The Unified Exemption and Gift Exemption

Among the basic tenets of estate taxation, unified and gift exemptions allow every individual to transfer significant amounts of assets free of estate and gift taxes.

Reform of the estate tax laws in 2001 divided the unified exemption amount into subcategories. The overall, or unified, exemption remains for the entire estate, but a gift exemption limits the amount that can be given during a lifetime. Legislation enacted in late 2010 boosted the exemption amounts and "re-unified" the various exemptions.

As a result of law changes in 2010, the estate tax applicable exclusion amount will increase to $5 million (from $3.5 million pre-2010) for the estates of decedents dying after 2009 and before 2013. The Generation Skipping Transfer tax exemption amount, which is computed by reference to the estate tax applicable exclusion amount, will also be $5 million for GSTs occurring after 2009 and before 2013. Both the estate tax applicable exclusion amount and the GST tax exemption will be indexed for inflation beginning in 2012.

The gift tax applicable exclusion amount, which had remained at $1 million since 2002, will also be $5 million, effective for gifts made after 2010 and before 2013. It will be indexed for inflation beginning in 2012. Also, beginning in 2011, the estate of a surviving spouse may be entitled to the unused portion of his or her predeceased spouse's applicable exclusion amount, assuming the predeceased spouse's estate made an irrevocable election to take advantage of this provision.

Once the unified exemption is used up, the tax rates that apply are quite high. While the exemption might, at first glance, seem generous enough so as not to even warrant any estate planning, it must be remembered that the goal of every small business owner is to build the business and amass wealth. While not every small business owner will be successful, many will find that they have accumulated a significant net worth, which will trigger the federal estate tax.

The law imposes a gift tax out of concern that, with no gift tax, wealthy families would use gifting of assets to family members in lower income brackets as an income tax splitting strategy. Of course, this concern underscores the effectiveness of this strategy--which remains effective, subject to the $1 million lifetime gift tax exemption.

Furthermore, the annual gift tax exclusion is not affected by this legislation ($13,000 in 2011, annually adjusted for inflation). This fact again bolsters gift giving as an effective strategy in reducing income and estate taxes.

Ultimately, many other factors can make a taxable estate larger than it may seem. During the 1990s, for example, the stock market made portfolios, and thus taxable estates, swell in value. In addition, without the use of other estate planning strategies, retirement benefits and life insurance can significantly add to the value of a taxable estate.

At these rates, much of the value of the business, built up through years of hard work, could end up being passed on to the federal government, rather than to the next generation, if estate planning strategies are not employed to avoid this outcome.