by Dorothy M. Bickford

In 2001, the United States Congress enacted, and President Bush signed, the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Tax Act). There has been a lot of publicity about some of the provisions of this law, especially the so-called "repeal" of the federal estate tax. The purpose of this article is to explain some of the provisions of the 2001 Tax Act regarding estates and gifts and to clarify what the law did and did not do. One aspect of the law which has recently received some publicity, is that the "repeal" of the estate tax is effective only for the year 2010. The law contains a "sunset" provision which causes all of its changes to disappear on January 1, 2011. Unless specifically reauthorized by Congress before December 31, 2010, the 2001 Tax Act expires on that date and the law in effect in 2001 again becomes effective.

Prior Law. Under the law that was in effect before the passage of the 2001 Tax Act, each individual could pass on up to $675,000 (the exemption amount) to any person without incurring any federal estate or gift tax liability. That meant that an individual could leave up to that amount at death and not have any estate tax to pay or could give away up to that amount during lifetime without paying any gift tax. In addition, any amount you given to a surviving spouse or to a charity was not subject to federal estate tax or gift tax.

One important difference between leaving assets to someone at death and giving them away while you are alive involves the basis of those assets. When you leave assets at death, the person who inherits them, whether there is an estate tax return or not, receives those assets with a "stepped-up" basis. That means that the value the assets had at your death becomes the tax cost or basis to your heir. When your heir sells those assets, his or her capital gain or loss is determined by referring to the value the assets had at your death. For instance, if you acquired stock in IMB at $10 per share, but that stock is worth $90 per share at your death, your heir's tax basis becomes $90 per share. If your heir sells the stock for $100 per share, his or her capital gain is only $10 per share, the difference between the $90 date of death value and the sale price. What you originally paid for it no longer matters.

When you give away property, however, the recipient of the gift generally takes your basis or tax cost in those assets (subject to some adjustments if gift tax is actually paid). That means, for example, that if you bought IBM stock at $10 a share and then gave it away when it was worth $90 a share, the recipient of your gift would also take that $10 a share as his or her basis. If he or she then sells the stock for $100 per share, his or her capital gain is $90 per share. The value of the stock when you gave it away generally does not matter when the recipient of your gift sells it.

Because of the exemption from estate tax and the step-up in basis rules at death, a person's heirs will avoid both federal estate tax and capital gains tax on the assets that person left, if the value of those assets did not come up to the federal estate tax threshold (presently $1.5 million). Therefore, so long as there is a federal estate tax and an estate tax exemption, an individual will be able to pass on up to the exemption amount ($3 million for a married couple this year) without estate tax and with a step-up in the tax basis of those inherited assets for their families. Not only does this allow you to avoid estate tax on at least $1.5 million in assets, but your heirs will avoid capital gains tax on any appreciation in the value of your assets up to that exemption amount.

The 2001 Estate Tax Rules. During the years 2005 through 2009, the 2001 Tax Act gradually eliminates the federal estate tax by increasing the amount of the federal estate tax exemption. The exemption (presently $1.5 million) will increase to $2 million in 2006 and $3.5 million in 2009. In all of those years, amounts passing to a surviving spouse will remain free from estate tax, as they are now, at least until the surviving spouse's death. In addition, the top estate and gift tax rates will decrease gradually from the current 47% rate (affecting the portion of estates above $3 million) to a top rate of 45% in 2007. The gift tax exemption does not increase, however, but remains at $1 million for all years after 2001.

For people who die in 2010, there will be no federal estate tax at all. However, during that year, there will be income tax consequences to the heirs inheriting property in that year. Under the 2001 Tax Act, if you die in 2010, your heirs will inherit not only your stock in IBM, but also your basis in the stock or its value at the date of your death, whichever is lower. That means that, in our example, if your IBM is worth $5 a share at your death, even if you paid $10 a share for it, your heirs will inherit it with a basis of $5 a share. Similarly, if you paid $10 a share for it and it was worth $90 when you died, they would take the stock with your $10 a share basis for purposes of determining capital gains. Factoring in the income tax costs, some heirs will pay more in total taxes if they inherit assets in 2010 than they would if they inherit them before the estate tax is repealed.

There are also new provisions that will be effective in 2010 to allow an executor to increase the basis of some assets up to $1.3 million and, for assets going to a surviving spouse, an additional $3 million of assets may qualify for a basis adjustment. However, not every kind of property will qualify for this basis adjustment and there are significant requirements for reporting basis information at the time assets are transferred. It will be very important for you to keep careful records from here on regarding the purchase price of assets, any adjustments (such as capital improvements to real estate) and depreciation taken on assets. For assets you have purchased, that means you need to keep receipts or statements showing what you paid for it. For property you inherited, it is important for you to have a record of the value at the date of the death of the person who left it to you. For property you acquired as a gift, you need to have a record of the basis of the person who gave it to you. You need to keep these records in a safe place and keep them indefinitely.

State Death Tax Issues. At present, many states (including New Hampshire) do not have a separate estate tax. Under prior law, the federal law allowed a portion of the federal estate tax to be paid to the states in which you have taxable assets. This was called the "state death tax credit" and reduced the amount going to the federal government, but did not affect the total amount of tax an estate paid. Under the 2001 Tax Act, beginning in 2002, the credit for state death taxes was reduced and has been replaced in 2005 with a deduction for estate taxes actually paid to a state. A deduction is worth a lot less than a credit, in general. More importantly, however, the amount of the federal tax that the federal government used to allow to be paid to the states has been completely eliminated. This is a significant revenue loss to the states, insuring that each state will soon enact (and, in the case of Massachusetts, has already re-enacted) its own separate estate tax system.

Finally,Other Estate Tax Changes under the new law include the eventual repeal of the generation-skipping transfer (GST) tax in 2010, with an increase of the generation-skipping transfer tax exemption amount. At present, the amount of the GST exemption is $1.5 million, will continue to equal the amount exempt from federal estate tax ($1.5 million) and will track the estate tax exemption thereafter. Until its repeal, the GST tax rate is also reduced, from its present flat 55% to equal the top estate tax rate. The GST tax is imposed on transfers that skip the generation just below yours, e.g., from grandparent to grandchild, skipping the child.

The 2001 Tax Act also improved the exemption for conservation easements and the provision that allows a deferral of estate tax on a closely held business. However, it also eliminated the family-owned business deduction.

There are also changes to the laws governing retirement plans, allowing for an increase in the maximum amounts that can be contributed to various types of plans and an expansion, beginning in 2006, of a Roth-type program as an adjunct to a 401(k) plan. Moreover, education IRAs and so-called Section 529 funds are now more attractive. Funds gifted to a Section 529 fund are exempt from income tax, similar to an IRA, while they remain in the fund and are also exempt from income tax when withdrawn and used for qualified education expenses. These expenses are limited to higher education, however, and can not be applied to private secondary schools.

Uncertain Impact on Planning. It is still very uncertain whether Congress will avoid the sunset provision which would cause the current law to cease to exist after January 1, 2011. If Congress does not re-authorize the 2001 Tax Act, the estate tax law in effect for 2001 will be reinstated. Congress may also tinker with the tax laws and significantly alter them between now and 2010, given that there will be several elections in the interim. The House of Representatives has recently passed legislation to repeal the estate tax on a permanent basis, but the matter has not yet passed the U. S. Senate. Some compromise proposals are to set the estate tax exemption at $3 million but retain all of the other provisions of the 2001 Tax Act, along with a proposal to set the exemption at $10 million. Given the size of the budget deficit and other economic problems facing the country, the ultimate fate of the federal estate tax is still uncertain.

All of this uncertainty makes estate planning more difficult, but not any less necessary.

Planning Strategies. You should continue to have a good will and a sound estate plan in effect to ensure that your assets will pass as you desire and that the special needs of your family will be properly addressed. This is so even if there is a good chance that you will survive at least until a year when you will not owe estate tax because of the increasing amount of the exemption. If you have an estate larger than the increasing exemption, you may want to consider making gifts at least in the amount of the annual exclusion each year. The federal gift tax law allows you to give away up to $11,000 to an unlimited number of people each year without paying gift tax. By doing this, you remove the gifted amounts from your estate and save on estate tax. In addition, you remove from your estate the post-transfer appreciation in the value of those gifted assets.

Other still important steps to reduce estate taxes include setting up an irrevocable trust to own life insurance on your life, transferring real property to a qualified personal residence trust, forming family limited partnerships, and making use of other still valuable techniques.

For married couples, it remains important to make sure that each spouse has sufficient assets to take advantage of the increasing estate tax exemption. Many wills or trusts should continue to use a bypass or credit shelter trust, funded with an amount equal to the federal estate tax exemption.

In second-marriage situations, it is very important to have your existing documents reviewed carefully. An unintended result of the increasing amount of the federal estate tax exemption could be to pass on all or the major portion of assets to someone other than the surviving spouse.

All estate plans need to be reviewed and perhaps revised to take into account the new basis rules that will become effective in 2010. It may be necessary to provide instructions to your executors regarding how the allowable basis increases are to be allocated among your heirs, given that the change in the law regarding basis will affect each heir's inheritance.

A macabre scenario reported in some newspapers involved the importance of stating wishes regarding life support systems in a carefully prepared health care advance directive. Under the situation described, a family could potentially keep a wealthy elder member alive on life support systems, against his or her wishes, until January 1, 2010, in order to take advantage of the repeal of the estate tax that will be effective on that date.

Finally, all estate plans, including trusts, should be reviewed in light of the new laws, to make certain that there are no unintended consequences under the new law flowing from the language used under existing or prior law or from the transfers of various types of assets, such as retirement accounts, to a trust at death.