New Estate Tax Rules Show Some Love For Now

Those who must ante up estate taxes for 2011 can't like that the tax is back but at least there's some relief from what could have been a painful payout to Uncle Sam.

As part of the Tax Relief Act signed into law last December, taxpayers now face a rate of 35 percent with an individual exemption up to $5 million.

That's certainly a jolt to the portfolio from last year's estate  tax holiday—a 'gift' from the Bush administration.

But compared to what was scheduled for 2011—a 55 percent rate and an exemption of only up to $1 million—it may be love at first sight for most estates.

"People are just thrilled with the higher exemption and lower rates," says Christina Mason, a trusts and estates attorney at Kelley Drye & Warren. "While taxpayers were unhappy with the prospect of reverting to the old rates, I'd say that no one was panicked. Most people are more or less resigned to paying it. But this is much better."

Many estates won't even have to pay. The $5 million exemption is large enough that about 99 percent of estates in the U.S. won't end up owing any tax, according to sources. That's helped by the new rule that allows surviving spouses to combine their exemption with that of a spouse that died for a total exemption of $10 million.

"Most taxpayers are less concerned about the estate tax than they were before," says John Gast, partner and tax attorney at Brennan, Manna & Diamond. "And the people paying realize these new rates are better than the ones they could have faced."

Still, there is some devil in the details that shouldn't be overlooked, say analysts.

"One benefit of the new law is that you don't need a credit shelter trust (assets designed to be passed on to heirs at time of death) to have the exemption as you did before," says Thomas J. Casey, CFP of Casey Thomas & Associates in Shelton, Connecticut. "But if someone remarries, they can lose the exemption, so I'm telling my clients having a credit shelter trust is still a good idea. People do marry again."

Another regulation combines estate- and gift-tax exemptions for the first time. That means the $5 million estate-tax exemption can also be applied to gifts—which had a previous exemption of only $1 million. It's something financial planners say is worth thinking about.

"I'm stressing that clients take advantage of the lifetime gift-tax exemption," says Gast. "If the client has enough to live on, why not make gifts during his lifetime to his children or grandchildren with the lower exemption and rates (35 percent). It makes perfect sense."

For heirs of very large estate owners who died in 2010 and want to sell any of the inherited assets, they have some figuring to do as well. Do they want to pay estate taxes or pay capital gain taxes from the sale of the assets?

The law now allows heirs to choose 2011's rates and exemptions or—if they sell assets this year—enjoy last year's estate tax break and be subject to capital gains. The problem is that the new law forces estates to determine the value of the stocks/property that's being sold, at the original time of purchase—plus capital improvements. That figure will decide how much capital gain tax is owed after the sale.

For a stock that's split many times or a house that's been in the family for decades and had renovations, it can be difficult to come up with the original cost, say experts, and know what rate of capital gains to pay. So it comes down to calculating which check to the IRS might be bigger—estate taxes or capital gains.

And estates can't forget the states. While many also had a tax holiday for 2010, fifteen of them, including Hawaii, New Jersey, New York and Oregon reinstated the tax in 2011—with exemptions and rates varying from state to state.

Future Planning

The tax relief package President Obama signed only covers 2011 and 2012. That means the economic and political arguments over estate taxes will be resurrected for 2013.

"The real question is what will happen in two years and we face the same situation," says Christina Mason. "It will likely turn on the outcome of the 2012 elections. If Democrats control the government, it's probable a new estate tax would resemble the law in effect in 2009 ($3.5 million exemption, 45% rate). If Republicans win, the prospect for repeal is more likely."

What's really needed, say experts, is an end to uncertainty.

"It's hard for financial planning. Someone needs to decide once and for all," says Casey.