The 2010 Tax Relief Act does more than reduce income taxes; it also provides favorable provisions that affect estate planning

The 2010 Tax Relief Act establishes a new (but temporary) estate and gift tax regime for 2011 and 2012. It also clarifies the situation for the estates of individuals who died in 2010. Here is a summary of the relevant provisions.

Exemption and Tax Rate. For estates of individuals who die in 2011 or 2012, the federal estate tax exemption is $5 million, and the tax rate is 35%. In 2012, the exemption amount may be increased by an inflation adjustment.

Deceased Spouse’s Unused Exemption Is Portable. Under the new law, unused federal estate tax exemptions of individuals who die in 2011 or 2012 are “portable,” which means they can be passed along to surviving spouses.

The Impact for Married Couples. Thanks to the portable estate tax exemption in conjunction with the unlimited marital deduction, the first spouse to die may leave everything to the surviving spouse without any federal estate tax bill (assuming the surviving spouse is a U.S. citizen and, thus, eligible for the unlimited marital deduction). The surviving spouse will then have two $5 million exemptions with which to work, for a total of $10 million (assuming the surviving spouse dies in 2011 or 2012).

Therefore, the surviving spouse can leave up to $10 million to his or her heirs (typically the couple’s children) without any federal estate tax bill (assuming the surviving spouse dies in 2011 or 2012).

In effect, the new portable estate tax exemption, in conjunction with the longstanding unlimited marital deduction, allows the first spouse to die to simply leave everything to the surviving spouse without losing his or her $5 million federal estate tax exemption. Because the deceased spouse’s unused exemption can be passed along to the surviving spouse, he or she effectively is given a $10 million federal estate tax shelter.

Before the new law, it was necessary to take tax planning steps such as (a) transferring assets between the spouses while they were alive, in order to equalize their respective estates or to make sure each spouse’s estate was worth at least the estate tax exemption amount; or (b) setting up credit shelter trusts to make sure that both spouses took advantage of the estate tax exemptions without shortchanging what the survivor inherited from the deceased spouse.

Such tax planning steps may no longer be necessary – if both spouses die in 2011 or 2012. But such steps might be necessary again in 2013 and beyond, because we don’t know what the rules will be then.

Inherited Capital Gain Assets. For heirs of decedents who die in 2011 and beyond, a familiar rule allows the federal income tax basis of inherited capital gain assets (such as real estate and stock) to be stepped up to reflect the date-of-death fair market value. Thanks to the reinstated unlimited basis step-up rule, heirs won’t owe federal capital gains taxes on asset appreciation that occurs through the date of death, as long as the date occurs after 2010.

Estate and Gift Tax Rules. For 2011 and 2012, the new law sets the lifetime federal gift tax exemption at $5 million (the 2012 amount will be indexed for inflation). Thus, the gift tax exemption is now equal to the estate tax exemption, which is a big improvement from the $1 million gift tax exemption that was available previously.

Therefore, an unmarried person can gift up to $5 million in 2011 and 2012 without owing any gift tax, and a married couple can gift up to $10 million. Those amounts are in addition to gifts that are already sheltered by the annual federal gift tax exclusion ($13,000 per gift recipient for 2011). To the extent a taxpayer makes gifts that utilize part of his or her $5 million federal gift tax exemption, the taxpayer’s $5 million federal estate tax exemption is reduced dollar for dollar. (Similarly, if a taxpayer had previously gifted some or all of the prior $1 million limit, the new $5 million exemption is reduced by the previously gifted amount.)

Clarity for Estates of 2010 Decedents. The new law establishes two options for the estates of individuals who died in 2010.

The estate tax is actually reinstated for 2010, with a $5 million exemption and a 35% tax rate. However, personal representatives have the option of electing out of the tax for 2010, in accordance with the repeal of the tax for that year.

If the election out is made, the modified carryover basis rules described in this article apply to heirs for income tax basis purposes. Thus, heirs of large estates can owe capital gains taxes on appreciation that occurs through the decedent’s date of death, but there will not be a federal estate tax bill.

If an election out is not made, the $5 million exemption and 35% rate apply for 2010, and the income tax basis of inherited assets equals the fair market value on the date of death. Thus, the familiar unlimited basis step-up rule applies if the election out is not made.

Conclusion. The new estate and gift tax rules are as taxpayer-friendly as one could have reasonably hoped, but they are in place for only two years.

If nothing gets done on the estate tax front, we will once again be facing a confiscatory estate tax for 2013 and beyond, with only a $1 million exemption and a maximum tax rate of 55%. Similarly, the gift tax exemption would fall back to only $1 million, and the top gift tax rate would jump to 55%.