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Client Alert - Changes to the Federal Estate Tax under the New Tax Act Bring Relief, but Greater Complexity


Fundamental changes were made to the Federal estate, gift and generation-skipping tax system by the tax legislation recently enacted by Congress. (The new legislation also includes significant income tax relief. However, this bulletin deals only with changes to the estate, gift and generation-skipping taxes.) The changes benefit taxpayers by increasing the amounts exempt from tax and reducing the rate of tax, but the legislation has left considerable uncertainty in its wake. The estate tax is repealed in its entirety in 2010, and then reinstated (at current rates and exclusion amounts) in 2011. With the estate tax laws in a state of flux, we encourage you to review your current estate plan, and then to re-visit your plan on an ongoing basis until permanent estate and gift tax legislation is in place.

Current Law

To help explain the recent changes, we briefly review the estate tax law as it now exists. Today, gift and estate taxes work under a unified system. A gift tax is assessed when assets are transferred without full consideration during one's lifetime, and an estate tax is paid when assets are transferred at death. The rates of tax and the amounts that are excluded from both gift and estate taxes are the same. As a rule, transfers are taxed only once, when a gift is made during one's lifetime or when property passes upon death. One difference is that the gift tax laws do permit a $10,000 annual exclusion per donee that does not apply to the estate tax. Neither tax is imposed on transfers between spouses.

Estate and gift tax rates are graduated, ranging from 37% on amounts in excess of the first $675,000 (the current amount excluded from any transfer tax) to a maximum of 55% on amounts exceeding $3,500,000. In addition, for estates of $10,000,000 and over, a 5% surtax is imposed that has the effect of phasing out the benefits of graduated rates. Before the new tax act was enacted, the exclusion amount was scheduled to increase incrementally to $1,000,000 by the year 2006.

So called generation-skipping transfers are gifts or bequests to grandchildren or other remote beneficiaries designed to bypass estates of the 'next' generation. These transfers are subject to an additional tax when the value of the transfer exceeds $1,060,000 (the current generation-skipping tax exemption). The rate of tax is set at the highest transfer tax rate, currently 55%.

Current Estate Plans

While a decedent may leave the entire estate to a spouse tax free, doing so will result in the loss of the benefit of the Federal exclusion amount in the estate of the first spouse to die. Thus, many estate plans of married taxpayers include credit shelter trusts for spouses or children that are designed to take advantage of the exclusion amount for each spouse, effectively doubling the amount that is exempt from estate tax. The balance of the estate usually passes outright or in trust to the surviving spouse. As an aside, different rules apply to gifts and bequests between spouses if one of the spouses is not a U.S. citizen.

Because the exclusion amount increases from year to year, and would have increased to $1,000,000 by 2006 were it not for the new legislation, wills that were drafted in recent years use language such as 'I give the maximum exclusion amount' to fund the credit shelter trust rather than specifying a fixed dollar amount (e.g., 'I give $675,000' to the credit shelter trust). This eliminates the need to amend the will each time the exclusion amount increases.

Conventional wisdom also calls for assets to be transferred to or divided between spouses so that each spouse will have sufficient assets to fund the exclusion amount.

In larger estates, some wills include generation-skipping trusts for grandchildren to take advantage of the $1,060,000 generation-skipping tax exemption. The language used to fund these trusts is similar to that used for credit shelter planning purposes; i.e., 'I give my remaining generation-skipping exemption amount' (rather than a dollar amount) to the trustees of the generation-skipping trust.

Life insurance and life insurance trusts are other estate planning devices often used today. These are designed to provide liquidity to pay estate taxes while insulating the policy proceeds from one's taxable estate. With the recent changes in the estate tax laws, we urge you to consider the recent tax changes before purchasing any life insurance designed to work in tandem with an estate plan.

The New Law

1. 2010 and Beyond

As of January 1, 2010, all estate and generation-skipping taxes are repealed for one year. Gift taxes, on the other hand, remain in effect after January 1, 2010, albeit at lower rates than today. The lifetime gift tax exemption amount increases to $1,000,000 in 2002, and remains at that amount beyond 2010.

2. The 'Sunset Provision'

The new law contains a 'sunset provision' that repeals all of the changes just enacted, thereby reinstating in 2011 the law as in effect in 2001. If the new legislation is to remain in effect after December 31, 2010, it must be reenacted by a future Congress.

While it is likely that new legislation will be enacted before 2010, what that legislation might look like is obviously unknown. Will total repeal continue? Will there be partial relief such as reduced rates or increases in the exclusion amount? What will happen to the gift tax? The only prudent course of action is to review your estate plan periodically.

3. From 2002 Through 12/31/2009

Until the estate tax law is repealed in 2010, the new law provides for a steady reduction in the maximum estate and gift tax rates and a steady increase in the amount of the exclusion for estate and generation-skipping tax purposes, as follows:

YearHighest Estate
and Gift Tax Rates
Estate Tax
Exclusion Amount
2002 50% 1,000,000
2003 49% 1,000,000
2004 48% 1,500,000
2005 47% 1,500,000
2006 46% 2,000,000
2007 45% 2,000,000
2008 45% 2,000,000
2009 45% 3,500,000
2010 Estate and GST Tax Repealed

The generation-skipping transfer ('GST') tax exemption is $1,060,000 in 2001, and will continue to be indexed for inflation in 2002 and 2003. In years 2004 through 2009, the GST tax exemption is the same amount as the estate tax exclusion amount, followed by full repeal in 2010. As previously noted, the gift tax will remain in force and the gift tax exemption amount will be capped at $1,000,000.

YearNew Limits
2002 $11,000
2003 $12,000
2004 $13,000
2005 $14,000
2006 and thereafter $15,000
Under Age 50
Over Age 50
2002 3,000 3,500
2003 3,000 3,500
2004 3,000 3,500
2005 4,000 4,500
2006 4,000 5,000
2007 4,000 5,000
2008 and after 5,000 6,000

4. State Death Taxes

Most states impose their own estate tax. However, the IRS allows a credit against the Federal estate tax for some or all of the state death taxes paid by the estate. The amount of the credit increases with the size of the estate. For example, in the case of a $2,000,000 estate, the credit is 8% of the estate. For estates in excess of $10,100,000, the credit is 16%.

The new tax act reduces the amount of the state tax credit by 25% in each of the next four years. The credit will be eliminated by the end of 2004, but will be replaced by a deduction for state estate taxes beginning in 2005.

Many states, including New York and Florida, merely collect an amount for estate tax equal to the state death tax credit currently allowed by the IRS. Ultimately, this means that the estate does not pay any additional tax to the state; it merely pays a portion of the estate tax to the state, and the balance to the Federal government. The reduction in the state tax credit amount has thrown a monkey wrench into this system. Unless a state amends its laws to conform to the reduced Federal credit, the taxes paid to that state could exceed the Federal credit, thereby reducing some of the benefits of the anticipated Federal tax savings. For some estates, the result will be a total tax bill larger than it is today. It is entirely possible that states, faced with loss of revenue, may revise their estate tax laws. We will continue to monitor this area of concern.

5. Capital Gains Carryover Basis

Under current law, heirs receive a 'stepped-up' tax basis for inherited assets equal to the value of the property as reported on the decedent's estate tax return. For capital gains tax purposes, therefore, if a decedent paid $1 million for a building that is valued at $2 million on the estate tax return, the heirs would calculate the capital gain on the sale of the building using the stepped-up $2 million basis.

Beginning in 2010, the basis of property received from an estate, as a general rule, will not be stepped up to the value at date of death. Instead the basis will be the lesser of (a) the decedent's basis, or (b) the market value on the date of the decedent's death. There are two exceptions to this general rule:

1. The new tax act grants an executor the power to step up the basis of assets formerly owned by the decedent by a total of $1,300,000.

2. For assets transferred to or for the benefit of the decedent's surviving spouse, an additional $3,000,000 of basis step-up is available.

Both of these exceptions apply to property received by a spouse. Thus, up to $4,300,000 of basis increase can be allocated to property transferred to one's spouse. Note, however, that the basis of an asset cannot be increased above its market value on the date of the decedent's death.

The basis increase rules do not apply to property acquired by gift within three years of death (other than from a spouse). This restriction is meant to discourage gift giving of low basis assets to individuals who would be expected to bequeath the identical assets to the donor.

6. Gain From Sale of Principal Residence

Taxpayers today can exclude up to $250,000 ($500,000 for married taxpayers filing jointly) of gain from the sale of their personal residence, provided that (a) the residence was owned and occupied as a principal residence for an aggregate of at least two of the five years preceding the sale; and (b) the taxpayer has not applied the exclusion to the sale of another residence within the past two years. Currently, this exclusion does not apply to a sale of the residence by one's estate or heirs because of the stepped-up basis rules.

Beginning in 2010, when the new basis rules go into effect, the $250,000 exclusion will apply to the sale of a decedent's principal residence by either the estate (or a revocable trust) or by an individual who acquires the residence as a result of the decedent's death, provided that the two-out-of-five year residence rule is satisfied for the decedent. In addition, the decedent's period of occupancy can be added to an heir's subsequent ownership and occupancy in determining whether the property was owned and occupied for the necessary two years as a principal residence.

7. Increased Contributions to 401k Plans and SEPs

Annual contribution limits to 401k plans, SEPs (Simplified Employee Pensions) and similar retirement plans have been increased, as follows:

Beginning in 2006, the $15,000 limit will be indexed for inflation in $500 increments.

8. Increased Contributions to IRAs

Maximum annual contributions to traditional and Roth IRA's have been increased from the present cap of $2,000. In addition, 'catch-up' contributions may be made by individuals age 50 and over for tax years beginning in 2002. Annual income limits still apply to IRA's. The annual contribution limits are as follows:

Peter R. Porcino 212-790-9208
Burt A. Lewis 212-790-9226
Morton L. Price 212-790-9254
Simon Gerson 212-790-9206
Robert Halper 212-790-9260
Robert J. Giordanella 212-790-9234
Sidney I. Liebowitz 212-790-9220
Lewis R. Cowan 212-790-9230

9. More Liberal Educational Plans

a. Educational IRA's

Annual cash contributions to tax exempt educational IRA's are increased from $500 to $2000 per beneficiary, and the income levels for married taxpayers filing a joint return at which this benefit is phased out are increased to twice the range for single taxpayers. The phase-out range for married taxpayers filing jointly will now be $190,000 to $220,000 of modified adjusted gross income.

Earnings on contributions to education IRA's are generally not taxed until distributed. When distributions are made, the earnings portion of the distribution is excluded from gross income to the extent used to pay qualified higher education expenses. The account may now be used for elementary and secondary education expenses as well as for higher education.

b. Qualified State Tuition Programs

Qualified state tuition programs are tax exempt state-sponsored programs under which taxpayers may make contributions to an account to pay qualified education expenses for a designated beneficiary. Contributions to these plans may be made only in cash. Investment earnings generated from account assets are exempt from tax.

Under the new law, the definition of qualified tuition programs is extended to include private as well as public institutions. In addition, beginning January 1, 2002, distributions from such programs used to pay qualified education expenses will be excluded from income for income tax purposes.


These changes are far-reaching and complex. It is important that everyone review his or her estate plan to determine if the changes adversely affect existing estate plans or if greater benefits can be achieved through revisions to existing plans. Particular attention needs to be paid to language in wills or trusts using a formula to fund credit shelter and generation-skipping trusts, as this language may cause a greater than intended portion of one's estate to be allocated to such trusts, and conversely, less to a surviving spouse or other intended beneficiaries. Although 2010 is a long way off, estate plans should be designed flexibly to account for the uncertainty that will arise in the coming years and after 2010. The increased gift tax credit creates additional gift-giving opportunities, but requires greater planning to take full advantage of the credit. Finally, improved record keeping and planning will be needed to meet the changes in the basis rules for capital assets.

We at Cowan Liebowitz & Latman would be pleased to answer your questions and assist you in meeting your estate planning needs.

Copyright 2001
Cowan, Liebowitz & Latman, P.C.

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