The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Act) created a major change that came as a surprise to many observers: the “reunification” of the federal gift and estate tax systems. Since 2002, the gift and estate tax exemption amounts had been “decoupled.” This meant, for example, that in 2009, the $1 million an individual could give to others free of tax during his lifetime was significantly less than the $3.5 million that could be transferred tax-free at death.

The 2010 Act brought the two systems back into alignment. It's now possible to give up to $5 million tax-free to others during lifetime or at death. If a decedent has used the $5 million exemption during his lifetime, no additional exemption is available at death. Under new portability provisions, however, a spouse may be entitled to use any of a predeceased spouse's unused exemption without the use of trusts or other special planning.

The large increase in the gift tax exemption can be expected to have a major impact on estate and financial planning over the next two years and perhaps beyond, especially with regard to philanthropic transfers.

Window of Opportunity?

It's important to note that the changes Congress made to estate and gift tax laws aren't permanent. The adjustments to the estate tax rates and exemptions are definite only for individuals who pass away on or before Dec. 31, 2012. So, the planning opportunities surrounding the increased exemption at death are relatively limited unless one “plans” to die before the sunset provisions take place and much higher estate and gift taxes imposed under 2001 exemptions and rates return. But, immediate opportunities for estate and gift planning spring from the reunification of the estate and gift tax systems.

Recall that it's possible to transfer up to $5 million free of gift tax over the two-year period the provisions of the 2010 Act are in place. A person who has already transferred $1 million under the prior gift tax exemption available through 2009 will be able to transfer an additional $4 million. A couple who have already transferred $1 million each could together transfer an additional $8 million.

Wealthier individuals now have an opportunity for what may be a limited time period to permanently remove assets from their estates. Should Congress raise the estate and gift rates or exemptions in the future, assets will already have been transferred and most would agree it's highly unlikely that Congress would attempt to retroactively tax transfers made during the 2011-2012 window.

Those charitably inclined may wish to make philanthropic transfers in ways that meet personal objectives while also making significant charitable gifts. For example, experienced planners know that individuals may sometimes wish to fund a split-interest gift such as a charitable remainder trust to benefit a loved one other than a spouse for life or a period of years. They will sometimes fail to follow through, however, when informed there could be gift tax due on the value of the income interest.

In the case of a $500,000 charitable gift annuity for the benefit of a 75-year-old sister, for example, a donor would not only enjoy a $190,000 charitable income tax deduction, but also make a taxable gift to his sister of the income interest valued at $310,000. This could give rise to a gift tax liability of over $100,000. If the donor has already used the $1 million gift tax exemption amount available through 2009, he'll be pleased to learn he now has an additional $4 million available to offset such gifts completed during his lifetime.

The 2010 Act may also change the way people handle the potential taxable gift element when structuring gifts that benefit individuals other than the donor or his spouse. It has become common for donors to retain the right to revoke by will a successor income recipient's right to receive income to avoid triggering a taxable gift at the time the gift is funded.

Over the next two years, some may choose to omit a right of revocation to “lock in” a taxable gift, thereby making it possible to use a portion of the new exemption while it's available.

Individuals who would like to transfer more than the $5 million lifetime exemption amount may find a charitable lead trust (CLT) funded during the 2011-2012 tax exemption window to be an attractive alternative.

For example, if a donor funds a $10 million charitable lead annuity trust paying 5.7 percent for 10 years, he will be making a $5.7 million charitable gift at the rate of $570,000 per year over 10 years. The charitable gift tax deduction under the January 2011 applicable federal midterm rate of 2.4 percent would be $5 million, leaving a taxable gift of $5 million that would be offset by his $5 million gift tax exemption. Historically low discount rates continue to make this option attractive from a financial standpoint as well.

The net result is to transfer the amount remaining in the trust to heirs free of gift and estate tax ($10 million if the trust earns enough to make the payments without encroaching corpus), after first making a $5.7 million gift to charity. If the trust should earn just 4 percent each year, the heirs would receive just under $8 million. If the trust regularly earned 7 percent, they could receive in excess of $11 million.

This will undoubtedly be one of the ways that some will choose to structure significant charitable transfers between now and Dec. 31, 2012, while the $5 million window of opportunity is open.

As an additional planning consideration, keep in mind that Congress also continued the favorable tax treatment for capital gains and qualified dividend income at least through 2012. This will add to the attraction of charitable remainder trusts and certain other plans that can distribute income in the form of capital gains or qualified dividends

In the case of CLTs, some may also choose to fund such trusts with appreciated assets, liquidate the assets inside the trusts at a 15 percent capital gains tax rate and diversify for greater growth that will ultimately pass tax free to heirs without a 35 percent estate or gift tax.

When the Dust Settles

Looking to the future, we can expect those who can afford to transfer the maximum amounts permissible to heirs during the next two years to do so. Those individuals will still have significant remaining assets in most, if not all cases. As a result, when they pass away they won't have any unified credit left to shield their remaining estate from tax.

That means the first dollar left in their estate will be subject to tax at 35 percent (or whatever the rate may be). This will provide a greater incentive for some to make charitable dispositions at death or fund split-interest gifts that result in additional income and tax benefits during their lifetime while effectively removing assets from their estates.

From a charitable planning perspective, the estate and gift tax changes in the near term may ultimately encourage more funding of trusts and other life income gifts for nonspousal heirs, creation of CLTs that help leverage the gift tax exemption and other plans that take maximum advantage of what may be temporary provisions.

As we move into next year, other ramifications of the 2010 Act will undoubtedly emerge. In the meantime, those who work with charitably inclined individuals will want to carefully consider how they may use opportunities extended under the 2010 Act to achieve multiple goals.