KEYWORD:

M E M O R A N D U M

TO: Estate Planning Clients and Friends of LSRS

FROM: Robert T. Gardner

SUBJECT: Economic Growth and Tax Relief Reconciliation Act of 2001

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On June 7 President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "Act"). The Act represents the most significant reduction in estate and gift tax since 1981.

There are several major provisions that apply to estate planning clients. These include an increase in the estate tax exemption, reduction of estate tax rates, institution of carryover tax basis, and ultimately repeal of the estate tax and generation-skipping transfer ("GST") tax but not the gift tax.

The 2001 Act repeals the estate tax, but repeal will not be effective until January 1, 2010, and is scheduled to last for just one year. Budgetary constraints delayed outright repeal for more than eight years and also required that the Act provide for the reinstatement of the estate tax starting in 2011. It is very likely, however, that there will be further changes to the transfer tax laws prior to 2011. Although clients should not rely upon these changes for long-range planning since future legislation is almost certain, most clients need to review their estate plans in light of the Act.

Estate Tax Repeal
Although repeal lies well in the future, the 2001 Act reduces the estate tax on the estates of those who die during the transitional period. It does this in two ways. First, in a provision that benefits all estates, it steadily increases the estate tax exemption amount to $1.0 million in 2002 and 2003, $1.5 million in 2004 and 2005, $2.0 million in 2006, 2007, and 2008, and $3.5 million in 2009, the final year before repeal. Second, during the transitional period there is a reduction in the top estate and gift tax rates, currently set at 55% and 53%. This change will help only wealthier taxpayers, since these top rates affect only estates of more than $2.5 million. Effective January 1, 2002, the top rates of 53% and 55% are eliminated and replaced with a rate of 50% on taxable estates in excess of $2.5 million. The top rate is then further reduced by 1% a year until 2007, when it will be 45%, and it remains at that level until the estate tax is repealed at the end of 2009.

Retention of the Gift Tax
The Act did not repeal the gift tax. Even after estate tax repeal, the gift tax will continue to be imposed on gifts in excess of the individual exemption amount, which will not be the same amount as the estate tax exemption. Like the estate tax exemption, the gift tax exemption increases to $1.0 million in 2002, but receives no further increases after that. Thus, it will indefinitely remain at $1.0 million.

In 2010 the maximum gift tax rate will drop to 35%, equal to the top income tax rate for individuals. The reason for retaining the gift tax and linking the top gift tax and income tax rates was due to Congressional concerns that lack of a gift tax would encourage taxpayers to make tax-free gifts of income-producing property to family members in lower income tax brackets. Such transfers would have been an easy way to reduce the overall income tax burden on the family. It will be possible, however, to make such transfers that are within the exemption amount without paying gift tax.

Generation-Skipping Transfer Tax Repeal
The Act also repeals the GST tax, effective for transfers after December 31, 2009. This tax is imposed on gifts and bequests to grandchildren, great-grandchildren, and trusts established for their benefit. Currently, planning for the GST tax is focused on the effective use of the $1.0 million GST exemption. This exemption is scheduled to increase in tandem with the estate tax exemption, so that the GST exemption will be $3.5 million in 2009, the year before repeal. If your estate plan includes a generation-skipping trust, we should reexamine it in light of this increased exemption.

There will also be a reduction in the current GST tax rate of 55% during the transition period, since that rate is linked to the highest estate tax rate, which will fall to 45% by 2007.

The schedule of estate, gift, and generation-skipping tax rates and exemptions under the new law is as follows:

Year	Top Rate	Exemption
2001	55%, plus 5% surtax on certain estates and gifts over $10 million
2002	50%
2003	49%
2004	48%
2005	47%
2006	46%
2007	45%
2008	45%
2009	45%
2010
2011

$675,000 for estate and gift taxes; $1,060,000 for GST tax
$1 million for estate and gift taxes (indexing for GST exemption eliminated)
$1 million
$1.5 million for estate and GST taxes; $1 million for gift tax
$1.5 million for estate and GST taxes; $1 million for gift tax
$2 million for estate and GST taxes; $1 million for gift tax
$2 million for estate and GST taxes; $1 million for gift tax
$2 million for estate and GST taxes; $1 million for gift tax
$3.5 million for estate and GST taxes; $1 million for gift tax
Repeal of estate and GST taxes; 35% gift tax rate $1 million for gift tax
Reinstatement of the estate and GST taxes – 55% $1 million for estate, GST, and gift taxes

Repeal of State Death Tax Credit
Under current law, an estate is entitled to a dollar-for-dollar federal estate tax credit (subject to a cap) for the amount of any state death taxes paid by the estate. This credit was repealed by the Act, effective for those dying after 2004, and replaced with a state death tax deduction.

The phase-out of the state death tax credit will have no immediate effect in most cases since, like most states, Alabama’s estate tax applies only if the decedent’s estate qualifies for the federal credit. The repeal of the federal credit will cause an automatic repeal of these state taxes. It is anticipated that most states will revise their laws to impose their estate taxes (or some form of death tax) even if the credit is no longer available in order to offset the loss in revenue resulting from repeal of the credit. The federal tax legislation allows a deduction for state inheritance tax paid to the states after the credit for state estate taxes is phased out.

Loss of Basis Step-Up at Death
The quid pro quo for repeal of the estate tax is the loss of step-up in income tax bases of assets at death. Currently, each asset owned by a decedent for estate tax purposes receives an increase in its basis to the asset’s fair market value on the date-of-death (unless the alternate valuation date is elected on the estate tax return). This basis step-up allows heirs to sell property acquired from a decedent and incur far less capital gain, if any, than the decedent would have incurred if the asset were sold prior to death.

Under the Act, effective for persons dying after December 31, 2009, property acquired from a decedent will retain the decedent’s tax basis. This is referred to as "carryover" basis. When the recipient of the property eventually sells it, he or she will compute the gain using the decedent’s adjusted basis. In most cases, the decedent’s basis will be less than the date-of-death value (step-up basis), resulting in an increased capital gains tax.

The Act contains two exceptions to carryover basis. First, the estate of every decedent who is a U.S. citizen or resident will be entitled to increase the basis of the decedent’s property by up to $1.3 million, although no item of property may have its basis increased above its fair market value on the date of death. If the estate is valued at $1.3 million or less, each asset will automatically receive a basis equal to its date-of-death value. If the estate is larger than $1.3 million, the estate must file a return allocating the basis increase to specific assets.

If the decedent was married, the estate is entitled to an additional basis increase of up to $3.0 million for property passing to the surviving spouse, regardless of citizenship or residence. This increase can be applied to property passing outright to the spouse or in the form of a qualifying trust. It will also be necessary to file a return to claim the $3.0 million basis increase and to allocate it to the marital property.

Planning Considerations During the Transition Period
Because the estate tax remains in effect until the end of 2009, it is not recommended that you immediately revise your estate plan in anticipation of its repeal. However, it is important that your current estate plan be reviewed to ensure that it takes advantage of this increase in the estate tax exemption that takes place during the transitional period. Most estate plans we have prepared use a "formula clause" that allocates a portion of your estate to a shelter trust that is equal to the amount of the estate tax exemption on the date of death and, therefore, will be able to take advantage of the increased exemption. In many cases, however, a formula clause may no longer be appropriate considering the size of your estate and your wishes for the testamentary disposition of your estate. If the value of your estate is not well in excess of the increasing exemption amount, a formula clause could have the effect of shifting too much of the estate into the shelter trust and leaving too little to the surviving spouse.

Since the gift tax is not scheduled for repeal, valuation discounts will remain a valuable tool in making lifetime transfers. Family limited partnerships and limited liability companies will continue to be used to minimize the value of lifetime gifts to family members, thereby maximizing the use of the $1.0 million gift tax exemption.

Lifetime charitable gift planning is unlikely to change, since much of it is income tax driven. Charitable remainder trusts will still be valuable tools for eliminating the capital gain tax on appreciated assets, while at the same time converting those assets into a lifetime income stream.

The role of life insurance in estate planning will likely change, but not immediately. As the estate tax exemption rises, it may no longer be necessary to maintain policies solely for the purpose of paying estate tax. Also, irrevocable life insurance trusts may no longer be appropriate after the scheduled repeal, since most such trusts are established for the purpose of insulating the proceeds from estate tax. You should not cancel or cash in any life insurance policies without first consulting with a professional advisor. If you have purchased a policy to pay estate taxes, we should reexamine its purposes in light of the Act and your particular circumstances.

Conclusion
The estate and GST taxes were finally repealed by the Act, but effective only for 2010 - one year! Since the estate tax exemption is rising and more legislation in this area of the tax law is likely, it is as important as ever that you diligently consider effective estate planning, particularly in light of the increased capital gains taxes that could be imposed on property received from an estate.