Estate and Gift Tax 2012....Reunited, and It Feels So Good

The impact of the 2010 Tax Relief Act passed on December 17, 2010 with respect to estate taxes is significant. In 2010, there was no estate tax. What this meant, quite literally, is that any estate of any size could pass without any estate tax. The downside to this absence of tax is the corresponding absence of an increase of basis. What this means is that inheritances received from decedents’ estates in 2010 (with limited exceptions) received carryover basis instead of stepped up basis.

Basis is another term for “starting point” in tax lingo. What it means for the taxpayer is what a thing was worth when that thing was acquired by the taxpayer. For example, if you paid $10 for a widget in 2010, your basis is $10 (obviously, this is a simplified example). A carryover basis is a basis that “carries over” from the prior owner (in this discussion, the decedent). The new owner (beneficiary or heir) just gets the decedent’s basis. Basis goes up when taxes are “paid.” So, when no taxes are paid as in 2010 estates, the basis “carries over” with no change.

In estates where taxes are “paid” either by literal payment or by use of the exemption equivalent, basis goes up because taxes have been paid. This is called a “stepped up” basis. For example, an estate in 2011 with $4.0 million in assets will distribute to the beneficiaries tax free (the exemption equivalent is $5.0 million). The beneficiaries will receive a stepped up basis of $4.0 million.

The effect of receiving a carryover basis as opposed to a stepped up basis is felt by the recipient when the recipient liquidates the asset and has to pay income tax based on the presumably lower carry over basis (resulting in a much higher gain and therefore, much bigger tax). While in 2010 there was a $1 million dollar basis allocation allowed, otherwise your basis remained the same and while there was no estate tax, there was certainly anticipated future income tax on a much larger portion of the appreciation in the asset.

For 2011 and 2012, the exemption equivalent is 5 million dollars per person. The exemption equivalent is portable between spouses as long as the surviving spouse does not remarry. Thus, for couples having estates worth a combined net of $10 million or less, so long as the surviving spouse does not remarry, there is no estate tax at the death of either spouse. In addition, the recipient of the assets receives a stepped up basis in value which thereafter results in lower income taxes on a subsequent sale of the assets.

The “portability” aspect of the exemption equivalent between spouses is a major improvement in the estate tax code. In addition, gift and estate tax is unified again which means that an individual may either leave an estate of $5 million or during their lifetime give away up to 5 million dollars in assets, without incurring any tax. This is in addition to any gifts which qualify for the annual exclusion. The annual exclusion for 2011 and 2012 is $13,000, thereafter, the annual exclusion is tied to inflation and set to increase annually.

Lastly, for estates of individuals dying in 2010, a provision was included which allows the estate to elect to be treated under the 2011 tax code. This is beneficial for estates between $1 million dollars and $5 million dollars since the 2011 tax code will provide a stepped-up basis for all of the assets (whereas the 2010 tax code would provide a stepped-up basis for only the first $1 million in assets). The law is in effect until December 31, 2012. Thereafter the law reverts to year 2000 law with an exemption equivalent of $1,000,000.

This is a good example of why it is important to review your estate plan every two to three years: the laws change very frequently and not always to your advantage.

Julie

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