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Trusts & Estates

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President Signs New Tax Bill Into Law – Significant Estate Tax Changes Are Not What They Seem

Summer 2001

The Economic Growth and Tax Relief Reconciliation Act of 2001, which President Bush signed into law on June 7, 2001, has been widely reported as providing for the repeal of the estate tax. Due to the budgetary and process restraints under which Congress operates, the "repeal" is more illusion than reality: The new law "sunsets" on December 31, 2010 and existing law is reinstated at that time. Once all the smoke and mirrors are removed, what is left are provisions which modestly and temporarily reform the estate tax over time, but which do not accomplish an effective repeal. The Act is not the end of the political war over the estate tax. It is simply the outcome of another skirmish within its long history.

Our advice to clients is that their estate planning must continue on a consistent basis in order to achieve their long-term goals. There is change brought about by the Act. Any time there is change, whether in the law or in a client's personal situation, there is both opportunity and potential hazard. We are here to assist you in taking advantage of the opportunities while avoiding the hazards that change may present.

What follows are brief highlights of the changes to the estate tax, gift tax, and generation-skipping transfer tax under the Act.

Estate Tax

  • The estate tax exemption is currently $675,000. The exemption will be increased as follows:
    • $1 million in 2002
    • $1.5 million in 2004
    • $2 million in 2006
    • $3.5 million in 2009
    • The estate tax will be repealed on January 1, 2010, but reinstated on January 1, 2011.
  • The maximum estate tax rate (currently 55%) will be reduced as follows:
    • 50% in 2002
    • 49% in 2003
    • 48% in 2004
    • 47% in 2005
    • 46% in 2006
    • 45% in 2007
  • In 2002, the 5% surtax on estates larger than $10 million will be eliminated.

Income Tax Basis of Property Passing at Death

  • Current law generally provides that the income tax basis of most appreciated property received from a deceased individual is equal to its fair market value as of the date of death (i.e. the inherited property receives a "stepped-up" income tax basis).

  • Beginning January 1, 2010 (and coinciding with the repeal of the estate tax), the income tax basis of inherited property will not automatically receive a "stepped-up" income tax basis. Instead, subject to certain exemptions, most inherited property will have the same income tax basis it had in the hands of the deceased individual (i.e. carryover basis). This means that appreciated assets passing at death will be subject to capital gains tax on sale.

  • The change in the law will require individuals to keep precise records in order to track the income tax basis of the property.

  • Congress previously enacted a carryover basis tax structure in the 1970's, which was repealed by Congress a few years later because it proved to be unworkable.

Gift Tax

  • The gift tax exemption is currently $675,000. In 2002, the gift tax exemption will be increased to $1 million.

  • The maximum gift tax rate will be the same as the top estate tax rate until 2010. Beginning January 1, 2010, the maximum gift tax rate will be reduced to 35%.

  • The gift tax is not repealed.

Generation-Skipping Transfer Tax

  • The generation-skipping transfer (GST) tax exemption is currently $1,060,000. This exemption will continue to be increased for inflation until 2004.

  • From 2004 through 2009, the GST tax exemption will equal the estate tax exemption.

  • The GST tax rate (currently 55%) will be reduced to equal the maximum estate tax rate.

  • The GST tax will be repealed on January 1, 2010, but reinstated on January 1, 2011.

  • The rules governing the allocation of GST exemption have been modified to provide for an automatic allocation to certain trusts. Some taxpayers may have to elect out of this automatic allocation in order to avoid an unintended result. Therefore, all taxpayers who have made or will make gifts to trusts after December 31, 2000 should seek advice regarding the application of the automatic allocation rules to their particular situation.

Economic Growth and Tax Relief Reconciliation Act of 2001

Timeline of Estate, Gift and Generation-Skipping Transfer Tax Provisions

Estate tax exemption Top estate tax bracket Gift tax exemption Top gift tax bracket GST exemption Basis of estate assets
2001 675,000 55% 675,000 55% 1,060,000 Basis Step-up
2002 $1,000,000 50% $1,000,000 50% *** same as above
2003 $1,000,000 49% $1,000,000 49% *** same as above
2004 $1,500,000 48% $1,000,000 48% $1,500,000 same as above
2005 $1,500,000 47% $1,000,000 47% $1,500,000 same as above
2006 $2,000,000 46% $1,000,000 46% $2,000,000 same as above
2007 $2,000,000 45% $1,000,000 45% $2,000,000 same as above
2008 $2,000,000 45% $1,000,000 45% $2,000,000 same as above
2009 $3,500,000 45% $1,000,000 45% $3,500,000 same as above
2010* Estate tax repealed Estate tax repealed $1,000,000 35% GST tax repealed Carryover basis
2011** $1,000,000 55% $1,000,000 55% *** Basis Step-up

*Effective for the year 2010 only, the estate tax and GST tax is repealed.

**Barring additional legislation between now and 2011, starting in 2011, the estate, gift and generation-skipping transfer tax laws revert to current law.

***The GST exemption amount is increased annually for inflation. Based on current law, it will increase in 2002 and 2003. It also appears that if the law reverts to current law in 2011, there will be an adjustment to the GST exemption to take into account inflation from 2003 through 2010.

© 2001, Fredrikson & Byron, P.A.

Miscellaneous Estate, Gift and Generation-Skipping Transfer Tax Changes

In addition to the changes discussed above, there are several other notable changes under the Act. These changes include:

  • Reduction of the state death tax credit starting in 2002 and replacement of the credit with a state death tax deduction in 2005. This change will cause a reduction in revenue for many states, with some states suffering significant losses of revenue.

  • Expansion of the property that can be subject to a Qualified Conservation Easement.

  • Liberalization of the ability for some estates with closely-held business interests to qualify for payment of estate taxes on an installment basis.

  • Elimination of the deduction for qualified family-owned business interests starting in 2004.

  • Additional modifications to the generation-skipping transfer tax rules.
    Waiver of the statute of limitations period for certain estates electing special use valuation for farm real estate.

Summary

As a practical matter, these changes in the tax laws may lead to some inadvertent results which may significantly affect the economics of your estate plan. We encourage you to contact your Trusts & Estates counsel at Fredrikson & Byron to learn more about what these changes mean to you.