How does the new estate tax work?

Chad Bice | December 22nd, 2010

Congress has finally gotten around to fixing the federal estate and gift tax, even if they are a full year late and have made only temporary rules for the next two years.  The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 revives the estate tax for 2010 and makes a number of other changes for 2011 and 2012.

The federal estate tax exemption is now $5 million for 2010-2012 and the maximum rate is 35 percent. This is up from $1 million and less than the 55 percent maximum rate that would have otherwise applied. This means that up to $5 million of assets can be transferred to non-spouse beneficiaries federal estate tax free. There is no limit on transfers to spouses. The gift tax has also been unified with the estate tax exemption at $5 million.  Think of the estate and gift tax exemptions as a single pool of money and assets that you can transfer tax-free while you are alive or at death. Previously, you could only gift $1 million during life and then another $2.5 million at death (the 2009 rules had a $3.5 million total exemption). Now, whether you gift $5 million of assets during life or at death makes no difference in tax liability.

The new law also addresses the issue of a spouse who dies without using his or her full estate tax exemption due to faulty planning or reasons.  It provides an election on the estate tax return of the first spouse to die to allow the surviving spouse to use the unused portion of the estate tax exemption when they die. For example, if a husband dies and has a $3 million estate, he can give his spouse the extra $2 million exemption to use on her eventual estate tax return, meaning she’ll have a total of $7 million in exemption.  There are also special rules in place to resolve the estate situation of remarriage by a widower.

The “step-up in basis” rules have been reinstated for 2010-2012.  This means that when beneficiaries receive estate assets, it’s as if they paid whatever the fair market price was at the date of death.  Under the old 2010 rules for moderate to large estates, beneficiaries could only use the value the decedent paid for the item whenever they had bought it (e.g. Microsoft stock they bought back when it was $1/share), not the fair market value at the date of death.  Under the old 2010 rules, this meant that if a beneficiary wanted to sell the item they received from an estate, they would likely have a large capital gain on the sale on which they would have a tax liability. 

Because in many situations the new rules come out better for decedents and beneficiaries (even with an estate tax being imposed), Congress has provided an election to use the old 2010 rules (no estate tax, but no step-up) or the new rules (estate tax, but including step-up) for estates created in 2010.  Since Congress did this at the last minute, legislators have also provided extended deadlines to file and pay returns for estates created in 2010 so that tax professionals can better assist beneficiaries and decedents. 

Here are some tips for making the new provisions work for you:

  • With the changes to the gift tax rules, you can now gift more assets during life tax-free (so your children can enjoy some of their inheritance now, when you are around to see it).
  • Get your will updated! Several of these changes impact traditional planning techniques such as A/B trusts and may cause unexpected results if you should die in the next two years.
  • If you are the executor of an estate for 2010 or one of your family members has died in 2010, ensure that the professional doing the tax work for the estate explores both options for the 2010 rules.

Whether an estate was created in 2010 or you are doing estate planning for the future, your accounting professional can help you sort through the new estate tax provisions and help you determine which treatment will be most beneficial for you.

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