A huge dose of holiday cheer arrived December 17 for high-net-worth clients, including one of Jonathan Bergman's. That's when the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 was signed into law, and it provided a $4 million increase in the exemption from gift taxes, to $5 million per person, starting January 1, 2011.
Bergman's client had been planning to make a large taxable gift at the end of 2010. The client and his wife were willing to pay the 35% tax in effect at the time because by historical standards, that's a pretty low transfer-tax rate, Bergman explains. But with the change in the law, the transaction was put on hold until January. "Now they are making an $8 million gift at 0% tax," beams Bergman, vice president at Palisades Hudson Financial Group, Scarsdale, N.Y.
The popular press may be chirping about the new law's preservation of the Bush income tax cuts (e.g., a 35% top ordinary rate and the taxation of qualified dividends as long-term capital gains) but it is the act's transfer tax changes that have advisors atwitter. "Significant" and "generous" are how practitioners have hailed the new rules, and there's giddy talk of "amnesty" from the troika of transfer taxes-gift, estate and generation-skipping. Washington's largesse took the planning community a little by surprise. But there is a devastating wrinkle.
"Two more years! Two more years!" could be the Official Shout of the law whose name doesn't yield an easy-to-pronounce acronym. The 2010 Tax Relief Act, as it's being called, sunsets at the end of 2012, with some rules expiring this year. After 2012, Clinton-era tax rates and rules return just as they would have had 2001's Economic Growth and Tax Relief Reconciliation Act been allowed to sunset.
Planners would prefer greater certainty, of course, but the $850 billion law's brief lifespan is no accident, says Terry Headley, president of the Washington, D.C.-based trade group NAIFA, the National Association of Insurance and Financial Advisors. It is intended to buy the politicos time. "Both sides want this to be a political issue in the 2012 election," says Headley.
Gift And Estate Tax Changes
Through 2012, the gift and estate taxes are reunified with an exemption from each of $5 million per person (to be indexed next year), although any gift tax exemption used by the client while alive reduces his $5 million exemption from estate tax at death. Transfers above the exemption are taxed at 35%.
Now that the tax code treats life- and death-time transfers equally, lifetime gifts are preferable, according to Bergman. "It's better to pay gift tax because it is paid with non-gift assets. Paying estate tax is less favorable because the tax payment comes out of the gross estate, which was just taxed. The gift tax is tax-exclusive while the estate tax is tax-inclusive," Bergman says.
He argues that extremely wealthy clients who seem likely to owe estate tax under any scenario short of the death tax's repeal should consider gifting beyond each spouse's $5 million tax-free amount. Indeed, an increase in large lifetime gifts is widely expected around the profession. Dynasty trusts will be popular, observers predict.
Another new rule is spousal sharing of each other's unused estate tax exemption, notes Tom Kelley, a senior financial planner at Wilmington Trust in Baltimore. To illustrate portability, suppose the husband passes first having used only $4 million of his $5 million exemption. In that case, his widow can add $1 million to her unused exemption.
Portability helps the couple utilize their combined $10 million in exemptions, although the rules have to be followed carefully, Kelley cautions. Because the Tax Relief Act expires at the end of 2012, both spouses would have to die this year or next to take advantage of portability. An estate tax return must be filed at the first death to establish the unused exemption that is carrying over to the survivor.
The myriad changes and opportunities mean estate plans should be reviewed to see how they'll function under the new, albeit temporary, rules, says John Przybylski, director of financial planning at Boston's Federal Street Advisors. Tell clients that, absent congressional action, in 2013 the exemptions will decrease and tax rates increase-and that if Congress does act, who knows what the result might be? "You have to take advantage of opportunities while you can," Przybylski advises.
But saving taxes isn't everything, warns Thayer Willis, a wealth counselor and author on inheritors' issues in Lake Oswego, Ore. "This is a time to highlight to the client the potentially negative effects of transferring wealth on younger family members' well-being," Willis says.
The new law also looks backward. It clarifies (finally) the tax treatment of 2010 deaths. There are two options, explains Wilmington Trust's Kelley. One is to use the Tax Relief Act's $5 million exemption and 35% tax rate and pass the assets to the heirs with basis stepped up to current market value. Or the estate can elect EGTRRA's rules for 2010: no estate tax with a modified carryover basis regime, i.e., heirs assume the decedent's basis and holding period in assets.
Estate tax returns for 2010 deaths occurring prior to the law's enactment are due nine months from the enactment date.
Income Tax Issues
CPA/planner Gerald Townsend says estimated taxes will be easier to manage in 2011 because the Tax Relief Act has already extended to this year certain breaks that are prone to expiring. The most notable is 2011's bounteous exemption from the alternative minimum tax-$74,450 for joint filers, $48,450 for single taxpayers. There's no need to count on a late-year extenders bill that might never materialize.
Beyond that, there isn't much change to individual income tax planning, inasmuch as the legislation primarily maintained existing rules. "We'll just continue what we've been doing the last several years," says Townsend, who is president of Townsend Asset Management in Raleigh, N.C.
For instance, this year his beneficent clients can again make qualified charitable distributions from their IRAs. And through 2012, Townsend will be taking advantage of the 0% tax on long-term capital gains and qualified dividends for his clients in the lower brackets (joint filers with 2011 taxable income of $69,000 or less and single taxpayers with $34,500 or less). For these clients, given today's low interest rates, it's really worth considering stocks or funds that generate qualified dividends, says Townsend. "If you can pick up a 5% dividend and pay zero federal tax, that's pretty nice."
The continuation of modest tax rates through 2012 means Roth conversions are attractive, especially since the client can recharacterize if the result proves to be unsatisfactory, observes CPA Robert Keebler, a partner at Keebler & Associates LLP, in Green Bay, Wis. The full amount of the conversion must be reported in the year it takes place. Before acting, ascertain whether any state income tax owed on the conversion will cause the client to pay AMT, Keebler says.
Business owners' eyes may pop over the full, immediate deduction for equipment they purchase this year. Therefore, says Townsend, remind them, "It does no good to buy something just for a write-off. Make sure the business needs it."
Earnings Tax Tweak
Paychecks are already reflecting this year's 2% decrease in Social Security tax for workers and self-employed individuals, a provision intended to spur consumer spending and, hence, the economy. There is no corresponding decrease to the employer's portion of this tax; it stands at 6.2%. Self-employed clients remain entitled to an above-the-line deduction for the equivalent of the employer's portion. The tax applies to the first $106,800 of wages and net self-employment income in 2011.
Income Tax Breaks For Clients
The 2010 Tax Relief Act reinstated numerous individual and business income tax benefits that expired December 31, 2009. It extended others that were scheduled to expire after 2010 and created a few new breaks, too. Here's when clients can take advantage of some of them:
2010 through 2012
35% maximum ordinary tax rate
15% long-term capital gains rate* (0% for taxpayers in the lowest brackets)
Taxation of qualified dividends as long-term capital gains
No limitation on total itemized deductions for high-income taxpayers
No phase-out of personal exemptions for high-income taxpayers
American Opportunity tax credit of up to $2,500
Child tax credit of up to $1,000
2010 and 2011 only
Qualified charitable distributions of up to $100,000 from individual
Option to itemize state and local sales taxes instead of income taxes
Above-the-line deduction for tuition and fees
Above-the-line deduction for educators' classroom expenses
Research tax credit for businesses
100% first-year depreciation for investments in qualifying new business property**
Fifteen-year straight-line depreciation for qualified leasehold, restaurant and retail improvements
* higher rate applies to gains on collectibles
** for investments in property after September 8, 2010