarly, the gift tax “exemption” is made permanent at $5,250,000 (also indexed for inflation). Also, the Generation Skipping Transfer Tax exemption is made permanent at $5,250,000 (also indexed for inflation).
[However, as in the Bush era, the estate and gift tax exemptions are combined – that is, the maximum exemption for gifts and estates, combined, is $5,250,000 (indexed for inflation) – not $5,250,000 for gifts and another $5,250,000 for estates.]
Also, to the extent the estate of the first-dying spouse has not fully used the US combined gift and estate tax exemption it is possible for the surviving spouse to “inherit” the first-dying spouse’s unused combined gift and estate tax exemption, so that the surviving spouse has both the surviving spouse’s own $5,250,000 gift and estate tax exemption (indexed for inflation) and also the first-dying spouse’s unused exemption (but not indexed for inflation after the first-dying spouse’s death). In theory, this would allow the surviving spouse to enjoy a total US combined gift and estate tax exemption of as much as $10,500,000 (with the surviving spouse’s own exemption continuing to be indexed for inflation). This process of “inheritance” is called “portability”.
Meanwhile, for people who are concerned about exceeding their $5,250,000 US combined gift and estate tax exemption, the “annual exclusion” for most gifts to individuals is now $14,000 per donee (also indexed for inflation).
The downside of the new Act is largely for the really wealthy. The top tax rate for taxable estates (estates after all estate tax deductions, the exemption, and other tax credits) is now raised to 40%; the top tax rate for taxable gifts (after all gift tax deductions and the exemption) is also raised to 40%; and the GST Tax rate (after the GST exemption) is raised to a flat tax of 40%.
All told – pretty sweet for 98% of American taxpayers.
What are the implications for the 98%? As it happens, there is plenty to consider.
Massachusetts Married Couples: Although Massachusetts does not impose a gift tax, the Commonwealth does have a financially significant estate tax. Massachusetts married couples (whether straight or gay) who are within the fortunate 98% will have to consider whether, at the first spouse’s death, to leave everything to the surviving spouse or, instead, to try to take advantage of a Massachusetts “exemption” ($1,000,000). The way to take advantage of the Mass. exemption is for the first-dying spouse to leave up to $1,000,000 NOT DIRECTLY to the surviving spouse (for example, to a special kind of trust that may be written to financially benefit the surviving spouse but that is legally its own, separate, person; or to other individuals, like descendants or other relatives), and the balance of the first-dying spouse’s estate to the surviving spouse (either outright to the surviving spouse or in another special kind of trust for the surviving spouse).
By taking advantage of the Massachusetts “exemption” in this way the couple may avoid Mass. estate tax on not only the amount qualifying for the Mass. exemption but, also, on what that amount may grow to by the time the surviving spouse dies.
Depending upon the size of the surviving spouse’s own estate when the surviving spouse dies, the couple may save as much as $160,000 – or more – in Mass. estate tax. (The maximum Mass. estate tax rate is 16%).
US Estate Tax Considerations for Married Couples: Straight married couples (US tax law does not recognize gay marriage) who are within the fortunate 98% will also have to consider whether, at the first spouse’s death, to leave more than the $1,000,000 Mass. exemption in a way that would shelter from US estate tax not only the Mass. exemption amount of $1,000,000 but, also, additional amounts. For example, if the separate estate of each straight spouse would normally be $3,000,000 apiece, and if the couple decides that they do want to take advantage at the first death of at least the $1,000,000 Mass. estate tax exemption, they must also consider whether, at the first death, to shelter the first-dying spouse’s remaining $2,000,000 of assets under the US exemption (currently $5,250,000).
- Using more of the first-dying spouse’s US exemption may save estate tax if the surviving spouse “strikes it rich”. (For example – the surviving spouse, already with $3,000,000 of her/his own assets, wins $3,500,000 in the lottery; or has stock options that she/he exercises and the stock then skyrockets; or the surviving spouse owns $4,000,000 of life insurance on her/his own life and wants to pass the death benefit on to the children or grandchildren).
- Whatever is sheltered by the first-dying spouse’s US estate tax exemption – plus its appreciation – will likely avoid US estate tax when the surviving spouse dies. For example, if the first-dying spouse’s estate plan shelters under the US estate tax exemption a life insurance policy on the surviving spouse’s life; or if the first dying spouse’s estate plan shelters under the US estate tax exemption other potentially rapidly-appreciating assets like founders’ stock in a biotech or high tech company, or potentially valuable patents, the assets and the appreciation will likely avoid US estate tax at both deaths.
For some couples, this may put a premium on identifying assets with a high appreciation potential and singling them out for placement in a special kind of trust to shelter them under the first-dying spouse’s US estate tax exemption.
- If the couple intends to benefit grandchildren, whatever is sheltered by the first-dying spouse’s US estate tax exemption will likely be sheltered by the first-dying spouse’s US Generation Skipping Transfer Tax exemption. [The Generation Skipping Transfer Tax is a flat 40% tax on transfers for grandchildren and younger generation beneficiaries that exceed the exemption amount]. This can be especially important because, unlike the combined gift and estate tax exemption, there is no “inheritance” of unused GST exemption.
- Taking greater advantage of the first-dying spouse’s US estate tax exemption – by placing assets in a special kind of trust to financially benefit the surviving spouse – may help protect those assets from the surviving spouse’s creditors and from the surviving spouse’s subsequent romantic partners (whether or not the surviving spouse remarries).
Post-Death Planning For “Portability”: For the fortunate 98% a new consideration may arise after the first spouse dies. As mentioned, the new Tax Act enacts permanent “portability” of unused US combined gift and estate tax exemption between the estates of straight spouses. Typically, if the estate of the first-dying spouse is less than the US exemption amount the first-dying spouse’s estate does not have to even file a US estate tax return. However, if the surviving spouse, and the “personal representative” (executor) of the first-dying spouse’s estate are concerned that when the surviving spouse dies her/his own estate may exceed the US estate tax exemption, it may make sense for the first-dying spouse’s estate to file a US estate tax return, anyway. This is because filing a US estate tax return – even if the first-dying spouse’s estate is below the threshold for required filing, and even if the estate tax return reports no estate tax due – is the “admission ticket” for the surviving spouse to take advantage of portability and “inherit” the first-dying spouse’s unused combined gift and estate tax exemption.
As it happens, this is less of a burden for Mass. residents than for residents in many other states. The reason is that the Mass. estate tax return (which must be filed if the first-dying spouse’s estate exceeds $1,000,000) requires that a version of the US estate tax return be prepared and submitted to the Mass. Department of Revenue. Since much of the work will already be done simply to comply with Mass. law, it should not be much of a stretch to do the extra work needed to qualify the surviving spouse’s estate for US portability.
A Chance to Focus on What Really Matters: The very considerable easing of the threat of US estate tax will allow people to focus more thoughtfully, and perhaps with better results (because not so tax-motivated), on what estate planning is supposed to be about – a final and tangible expression of love and care for family, friends, and sometimes for institutions that do good in the world.
At its heart, estate planning hammers out the often hard answers to questions like – Who gets what? When? In what manner? Who should care for minor children? Who should be in charge of managing the estate? How to protect beneficiaries from their own imprudence? How to protect the assets of beneficiaries with special needs? How to protect the assets of beneficiaries from creditors? What to do about family homes and vacation homes? What to do about the family business? How to balance the inheritances of children working in the family business with children who are not? Who should, and who should not, get to look at personal email accounts? Should a grandchild conceived years after her parent’s death inherit with other grandchildren? And, many more.
Why Did the Title of this Article End With “Maybe”? The US government will lose a lot of revenue by making the exemptions permanent at $5,250,000, indexing the exemptions for inflation, and making “portability” permanent. Congress’ Joint Committee On Taxation has estimated that these changes will cost the Treasury some $396 billion in lost revenue over the next ten years.
Meanwhile, the “Fiscal Cliff” has not been completely avoided. The political conflict now seems to be focusing on reducing, preserving or perhaps increasing discretionary budget expenditures. In order to preserve or even increase politically preferred discretionary expenditures (like defense spending) Congress may need to find more revenue.
On its face, it seems that the estate, gift and generation skipping transfer taxes are off the bargaining table. Perhaps they are. But, even if they are, exempting 98% of all individuals and their estates from US estate, gift and GST taxes may only be the prelude to installing something like the Canadian tax system. But, to understand the Canadian system, let’s first take a detour to discuss “basis”.
“Basis” is what a taxpayer has paid to buy an asset. If the taxpayer later sells the asset the taxpayer has taxable gain (or some form of loss) depending upon whether the sale price is greater than, or less than, the taxpayer’s basis in the asset. Under the US tax system, when a person dies his or her basis in an asset owned at death changes to whatever is the asset’s market value at date of death (or, in some cases, six months after death). Historically, this has usually produced an asset basis that is greater than what the person paid for the asset. As a result, the US basis system has been given the nickname “basis step-up at death”.
In Canada there are no estate, gift or GST taxes. Instead, there is an enhanced income tax. At death, a person’s assets are considered to have been sold, and the difference between date of death market value and what the decedent originally paid for the assets (the decedent’s pre-death basis) is subject to an income tax paid by the estate or the heirs. (This is sometimes called “carryover basis at death”).
The US has never implemented “carryover basis at death”. But it could, if Congress wanted to badly enough. It’s not unreasonable to imagine that Congress – having gone 98% down the road towards a Canadian-type system – might, in seeking additional revenue, institute some form of “carryover basis at death”. Technically, that would not renege on the estate, gift and GST tax changes made by the new Tax Act – but it would find more revenue. It’s something to keep an eye on.
This Article is intended only to provide generalized information. It is not intended to provide information or advice with respect to specific situations. To address real life, specific situations you should obtain appropriate professional assistance.
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