Estate Tax Changes

By: Burt Levitch

Date: July 2001

To Our Estate Planning Clients and Friends:

Fasten your seat belts, as we begin to navigate the confusing terrain of new federal estate and gift tax legislation signed into law last month.

The good news?  Significant increases in the estate tax exemption amount beyond the current $675,000 should result in substantial savings for heirs over the next few years.  In addition, the top estate tax rate will fall during the same period, further reducing the tax burden in many cases.

The bad?  Other aspects of the legislation are so peculiar that further changes are almost inevitable.  As a result, long-range planning has become more difficult, and frequent document reviews will assume new importance.

The ugly?  Existing will and trust provisions that work fine in 2001 may produce dramatically different results in future years.  Some adjustments in your own plan may be required to avoid unintended consequences.

Now that I've got your attention, bear with me as I describe some of the most important changes.  As you think about your own circumstances in the context of the information presented, you should begin to get a sense of what these changes mean for you and your heirs.

I.     SO WHAT CHANGES?

        A.     Exemption amount increases (for a while).  The amount of assets exempt from estate tax will rise substantially in the coming years.  Under prior law, the current $675,000 exemption amount -- which could be used for tax-free transfers during lifetime, at death, or in combination -- was scheduled to rise incrementally to $1,000,000 by 2006.  As shown in the chart below, the exemption amount now becomes $1,000,000 on January 1, 2002.  At two-year intervals, the exemption rises to $1,500,000 and then $2,000,000, where it remains for three years.

                 Then all logic ceases.  The exemption leaps to $3,500,000 for decedents dying in 2009, and the exemption, for practical purposes, is unlimited in 2010 -- the estate tax is repealed for that one year.  But in 2011, the tax returns with a vengeance as the exemption amount drops back to $1,000,000.

                                                                                                             Estate Tax
                           Calendar Year     Estate Tax Exemption           Maximum Rate

                   2001                      $   675,000                            55%

                   2002                      $1,000,000                            50%

                   2003                      $1,000,000                            49%

                   2004                      $1,500,000                            48%

                   2005                      $1,500,000                            47%

                   2006                      $2,000,000                            46%

                   2007                      $2,000,000                            45%

                   2008                      $2,000,000                            45%

                   2009                      $3,500,000                            45%

                   2010                               -- No estate tax in 2010 --

                   2011                      $1,000,000                            55%

        B.     Maximum tax rate falls (for a while).  As the chart also shows, the top estate tax rate will drop from the current 55% to 50% on January 1, 2002, and then gradually ease to 45%.  But following the single "repeal" year of 2010, the maximum rate returns to the current 55%.

        C.     Generation-skipping transfer tax links more closely with estate tax.  Under prior law, individuals had a $1,000,000 exclusion from the generation-skipping transfer tax, long imposed -- in addition to the estate tax --on gifts and bequests to grandchildren and other beneficiaries more than one generation removed from the donor.  In recent years, the $1,000,000 has been indexed for inflation.  The tax rate is the same as the highest estate tax rate.  With the new legislation, the generation-skipping transfer tax exemption will be the same as the estate tax exemption beginning in 2004 (thereby encouraging larger bequests to grandchildren).

         D.     Gift tax lessens, but survives.  Until now, the estate and gift tax have been part of a unified federal transfer tax system -- and the exemption amount ($675,000 in 2001) could be used to reduce or eliminate tax on lifetime transfers, bequests at death, or a combination of the two.  Under the new legislation, the gift tax exemption increases along with the estate tax exemption to $1,000,000 on January 1, 2002, but the gift tax exemption remains at $1,000,000 throughout the decade.  The gift tax rate will fall in concert with the estate tax rate as shown on the preceding page, but when the estate tax is eliminated for 2010, the gift tax will remain in effect (although the gift tax rate then will drop further -- to the new top federal income tax rate of 35%).  Individuals may continue to transfer up to $10,000 per year to each of an unlimited number of beneficiaries without using their $1,000,000 gift tax exemption, and direct payment of tuition and medical expenses will continue to fall outside the transfer tax system.

        E.     What else changes?  It seems almost pointless to dwell on some of the additional changes contained in the new law, since the time at which certain changes would occur is so distant and because the likelihood of intervening legislation that will derail or modify these changes is so high.  Nonetheless, it is interesting to note that beginning in 2010, the year in which the estate tax is scheduled for repeal, heirs will no longer receive a stepped-up basis for income tax purposes on all inherited assets.  Instead, only $1,300,000 of assets will receive a new stepped-up basis equal to fair market value at the time of death, and a surviving spouse will be eligible to receive an additional $3,000,000 in assets with a stepped-up basis.  Careful recordkeeping would become critical.

II.     WHAT IS THE PRACTICAL EFFECT OF THESE CHANGES?

         The impact of the legislation is far-reaching.   Here are just some of the potential consequences and questions arising from these changes.

        A.     Some document provisions may be extraneous, or even create unneeded complexity.  For clients of relatively modest wealth who nonetheless had taxable estates under prior law, the pending increases in the exemption amount may eliminate estate tax liability in the coming years.  Existing wills and trusts may contain exemption planning provisions, including the mandatory establishment of exemption or "bypass" trusts, that in light of the new legislation add unnecessary complexity (and administrative expense) following the first death.

        B.     Some provisions may have alarmingly unintended consequences.  For other clients, the newly-scheduled increases in the exemption amount require a careful review of existing clauses, particularly those designed to shield the first spouse or partner's exemption amount from taxation on the second death.  Many such provisions retain the exemption amount in trust for the survivor, while some create outright bequests to others on the first death.  To avoid potentially disturbing surprises -- such as unexpectedly large bequests to children and grandchildren and relatively small bequests to a surviving spouse -- it is extremely important to determine the effect of the new legislation on your current documents.  Only then can you identify what, if any, changes are appropriate to your present circumstances.

        C.     Is this a good time to make gifts?  With the increase in the gift tax exemption to $1,000,000 less than six months away, you might consider making gifts to utilize this higher amount.  Many of you have not utilized any of the exemption, while others have exhausted the previous limit of $675,000 and may wish to use the "new" $325,000 that becomes available on January 1, 2002.  However, you must remember that gift recipients will have your historical, carryover basis in the gifted assets, and the resulting income tax impact (capital gains tax imposed on the recipient's eventual sale of the asset) must be weighed against possible estate tax savings (achieved by removing an appreciating asset from your estate) and even possible estate tax repeal.

III.   IN CONCLUSION.

        While the foregoing information will get you thinking about the impact of this legislation on your own circumstances, your reading of this presentation is not a substitute for a careful review of your documents and overall situation by a qualified professional.

        A thorough estate planning checkup under the new law would include not only existing will and trust provisions but also beneficiary designations for retirement plans and life insurance policies.  (Indeed, one consequence of the new law is a reexamination of life insurance coverage and whether it still makes sense, particularly for those policies that were obtained to compensate for future estate tax liability.)  And no review would be complete without considering the nature and extent of your assets -- many of which have appreciated since your estate plan was designed.  So, in addition to reviewing the impact of change coming from Washington, you need to determine whether your current estate plan makes sense in light of your changing net worth.

        If we can be of assistance in sorting through the issues presented, please let us know.

 With over a decade of tax-related legal experience, Burt Levitch, head of our Trusts and Estates Department, devotes his practice to estate planning and estate and trust administration.  In addressing these issues, he helps clients consider the financial and emotional needs of family and friends while facing the constraints imposed by estate taxation and other applicable laws.

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