In the weeks and months leading up to December 2010, there was great uncertainty in the United States regarding the fate of the politically divisive ‘estate tax.’ US estate tax has traditionally applied to the value of deceased US citizens’ and residents’ (referred to as “US Persons”) estates on death, with exemptions for values below a certain threshold. The estate tax also applies to the value of certain US-situs property owned by non-US residents in certain circumstances.
The uncertainty existed because the legislation governing the estate tax, initially enacted in 2001, was scheduled to sunset starting in 2011. The sunset would have resulted in a reversion to pre-2001 tax rates, which stood at 55%, compared to 45% in 2009, and a $1 million exemption, down from $3.5 million in 2009. (The exemption is pro-rated for non-US Persons regarding their US-situs property.) The 2001 legislation also provided for the repeal of the estate tax in 2010 (subject to the 2011 sunset), such that there was uncertainty regarding the potential retroactivity of any legislation implemented to prevent a return to the comparatively high pre-2001 rates.
Legislation was finally passed in December 2010, extending the estate tax to the end of 2012. The new legislation, The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, signed into law on December 17, 2010, sets the estate tax rate at 35% and the exemption at $5 million for 2011 and 2012. This rate and exemption level has retroactive application for US Persons who died in 2010. For estates of Canadians who owned property in the US at death, the increased exemption means a higher prorated exemption amount.
For 2010, estates of US Persons may elect to use the “modified carryover basis” provisions that were to apply in lieu of the estate tax for 2010. The carryover basis option generally involves permitting a limited “step-up” of up to $1.3 million in the cost base of inherited property. An executor will need to consider the value of the estate, the amount of any accrued gain at death and the situations of the beneficiaries and the estate generally when determining whether to elect to use the carryover basis or have the estate tax apply with the increased exemption.
At the end of 2012, the legislation is scheduled to sunset once again. It is entirely likely that a period of uncertainty will again ensue leading up to the end of 2012 and that legislation determining the future of the estate tax will once again be passed at the last possible moment, if at all. At this time, it is impossible to say whether the estate tax will be repealed, reduced, increased, extended or reformed after 2012.
Two related components of the recent legislation are the generation-skipping transfer tax (“GSTT”) and the gift tax, both of which are tied to the estate tax exemption. The gift tax applies to gifts made during a person’s lifetime and prevents the avoidance of the estate tax by simply transferring property during one’s lifetime. For 2010, the gift tax rate is 35% and there is a lifetime exemption of $1 million. For 2011 and 2012, the gift tax will match the estate tax with a 35% rate and a lifetime exemption of $5 million. The gift tax and estate tax are “unified” with respect to the $5 million exemption, meaning the exemption is cumulative in terms of amounts claimed under both taxes. Like the estate tax, the gift tax rates will revert after 2012 unless the US government takes legislative action.
GSTT applies to transfers made to related persons who are at least two generations younger than the transferor. Like the estate tax and the gift tax, the GSTT applies for 2011 and 2012 with a 35% rate and a $5 million exemption. However, the GSTT does not (for practical purposes) apply to 2010; 2010 has a $5 million exemption, but a “0% rate”. Again, if no action is taken prior to the end of 2012, the GSTT will revert to a $1 million exemption and a 55% rate.
The $5 million exemption for all three taxes is indexed starting in 2012. The new legislation also provides for “portability” of the estate tax exemption as between spouses, whereby a deceased spouse’s estate can, under certain conditions, transfer any unused portion of the exemption to the surviving spouse, to be used in addition to the surviving spouse’s $5 million exemption. Where one or both spouses are not US citizens or residents, professional advice should be sought regarding the potential application of the exemption and portability provisions to the spouses’ particular circumstances.
Canadian taxpayers who own US real estate or other US-situs property should carefully consider the potential impact of the new legislation in their estate plans. Although the exemptions in 2011 and 2012 are significant, the continued uncertainty as to the nature and existence of the estate tax and related taxes beyond 2012 makes dealing with these issues a difficult but necessary component of sound estate planning for many Canadians. Flexibility in estate planning devices is the key to being prepared for whatever may lie ahead. Seeking the advice of professionals with experience in estate planning is highly recommended.