In light of the recent changes to the tax code, today we're turning our blog over to Victor Adefuye, a lawyer and financial planner, to help us better understand what exactly changed in terms of the estate tax and related estate planning taxes in the fiscal cliff compromise.
It’s January 4, 2013, and by all accounts, we’ve survived the Mayan Apocalypse and, even more scary in some circles, the dreaded "fiscal cliff." The sudden and drastic increases in taxes and spending cuts that were supposed to strike as the ball dropped on January 1, 2013 were narrowly averted by last-minute negotiations and palace intrigue, as both houses of Congress overwhelmingly passed into law a compromise bill that preserved current tax rates for most Americans, with some small exceptions. We can all breathe a little easier today.
A brief history of the estate tax from 2000-2012
Despite all the talk about the appropriate income tax rates for the “wealthy,” few areas of the fiscal cliff debate drew more attention from financial advisors and attorneys than the anticipated changes to estate and gift tax laws. In 2001, under the changes to the tax code popularly known as the “Bush Tax Cuts,” the estate and gift tax exemption amount was raised over the subsequent 10 years from about $700,000 in 2001 to $3.5M in 2009. This meant that individuals who died in 2009 could pass property valued at $3.5M to their heirs without paying any estate tax. Over this period, the highest rate was lowered from 55% to 35%. The Bush Tax Cuts also abolished the estate tax entirely in 2010, so for those families who had wealthy family members die in 2010, their estates avoided paying any estate tax.
Congress didn’t allow this situation to go on for long, so in 2011, the gift tax was reinstated at a maximum rate of 35%, and an exemption amount of $5M, subject to inflation. By 2012, the exemption amount had increased to $5.12M. A married couple could give away twice that amount, either at death or during their lifetimes as gifts. Any gifts or bequests valued above this exemption amount were subject to the 35% rate.
What was at stake in the fiscal cliff
So this is where we found ourselves on the evening of December 31, 2012. However, the Bush Tax Cuts and subsequent extensions were intentionally designed to expire, including the estate and gift tax provisions. On January 1, 2013, the basic exclusion amount was set to drop down to back down to $1M and the estate and gift tax rate was supposed to rise to a whopping 55%, amounts not seen since 2001. Financial advisors and estate planning attorneys around the country were striking fear into the hearts of existing clients and potential clients, demanding that they review their estate plans and give away as much as possible—to trusts, charities or as outright gifts—to take advantage of the higher exemption amounts before they expired. But alas, it appears all that anxiety was for naught. The law passed by Congress this week prevented the “worst-case scenario” from happening. In fact, the estate tax law largely remains the same as it was last week.
The current state of estate planning taxes
Here are summaries of the some of the new—or not so new—provisions:
• Estate and Gift Tax Exemption. The estate tax will continue to exclude property valued in the range of about $5M, indexed annually for inflation. In 2013, the exemption will be $5.25 million. This same amount will apply to the gift tax, which means that over his or her lifetime, an individual can give cumulative gifts valued up to $5.25M without having to pay the gift tax. A married couple may give away a total of $10.5 million, either during life or at death. Unlike with the Bush Tax Cuts, this exemption amount is permanent and is not set to automatically expire.
• Generation Skipping Tax Exemption. The generation skipping transfer tax (GST) is similar to the gift and estate tax, but applied to transfers to family members at least one generation away, like grandchildren (or for those unrelated, 37.5 years younger than the donor). Notably, the GST tax is paid in addition to any or gift taxes paid, so, for example, in 2012, any amounts remaining after payment of the 35% gift tax would have been subject to an additional 35% GST. The bill passed by Congress this week left the GST exemption amount the same as the estate and gift tax exemption, and also indexed for inflation and permanent. So, in 2013 just as in 2012, an individual can pass $5.25M and couple can pass $10.5 million in a generation skipping trust or by direct gifts to grandchildren without being subject to the GST tax.
• Tax Rates. The estate, gift and GST tax rates will be 40%, instead of the current 35%. This is the only change between the law now and the law as it was in 2012.
• Marital Exemption and Portability. The marital exemption—where one spouse can transfer unlimited amounts of property by gift or bequest to a citizen spouse without being subject to gift or estate tax—remains unaffected by the new law. Additionally, the rules enacted in 2010 regarding portability, which allowed the transfer of a deceased spouse’s unused exemption amount to a surviving spouse, were left unchanged and has been made permanent.
• Gift Tax Annual Exclusions. In 2013 the annual exclusion amount will increase to $14,000, slightly higher than the $13,000 allowed in 2012. This means that an individual can transfer property valued at $14,000 annually to anyone he or she wishes as a gift, without having to pay gift tax.
So it turns out all the fear and concern about the drastic changes in the estate tax law was overblown. Unfortunately it took until the final hours of 2012 to get such clarity. The uncertainty was great for financial advisors and attorneys who wanted to encourage clients to do some much-needed planning. For the rest of the country, the uncertainty was considerably less enjoyable, particularly with respect to the questions of income and investment taxes.
Victor A. Adefuye, JD, is a graduate of Duke University and George Washington Law School. He practiced law for four years before becoming a financial representative with the Nemec Financial Group of Northwestern Mutual. His financial planning practice focuses on risk management, estate planning, and investments.