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To: Our Clients and Friends
From: Jane L. Brody, Esq.
Date: July 2001
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As you know, a sweeping tax law change was recently passed by Congress and signed by President Bush.
I am writing this letter to provide you with some basic information as to how your estate planning may be affected by the “Economic Growth and Tax Reconciliation Act of 2001”.
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The new law gradually eliminates the estate tax by increasing the amount that is exempt from the tax over several years and reducing the top rate over several years. It finally repeals the estate tax for individuals dying after 2009. There is, however, a quirk in the new law. To comply with budgetary rules, the 2001 Tax Act contains a “sunset rule” under which the pre-2001 Act rules return after 2010, unless Congress provides otherwise at some future time. This means that although the estate tax is repealed, it is repealed only for those who die in 2010; absent Congressional action, the estate tax returns thereafter unless Congress provides otherwise.
Under pre-2001 law, each individual could give, either during his/her lifetime or at death, $675,000, free of transfer taxes. This meant that a married couple could, with proper asset allocation and a carefully drafted Will, shield $1,350,000 from estate taxes, irrespective of which of them passed away first. Under pre-2001 law, there were differences in a recipient’s income tax consequences, depending on whether the recipient received property by gift during the donor’s lifetime, or after the decedent’s death. Under pre-2001 law, a donee generally has the donor’s basis (usually cost) for property received as a gift. So, for example, if a donee received a gift of appreciated stock, the recipient will have a taxable gain if the recipient sells the appreciated stock. On the other hand, a recipient of property from a decedent’s estate generally receives a basis equal to its value of the asset at the decedent’s death. So, for example, the appreciated stock received as an inheritance, rather than as a gift, is received with a basis equal to its value on the date of the decedent’s death. This means that a recipient generally pays less income taxes on the sale of an asset which the recipient received as an inheritance than if he/she had received the asset as a gift.
The new law substantially increases the $675,000 exemption after 2001 for estate (but not gift) tax purposes. The estate tax exemption rises to $1,000,000 for 2002 and 2003, $1,500,000 for 2004 and 2005, $2,000,000 for 2006 through 2008, and $3,500,000 in 2009. The estate tax is repealed in 2010; however, under the sunset rule, the estate tax returns in 2011 and the exemption returns to $1,000,000 for both estate and gift tax purposes in 2011. The gift tax exemption amount, on the other hand, remains at $1,000,000 for all years after 2001, and the gift tax is not being repealed during 2010 as the estate tax is. Only the estate tax exemption amounts will rise above $1,000,000.
The highest estate and gift tax rate (55% under pre-2001 law) drops to 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007 through 2009. In 2010, there will be no estate tax and the top gift tax rate will be 35%. The top estate and gift tax rate reverts to 55% in 2011.
When the estate tax is repealed in 2010, the basis rules will change also to be similar to the gift tax rules, but with some opportunities for heirs to get increases in basis. For example, it will be possible to increase the basis of assets received from an individual dying in 2010 by $1,300,000 and by an additional $3,000,000 for assets going to a spouse. Under the sunset rule, the step-up in basis rules return for 2011 when the estate tax returns.
The 2001 Act contains a number of other changes, some of which are retroactive. On the positive side, it simplifies and reduces the generation-skipping transfer tax, which is a special tax that is designed to prevent individuals from avoiding the estate tax by transferring assets to a generation below the next one (e.g., a grandparent transferring to a grandchild rather than to child). It also improves the provision that allows deferral of estate taxes which are due with respect to a closely held business. On the negative side, it eliminates the family-owned business deduction for individuals dying after 2003.
As you can well imagine, the uncertainty of whether the sunset provision will take effect and whether an individual will die during a period of increasing exemption amounts makes planning difficult. Also, unfortunately, the way the new law works, when income tax costs are factored in, some heirs will face higher tax costs if their benefactor dies in 2010 when the estate tax is repealed than they would have if their benefactor had died before 2010.
We suggest the following:
• Continue to have wills to ensure that your assets will pass in accordance with your wishes and to ensure that special needs of particular heirs will be properly addressed. This is so even if there is a good chance of survival until a year when estate taxes will not be owed because of the increasing exemption or repeal. Individuals who may have an estate larger than the increasing exemption amount (or the $1,000,000 amount that will apply for 2011 after estate tax is restored one year after it is repealed) should consider making annual exclusion gifts each year. The gift tax annual exclusion allows you to give $10,000 to an unlimited number of donees each year without paying gift tax. By doing this, you remove the gift amounts from your estate and save estate tax. In addition, you remove the post-transfer growth in the gifts from your estate. Other steps that can be taken to reduce the potential estate taxes due include setting up a life insurance trust, establishing a grantor retained annuity trust, establishing a family limited partnership and placing one’s residence in a qualified personal residence trust.
• Married couples should continue to allocate the ownership of their assets to make sure that each spouse has sufficient assets to take advantage of the increased exemption. Also, married couples should consider establishing the so-called “bypass” or “credit shelter trust” under their Wills. Such a trust can be required by the provisions of the Will or can be an option provided to the surviving spouse. If the trust is required under the Will, the trust would be funded with an amount of assets owned by the deceased spouse equal to the exemption. If the surviving spouse has the option to establish the trust, it will be funded with an amount of assets owned by the deceased spouse determined by the surviving spouse; provided that the amount would not exceed the exemption amount. In either case, the surviving spouse can receive income and principal from the trust. The assets in the trust then pass to the heirs free of estate tax in both estates on the survivor’s death. Assets above the exemption amount can be given outright to the surviving spouse or placed in a special marital trust for him or her.
• Retain all records of cost or other basis (for purchased items, this means receipts and statements showing the amount you paid for it; for items inherited before 2010, basis ordinarily is the date of death value of the item; for property acquired by gift, the donee’s basis is usually the same as the donor’s; for depreciable property, basis is reduced to reflect allowable depreciation). With the scheduled change to a modified carryover basis system in 2010, it is essential that you do this.
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While the 2001 Act may well save estate tax to the benefit of your heirs, it has added many new planning complications. Please feel free to contact me to set up an appointment so that we can properly reexamine your estate plan to help to keep your estate tax, and income tax for your heirs, to a minimum.
Best regards.
Contact: Jane L. Brody
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