This story was first published in Registered Rep. sister publication Trusts & Estates.

On Dec. 17, 2010, the President signed into law changes in the tax laws for calendar years 2011 and 2012 that: (1) increase and reunify the federal estate and gift tax exemption to $5 million per person, (2) increase the generation-skipping transfer (GST) tax exemption to $5 million per person, (3) reduce the top estate, gift and GST tax rates to 35 percent, (4) extend the Bush-era individual income tax rates, and (5) create portability of the unused estate tax exemption amount for spouses. These and other changes (not discussed in this overview) have long- and short-term consequences that clients and their advisors should consider. Here’s a general overview of some the issues that should be discussed.

Estate Tax Exemption Increase


The estate tax exemption increase has the obvious benefit of excluding a significant amount of assets from federal estate tax, especially for a married couple taking advantage of each person’s exemption. There may be unintended consequences, however, to a taxpayer utilizing the $5 million exemption. Notably, there may be a significant disparity between a particular state’s estate tax exemption (for example, $1 million in New York) that could trigger or accelerate a state estate tax for a non-marital disposition on the difference between the federal $5 million and the state’s exemption amount on the death of the first spouse.

Also, many clients executed testamentary documents with formula clauses based on the largest amount that can pass free of estate tax with the presumption that a trust would be funded with $3.5 million (or lesser amount), rather than $5 million. The increase in the exemption may necessitate revising the document to create a lower ceiling than $5 million, or alternatively, changing the dispositive provisions of the trust to include or exclude beneficiaries or change the mandatory or discretionary distributions.

GST Tax Exemption


The GST tax exemption will increase to the estate tax exemption amount. This increase provides additional benefit and flexibility to pass property to skip persons during the transferor’s life or at death. The exemption increase may reduce the chances of an inadvertent GST taxable transfer. The exemption increase, which allows for more transfer tax opportunities for skip persons, may reduce legacies to non-skip persons if a formula clause in a trust (or outright dispositive provision) is used to pass the largest amount that can pass free of GST tax to skip persons. Therefore, clients may decide to put a ceiling on any formula clause. Alternatively, clients may include non-skip persons as beneficiaries or liberalize provisions for distributions to non-skip persons who are beneficiaries of a GST tax-exempt trust.

Estate, Gift and GST Taxes

The reduction in rates reduces overall estate, gift and GST taxes and allows more assets to pass to non-charitable beneficiaries. The reduction in the rates (and likely increase in bequest amounts) may be a factor in reevaluating dispositive plans. Also, even with the disparity between the tax-inclusive nature of the estate tax and tax-exclusive nature of the gift tax, a client may be less-inclined to make taxable gifts during lifetime with the increased estate and gift exemption amounts and step-up in basis at death.

In addition, those taxpayers who were considering accelerating gifts in 2010 to take advantage of a reduced gift tax rate may no longer feel compelled to make a taxable gift in 2010 and may decide to wait because the gift tax exemption amount will be increased to $5 million. With the increase in the gift tax exemption amount, clients can be more proactive in initiating gift plans or revising existing plans. The likelihood of gifts resulting in gift taxes will be significantly reduced.

Income and Deductions

In anticipation of increased tax rates in 2011, many tax advisors suggested to clients that they consider accelerating receipt of income in 2010 and deferring deductions until 2011. If all other factors are equal, assuming sufficient time to act before the end of the year, clients may now choose to defer receipt of income to 2011 and accelerate taking deductions in 2010. In addition, clients may have consulted with their tax and investment advisors to discuss tax loss harvesting for gains and losses on their investment income. While the primary consideration for tax loss harvesting is offsetting gains and losses from investment income in a particular tax year, a secondary consideration in the decision-making process may be tax rates. Clients’ advisors can focus on offsetting gains and losses now that income tax rates are expected to remain the same in 2010, 2011 and 2012.

Portability

The new law will provide for the executor of a deceased spouse’s estate to transfer unused exemption, if any, to the surviving spouse. This provision can obviate the need for a particular client to use a credit shelter trust, re-title assets or accelerate state estate taxes at the first death (for those who want to take advantage of the full federal estate tax exemption). As with all the provisions, the caveat is that the law is effective for calendar years 2011 and 2012.

Asset Allocation

Clients who were expecting to factor in rising income tax rates (ordinary income, capital gains and dividend income) for asset allocation purposes may decide to reevaluate future investment decisions. Keeping the income tax rates the same as in 2010 may encourage investing in asset classes that provide for tax preferential treatment, such as qualified dividend income versus taxable interest income and long-term equities versus fixed income. Of course, tax considerations are only one factor in a sound investment strategy.


Disclaimer: Asset Allocation cannot eliminate the risk of fluctuating prices and uncertain returns. All asset classes are not suitable for all investors. Each investor should select the asset classes for them based on their goals, time horizon and risk tolerance. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

This article is designed to provide general information about ideas and strategies. It is for discussion purposes only since the availability and effectiveness of any strategy are dependent upon your individual facts and circumstances. Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate-planning strategy. The content represents thoughts of the author and does not necessarily represent the position of Bank of America. U.S. Trust Bank of America Private Wealth Management operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A. Member FDIC.

IRS Circular 230 Disclosure: Pursuant to IRS Regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding IRS tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.