This article is part of a series on the American Taxpayer Relief Act of 2012 (ATRA) and how it affects estate planning in 2013 and beyond.
Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA)
The Internal Revenue Code gives each person an exemption from the so-called transfer taxes—the Federal estate, gift, and GST taxes. This exemption is known as the applicable exclusion amount and represents the value that a person can leave to others free of transfer taxes. The applicable exclusion amount has fluctuated over time and been set at different amounts for the different types transfer taxes.
Historically, the Internal Revenue Code had a simple rule about basis of property inherited from a decedent: As long as a person held an asset until death, the basis of the asset was “stepped up” to the asset’s fair market value at the date of death. This allowed the recipient to sell the asset without paying tax on appreciation that accrued during the decedent’s lifetime.
EGTRRA changed these rules. It gradually raised the applicable exclusion amount from 2001 to 2009 and, in 2010, repealed the estate tax altogether. But it also repealed the unlimited basis step-up that existed under prior law. Under EGTRRA, those who inherit assets from a decedent who died in 2010 take a basis equal to the lesser of the decedent’s adjusted basis or the fair market value on decedent’s date of death. Because those who inherit property from the decedent usually take the decedent’s basis in the asset (carryover basis), the appreciation that is built in to the asset when it is transferred will eventually be taxed when the asset is sold.
For political reasons, Congress provided that EGTRRA would sunset on December 31, 2010. At that time, the applicable exclusion amount would return to $1 million and the estate tax rates would go up to 55 percent, a prospect that neither the Republicans nor the Democrats were happy with. This sunset provision put Congress under pressure to either extend EGTRRA or come up with a new law before the end of 2010. (Note: for a more comprehensive discussion, see our prior article on Estate Planning in 2010).
As we neared the end of 2010, it looked like Congress would not reach a solution by the end of the year. But early December saw a flurry of legislative activity. On December 2, 2010, Senator Max Baucus (D-MT) introduced a bill that reinstated the estate tax with a $3.5 million exemption and a 45 percent tax rate, a proposal that was unacceptable to Republican leaders. On December 6, President Obama announced a compromise with Republican leaders to extend the Bush tax cuts for two years and reinstate the estate tax with a $5 million exemption and a 35 percent tax rate. The text of TRA 2010 was released on December 9. It was eventually passed by both the House and the Senate and signed into law by President Obama on December 17, 2010.
Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRA 2010)
TRA 2010 was not a new law as much as an extension and revision of EGTRRA, with three important changes:
- Reinstatement of Estate Tax and Repeal of Carryover Basis – TRA 2010 reinstated the estate tax and repealed carryover basis for decedents who die after December 31, 2009. Under the default rules, the estates of decedents who die in 2010 were subject to estate tax, but entitled to full basis step-up. But executors could opt out of the default rules, choosing instead to apply EGTRRA to the estates of decedents who die in 2010. This allowed executors to elect out of the estate tax, but at the cost of losing stepped-up basis.
- New Tax Rates and Unified Applicable Exclusion Amount – The exclusion amount was truly unified, meaning that the exclusion amount was the same for estate, gift, and GST taxes. And the exclusion amount was higher than it has ever been—$5 million. This allowed individuals to transfer up to $5 million in assets to the next generation free of estate tax, regardless of whether the transfer occurs during lifetime or at death. Transfers in excess of $5 million were taxed at the relatively low tax rate of 35 percent.
- Portability – Portability allows a surviving spouse to use a predeceased spouse’s unused applicable exclusion amount, effectively doubling the amount that a married couple can pass to their beneficiaries free of tax. See Portability Under the New Estate Tax Law for a more detailed explanation.
TRA 2010 extended the sunset of EGTRRA for two years by replacing “December 31, 2010” with “December 31, 2012.” The provisions of EGTRRA that were set to expire at the end of 2010 will now expire at the end of 2012. This two-year extension made TRA 2010 part of the much-hyped “fiscal cliff.” Without Congressional action prior to December 31, 2012, both EGTRRA and TRA 2010 would have disappeared, leaving a $1 million applicable exclusion amount and tax rates of up to 55 percent.
American Taxpayer Relief Act of 2012 (ATRA)
President Obama signed the American Taxpayer Relief Act of 2012 (ATRA) on January 2, 2013. ATRA set the exemption for federal estate, gift, and generation-skipping transfer taxes at $5 million, indexed for inflation since 2011. For 2013, that means that taxpayers can pass $5.25 million ($10.5 for a married couple using credit shelter planning or portability) to the next generation free of all transfer taxes. But ATRA also raised the maximum estate tax rate from 35 percent to 40 percent.
Unlike its predecessors (EGTRRA and TRA 2010), ATRA is permanent. There is no automatic sunset provision that will cause ATRA to expire automatically if not extended. ATRA gives a much-needed reprieve from the uncertainty that has plagued estate and gift tax planning for the past decade.