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Navigating the Federal Estate Tax in 2011

Navigating the Federal Estate Tax in 2011

SML Perspectives
(March 8, 2011)

On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “Act”). Although the primary feature of this legislation is a two-year extension of the Bush-era income tax cuts, the Act also addresses the repeal of the estate tax for 2010 and its reinstatement in 2011. The legislation reenacts the estate tax for 2010 (but grants an option to elect back into the repeal) and provides generous estate and gift tax exemptions and rates for 2011 and 2012. Unfortunately, the Act is only a temporary measure — in 2013, the pre-2001 estate and gift tax provisions will return, with the potential to impose a much greater tax burden on estates and gifts.

The Act presents a number of planning opportunities and also requires that a number of existing estate plans be reconsidered. A few observations follow.

Estates of Decedents Who Died in 2010

The estates of those who died in 2010 faced considerable uncertainty prior to the passage of this legislation. A 2001 law repealed the estate tax for persons dying in 2010 but also imposed a carryover basis regime that generally required heirs to use the decedent’s tax basis, with some adjustments, for inherited property. Before 2010, inherited property had received a basis step-up at death. For some heirs, this 2010 requirement was a greater tax burden than would have been imposed by the estate tax. In addition, there was a risk that the estate tax would be retroactively reinstated for 2010.

Congress has now eliminated that uncertainty for 2010 estates. It has repealed carryover basis and reinstated the estate tax for 2010, but with a $5,000,000 exemption and a 35 percent tax rate. The new law also provides that estates of persons dying in 2010 can elect out of the estate tax, provided that they accept the carryover basis regime.

Estates of decedents who died in 2010 should carefully consider whether to accept the new default regime ($5,000,000 exemption; 35 percent tax rate) or to elect out of the estate tax and into the prior 2010 law (no estate tax; but with carryover basis). If the estate is less than $5,000,000, in most (but not all) cases it will be best to accept the application of the estate tax and thereby acquire a basis step-up in the assets. However, an analysis should still be undertaken to determine whether the heirs are better off with a stepped-up basis or the carryover basis regime. It is worth noting that, if the estate of a married decedent accepts the application of the estate tax in 2010, the portability provisions discussed below do not apply to the unused portion of the $5,000,000 exemption.

The estate tax return is normally due nine months after the date of death. In light of the special circumstances in 2010, the Act extends that filing date (as well as the payment date for the tax) for 2010 decedents to September 19, 2011.

The 2001 legislation also repealed the generation-skipping transfer tax (the “GST tax”), as discussed below, for 2010 only, but there was a lack of clarity as to the effect of that repeal. The recent Act should eliminate that uncertainty, because it provides that the GST tax was in effect in 2010, but with a zero percent tax rate. This means that any generation-skipping transfers that occurred in 2010 were tax-free, but that taxpayers could still take advantage of the various GST tax exemptions that could reduce or eliminate the tax in future years.

Estate and Gift Taxes in 2011, 2012 and Beyond

For decedents dying in 2011 and 2012, the Act greatly reduces the reach of the estate tax by granting estates a $5,000,000 exemption for property subject to the tax. In 2009, the last year in which there was an estate tax, the exemption was $3,500,000, so this is a significant increase. Estates that exceed the exemption threshold will be subject to a new 35 percent tax rate, which is a bit lower than the 45 percent rate that prevailed before 2010.

In addition, the Act introduces the concept of exemption “portability” between spouses. This means that if one spouse does not use all of his or her $5,000,000 exemption, the unused portion, with proper planning, apparently may be available to the estate of the surviving spouse. For example, if a husband dies in 2011 and his estate uses $2,000,000 of his $5,000,000 exemption, with proper planning the unused portion of the exemption ($3,000,000) may be added to the separate exemption of the wife when she later dies.

The gift tax burden also has been reduced. Since 2001, taxpayers have had only a $1,000,000 lifetime exemption for gift tax purposes. That exemption is increased to $5,000,000 ($10,000,000 for a couple) for gifts made in 2011 and 2012, and the tax rate on 2011 and 2012 gifts in excess of that amount is 35 percent.

In 2013, the estate and gift tax rules generally revert to a $1,000,000 gift and estate tax exemption and a 55 percent tax rate.

The Generation-Skipping Transfer Tax

The Act makes a number of changes to the GST tax, which, to simplify things a bit, is an additional tax imposed on gifts and bequests to or in trust for grandchildren and great-grandchildren.

Going forward, the Act aligns the GST tax with the reformed estate and gift taxes. In 2011 and 2012, the GST exemption is increased to $5,000,000 and the tax rate is 35 percent. In 2013, the GST tax, somewhat like the estate and gift taxes, will revert to a $1,000,000 exemption (but with an inflation adjustment) and a 55 percent tax rate.

Planning Opportunities and Observations

A Window of Opportunity for Gifts. The existence of the $5,000,000 gift tax exemption ($10,000,000 for a couple) for 2011 and 2012 presents a “window of opportunity” for the making of substantial gifts. This is particularly important inasmuch as there is no certainty whatsoever that an exemption of this size will exist after 2012. Gifts might be made outright to or in trust for children, grandchildren, or other descendants. An individual contemplating a sizeable gift might consider making the gift to a “grantor trust” so that income tax advantages may be achieved as well.

Credit Shelter Trusts. A great many estate plans follow the typical pattern of dividing a decedent’s estate into two portions. The first portion usually is equal to the amount of the estate tax exemption then available and is paid over to a trust. The trust which receives this portion is sometimes referred to as a “credit shelter trust” or a “Trust B.” The second portion typically consists of the balance of the decedent’s estate. This second portion is often referred to as the “marital share,” or “Share A.” This second portion will be for the benefit of the surviving spouse inasmuch as it will be the decedent’s wish that this portion qualify for the federal estate tax marital deduction. In many cases the decedent’s estate plan will have been prepared at a time when the estate tax exemption amount was far less than $5,000,000. Consequently, the allocation of up to $5,000,000 of assets to the credit shelter trust (if the decedent dies in 2011 or 2012) may completely distort the decedent’s intentions. These types of estate plans should be reviewed to determine whether they continue to be consistent with the decedent’s wishes.

Portability. A number of questions exist with respect to the idea of portability. If an individual dies in 2011 or 2012, theoretically the individual’s unused exemption amount is portable to the decedent’s spouse. However, if the decedent’s spouse dies after 2012, a current reading of the law would suggest that the surviving spouse’s estate cannot take advantage of the first spouse’s unused exemption inasmuch as the portability rules, under the Act, cease to exist after 2012. Hopefully this will be addressed by legislation this year or next year, but obviously a degree of uncertainty currently exists.

It should be noted that in many cases it still will be highly preferable to use a credit shelter trust arrangement rather than relying on portability. First, if assets are left in a credit shelter trust, all future growth of the assets within the trust should be sheltered from the estate tax. Under the portability rules, the unused exemption of the first spouse is not even indexed for inflation. Second, portability does not apply with respect to the GST exemption. For couples with large estates who wish for the credit shelter trust assets to be exempt from the GST tax, portability will be of limited usefulness. Third, the use of the credit shelter trust provides a number of nontax advantages, including potentially the protection of the trust assets from the claims of creditors of the beneficiaries and the protection of the trust assets from the claims of a spouse of a beneficiary (including a new spouse if the decedent’s spouse is a beneficiary and remarries).

The Basis of Assets. If the first spouse to die creates a credit shelter trust for the benefit of the surviving spouse, the assets held in the credit shelter trust, because they are not included in the surviving spouse’s estate for estate tax purposes, will not receive a stepped-up basis for income tax purposes upon the surviving spouse’s death. If the surviving spouse does not have an estate tax concern —which may be the case if, for example, the $5,000,000 estate tax exemption is available and that exemption would shelter all of the surviving spouse’s assets as well as the credit shelter trust assets—the estate of the surviving spouse may prefer that the trust assets be treated as a part of the surviving spouse’s estate for estate tax purposes so that the assets will receive a stepped-up basis. Proper planning and drafting with respect to the credit shelter trust arrangement perhaps can create the flexibility to allow these trust assets to be included in the surviving spouse’s estate, for estate tax purposes, if this appears to be the more appropriate alternative at the time of the surviving spouse’s death.

The Administration’s Budget Proposal

In February, 2011, the Obama Administration published its revenue proposals for the fiscal year 2012. Several of those proposals are worth commenting upon at this time.

First, the proposals seek to make portability permanent. If this becomes law, this would eliminate a bit of the uncertainty with respect to portability as mentioned above.

Second, the proposals seek to eliminate the ability to discount the value of an interest in a family controlled entity, such as a corporation or limited liability company, if the interest, either by gift or at death, passes to or for the benefit of other family members. It appears that these new rules would apply to transfers after the date of enactment. Proposals such as this have been made on a number of occasions in the past by both the Administration and members of Congress, but to date opposition to these types of proposals has prevented enactment. Whether this will continue to be the case remains to be seen.

Third, the Administration proposes that assets held in a multigenerational trust which under current law would be exempt from the GST tax (as a consequence of the allocation of GST exemption) will no longer be exempt after 90 years. In other words, upon the 90th anniversary, the GST exemption applicable to the assets of the trust would terminate. In one sense, this is an effort to restrict the tax advantages that over recent years have been achieved as a consequence of many states’ changing their laws to allow trusts to continue to exist in perpetuity. Inasmuch as this proposal presumably would generate no additional taxes for 90 years, generally speaking, one must wonder how much interest will exist to implement this type of law.

Fourth, consistent with prior proposals, it is again being proposed that a grantor retained annuity trust (“GRAT”) have a minimum term of ten years. Inasmuch as the creator of a GRAT generally needs to survive the term of the GRAT in order to assure that the GRAT assets will not be included in the creator’s estate for estate tax purposes, presumably this would make GRATs far less desirable. This proposal would apply to GRATs created after the date of enactment.


The old saying that the more things change the more they stay the same seems to apply to the estate, gift, and GST tax laws. The laws constantly change, but uncertainty and the lack of permanency stay the same. Nevertheless, the changes made by the Act do provide a very meaningful window of opportunity for some types of planning, such as substantial gifts in 2011 and 2012, and also suggest that a number of estate plans need to be reviewed to ensure that they are still consistent with the client’s wishes and still maintain adequate flexibility.

Click here to view the full digital version of the The Boomers & Beyond edition of SML Perspectives.

William L. Dennis
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