Estate Planning Tax Law Changes: General

  
You have probably heard that Congress has repealed the estate tax as part of the 2001 Tax Relief Act.  I am sure that you are wondering what effect, if any, this will have on your estate plan, which was prepared at a time when estate tax repeal seemed unlikely.  This letter is intended to provide you with the details of estate tax repeal.  It also discusses the little-known tax increase that will replace the estate tax and offers planning ideas for minimizing your taxes, both before and after repeal takes place.

1.    Estate Tax Repeal

      The 2001 Act repeals the estate tax, but repeal will not be effective until January 1, 2010.  Although the proponents of repeal had hoped for more immediate action, budgetary constraints delayed outright repeal for more than eight years.  Budget rules also required that the Act provide for the reinstatement of the estate tax starting in 2011.  It is unclear whether a reinstatement of the tax will take place if repeal actually occurs.

       Although repeal lies well in the future, the 2001 Act reduces the estate tax on the estates of those who die during the transitional period.  It does this in two ways:  First, in a provision that benefits all estates, it steadily increases the individual exemption amount (set at $675,000 for 2001) so that it will be $1.0 million in 2002 and 2003, $1.5 million in 2004 and 2005, $2.0 million in 2006, 2007, and 2008, and $3.5 million in 2009, the final year before repeal.  Married couples, with effective planning, are able to take advantage of two exemptions in their estates.  Thus, as early as 2002, a married couple with a $2.0 million estate will no longer be subject to the estate tax.

       The other tax-saving feature during the transitional period is a reduction in the top estate and gift tax rates, currently set at 55% and 53%.  This change will help only wealthier taxpayers, since these top rates affect only estates of more than $2.5 million.  Effective January 1, 2001, the top rates of 53% and 55% are eliminated and replaced with a rate of 50% on taxable estates in excess of $2.5 million.  The top rate is then further reduced by 1% a year until 2007, when it will be 45%, and it remains at that level until the estate tax is repealed at the end of 2009.

2.    Loss of Basis Step-Up at Death

       The quid pro quo for repeal of the estate tax was the loss of step-up income tax basis at death.  Currently, all property owned by a decedent for estate tax purposes receives a date-of-death basis for income tax purposes, unless the alternate valuation date (six months after death) is elected on the estate tax return.  Effective for persons dying after December 31, 2009, property acquired from a decedent will retain the decedent's tax basis.  This is known as "carryover" basis.  When the recipient of the property eventually sells it, he or she will be compelled to compute the gain using the decedent's adjusted basis.  In most cases, the decedent's basis will be less than the date-of-death value, resulting in an increased capital gains tax.

       The legislation contains two major exceptions to carryover basis.  First, the estate of every decedent who is a U.S. citizen or resident will be entitled to increase the basis of the decedent's property by up to $1.3 million ($60,000 for estates of nonresident aliens), although no item of property may have its basis increased above its fair market value on the date of death.  If the estate is valued at $1.3 million or less, each asset will automatically receive a basis equal to its date-of-death value.  If the estate is larger than $1.3 million ($60,000 for estates of nonresident aliens), the estate must file a return allocating the basis increase to specific assets.

       If the decedent was married, the estate is entitled to an additional basis increase of up to $3.0 million for property passing to the surviving spouse, regardless of citizenship or residence.  This increase can be applied to property passing outright to the spouse or in the form of a QTIP trust.  It will also be necessary to file a return to claim the $3.0 million basis increase and to allocate it to the marital property.

       Both the $1.3 million and $3.0 million basis increases (as well as the $60,000 amount for nonresident alien estates) will be subject to an annual inflation adjustment after 2010. 

3.      Retention of the Gift Tax

       To the surprise of many, the 2001 Act did not repeal the gift tax.  Even after estate tax repeal, the gift tax will continue to be imposed on gifts in excess of the individual exemption amount.  Congress was less than generous in setting the lifetime exemption amount for gift tax purposes.  Like the estate tax exemption, the gift tax exemption increases to $1.0 million in 2002, but receives no further increases.  Thus, it will indefinitely remain at $1.0 million.

       In 2010 the maximum gift tax rate will drop to 35%, equal to the top income tax rate for individuals.  There is good reason for this linking of the top gift tax and income tax rates.  Congress decided to retain the gift tax due to concern that lack of a gift tax would encourage taxpayers to make tax-free gifts of income-producing property to family members in lower income tax brackets.  Such transfers would be an easy way to reduce the overall income tax burden on the family.  Although it will still be possible to make such transfers after estate tax repeal, the reduced gift tax will act as a "toll charge" for taxpayers engaging in this type of planning.

4.      Generation-Skipping Transfer Tax Repeal

       The Act also repeals the generation-skipping transfer (GST) tax, effective for transfers after December 31, 2009.  This tax is imposed on gifts and bequests to grandchildren, great-grandchildren, and trusts established for their benefit.  Currently, planning for the GST tax is focused on the effective use of the $1.0 million GST exemption.  This exemption is scheduled to increase in tandem with the estate tax exemption, so that the GST exemption will be $3.5 million in 2009, the year before repeal.  If your estate plan includes a generation-skipping trust, we should reexamine it in light of this increased exemption.

       There will also be a reduction in the current GST tax rate of 55% during the transition period, since that rate is linked to the highest estate tax rate, which will fall to 45% by 2007.

 5.    Repeal of Family-Owned Business Deduction

       The Act repeals the family-owned business deduction, effective for persons dying after December 31, 2003.  At first glance, this repeal seems not in keeping with Congress' goal of reducing estate taxes.  However, the amount of the family-owned business deduction, when combined with the exemption amount, is limited to $1.3 million.  Since the exemption amount increases to $1.5 million in 2004, the allowable deduction would have decreased to zero.  As a result, Congress concluded that there was no longer a need for the deduction.  Given the complex requirements for qualifying for the deduction, this is a good result for taxpayers.

 6.    Repeal of State Death Tax Credit

       Under current law, an estate is entitled to a dollar-for-dollar federal estate tax credit (subject to a cap) for the amount of any state death taxes paid by the estate.  This credit was repealed by the Act, effective for those dying after 2004, and replaced with a state death tax deduction.

       The repeal of the state death tax credit will have no immediate effect on most estates, since Alaska's death tax is written in such a way that it only applies if the estate qualifies for the federal credit.  The repeal of the federal credit will effectively repeal the state taxes.  But do not be surprised if Alaska, or other states, revises their laws to impose their estate taxes even if the credit is no longer available.  The result will be a net tax increase for estates located in those states.

7.      Planning Considerations During the Transition Period

       Because the estate tax remains in effect until the end of 2009, it is not recommended that you immediately revise your estate plan to take advantage of its repeal.  Since we all have a chance of dying before repeal takes place, it is necessary to have an estate plan that is designed to minimize the estate tax.  Estate tax repeal will do little good for the individual who dies on or before December 31, 2009, when the tax is still in effect.

      Because of the phased-in increase in the unified credit that takes place during the transitional period, it is important that your current estate plan be reviewed to ensure that it takes advantage of this increase.  If your plan uses a "formula clause" that allocates a portion of your estate to a credit shelter trust that is equal to the amount of the unified credit on the date of death, it will be able to take advantage of the increased credit.  If, however, it refers to a specific dollar amount, it needs to be revised if you wish to use the increased credit.  In some cases, however, a formula clause may no longer be appropriate.  If the value of the combined estates of both spouses is under $4.0 million, a formula clause could have the effect of shifting too much of the estate into the credit shelter trust and leaving too little outright to the surviving spouse.

8.      Planning Considerations After Repeal

            It is not too soon to start thinking about how your estate plan will be affected by estate tax repeal.  After 2009, the focus of estate planning will shift to income tax planning, and you should consider the effect that this will have on your plan.  Because of the loss of stepped-up basis, planning will concentrate on the effective use of the total $5.6 million basis increase that is available to a married couple and the $1.3 million increase that can be used by a single individual.

       For a married couple, it is likely that their revised estate plan will include a "shelter" trust that will hold property with a basis that is $1.3 million less than its date-of-death value.  Such a trust, which could benefit both the surviving spouse and the children, would take advantage of the $1.3 million basis increase available to every estate.  The second component of the plan would be a bequest to the surviving spouse (either outright or in trust) that would be funded with property that has a basis that is $3.0 million basis increase available for transfers to a surviving spouse.  When the surviving spouse died, his or her estate will still have its own $1.3 million basis increase that could be allocated where it could do the most good.

       In larger estates, the ability to allocate the basis increase will bring its own problems.  If the potential capital gain in the estate assets is greater than the available basis increase, the executor will be placed in the situation of deciding which assets and beneficiaries receive the advantage of the basis increase.  Your will or trust document will have to provide explicit instructions to your executor as to how he or she should allocate the basis increase.  Otherwise, the estate may face litigation from unhappy beneficiaries.

       Since the gift tax is not being repealed, valuation discounts will remain a valuable tool in making lifetime transfers.  Family limited partnerships and limited liability companies will continue to be used to minimize the value of lifetime gifts to family members, thereby maximizing the use of the $1.0 million gift tax exemption.  There will, however, be a disincentive to making lifetime gifts in excess of $1.0 million, since such gifts will be subject to a 35% gift tax rate.  By waiting to make such gifts until death, the gift tax will be avoided.

       Lifetime charitable gift planning is unlikely to change, since much of it is income tax driven.  Charitable remainder trusts will still be valuable tools for eliminating the tax on appreciated assets, while at the same time converting those assets into a lifetime income stream.  With the loss of the state tax, there will be less of an economic incentive for making charitable gifts at death, yet some clients may still wish to fulfill their charitable impulses by making such gifts.  With the loss of stepped-up basis at death, it will become important to give the executor the ability to satisfy charitable bequests with appreciated property, rather than cash, to get the appreciated property out of the estate.

       The role of life insurance in estate planning will change.  After estate tax repeal takes effect, it will no longer be necessary to maintain policies solely for the purpose of paying estate tax.  It may be advisable to cash in or sell such policies at that time.  Likewise, irrevocable life insurance trusts may no longer be appropriate after repeal, since most such trusts are established for the purpose of insulating the proceeds from estate tax.  If you have established such a trust, we should reexamine its purposes in light of estate tax repeal.

Conclusion

       Congress, in the 2001 Tax Relief Act, finally achieved the goal of estate tax repeal.  Repeal does not, however, eliminate the need for effective estate planning, particularly in light of the increased capital gains taxes that will be imposed on property received from an estate.  Fortunately, the eight and one-half year transitional period gives us sufficient time to review your current estate plan and, if necessary, modify it to meet the challenges of the new tax regime.