Tax Law: 2010 Tax Relief Act Has Far-Reaching Consequences

Tax Law: 2010 Tax Relief Act Has Far-Reaching Consequences

Jan 1, 2011

On December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“2010 TRA”), major tax legislation that includes, among many other items, an extension of the Bush-era federal income tax cuts for two years, federal estate tax relief, a two-year “patch” of the alternative minimum tax (“AMT”), a two percent reduction in employee-paid payroll taxes and self-employment taxes for 2011, new business incentives to invest in machinery and equipment, and a host of retroactively re-enacted and extended tax breaks for individuals and businesses.

Some Key Income Tax Provisions

While a listing and discussion of all provisions of the 2010 TRA is beyond the scope of this article, some of the important elements of the new tax package include:

  • The current, favorable Federal income tax rates will be retained for two years (2011 and 2012), with a top tax of 35 percent on ordinary income and 15 percent on qualified dividends and long- term capital gains.
  • Employees and self-employed workers get a reduction of two percent in Social Security tax in 2011, bringing the rate down from 6.2 percent to 4.2 percent for employees, and from 12.4 percent to 10.4 percent for the self-employed.
  • A two-year AMT “patch” for 2010 and 2011 provides a modest increase in AMT exemption amounts and allows personal nonrefundable credits to offset AMT, as well as regular federal income tax.
  • Key tax credits for working families that were enacted or expanded in the American Recovery and Reinvestment Act of 2009 are retained. For example, 2010 TRA extends for two years (a) the $1,000 child tax credit (and maintains its expanded refundability) and (b) the American Opportunity Tax Credit for Higher Education and its partial refundability.
  • Two limitations on deductions for higher-income taxpayers have been deferred. For 2011 and 2012, higher-income individuals will not be required to reduce their itemized deductions or be subject to a phase out of personal exemptions.
  • Businesses can write off 100 percent of their new equipment and machinery purchases in the placed-in-service year, effective for property placed in service after September 8, 2010 and through December 31, 2011. For property placed in service in 2012, 2010 TRA provides for 50 percent additional first-year depreciation.
  • Many of the popular tax provisions that expired at the end of 2009 have been retroactively reinstated for 2010 and extended through the end of 2011. Among many others, the retroactively reinstated and extended individual and business provisions include the election to take an itemized deduction for state and local general sales taxes instead of the itemized deduction for state and local income taxes; the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers; and the research credit. The credit for making energy-saving improvements for a home has been extended for one year, through 2011, but stricter rules apply after 2010.

Federal Estate, Gift and Generation-Skipping Taxes

Other than the preservation of the federal income tax rates and brackets existing since 2001 for two additional years as above described, the most important aspects of the 2010 TRA as to individuals and families with wealth preservation objectives are the federal estate, gift and generation skipping tax (“GST”) changes enacted.

Higher Exemption; Highest Tax Rate Reduced

2010 TRA reduces Federal estate and GST taxes for 2011 and 2012. The exemption (or applicable exclusion) amount has been increased by $1 million to $5 million per person, which is to be indexed after 2011. The highest tax rate has been reduced from 55 percent to 35 percent.

Decedents Dying in 2010

Taxable estates of persons dying in 2010 can elect to either: (1) be subject to the federal estate tax (subject to a $5 million exemption and tax rate not exceeding 35%) and the ability to step-up basis, or (2) not be subject to any federal estate tax, but be subject to certain modified carryover basis rules. In considering this choice, estate fiduciaries will need to calculate which choice produces less combined estate and income tax. However, the calculation of income tax must consider when the estate or heirs will sell assets.

  • No matter what election is made, it will have no effect on the GST.
  • IRS will determine the time and manner to make the election, which will be revocable only with the consent of the IRS.

Gift Tax Reunified

Under 2010 TRA, for gifts made after 2010, the federal gift tax exclusion amount is $5 million, with a reunified estate and gift tax rate capped at 35 percent.

Generation Skipping Tax (GST)

Under 2010 TRA, the GST exemption for persons dying or gifts made in 2010 is $5 million. Consequently, one can allocate up to $5 million in GST exemption to a trust created or funded in 2010. While the GST does apply for 2010, the GST tax rate for 2010 transfers is 0 percent. For persons dying or gifts made after December 31, 2010, the GST exemption is equal the basic exclusion amount for federal estate tax purposes ($5 million, as indexed). The GST tax rate for transfers made in 2011 and 2012 is 35 percent.

Portability of Unused Exemption

2010 TRA introduces the concept of “portability” for unused federal estate and gift tax exemptions between spouses. Under this rule, any exemption remaining unused as of the death of a spouse who dies after December 31, 2010 (deceased spousal unused exclusion amount) can generally be used by the surviving spouse as additional exemption. The predeceased spousal carryover amount can be used by the surviving spouse for lifetime gifts or transfers at death. In the event a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion available for use by the surviving spouse is limited to the lesser of $5 million or the unused exclusion of the last deceased spouse. It is interesting to note that in order to use a deceased spousal unused exclusion amount, the surviving spouse must make an election on a timely filed federal estate tax return (including extensions) of the predeceased spouse concerning whom such amount is computed, whether or not the estate of such predeceased spouse otherwise must file a Federal estate tax return. This election may have to be made many years in advance and may often be missed by many estates. It will probably be considered standard practice to file “protectively” even in the case of small estates.

Furthermore, notwithstanding the statute of limitations for assessment of Federal estate and gift tax, the federal estate tax return of the predeceased spouse may be examined by IRS to determine what it views as the proper deceased spousal unused exclusion amount. Such examination may result in the IRS claiming that the deceased spousal unused exclusion amount is less than that claimed by the estate of the surviving spouse.