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Temporary fix: Estate tax strategies for the next 2 years

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in Small Business Tax,Small Business Tax Deduction Strategies

The new tax law signed by the president on Dec. 17 finally resolves the uncertainty over federal estate taxes … at least for the time being.

Alert: The new law increases the estate-tax exemption and lowers the top estate tax rate for a two-year period. It also includes several other changes that will be beneficial for families of decedents who die in 2011 or 2012.

But the estate tax relief is only temporary. These changes are scheduled to “sunset” after 2012, so we’ll be facing uncertainty again in the near future.

Here’s the whole story: Prior to 2001, the estate-tax exemption could shelter only up to $675,000 of assets left to beneficiaries other than a surviving spouse. This exemption equivalent amount was gradually increased under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) until it topped out at $3.5 million in 2009. At the same time, the top estate tax rate declined from 55% to 45%.

The estate tax was completely repealed by EGTRRA, but only for decedents dying in 2010. Beginning in 2011, the estate tax was scheduled to be reinstated, with just a $1 million exemption and a top 55% estate tax rate. 

EGTRRA provided comparable changes for the generation-skipping tax (GST) affecting most transfers to grandchildren. It also severed the unified estate and gift tax system by locking in a $1 million lifetime gift tax exemption.

Finally, the rules allowing a step-up in basis on inherited assets were revised by EGTRRA for 2010. Heirs were required to “carry over” a decedent’s basis in property instead of receiving a step-up to the fair market value of the assets on the date of death. But two key modifications are allowed:

  1. The basis for qualified assets transferred to any beneficiaries may be increased by up to $1.3 million.
  2. The basis for qualified assets transferred to a spouse may be increased by another $3 million.

New estate tax relief

Under the new tax law, the estate tax exemption increases to $5 million, with a top estate tax rate of 35%. These figures will remain in effect through 2012.

The new law also replaces the modified carryover basis rules with the “step-up in basis” rules that existed prior to 2010.

New option: The executor of a decedent dying in 2010 can choose to use the new estate tax system in effect for 2011 or stick with the EGTRRA rules for 2010. In other words, you can elect to use the $5 million exemption and avoid carryover basis if it suits your family’s needs or they can go with the no-estate-tax option and live with the carryover basis rule for inherited assets.

Example: Your father died late in 2010 owning $4 million of assets with a basis of $1 million. You’re the sole beneficiary. By choosing the rules in effect for 2011, zero estate tax will be due (thanks to the $5 million exemption) and your basis in the inherited assets is stepped up to $4 million. If you then sell the assets for $4 million, you owe no federal income tax.

The new law also allows for “portability” of any estate tax exemption for decedents dying in 2011 or 2012. If a deceased spouse’s estate doesn’t use up the entire exemption, the remainder is available to the estate of the surviving spouse. Thus, the maximum $10 million in exemptions may benefit the heirs of a married couple, but only if both spouses die before 2013. This provision may encourage wealthy individuals to amend their existing trusts and wills.

For gifts made in 2010, there was a lifetime gift tax exemption of $1 million with a top tax rate of 35%. The estate and gift tax systems are “reunified” for transfers after 2010, with an exemption of $5 million and a top gift tax rate of 35%. Comparable changes were made to the GST.

Giving away property to reduce the size of your taxable estate remains a viable option. For 2011, you can give each recipient up to $13,000 without triggering any gift tax under the annual gift tax exclusion ($26,000 for joint gifts by a married couple).

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