How the 2001 Changes to
Estate and Gift Taxation Affect You

If your estate was large enough to be subject to the estate and gift tax under prior law, the tax bill passed by Congress in May 2001 is likely to affect you and your family positively. Just how positively depends upon a number of factors, many of which are beyond your control. This paper explains some of the likely effects of the tax bill on persons with varying sizes of estates. It is divided into two parts. First is an overview of how the new tax bill affects estate and gift taxation. Second is a more specific look at estates of specific sizes - how does the new tax law affect them, and what are some planning options appropriate to estates of these sizes.

Anything so sweeping as H. R. 1836 which passes so quickly is bound to have quirks, and this tax bill is no exception. Here are a few of these quirks, which will be explained later in this paper:

If you want to take advantage of the estate tax "repeal," you had better die in 2010. Persons dying before and after 2010 are subject to the tax, although persons dying during the period 2002 through 2009 benefit from reduced rates and increased exemptions which may reduce or eliminate the tax, depending upon the size of their estates.

Most people will be taxed less if they die in 2009 (prior to estate tax repeal) than in 2010 (the year of estate tax repeal). When the estate tax repeal is fully effective (2010), the current rules allowing a free step up in basis at death go away. (There is a way to mitigate the harshness of this change for smaller estates.) Thus, your kids may avoid the estate tax but have to pay capital gains tax. If your estate is $3,500,000 or less, your kids probably will be better off financially if you die in 2009 rather than 2010.

You might be able to leave property tax-free when you die, but you probably won't be able to give it away tax-free while you are alive. The tax-free amount for estate tax purposes increases dramatically through 2009 and disappears completely in 2010, but the gift tax tax-free amount is capped at $1,000,000. This will make it hard to transfer small businesses to the next generation so long as the older generation is still alive.

The single biggest change for most persons currently affected by estate taxes is an increase in the amounts which can be left tax-free to loved ones. Currently the tax-free amount is $675,000. That doesn't change for the rest of 2001 - the first benefits of the tax law go into effect in 2002. Here are the tax-free amounts for persons dying in the years 2002 through 2009:

The new law keeps the unlimited marital deduction. This deduction allows a husband to leave an unlimited amount to his wife tax-free, and vice versa. By using a common technique called "bypass trust planning," it continues to be possible to double the tax-free amount for married couples in many cases. ⁽¹⁾ Please note that doubling the tax-free amount requires proper planning - it doesn't happen automatically.

As you can see, most persons currently affected by the estate tax will drop (perhaps temporarily - see the discussion of the "sunset" provision below) from the system long before final repeal in 2010. For example, a married couple with as much as $4,000,000 in property and the appropriate tax planning in their wills may avoid estate taxation if they live until 2006 or later.

While the tax-free amounts will be increasing between now and 2009, the maximum estate tax rates will be decreasing. The current maximum rate is 55% (on amounts in excess of $3,000,000). When fully phased in, the new maximum rate will be 45%. This only affects estates in excess of $1,500,000 - the lower tax rates on estates of less than $1,500,000 remain the same.

Here are the new maximum rates:

The estate and generation-skipping transfer taxes are repealed, effective January 1, 2010. Assuming the law stays the way it is (and that may not be a valid assumption), a person dying during the calendar year 2010 can leave an unlimited amount of property to whomever he or she wishes without any estate or GST tax.

One trade-off between the income taxation and estate taxation systems has been that all property inherited from a decedent gets a new income tax basis at death equal to the property's value at the date of death. Thus, a farm worth $1,000,000 with low basis may be subject to estate tax when the owner dies, but the persons inheriting it get it with a new basis of $1,000,000, meaning that they can sell it at that price after death without having to pay capital gains tax.

The new law keeps this trade-off through 2009 (the last year of the estate tax). In 2010, however, the general rule will be that a person inheriting property keeps the decedent's basis. Thus, in the above example, the persons inheriting the $1,000,000 farm would have to pay capital gains tax on the sale of the farm, measured against the decedent's basis. This is often referred to as "carryover basis." Congress tried this approach once before (in the late 1970s), and it was an administrative nightmare. It could be even more complicated this time around, since the new law allows each person $1,300,000 in "basis increase," and the first spouse to die can get up to an additional $3,000,000 of "basis increase" for property left to the surviving spouse. The "basis increase" will help reduce the amount of capital gains tax, but it will have to be allocated on a tax return filed after the decedent's death.

Since most people now affected by the estate tax will drop out of the system as the tax-free amount increases between now and 2009, their kids will actually be financially better off if they die prior to 2010 - property will pass estate tax free and with the current step-up in basis without the need for filing a complicated tax return.

Since 1976 the estate tax and the gift tax have been part of one unified tax system - the tax-free amounts and the tax rates were the same whether you gave property away during life or left it to someone at death. Under the new law, unification ends in 2004. Beginning that year, increases in the tax-free amount for estate tax purposes will not apply to gifts. The gift tax tax-free amount will remain frozen at $1,000,000.

Congress originally proposed keeping estate taxes and gift taxes unified and repealing the gift tax along with the estate tax. Upon further reflection, however, the proponents of the tax law realized that eliminating the gift tax would permit families to shift property (and, therefore, income) from high-rate taxpayers to low-rate taxpayers. Their solution: keep the gift tax for lifetime gifts in excess of $1,000,000.

While this may curb income-shifting abuses, it leaves families with small businesses somewhat in the lurch. While the tax bill probably has a net positive effect on them, the new law's treatment of gift tax discourages bringing younger family members into the business through gifts of ownership interests.

The new law keeps the annual exclusion from the gift tax the way it is - $10,000 per donee per year, adjusted for inflation. There was widespread speculation that the exclusion would be increased to $30,000 and the "present interest" rule (which results in the need to use "crummey trusts" in some cases ⁽²⁾) would be dropped, but neither of these things happened.

The Congressional Budget Act of 1974 affects Congress's ability to enact tax legislation with effects more than 10 years in the future. To ensure compliance with this Act, the new tax bill provides that the act "shall not apply . . . to estates of decedents dying, gifts made, or generation-skipping transfers, after December 31, 2010." This leads to the odd result that the estate tax is repealed for persons dying in the year 2010, but the old law (with a $1,000,000 tax-free amount and a 55% maximum rate) applies to persons dying in 2011 or later.

This "train wreck" provision means that the tax laws are virtually certain to change between now and 2011. If the coalition which pushed through the new tax bill stays together, and if tax revenues under the new bill are sufficient to support the government, then it is likely that legislation in future years will push the effects of repeal further into the future. If the coalition breaks down, or if tax revenues falter, then a freezing - or a reversal - of the phase-in of tax benefits is likely. If nothing changes, we go back to current law in 2011.

Each person's estate is made up of unique components, and each person's family situation is different. This makes it impossible to give "one size fits all" estate planning advice. However, we can draw some general conclusions about the effect of the new tax law on estates of various sizes if we make certain general assumptions. If nothing else, this enables us to compare the effects of the new tax law across estates of various sizes.

We've made a calculation of the total tax due on estates ranging from $1 million to $10 million, using these assumptions:

None of the assets are tax-deferred (IRAs, 401(k)s, etc.). Obviously, most people have assets such as these, but they make comparisons of this type difficult because of their peculiar income tax characteristics. We ignored these factors for purposes of these rough comparisons.

All assets have a basis of zero, and all assets are sold by estate beneficiaries at fair market value shortly after death. Again, it is obvious that this is an invalid assumption, but it is necessary if we are to compare the effects of the new "carryover basis" rules for persons dying in 2010.

All property of married persons is community property (in other words, half owned by the husband and half owned by the wife).

The "Married" row on the charts assumes that the couple uses basic bypass trust planning and leaves everything else in a way that qualifies for the marital deduction. There are other techniques which might be used which could further reduce taxes, but these aren't illustrated. The "Unmarried" row shows the effect on single persons and on married persons who do not do bypass trust planning.

We assume no estate administration expenses, no appreciation of assets between the deaths of the two spouses, etc.

Estate planning must be tailored to each person or family. Some techniques may be appropriate for some families with estates of a particular size, while the same technique may be inappropriate for another family with an estate of the same size due to asset allocation, family dynamics or personal preference. What follows is a general discussion of estate planning techniques which may be appropriate for persons and families with estates of the sizes indicated. It does not replace a lawyer's specific advice about your situation.

Don't forget that your estate may grow. A $1,000,000 estate now may grow. In years 2002 and 2003, any property over $1,000,000 will be taxed at a 41% rate. Consider planning for the possibility of growth.

Consider a disclaimer trust. Most bypass trusts are mandatory - when the first spouse dies, the trust has to be set up. With the exemption amounts going up, more people should consider disclaimer trusts. This is a type of bypass trust that is established only if the surviving spouse so elects at the death of his or her husband. That way, if the first spouse dies when bypass trust planning still is a good idea, the surviving spouse can elect to create the trust, but if the first death occurs after the tax-free amounts are phased in, the surviving spouse can elect not to create the trust.

Disclaimer trusts may be a good idea. If you are married, consider using a disclaimer trust. That way the surviving spouse can decide after the death of the first spouse to die whether or not to create the bypass trust. The situation may be different at the time of the death of the first spouse, and the disclaimer trust provides added flexibility.

Consider an annual gift-giving program. The $10,000 per donee per year gift tax exclusion was maintained in the new law. If you have more property than you need to sustain yourself, consider gifts worth up to $10,000 per year to your children, grandchildren, etc.

Use a bypass trust. If you are married, you should use a bypass trust unless your family situation dictates otherwise. This can effectively double the tax-free amount for your family. Because it is uncertain whether or not the estate tax repeal will remain (especially in light of the sunset provisions described above), consider sticking with the bypass trust even after the tax-free amount increases to cover the size of your estate.

Disclaimer trusts may be a good idea. If you are married, consider using a disclaimer trust. That way the surviving spouse can decide after the death of the first spouse to die whether or not to create the bypass trust. The situation may be different at the time of the death of the first spouse, and the disclaimer trust provides added flexibility.

Consider an annual gift-giving program. The $10,000 per donee per year gift tax exclusion was maintained in the new law. If you have more property than you need to sustain yourself, consider gifts worth up to $10,000 per year to your children, grandchildren, etc.

Consider an irrevocable life insurance trust. One common planning technique which will survive the new tax law is the irrevocable life insurance trust. Consider setting up a trust, making it possible for the trust to buy a life insurance policy on your life (or on your and your spouse's joint lives) with cash gifts you make to the trust each year. Prior to the law change, these types of trusts most often used cash value life insurance - insurance with an investment component. Now it may be appropriate to consider term life insurance with a five- or ten-year level premium. Term insurance is cheaper, and if the estate tax repeal continues unabated and it looks like no estate tax will be due, the trustee can simply allow the policy to lapse. On the other hand, if the estate tax hits in the next few years or returns because of the sunset provision or future acts of Congress, the insurance policy can help provide liquidity to assist your family in paying the tax (without adding the amount of the policy to your estate for tax purposes).

Insurance trusts. Irrevocable life insurance trusts owning term life insurance are a good way to deal with the incredible shrinking estate tax bill. The insurance is available if death occurs during the time the estate tax is applicable, and the policies can be dropped if the estate tax repeal becomes reality.

Maximize generation-skipping planning. As the estate tax tax-free amount increases, so does the generation-skipping tax (GST) tax-free amount. Parents should consider dynastic trust planning - leaving part or all of a child's inheritance in trust for his or her life, with benefits passing on to grandchildren and great-grandchildren. This will help protect family wealth not only from taxation (if the estate tax returns in the future) but also from erosion due to creditors' claims or a child's divorce.

Family limited partnerships. This popular planning technique still works under the new law, although they may be an unnecessary step for persons with relatively modest estates. At the $4,000,000 level and up, the management advantages and potential tax advantages start to outweigh the costs of setting up a family limited partnership.

Split-interest charitable planning. The new tax law is likely to reduce dramatically the amount of tax-motivated charitable giving, but at higher estate levels there still are advantages to be had by using devices such as charitable remainder unitrusts and private foundations.

Use all the basic techniques. Persons with large estates should be sure to employ all of the basic estate planning techniques appropriate to their situations - bypass trust planning, life insurance trusts, etc.

Maximize generation-skipping planning. Steps should be taken to protect part or all of the wealth passing to the children's generation from taxes, creditors' claims and divorce so that something is left for grandchildren and more remote generations. There are ways to do this type of planning that help avoid "trust baby" syndrome - situations where trust beneficiaries spend all their energy trying to get more money from the trustee rather than living productive, fruitful lives.

Charitable planning. Consider advanced charitable planning techniques, such as a family foundation. In addition to having tax advantages, family foundations can become an important part of the family dynamic. They provide ways to express a family's values and a way to involve younger generation in business and management tasks - on-the-job training for when they become active owners and managers of the family's wealth.

Other advanced techniques. There are other planning techniques which may help save taxes and accomplish family goals.

Footnotes

1. A full discussion of bypass trust planning is beyond the scope of this paper. Contact us at Barnes & Karisch, P. C., for an explanation of this technique and a consultation to see if you could benefit from it.

2. "Crummey trusts" are used when gifts are made to a trust and the donor wishes for the gifts to qualify for the $10,000 per donee per year annual gift tax exclusion. It involves giving notices to the beneficiaries of the trust that they have limited rights to withdraw property from the trust. For a detailed explanation of "crummey trusts" and a consultation to see if you could benefit from this technique, contact us at Barnes & Karisch, P. C.