Posted January 1st, 2011

New Year Brings Tax Law Changes

This year marks the 10-year anniversary of the Economic Growth and Tax Relief Reconciliation Act of 2001. That legislation featured a number of popular tax cuts but also included an automatic sunset provision designed to return many of the nation’s tax laws to their 2001 state unless Congress took other action.

Originally, most observers believed Congress would implement a more permanent tax solution before the end of 2010 since some of the more extreme provisions, including the one-year repeal of the federal estate tax scheduled for 2010, provided a clear deadline for legislative action. No one apparently foresaw the extent of the gridlock that prevented legislative action and resulted in the repeal of estate taxes for 2010.

What a difference a decade makes

The first decade of the 21st century has been a tumultuous time on many fronts. As we enter 2011, we are still emerging from the longest and deepest recession since the Great Depression. The budget surplus of the 1990s has morphed into a growing mountain of debt, and everyone reading this article is 10 years older than they were in 2001, contributing to the graying of the American work place.

According to reports from the Pew Research Center (pewresearch.org), for the next 19 years some 10,000 persons will pass the age of 65 every day. This unprecedented growth in the retirement-age population will place enormous stress on the Social Security Administration, health care programs and innumerable other aspects of American society.

In December 2010, against this backdrop of economic distress, members of Congress from across the political spectrum agreed to a compromise to prevent the fiscal and political carnage that could have resulted if the full number of sunset provisions in the 2001 Tax Act had been allowed to take effect. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act is an attempt to avoid a significant increase in federal income, gift and estate taxes that could trigger a double-dip recession—and possibly a global depression.

A temporary fix

The legislative measures passed in December are not intended as a permanent answer to the long-term fiscal issues facing the U.S. government and its citizens. Instead, Congress has put forth an array of temporary measures that are designed to more or less preserve the status quo while also providing a degree of stimulation to the economy over the next few years. As is the nature of most compromises, nobody is pleased with every aspect of the new law, but it arguably includes something for everyone.

Highlights of the new law

The major provisions of the new tax law include the temporary two-year extension of 2010 ordinary income tax rates for all individual taxpayers. If Congress had not acted, virtually all taxpayers would have seen an increase in their income tax bills and a corresponding reduction in resources available to spend, invest or share with others.

The extension also continues lower tax rates for qualified stock dividends and long-term capital gains. Some experts had predicted that an increase in these rates could have caused a sell-off in the stock market prior to January 2011 and created another drag on the economy.

A variety of other provisions were included in the legislation as part of the compromise package that gained bipartisan support. In the final hours of debate, the most contentious part of the new law was the treatment of the estate tax.

Estate tax compromise

Over the past decade, the threshold for estate tax filing and liability was gradually increased and the maximum estate tax rate was reduced, resulting in ever higher amounts that could be transferred free of federal gift and estate tax. By 2009, the estate tax exemption equivalent had increased to $3.5 million per person ($7 million for a married couple with minimal planning) with higher amounts subject to a maximum tax rate of 45 percent. Had Congress not acted, the estate tax would have returned with a vengeance in 2011 and would potentially have levied a tax of up to 55 percent on estates greater than $1 million.

As noted above, a provision of the 2001 law called for the complete elimination of the federal estate tax for 2010. When that occurred on January 1, 2010, many executors of persons who died in 2010 did not know if the tax would be reinstated retroactively to the beginning of 2010 or would actually be allowed to expire.

This uncertainty resulted in a freezing of the charitable and other distributions from larger estates as executors awaited guidance. The compromise legislation reinstates the federal estate tax retroactive to January 1, 2010, but allows 2010 estates to be settled under the 2010 law or the new law, whichever provisions are more favorable from a tax standpoint.

The new law represents a compromise between extending the complete repeal of the estate tax and reverting to 2001 tax levels by providing a temporary $5 million exemption with a 35 percent rate on additional amounts for persons dying before January 1, 2013. Thereafter, the 2001 sunset provisions are scheduled to kick in, and we will again be faced with the prospect of a $1 million per estate exemption and a 55 percent maximum rate. Congress has ensured that the estate tax will be a central point of contention in the 2012 election cycle; it will likely also be a project for the next lame duck Congress to deal with in 2012.

Renewed interest in gift planning

In a surprise move, Congress also acted to reunify the gift and estate tax systems that were placed on separate tracks as part of the 2001 legislation. The $5 million per estate exemption now applies to amounts given either during lifetime or at death. Under the 2001 legislation the gift tax exemption for lifetime gifts was frozen at $1 million as the estate tax exemption rose over time. This created an incentive to delay gifts to one’s heirs until death in some cases. The new law also struck section 2511(c), which had raised gift tax concerns for various charitable trusts.

This change will result in a renewed interest by some donors in charitable gift planning vehicles such as lead trusts and life income gifts for those other than spouses that help multiply the benefits available under the new, higher gift tax exemption. Keep in mind that many will be advised to take advantage of these possibilities during the coming two-year window that may close at the end of 2012 if Congress again becomes mired in gridlock and does not extend or make permanent the recently enacted provisions.

Act now

The 2010 Tax Act is almost certain to unleash a flood of estate planning the likes of which has not been seen in a decade or more. Some reports indicate that as a result of tax uncertainty and other factors the percentage of adults with a valid will has recently fallen to just 35 percent. Studies show that the average age of persons making their final will and leaving funds to charity is approximately 80 years. The median age is nearly the same.

For many persons, especially those in their late 70s and older, the plans that are made in the wake of the 2010 tax legislation will likely be their last. The future income of many organizations will depend on how donors who are planning their estates respond when their attorney asks them if their charitable interests have changed. Charitable entities that have maintained regular contact with their older constituents will be most likely to stay at the top of donors’ minds as they revise their wills.

Nonprofits that communicate with their constituents early in the new year will be more likely to benefit from planning done as a result of the new law than those who wait until later in the year, or than those who simply fail for whatever reason to address the opportunities opened up by the new law. Once again we are dealing with temporary measures. It is important to act now as discussions about future changes may soon distract your constituents from the planning opportunities that are now possible.

Editor’s note: The Sharpe Group will host a special webinar Thursday, January 13, at 2:30 p.m. EST that will explore opportunities to increase charitable giving created by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. See details on page 4 and visit www.sharpenet.com for details and to register.

The publisher of Give & Take is not engaged in rendering legal or tax advisory service. For advice and assistance in specific cases, the services of your own counsel should be obtained. Articles in Give & Take may generally be reprinted for distribution to board members and staff of nonprofit institutions and other non-donor groups. Proper credit must be given. Call for details.

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