"Recent Tax Changes Affecting Estate Planning"

by Thomas J. Stikker

As you probably know, Congress recently passed the Economic Growth and Tax Relief Reconciliation Act of 2001 which, among other things, significantly alters the current federal transfer tax scheme (estate, gift and generation-skipping transfer taxes). We are writing this letter to give you a brief overview of some of the most important of these changes affecting estate planning.

Reduction of Estate and Gift Tax Rates

Under the Act, the estate and gift tax rates are gradually reduced until the estate tax is repealed in 2010. In 2002, the highest estate and gift tax rate will be 50% and the 5% surcharge on estates over $10 million is repealed. Thereafter, the highest estate and gift tax rate is reduced by one percentage point each year until it reaches 45% in the year 2007. In 2010, the estate tax is repealed and the highest gift tax rate is equal to the top individual income tax rate at that time.

Estate and Gift Tax Exemption Amount

As you may recall, every individual has a tax credit which allows him or her to pass a certain amount to beneficiaries free from federal estate and gift taxes (either during lifetime or upon death). This exempt amount currently is $675,000. Under the Act, the estate tax exempt amount is increased to $1 million in 2002, $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009 (the year prior to the scheduled repeal of the estate tax).

The exemption amount for lifetime gifts is increased to $1 million in 2002 and will not be increased thereafter. In addition, the use of any portion of your gift tax exemption amount to shelter any lifetime gifts from tax will correspondingly reduce your estate tax exempt amount (i.e., the amount you may leave tax free upon your death).

Generation-Skipping Transfer Tax Exemption

The generation-skipping transfer tax (the "GST tax") is a flat tax equal to 55% of the value of property transferred to persons in your grandchildren's generation or younger (called "skip persons"). Currently, every individual has an exemption which allows him or her to transfer $1,060,000 in assets to skip persons without the imposition of the GST tax. Under the Act, the GST exemption will stay the same through calendar year 2003 (with adjustments for inflation). Thereafter, it will track the increases in the estate tax exemption amount.

Repeal of Estate Tax and GST Tax; Retention of the Gift Tax

The Act provides for the repeal of the estate tax and GST tax as of January 1, 2010. The gift tax, however, will remain in effect, with a top tax rate which is equal to the highest individual income tax rate. Therefore, any lifetime transfers to an individual or a trust for the benefit of someone other than the transferor (or his or her spouse) which exceed the transferor's $10,000 annual exclusion from gift tax will still be subject to the gift tax.

Hopefully, the table below will help you organize the various reductions in rates and increases in exemption amounts which are discussed above.

*Indexed for inflation

Plans Which May Need Attention

To the extent that your estate plan includes substantial tax planning for the estate, gift and generation-skipping transfer tax exemptions, you will want to review it to ensure that your objectives continue to be met. You should promptly review your plan if it includes substantial provisions for grandchildren or other beneficiaries with your GST exemption. Individuals who make a gift of their maximum estate tax exempt amount upon their death outright to, or in trust for the benefit of, anyone other than a surviving spouse may want to consider whether this approach will be appropriate when the estate tax exempt amount gradually increases to $3.5 million between now and 2009.

Moreover, the increase in the estate tax exemption amount, lower marginal estate tax rates and eventual repeal of the estate tax may significantly increase the amount which you leave to your children or other heirs. If you are concerned that the amount which your children will receive may now be too much, you may want to provide for specific dollar amounts for them or caps on their inheritance. If you make charitable gifts in your estate plan primarily to reduce estate taxes, you may want to reevaluate this approach.

Carryover Basis Regime

Under current law, an asset acquired from a decedent receives a step-up in basis to its fair market value as of the decedent's date of death for purposes of calculating capital gain and loss on subsequent sale of the asset. Under the Act, starting in 2010, such property will no longer receive a stepped-up basis. Instead, the recipient of such property will receive the decedent's carryover basis, which is the lesser of the adjusted basis of the decedent (the amount the decedent paid for the asset, plus any improvements, minus any depreciation) or the fair market value of the property on the date of death of the decedent. Thus, the recipient will pay capital gain tax on the sale of such property to the extent that the sale price exceeds the decedent's carryover basis in the property.

The Act provides for several adjustments which may increase the basis of an asset acquired from a decedent. Each individual's estate will receive $1.3 million of additional basis which the executor may allocate to any asset in a decedent's estate, another $3 million of basis which the executor can allocate only to assets passing to a surviving spouse and additional basis equal to certain losses the decedent could have carried forward. No addition to basis may increase the new basis of any asset above its fair market value as of date of death. In addition, an estate, heir or qualified trust that sells the decedent's principal residence may be able to exclude up to $250,000 of capital gain on the sale if the decedent lived in the residence for 2 out of the 5 years preceding his or her death.

If you do not already do so, we recommend that you keep meticulous records of your income tax basis in each asset you own or acquire. For the most part, this means the purchase price of the asset. However, you also should keep track of receipts regarding improvements to real property and depreciation deductions.

529 Plans

College savings plans (known as "529 plans") are investment plans designed to help families save for future college costs. These plans are appealing because, among other things, the assets in them can grow tax-free and the donor can change the beneficiary at any time. The Act makes 529 plans even more attractive by providing that distributions from a plan for the qualified educational expenses of the designated beneficiary will not be taxed to the donor or the beneficiary. This change means that the growth and appreciation in the account will never be subject to income tax, to the extent that distributions are made for educational expenses.

Some Final Thoughts

The Act contains many other changes to the estate, gift and generation-skipping transfer tax laws which are beyond the scope of this letter. Keep in mind that all of these changes are phased in over a nine year period. More importantly, it will take an affirmative act by Congress on or before December 31, 2010 to extend the provisions of the Act beyond January 1, 2011. Without such additional action, we will return to the transfer tax system which we have had up until now (including reinstatement of the estate and generation-skipping transfer taxes in 2011). Any predictions as to what the politicians in Washington, D.C. will do in this regard between now and then would be pure speculation.

We hope this article gives you a basic understanding of the Act's impact on the current transfer tax scheme. Again, you should review your estate plan as the changes made by the Act phase in to make certain that your estate plan carries out your wishes. However, since most of the tax relief in the Act is "back-end loaded," much of the tax planning in current estate plans will remain appropriate for at least the next few years.

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Thomas J. Stikker is a partner with Dudnick Detwiler Rivin & Stikker LLP in San Francisco, California.

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