American Taxpayer Relief Act Brings Estate Tax Relief

After some last minute political posturing, in the wee hours of January 1, 2013 the U.S. Senate passed the American Taxpayer Relief Act ("ATRA") by a margin of 89 to 8. The U.S. House of Representatives, after initially balking at the provisions of ATRA, which does not include any significant spending cuts, ended up passing the bill around 11 p.m. on January 1 by a margin of 257 to 167. Shortly after the House passed ATRA, President Obama made a public statement in support of it and then within 30 minutes was whisked away to his Hawaiian vacation home, where he signed the bill into law using an autopen on January 2, 2013.

Now that we have been delivered from the precipice of the so-called fiscal cliff, below is a summary of what ATRA means for American taxpayers in 2013 as well as some retroactive changes for 2012.

Initially, though, you will probably hear more about what ATRA did NOT change. The temporary reduction of the Social Security payroll tax that went into effect in 2011 and was extended for 2012 was not addressed by ATRA, so in 2013 the share of the Social Security payroll tax paid by workers will increase from 4.2% to 6.2% for employees and 10.4% to 12.4% for those who are self-employed.  This increase will likely result in actual take-home pay remaining the same for many taxpayers, despite wage increases for 2013. Since this is the most effect of ATRA that most taxpayers will realize, many taxpayers won't see ATRA as real "relief.'    

Estate Tax, Gift Tax and Generation Skipping Transfer Tax

ATRA makes the rules governing estate taxes, gift taxes and generation skipping transfer taxes that went into effect under the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010 ("TRUIRJCA") permanent for 2013 and beyond, with one exception - the maximum tax rate for each of these taxes is increased from 35% to 40%. Since TRUIRJCA unified the estate tax, gift tax and generation skipping transfer tax exemptions and provided for inflation indexing of these exemptions beginning in 2012, the 2013 exemption for each of these taxes is $5,250,000.

"Portability" of the Federal Estate Tax Exemption Becomes Permanent

 In addition, TRUIRJCA introduced the concept of portability of the estate tax exemption between married couples, and so ATRA has made portability permanent.In 2009 and prior years, married couples could pass on up to two times the federal estate tax exemption by including "AB Trusts" in their estate plan. TRA 2010 eliminated the need for "AB" Trust planning for federal estate taxes in 2011 and 2012 by allowing married couples to add any unused portion of the estate tax exemption of the first spouse to die to the surviving spouse's estate tax exemption, which is commonly referred to as "portability of the estate tax exemption."

In simple terms, portability of the federal estate tax exemption between married couples means that if the first spouse dies and the value of his or her estate does not require the use all of his or her federal exemption from estate taxes, then the amount of the exemption that was not used for the deceased spouse's estate may be transferred to the surviving spouse's exemption so that he or she can use the deceased spouse's unused exemption plus his or her own exemption when the surviving spouse later dies.

Some examples using numbers should help to illustrate the concept of portability of the federal estate tax exemption between spouses:

Result Without Portability

Assume Bob and Sue are married and have all of their assets jointly titled and their net worth is $8,000,000, Bob dies first and the federal estate tax exemption is $5,250,000 on the date of his death, and portability of the estate tax exemption between spouses is not in effect:

1. Under these facts, when Bob dies his estate will not need to use any of his $5,250,000 estate tax exemption since all of the assets are jointly titled and the unlimited marital deduction will allow Bob's share of the joint assets to be automatically transferred to Sue by right of survivorship without incurring any federal estate taxes.
2. Assume that at the time of Sue's later death the federal estate tax exemption is still $5,250,000, the estate tax rate is 40%, and Sue's estate is still worth $8,000,000.
3. With Bob's $5,250,000 estate tax exemption completely wasted, when Sue later dies she can only pass on $5,250,000 free from federal estate taxes. Thus, Sue's estate will owe about $1,100,000 in estate taxes after her death:

$8,000,000 estate - $5,250,000 exemption = $2,750,000 taxable estate

$2,750,000 taxable estate x 40% estate tax rate = $1,100,000

Result With Portability

Assume Bob and Sue are married and have all of their assets jointly titled and their net worth is $8,000,000, Bob dies first and the federal estate tax exemption is $5,250,000 on the date of Bob's death, and portability of the estate tax exemption between spouses is in effect:

1. As above, when Bob dies his estate will not need to use any of his $5,250,000 estate tax exemption since all of the assets are jointly titled and the unlimited marital deduction allows for the automatic transfer of Bob's share of the joint assets to Sue by right of survivorship and without incurring any federal estate taxes.
2. Assume that at the time of Sue's later death the federal estate tax exemption is still $5,250,000, the estate tax rate is 40%, and Sue's estate is still worth $8,000,000.
3. Enter portability of the estate tax exemption - Using the concept of portability of the estate tax exemption between spouses, under these facts Bob's unused $5,250,000 estate tax exemption will be added to Sue's $5,250,000 exemption, in turn giving Sue a $10,500,000 exemption.
4. Since Sue has "inherited" Bob's unused estate tax exemption and she can pass on $10,500,000 free from federal estate taxes at the time of her death, Sue's $8,000,000 estate will not owe any federal estate taxes at all:

$8,000,000 estate - $10,500,000 exemption = $0 taxable estate

5. Thus, portability of the estate tax exemption will save the heirs of Bob and Sue about $1,100,000 in estate taxes.
6. Note that Sue will not automatically "inherit" Bob's unused exemption; instead, she must timely file IRS Form 706, United States Estate and Generation Skipping Transfer) Tax Return, in order to make an affirmative election to add Bob's unused exemption to her exemption.

Of course, these examples only illustrate how portability of the estate tax exemption between spouses really works in the same way that the "AB" Trust works for tax purposes, without the need for setting up "AB Trusts."  Of course, there are advantages to "AB" trusts other than estate tax avoidance, such as asset protection, sheltering appreciation, using your generation-skipping transfer tax exemption, benefiting children from a previous marriage, providing for management of assets, protecting of assets from subsequent marriage, and protecting assets from long-term care costs.

ATRA makes portability of the estate tax exemption between married couples permanent for 2013 and beyond, which means that in 2013 a married couple can pass on $10.5 million to their heirs free from federal estate taxes so long as the proper estate tax returns and elections are filed.  Note, however, that even if the deceased spouse's estate will not be taxable (in other words, is valued less than $5.25 million), the surviving spouse will nonetheless be required to file IRS Form 706, United States United States Estate (and Generation-Skipping Transfer) Tax Return, in order to take advantage of the deceased spouse's unused estate tax exemption, otherwise the deceased spouse's exemption will be lost.

Charitable Donations from IRAs

Under ATRA, in 2013 IRA owners who have reached the age of 70 1/2 can make donations of up to $100,000 to charitable organizations directly from their IRAs and have the donations count towards their IRA required minimum distributions. If this is done, although the IRA owner will not be able to take a charitable deduction for this type of donation, the amount donated will not be included in the IRA owner's adjusted gross income.

ATRA also retroactively restored this income tax break for the 2012 tax year, however, specific rules apply, but until January 31, 2013, if an IRA owner took a required minimum distribution in cash at any time during December 2012, then he or she can send an amount equal to the December distribution to one or more charitable organizations before January 31, 2013, and exclude the charitable donation from his or her 2012 income.

Individual Income Tax Rates

ATRA did not change the individual income tax rates for the majority of American taxpayers, so the 10%, 15%, 25%, 28%, 33% and 35% rates remain in effect for most taxpayers in 2013. However, a new top rate of 39.6% has gone into effect in 2013 for taxpayers who earn above the following income levels:

• $225,000 for married taxpayers who file separately
• $400,000 for single taxpayers
• $425,000 for head of household taxpayers
• $450,000 for married, joint-filing taxpayers

Capital Gains and Dividend Rates

ATRA also did not change the capital gains and dividend rates for the majority of American taxpayers, so the 15% rate remains in effect in 2013 for taxpayers in the 25%, 28%, 33% and 35% brackets. However, a new maximum rate of 20% goes into effect in 2013 for taxpayers who earn above the following income levels:

• $225,000 for married taxpayers who file separately
• $400,000 for single taxpayers
• $425,000 for head of household taxpayers
• $450,000 for married, joint-filing taxpayers

Also, do not overlook the 3.8% Medicare surtax on net investment income that went into effect on January 1, 2013 for the following taxpayers:

• Married taxpayers, filing jointly - $250,000
• Married taxpayers, filing separately - $125,000
• All other individual taxpayers - $200,000

The 3.8% surtax is part of the provisions of The Patient Protection and Affordable Care Act(Obamacare) that will help support the expanding costs of Medicare. For individual taxpayers (as opposed to estates and trusts), the surtax is based on the lesser of (1) net investment income, or (2) the amount by which modified adjusted gross income (MAGI) exceeds the threshold amount in that tax year.

For estates and trusts, the 3.8% surtax is based on the lesser of (1) the undistributed net investment income of a trust or estate, or (2) the excess of adjusted gross income over the top bracket for estate and trust income (the brackets are adjusted for inflation and the top bracket is expected to be approximately $12,000 in 2013).

The surtax is levied on Interest, dividends, royalties, annuities, certain rents, capital gains from the sale of property that is not used in an active trade or business, and trading of financial instruments and commodities.

Some types income won't be subject to the 3.8% surtax.  These include active business income, ordinary and capital gain on the sale of an active interest in a partnership or S corporation, distributions from IRAs and qualified retirement plans, income from tax-exempt municipal bonds, tax-deferred nonqualified annuities, income subject to self-employment tax, and excludable gain from the sale of principal residence.

Personal Exemption Phaseout

Under ATRA, in 2013 the personal exemption phaseout begins at the following adjusted gross income thresholds:

• $150,000 for married taxpayers who file separately
• $250,000 for single taxpayers
• $275,000 for head of household taxpayers
• $300,000 for married, joint-filing taxpayers

Itemized Deduction Phaseout

Under ATRA, in 2013 the itemized deduction phaseout, which may result in the loss of up to 80% of itemized deductions (such mortgage interest, property taxes, state and local income taxes, charitable contributions), begins at the following adjusted gross income thresholds:

• $150,000 for married taxpayers who file separately
• $250,000 for single taxpayers
• $275,000 for head of household taxpayers
• $300,000 for married, joint-filing taxpayers

Alternative Minimum Tax

Under ATRA, a permanent patch has been made to the alternative minimum tax ("AMT") rules, which is retroactive back to January 1, 2012. The exemption amounts for 2012 are $50,600 for individuals and $78,750 for married couples filing jointly and will be indexed for inflation in future years. In addition, nonrefundable personal credits against the AMT will be allowed.

Deduction for State and Local Sales Taxes

ATRA retroactively restored the deduction for state and local sales taxes for the 2012 tax year and extends it through December 31, 2013.