Introduction

On June 7, 2001, President Bush signed into law a ten year tax relief program. The law increases the estate/gift tax exemptions over the next ten years, eliminates the estate tax for the year 2010, and then re-instates the old tax law. The new law will provide tax relief to estates if the person dies before December 31, 2010, but the old tax laws go back into effect after that date.

The Law Prior to 2001

Under the former tax laws, we had a unified estate tax and gift tax. That means that in any year when a person gave more than $10,000 to any one person, the amount over $10,000 reduced the person's estate tax exemption. For example, in 2001 if you gave a person $25,000, $15,000 of that gift would be applied against your unified tax exemption. If you die in 2001, your estate has an exemption of $675,0000. The gift would reduce that exemption to $660,000. The portion of your estate over $660,000 would be taxed.

The unified credit was scheduled to increase until 2006, when the credit would increase to $1,000,000

The estate and gift tax rules will go back to these rules starting January 1, 2011 unless Congress changes the new law before then. Although your estate may not be $1,000,000 at this time, many estates will reach the $1,000,000 mark by 2011. If you anticipate that your estate (or if you are married, the combined estates of your spouse and you) will be more than $1,000,000 by 2011, estate planning which includes consideration of tax issues continues to be important. Keep in mind that the $1,000,000 figure includes all of your assets- your home, investments, retirement funds, life insurance, and personal property. Many people are surprised at the size of their estate when they total all of those items.

The New Law

Over the next eight years, the estate and gift tax rates will decrease, and the unified credit exemption will increase. In 2011, the new law disappears and we return to the old law.

How It Works

The gradual rate reduction and unified credit increase phase out of the present tax. The following chart demonstrates how the tax rates will decrease while the credit increases:

Gift Tax

The gift tax exemption increases to $1 million in 2002 and remains at that level until 2010. In order to prevent people form using gifts to transfer income-laden property from higher to lower rate taxpayers, the new law retains a modified gift tax. In the year 2010, gifts in excess of the lifetime $1 million exemption would be subject to a gift tax equal to the top individual income tax rate at that time.

Step-up in Basis

Under the Old Rules, an heir receives a stepped up basis for inherited property. Thus, if you inherit stock purchased for $10/share, and at the time of the decedent's death, the value was $50/share, you would pay capital gains tax only for the difference between the sale price and $50/share. Inheriting appreciated property worked very well for both the decedent and the heir.

Once the estate taxes are fully repealed in 2010, a modified carryover basis rule goes into effect. This means that the amount of property eligible for the stepped-up basis will be capped in most cases. Up to $1.3 million of certain assets will be allowed a basis increase, and up to $3 million of assets will be permitted a basis increase if transferred to a surviving spouse.

What does this mean for you? It becomes very important to keep accurate records to determine the basis for property. For real estate, this means that you should keep records of the original purchase, and any improvements that affect the tax basis. For stocks, you should keep track of all splits, forward or reverse. If you own mutual funds, you should track of all income items such as interest, dividends and gains in order to determine basis. Additionally, basis records must be kept for all assets acquired by gift or by inheritance. If basis cannot be determined, basis will be zero.

What happens in 2011?

Starting in 2011, estates valued at more than $1 million will be taxed at a top rate of 55%. The way the new tax program is set up Congress must vote to continue to repeal the estate tax. The tax provisions 'sunset' on December 31,2010; it will take a 3/5 vote or better in the Senate to override the 'sunset provisions.' If the 'sunset provisions' are not overridden the law reverts to the Old Rules.

What does this mean for you? It's anyone's guess. There will be at least one change in the presidency. There are four congressional elections before 2011. These tax changes were made during a period of prosperity. If the economy "goes south," the government may be looking in every corner for a way to raise taxes.

What Should You Watch Out For?

The new tax law seems very appealing and may well encourage complacency. However, it is unwise to sit back and allow things to happen. "Proactive" taxpayers will be the ones whose estate plans will continue to function favorably with the new tax law.

Currently, the federal estate tax is shared with the state or states where the deceased owned property. Under the new law, this revenue sharing will be gradually reduced and completely eliminated by the year 2005. This rapid phase out will reduce state revenues and could cause increases in state taxes. Most states repealed their inheritance tax laws because the portion of the federal estate tax received generate as much, if not more, money than the state's inheritance tax. States may be forced to implement new inheritance tax laws to replace the lost revenues.

In the Meantime

Keep records of what you paid for assets. If you anticipate that your estate may be more than $1,000,000 in 2011, consider a credit shelter trust if you are married. Additional planning options which are available include qualified personal residence trusts, family limited partnerships, and grantor retained annuity trusts. Keep in mind that you may give any person up to $10,000/year without triggering gift tax or using up any of your lifetime limit.

Estate planning is not just about reducing or eliminating estate taxes. There are other issues as or more important than the estate tax issue: 1. Is your estate plan disability proofed? Why is this important? If your plan is not set up for management in the event of a disability, a future disability could prevent necessary updates to your estate plan, and may require appointment of a conservator or guardian.

2. Does your estate plan comply with your wishes?

a. Who are the beneficiaries? How much of the estate is to pass to each beneficiary? How is each beneficiary to receive his/her share of the estate?
b. Who are the Trustee and/or Personal Representative? Is this the best person to serve as Trustee or Personal Representative?
c. Do you have a financial power of attorney and health care directive? Are these the best persons to serve in these capacities?
d. Are your assets properly coordinated with your estate plan? Who are the beneficiaries of your retirement plans and your life insurance?
f. What have you done with respect to long term care planning?

Conclusion

The new tax program offers relief, but it also offers a challenge to taxpayers. It requires you to stay current with the tax law, and to make changes to your estate plan in order to remain current with the new temporary law.

You should continue to review your estate plan at least every three years and when there are any major changes occur in your life (e.g., marriage, death of a spouse, divorce, birth of another child).

Sally K. Mortenson
July 2001