The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act) was signed into law in December 2010. This law contained dramatic changes to the federal gift and estate tax and the federal generation-skipping transfer (GST) tax. These changes are only temporary–for 2011 and 2012 only. Unless Congress enacts further legislation, the rules that were in effect in 2000 are scheduled to be reinstated in 2013.


The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) significantly changed the federal gift and estate tax and the GST tax for the years 2001 through 2010. The maximum tax rates gradually decreased from 55 percent to 45 percent (35 percent for gift tax) and the exemptions gradually increased from $675,000 to $3.5 million ($1 million for gift tax). The provisions of EGTRRA repealed the estate and GST taxes (but not the gift tax) for 2010; then, for 2011, reinstated the tax rules that were in effect prior to EGTRRA. Also, from 2004 through 2010, the gift tax was “dis-unified” from the estate tax.

Modified carryover basis in 2010 under EGTRRA

Generally, for tax years prior to 2010, a taxpayer’s income tax basis in property acquired from a decedent was stepped up (or stepped down) to the property’s fair market value on the date of death. If the property acquired from the decedent had increased in value, the unrealized gain permanently escaped income taxation. Conversely, if the property had declined in value, the unrealized loss was not recognized either by the decedent or the heir. In addition, the long-term capital gains holding period applied automatically. Because of this, taxpayers generally did not need to maintain basis information for assets that would be distributed at death.

Under EGTRRA, for deaths occurring in 2010 only, a modified carryover basis regime was substituted for the stepped-up basis rules. Under these rules, a recipient of property transferred from a decedent received a basis equal to the lesser of the decedent’s basis or the fair market value of the property on the decedent’s date of death. This carryover basis is then stepped up by an aggregate amount of $1.3 million, and property passing to the spouse of the decedent is stepped up by an aggregate amount of $3 million (but no interest in property acquired from the decedent is stepped up above its fair market value). There is also a carryover of the holding period. Thus, documentation of cost basis and acquisition dates is necessary.

Under both the modified carryover basis and the stepped-up basis rules, income in respect of a decedent does not receive a step-up in basis. Thus, for example, distributions from a qualified plan or a traditional IRA that you received from a decedent may be fully taxable to you.

Repeal of state death tax credit under EGTRRA

In addition to federal estate taxation, some states impose their own estate taxes. In order to reduce the dual burden, federal law provided for the sharing of revenue with states through the state death tax credit. EGTRRA gradually reduced and then eliminated the state death tax credit in 2005, replacing it with a state death tax deduction. Many states that tied their death tax to the federal credit (i.e., by imposing a “pick-up” or “sponge” tax) have since “decoupled,” and now impose a separate estate or inheritance tax.

The 2010 Tax Act

Just days before the sunset provisions of EGTRRA were to take effect, the 2010 Tax Act became law. Among other things, the 2010 Tax Act repealed the repeal of the estate and GST taxes for 2010, and, for the next two years, set the maximum tax rates at 35 percent, increased the gift and estate tax applicable exclusion amount to $5 million (and increased the GST tax exemption to $5 million as well), made the applicable exclusion amount “portable,” and extended the repeal of the state death tax credit and the allowance of the state death tax deduction.

Repeal of the repeal

The 2010 Tax Act retroactively reinstated the estate and GST taxes for 2010, along with the step-up in basis rules. For the estate tax, a top tax rate of 35 percent was imposed and an applicable exclusion amount of $5 million was established. For the GST tax, a top rate of 0 (zero) percent was imposed and a separate $5 million exemption was allowed. This presented a narrow window during which taxpayers could make gifts to grandchildren and other skip persons, without having to pay any GST tax; however, that window closed December 31, 2010. The gift tax, which had remained in effect, was “re-unified” with the estate tax: a top tax rate of 35 percent was imposed and the applicable exclusion amount of $5 million for gift and estate tax applied.

Election out of the estate tax for 2010

Under the 2010 Tax Act, executors of estates of persons dying in 2010 were given the choice of either the estate tax regime (with the step-up in basis rules) or electing out of the estate tax (with the modified carryover basis rules). Executors had to make an affirmative election to opt in to carryover basis. Absent such an election, the traditional automatic basis step-up rules will apply to assets passing as a result of deaths occurring in 2010.

The due date of estate tax returns for decedents dying between January 1 and December 16, 2010, is September 17, 2011 (nine months from December 17, 2010). For deaths on or after December 17, 2010, the return is due nine months from the date of death.

Estates that elect to opt out of the estate tax are also required to file Form 8939, Allocation of Increase in Basis for Property Acquired From a Decedent. Originally, the IRS stated that generally Form 8939 was to be filed along with the decedent’s final Form 1040 no later than April 18, 2011. Subsequently, the IRS said Form 8939 must be filed within 90 days after Form 8939 is finalized.

Executors should do an analysis comparing the potential estate tax liability to the potential capital gains tax liability to determine which option is better for the estate. Projecting potential capital gains tax liability requires the prediction of several factors, including: (1) the character of the gain, (2) the applicable tax rate, and (3) the applicable holding period.

Portability of the DSUEA

The surviving spouse of a person who dies in the year 2011 or 2012 can now use the deceased spouse’s unused exemption. When the surviving spouse dies, his or her executor can combine the estate tax exemption of the last spouse to die with the unused exemption of the first spouse to die. The ability to transfer the estate tax exemption to the surviving spouse is referred to as “portability.” Portability gives married couples the ability to exempt up to $10 million of assets from gift and estate tax. Before the 2010 Tax Act created the concept of the deceased spouse’s unused exemption (or exclusion) amount (DSUEA), a married couple would often preserve the estate tax exemption of the first spouse to die by setting up a bypass trust arrangement (often referred to as an A/B trust arrangement).

The executor of the estate of the deceased spouse must file an estate tax return (Form 706) with the IRS and claim the deceased spouse’s unused exclusion amount, even if no tax is due. Generally, the estate tax return must be filed within nine months after death. The IRS is expected to create a short Form 706 to make it easier to file and claim the DSUEA. If the estate of the deceased spouse does not file Form 706, the surviving spouse loses the right to portability. If a surviving spouse remarries and is predeceased by the second spouse, the surviving spouse must use the DSUEA of the second spouse, even if the unused exemption of the second spouse is less than the unused exemption of the first deceased spouse.

Example(s): Assume that Spouse 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on Spouse 1’s estate tax return to permit Spouse 2 to use Spouse 1’s DSUEA. As of Spouse 1’s death, Spouse 2 has made no taxable gifts. Thereafter, Spouse 2’s exemption is $7 million (his or her $5 million “basic” exclusion amount plus $2 million of Spouse 1’s unused exemption), which Spouse 2 may use for lifetime gifts or for transfers at death.

For many couples, the simplicity of portability along with the second step-up in basis for appreciated assets (which a credit shelter trust does not receive) may seem attractive. However, portability does have certain drawbacks that the married couple must consider when creating their estate plan.

  • The DSUEA is not indexed for inflation. In contrast, if assets are left in a bypass trust, the appreciation of those assets will not be subject to estate tax at the death of the surviving spouse. For example, say a bypass trust is funded with $5 million at the death of the first spouse, and the bypass trust grows in value to $6 million by the time the second spouse dies. That $1 million increase in value will not be subject to the estate tax. Under the DSUEA rules, the entire $6 million would be part of the surviving spouse’s estate, with only a $5 million DSUEA to shelter those assets from estate tax. The same $1 million increase in value would be taxable at the surviving spouse’s death. Keep in mind, however, that the estate tax savings from using a bypass trust could be offset by the capital gains taxes that may be owed on the trust assets when they are sold (the bypass trust will not get a step-up in basis at the survivor’s death).
  • The GST tax exemption is not portable. If a married couple wants to fully utilize their combined $10 million GST tax exemptions, they must still create a bypass trust at the death of the first spouse to use his or her $5 million GST tax exemption.
  • This portability feature is scheduled to sunset, or expire, after 2012. Unless and until portability is made permanent, it is problematic to rely on it in creating a successful estate plan.
Investment Advisor Representative: Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor.  Registered Representative: Securities offered through Cambridge Investment Research Inc., a Broker/Dealer, Member FINRA/SIPC.  Cambridge and Affinity Wealth Advisors Inc are not affiliated.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2011.