As part of last week’s tax compromise Congress approved to avoid tumbling down the “fiscal cliff,” the amount that is exempted from estate taxes will remain the same as it has been for the past two years, although the maximum tax rate will rise by 5 percentage points.

The American Taxpayer Relief Act, which passed the House by a vote of 257 to 167, permanently sets the estate tax exemption at $5 million for an individual (now $5.12 million due to inflation) and $10 million for a couple (now $10.24 million).  With new inflation adjustments, the exemptions are estimated to rise to about $5.2 million and $10.24 million in 2013.   The gift tax and generation-skipping transfer tax exemptions will also remain the same as last year, adjusting for inflation, and the estate tax portability provision likewise remains intact and has been made permanent .  However, Congress did make one notable change to the prior rules: the maximum tax rate on inheritances above $5.12 million will increase from 35 percent to 40 percent.

Without any action on the part of Congress and the White House, the amount that a deceased individual could pass tax-free to their heirs would have automatically reverted to $1 million per person, and the rate for most estates would have gone up to 55%.  Instead, lawmakers made the temporary deal that they cut in December of 2010 permanent, and only increased the rates for those few taxable estates that remain by an additional 5%, to a top rate of 40%.

Who Must Pay Federal Estate Tax Now?

The dreaded “Death Tax” is now only owed on estates valued in excess of $5 million, indexed for inflation.  Estates below this amount owe no tax at death, and the heirs receive an unlimited step-up in basis of property owned by the decedent.  However, even though no tax is owed, for married couples, the survivor still may be wise to file an estate tax return after the death of the first spouse in order to preserve any unused exemption of the first spouse to die.  This later tactic, known as “Portability” permits a surviving spouse to file a timely estate tax return upon the death of their spouse, and retain for themselves any unused estate tax exemption in addition to their own estate tax exemption.  In other words, the second spouse to die can have an estate up to $10 million, indexed for inflation, if the first spouse to die did not use any of their own exemption at death.  The surviving spouse is able to “port” the unused exemption to their own estate, effectively doubling the federal estate tax exception for married couples, without the necessity of bypass trusts and other estate tax avoidance mechanisms. The catch is that in order for portability to apply, a timely estate tax return must be filed following the death of the first spouse. This return is due within nine months of the spouse’s death, and is eligible for a six-month extension.  If the executor does not file the return or misses the deadline, the surviving spouse will lose the right to portability.

What About Lifetime Gifts?

Lifetime gifts are also subject to the $5 million gift tax exemption, also indexed for inflation.  In addition, annual gifts can be made up to $14,000 per person per year beginning in 2013 without any reduction of the lifetime of and our gift tax exemption.  Gifts exceeding this $14,000 per person per year will count against the lifetime unified credit of $5 million, thereby reducing the available estate size that can be passed free of taxes at time of death.  In other words, the lifetime gift tax exclusion and the estate tax exclusion are expressed as a total amount of $5 million per person.  Transfers in excess of this amount, whether during lifetime or at death, will result in taxes of up to 40%.

Are Lifetime Gifts to Trusts Still Advisable?

While the primary and most recently urged use of lifetime gifts – utilizing the $5 million exemption before it was reduced to $1 million – no longer exists, there are still very good reasons to utilize the lifetime gift exception rather than retaining assets in one’s own estate.

    Asset Protection

Most notable is the asset protection that can accompany such a transfer. Assets held in an individual’s name are subject to the creditor claims of that individual, such as lawsuits and business debts.  Assets transferred into a trust, however, can be protected and made unavailable to the grantor’s creditors if the trust is properly structured.

    Asset Growth

An additional benefit of such a lifetime gift to a trust permits growth of the gifted assets outside of the grantor’s taxable estate.  For clients with property that is likely to highly appreciate, such as a small business interests or real estate interests, the use of some, if not all, of their $5 million lifetime gift exemption to place those growing assets outside of the taxable estate can still result in their heirs saving hundreds of thousands if not millions of dollars in estate taxes which would otherwise be owed at their death.  One common mechanism for achieving lifetime creditor protection and removal of the growth from their own taxable estates, while retaining access to the assets for their own family purposes, is the use of a Spousal Lifetime Access Trust. Such a trust will remove the assets from giver’s taxable estate, will make the assets no longer subject to their creditor’s claims, but can be enjoyed by the giver’s family, including the spouse, during lifetime.

An alternative is the use of a Domestic Asset Protection Trust created under the laws of a state which permit their creation, such as Nevada, Wyoming, or Tennessee.  Even with the permanence of the $5 million estate and gift tax exemption, such strategies should still be considered strongly by wealthy clients because of their tax and non-tax benefits.