by Michael L. Hanks, Esq.
By now you are undoubtedly aware that Congress has passed and President Bush has signed the Economic Growth and Tax Relief Act of 2001 (the Act). Its broad provisions impact taxpayers in a variety of ways. However, this article will focus on the provisions affecting the federal estate tax, and discuss the impact such provisions have on existing estate plans.
The Act makes the following changes to the federal estate tax:
- Federal estate taxes will be steadily reduced and eventually abolished in 2010 (subject however to political uncertainties and the "sunset provisions of the current Act, discussed more fully below).
- The estate tax exemption, which is $675,000 in 2001, will gradually increase to $3,500,000 in 2009.
- The top estate tax rate, currently 55%, will drop to 50% in 2002, and then gradually decline to 45%.
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The increase in the estate tax exemption amount will be accelerated, such that each person will be entitled to an exemption of $1,000,000 starting in 2002. Under prior law, the exemption amount didn't reach $1,000,000 until 2006. The amount of the exemption increases each year until 2010 as follows:
Year Exemption Amount 2002 $1,000,000 2003 $1,000,000 2004 $1,500,000 2005 $1,500,000 2006 $2,000,000 2007 $2,000,000 2008 $2,000,000 2009 $3,500,000 2010 Estate tax repealed - Curiously, the Act does not repeal gift taxes, which under prior law were treated essentially as prepayments of estate taxes. Under the Act, each person is entitled to a single lifetime exemption of $1,000,000. Effective gift tax rates are reduced, such that by 2010, the maximum gift tax marginal rate will be 35%, which is equal to the new maximum income tax rate under the Act.
- In place of the prior "stepped up tax basis" rules, the Act provides that each after 2010, the heirs of a decedent will be entitled to increase the basis of assets by a total of $1,300,000. The basis of property transferred to a surviving spouse can be increased by an additional $3,000,000. Thus, the basis of property passing to a surviving spouse can be increased by a total of $4,300,000.
How do these new laws affect existing estate plans and conventional strategies?
The typical "A/B Trust" arrangement, which has been used in most substantial estate plans prepared by attorneys, employs a formula that is designed to allocate to an "exemption" or "bypass" trust at the death of the first spouse to die assets equal in value to the then applicable exemption amount. Thus, for example, in the case of a person who died in 2001, existing "A/B Trust" plans would generally require allocation of assets equal to $675,000 in value (the amount of the exemption in 2001) to the bypass trust, and the balance of the decedent's trust estate would be allocated to either a "marital trust" or a "survivor's trust."
Since the surviving spouse does not have a right to direct the disposition of assets in the bypass trust at his or her death, those assets (including any appreciation in the value of those assets between the date of death of the first spouse and the date of death of the second spouse) are not included in the gross estate of the surviving spouse at his or her death. Thus, if a husband and wife had a total estate equal to $1,350,000 at the date of death of the first spouse, $675,000 would pass to the bypass trust and $675,000 would go to a "survivor's trust," and (assuming no appreciation in value of any assets prior to the second spouse's death), there would have been no federal estate tax payable at the second death, since only the assets in the survivor's trust (which the surviving spouse retained a right to give away at his or her death) would have been included in his or her estate. Since the exemption amount to which the second to die spouse is entitled equals or exceeds $675,000, there would be no estate tax imposed at either the death of the first spouse or the death of the second spouse.
The various types of "formulas" which control the allocation to these "subtrusts" in existing "A/B Trust" plans generally provide that the amount allocated to the exemption trust depends on the then applicable federal estate tax exemption amounts. So, for example, under the new law, the amount allocated under the typical formula in existing plans would be $1,000,000 in 2002, even though when that particular trust was drafted, the "scheduled" exemption amount in 2002 was to be only $700,000. In other words, the formulas in most existing "A/B Trust" plans were flexible and not tied to a particular exemption amount.
Thus, the "subtrust allocation formulas" in most existing plans will not need to be amended to take the new law into account. However, your existing plans should be reviewed to insure that the existing allocation formula relates to the then existing exemption amount rather than a fixed amount based on prior tax laws.
It will certainly be increasingly the case that payment of estate tax will only be required of the largest estates, especially after 2006 when the exemption amount increases to $2,000,000. Through the use of the "A/B Trust" planning and the creation of exemption trusts at the death of the first spouse, as discussed above, that amount of exemption will allow us to completely shelter estates of up to $4,000,000 ($2,000,000 in an exemption trust and $2,000,000 belonging to the survivor and therefor included in his or her estate.) Assuming the Act remains unamended and in its current form up to and after 2010, at which time the entire estate tax is to be repealed, it will dramatically affect the fortunes of the favored few who have parents or relatives with large estates, which will pass to them undiminished by estate tax.
However, the change in the basis rules that is part and parcel of the Act will change the nature of estate planning and certainly the post mortem administration of an estate following the death of the first and second spouse. Under the pre-Act law, the basis of every asset included in the estate of a decedent for federal estate tax purposes received a stepped up income tax basis as discussed above, which eliminated the amount of "built in gain" in an asset (the amount of appreciation in value which has not yet been taxed for income tax purposes.) This stepped up basis rule applied, even if the estate was too small to result in the need to file an estate tax return, or pay any estate tax. It not only simplified the later computation of income taxes (eliminating the need to track a decedent's cost of acquisition and other adjustments to basis during his or her lifetime) but saved the heirs of the decedent a great deal of money in income taxes not paid.
Under the Act, once fully implemented, the decedent's trustee or administrator will be able to increase asset basis by up to $3,500,000. Thus, with respect to a married couple with a $7,000,000 combined estate, starting in 2009, there will be no estate tax payable at the death of either the first or second spouse to die (assuming the estate has been properly planned and all post death administration completed), and the heirs will be entitled to a stepped up basis on the entire estate. In a combined estate of $10,000,000, after 2010, there will be estate tax payable (remember that under the Act the entire estate tax is to be repealed in that year), but the heirs will only be able to allocate the $7,000,000 of stepped up basis, leaving $3,000,000 of assets with their old "carry over" basis and therefor the possibility of "built in gain" upon subsequent sale of those assets for fair market value. However, this problem will only affect the very rich, who can afford to pay the additional income tax anyway (although the very rich may disagree.) We would also expect various "basis allocation" strategies to arise, such as allocating the basis increase to low basis assets (i.e. those with the most "built in gain") and to assets which were not "stepped up" at the death of the first spouse. It may also give rise to disputes between heirs, some of whom may inherit "non-adjusted" assets and others who receive "adjusted assets." However, since the number and frequency of gross estates exceeding $7,000,000 in value is small, we would expect this "basis adjustment planning" to be required of only a relatively small number of estate planning professionals who regularly plan estates of that size.
Finally, the Act will change lifetime gift planning. It provides for a lifetime $1,000,000 exemption starting in 2002. Pre-Act conventional wisdom that with respect to otherwise taxable estates, a common strategy was to gift assets expected to appreciate in value during the remainder of the donor's lifetime, in order to remove post death appreciation from the estate. However, under the Act, gifts of amounts in excess of $1,000,000 (for those fortunate few able to even consider such a thing) will be generally inadvisable. Such gifts will result in a gift tax (albeit at reduced rates), while, except for the largest estates (and after 2010, for all estates), there will be neither gift nor estate tax if the asset remains in the donor's estate until his or her death. Further, in such event, the assets which would otherwise would have been gifted can receive, or at least be candidates to receive, a stepped up basis under the new $3,500,000 adjustment amount.
If all of this sounds a bit murky, relax. The Act is set to be automatically repealed in 2011 under the "sunset clause" in the Act. The idea is to require affirmative Congressional and Presidential action prior to 2011 in order for the estate tax repeal to be continued. Accordingly, whether Americans are ever freed from this unpopular exaction remains to be seen. Conventional wisdom says that the likelihood of complete repeal happening, even in 2010 is remote. As soon as the Democrats have sufficient votes to overturn the Act, or in the event the fiscal state of the Union around 2010 (or even before) is rocky, I expect to see the Act overturned, or at least substantially rewritten. One thing I don't expect is for Congress to dramatically reduce the size of the exemption amount below $1,000,000, or to significantly delay its effectiveness. There are simply too many politically powerful interest groups which will be negatively affected by such a move. Under the Act, if it remains law (which is likely unless and until a Democratic President and Democratic Congress coincide at some point in the future, in which event look for dramatic amendments to it), most of us don't have enough assets to worry about (from an estate tax standpoint, that is).
Michael Hanks is an attorney with offices in Gold River. His phone number is 916-635-0302. His website address is Hankslaw.com. This and other articles by Mr. Hanks can be viewed there. His email address is For over 25 years, he has been helping people think through and solve their general legal, business, real estate and estate planning problems.
