Articles

4416 East West Highway
Fourth Floor
Bethesda, MD 20814-4568
Phone: (301)986-9600
Fax: (301)986-1301
Toll Free: (888)986-9600
E-mail: sgro@sgrolaw.com

The Wild and Crazy New Estate Tax

Your estate may pay less tax, but you still need a good plan

To say that the tax relief act of 2001 phases out or repeals the federal estate tax is wishful thinking -- some would call it flimflam. True, if you happen to die in 2010, your estate will owe no estate tax whatsoever -- no matter what it's worth -- assuming Congress doesn't change the law again before then. But if you die in any other year, you'll have to do the math and maybe pay the piper.

We can't predict when we'll die, so we still have to try to minimize our estate tax using the traditional methods: trusts, life insurance and giving away assets. In response to the new act, you will need to update your current estate plan.

Here's a summary of how Congress changed the estate tax, and some suggestions about what you can do to eliminate or limit your liability.

Key Estate Tax Changes

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 changes the estate tax in two basic ways. It:

1. Increases exemption amounts, and
2. Lowers the top tax rates (see "Transfer Tax Exemptions and Rates" on page 2).

These changes occur incrementally over the next eight years until the estate tax disappears in 2010. But then in 2011 it reappears at roughly the same levels as in 2006.

Confusing? Sure is. Here's a more detailed explanation of the major changes in the estate tax.

Exemption Increases

The estate tax exemption, currently $675,000 (double that for married couples), is the amount you can pass along to your heirs free of estate tax. Before EGTRRA, the exemption was scheduled to rise incrementally to $1 million by 2006. Every penny over the exemption is subject to tax.

The act will accelerate and magnify the exemption increases. The exemption amount will gradually rise through 2009, then disappear in 2010. Then (this is the wild, crazy part) the exemption will revert to $1 million in 2011 (where it would have been at that time without EGTRRA), unless Congress changes it. (See "Transfer Tax Exemptions and Rates" above.)

The gift tax exemption, which currently is the same as the estate tax exemption, will also increase to $1 million in 2002. But it won't increase any further. And, if Congress makes no further changes, it will remain $1 million even in 2011, because that's where it would have been at that time without EGTRRA.

Keep in mind that the estate and gift tax exemptions are cumulative. In other words, whatever part of your gift tax exemption you use during your life is subtracted from the estate tax exemption at the time of your death to determine the available estate tax exemption for your assets. So if you die in 2009 having used up your $1 million gift tax exemption, $2.5 million of assets could pass estate tax free to your heirs.

Beginning in 2004, the generation-skipping transfer (GST) tax exemption also will increase -- to the same amounts as the estate tax exemption. Until that point, the exemption -- currently $1.06 million -- will be indexed annually for inflation according to pre-EGTRRA law. In 2011, it will also revert to where it would have been without EGTRRA.

Rate Cuts

The highest marginal estate tax rate, now 55%, will decrease to 50% in 2002. Thereafter, it will decrease by 1% each year until it reaches 45% in 2007. Then it will spring back to 55% in 2011.

The top gift tax rate will drop concurrently with the estate tax rate through 2009. Then when the estate tax is repealed in 2010, the gift tax rate will drop to the same level as the highest income tax rate at that time -- 35%. And, of course, it too will spring back to 55% in 2011. The GSTtax rate will continue to equal the top estate tax rate, falling and rising the same way. Previous law had no scheduled rate reduction.

Keeping Your Estate Plan Up To Date

For long-range planning, consider the reasonable likelihood that Congress will revise the estate tax again within the decade. The best strategy in most cases is to assume that Congress will not permanently repeal the estate tax.

The first set of changes will take effect in 2002, so review your estate plan as soon as possible. Exactly what action you should take in response to the estate tax changes depends mainly on your estate's value.

If you have a credit shelter trust and you and your spouse own assets exceeding $675,000, consider gradually increasing your allocation to the trust as the exemption increases. But do so only with advice from your attorney, because -- to take full advantage of this strategy -- you may need to transfer assets to your spouse as the exemption increases.

If you have a revocable trust with assets worth less than $1 million (or less than the revised exemption amount in any future year), what should you do? Keep the trust in force to avoid probate, but you probably won't need to do anything else with it.

Lifetime Gifts Still Make Sense

The act doesn't change the fact that you can annually give away $10,000 tax free to as many recipients as you choose. For persons with estates that will now fall below the increasing estate tax exemption, making these annual exclusion gifts will no longer be imperative. But if you have a large estate, giving away some of it isjust as important now as before.

If you don't want family members to completely control the assets you give them, you can establish Crummey gift trusts for them. Gifts to these trusts qualify for the annual exclusion. If Congress doesn't resurrect the estate tax and your gifts turn out to have been unnecessary, you haven't lost anything. But if Congress reinstates the tax in 2011, as the act now provides, gifts may reduce your estate and save a substantial amount of estate tax.

Remember that many assets appreciate in value and Congress could repeal the repeal or reduce the exemption increases. So giving away assets up to the exemption amount in 2002 may be sensible, depending on your circumstances.

Don't forget that each spouse is entitled to his or her own exemption. Suppose a couple exhaust their gift tax exemptions by making $2 million in taxable gifts in 2002, and after five years their remaining assets have increased in value by 50%. They will have removed an additional $1 million from their taxable estates without having to use an additional portion of their exemptions.

Before EGTRRA, making taxable gifts even beyond the exemption madesense, but no longer in most situations. What did the benefit used to be? First, as with the gift in the previous scenario, future appreciation is removed from the estate. Second, gift tax is less expensive than estate tax. Gift tax is paid only on the amount of the transfer itself, while estate tax is paid on the assets in the estate. But paying gift tax now doesn't make sense when you may be able to transfer assets tax free at death.

Living With Uncertainty

The act has not eliminated the need for smart estate planning. In fact, the resulting uncertainty has made planning more important and complicated. If you're not sure what to do about the changes, give us a call. We'll be glad to review your current estate plan in light of the new law.

Transfer Tax Exemptions and Rates

O Step-Up in Basis, Where Art Thou?

Under current law, when your heirs inherit appreciated stock and other assets from your estate, they get a step-up in basis to market value. Then when they sell those inherited assets, they determine their capital gain -- and resulting tax -- on the difference between 1) the value of the assets when sold, and 2) the value of those assets on the day of your death.

As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001, when the estate tax temporarily disappears in 2010, the step-up in basis will sort of fade away also. Actually, the step-up in basis will be limited to $1.3 million plus another $3 million for assets that you leave to your spouse.

So if you die in 2010, chances are your estate won't owe any estate tax, but your heirs will pay much more in capital gains taxes. Then in 2011, the full-blown, automatic step-up in basis returns. This part of the law is complex, so consult your advisor on how it will affect your plan.