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2011 Estate Planning Advisory

President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 at the end of last year. This law can simply be called the “Tax Relief Act.” The Tax Relief Act offers significant relief on the estate and gift tax front, but although the news is mostly good, there are some concerns as well.

The Good News
Before this act was signed, individuals were looking at the return of the federal estate tax (after its one-year hiatus) with a $1 million exemption and a 55% tax rate. The enactment of the Tax Relief Act instead gives each individual a $5 million estate tax exemption and lowers the estate tax rate to 35%.

Prior to 2010, as the estate tax exemption level was increasing, the lifetime gift tax exemption remained at $1 million. This meant that individuals were limited in their ability to make tax-free lifetime gifts. The Tax Relief Act “reunifies” the estate and gift tax exemptions, meaning that each individual may now make up to $5 million in lifetime gifts free of gift tax.

Although there was a significant amount of discussion regarding the limitation of certain beneficial planning techniques (most notably, Grantor Retained Annuity Trusts, or GRATs) prior to enactment of the Tax Relief Act, the Tax Relief Act does not affect those techniques.

The new estate tax rules established for decedents dying in 2011 may also be applied to the estates of decedents dying in 2010. This is particularly helpful for decedents who died in 2010 with less than a $5 million estate and whose families are now trying to contend with confusing carryover basis issues.

The Tax Relief Act also provides that estate tax exemptions will be “portable” between spouses – meaning that if Husband dies in 2011 and only uses $3 million of his estate tax exemption, the remaining $2 million will be added to Wife’s existing $5 million exemption, exempting a full $7 million of assets when Wife subsequently dies.

The Bad News
As background, the State of Maryland “decoupled” its estate tax from the federal estate tax in 2004. In other words, prior to 2004, Maryland estate tax was only payable if a federal estate tax was payable. After decoupling, the Maryland estate tax threshold was capped at $1 million per individual. Therefore, individuals dying with an estate of more than $1 million situated in Maryland are subject to the Maryland estate tax. For example, the estate of an individual dying in 2011 with a $1.5 million Maryland estate will be subject to a Maryland estate tax of approximately $65,000. The Federal Tax Relief Act does not affect the Maryland estate tax.

Estate plans prepared before the Maryland decoupling of state and federal estate tax may contain formula distributions that would make allocations based only on the federal estate tax exemption amount. If this is the case, such an allocation may cause a portion of an individual’s estate to be subjected to Maryland estate tax unintentionally. A simple review of your estate planning documents would indicate whether your documents require revision to avoid this unintentional result.

The Tax Relief Act is only effective through December 31, 2012, meaning that there are two years of relief, but also two years of uncertainty. The expiration of the Tax Relief Act without further action (see: December 2009) could lead to higher estate and gift taxes later. The intervening two years could also mean an overhaul of the existing estate and gift tax structure. The “portability” feature, which sounds like a great benefit, may not become permanent.  Either way, we face the specter of planning for the future while only knowing what the next two years will hold.

Estate Planning Opportunities
Although the tax climate is only temporarily clear, recent years have brought low interest rates and temporarily depressed asset values, which make an ideal combination for certain estate planning techniques. A few of these techniques are discussed below.

Grantor Retained Annuity Trusts (GRATs)

A GRAT is a trust that can be utilized on a short-term basis to transfer to your beneficiaries assets that you expect will appreciate relatively rapidly over the term of the trust. Because you receive an annuity from the trust in return, you are removing from your taxable estate the appreciation on the transferred assets over the duration of the trust. The upside is that you do so with little or no gift tax consequence. With currently low IRS interest rates, this is an ideal time to utilize a GRAT. A depressed asset that you expect will appreciate rapidly over the next two to three years is a good candidate for transfer via GRAT. Sales to defective trusts are also an attractive option along these lines.

Family Entities (LLCs, LPs, etc.)

A family that wishes to consolidate its assets into a single entity for management, consolidation, and/or asset protection purposes may consider establishing a limited liability company or limited partnership. The family may then make gifts of LLC or LP interests (rather than gifts of cash or individual assets) to beneficiaries. Although the IRS has attacked these arrangements, families that observe the appropriate formalities and procedures in establishing and maintaining these entities may reap the benefits of centralized management of family assets and tax-efficient gift-making.

Planning for Vacation Homes

With real estate values continuing to lag, this is also an excellent time to implement planning techniques involving your family vacation home. An LLC or LP might be a good vehicle for holding and managing your family vacation home, particularly if the home is out-of-state or if you also rent the home to others. A qualified personal residence trust may also be used to pass on a vacation home to your beneficiaries.

Intra-Family Loans

Low interest rates also allow for the opportunity to simply and efficiently loan assets to family members at historically low rates. This technique both effectively freezes the value of the asset transferred and transfers the appreciation in the asset to the next generation free of transfer tax.

The good news contained in the Tax Relief Act far outweighs the bad news, but everyone potentially affected by the estate and gift tax should pay careful attention to the ways in which these changes could affect their specific situation. Of particular concern is the continuing application of the Maryland estate tax. A simple review of your existing wills and/or trusts can determine whether you have adequately addressed these issues.

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