Repeal Sharpens Need for Estate Planning

On January 1, 2002, the gift and estate tax exemption amounts will each increase to $1 million. The estate and GST exemptions will increase again to $1.5 million in 2004, to $2 million in 2006, and to $3.5 million in 2009, but the gift tax exemption amount will be frozen at $1 million. Complete repeal of the estate and GST tax (but not the gift tax) is scheduled to occur on January 1, 2010.

Since the estate tax exemption will increase to $3.5 million, but the gift tax exemption will remain at $1 million, testamentary planning becomes more important for larger estates. Through leveraging, e.g., QPRTs, GRATS, FLLCs, lifetime gifts may also continue to play a prominent role in estate planning.

The federal credit for state death taxes will be reduced by 25% in 2002, by 50% in 2003, by 75% in 2004, and will be repealed entirely for decedents dying after December 31, 2004. However, new IRC §2058 will allow an unlimited estate tax deduction for state death taxes paid. Since the elimination of the federal credit precedes the reduction and then elimination of the estate tax, states will bear the brunt of lost revenues in the coming decade. New York raised $1.07 billion, or 3% of total revenues, from the estate tax in 1997.

Although New York adopted a “sop” tax in February 2000, the reference to the federal credit was frozen at $1 million. Since the federal rate decreases will be outpaced by the decrease in the federal credit for state death taxes, estate taxes for wealthy New York residents will actually increase in the next few years. Moreover, even New York residents whose taxable estates does not exceed the prevailing federal credit will continue to owe New York estate tax. To illustrate, a New York resident dying in 2004 with a taxable estate of $1.5 million will owe no federal tax, but will owe New York estate tax, since New York estate tax liability is  computed as if the federal credit were limited to $1 million. In 2010, when the federal estate tax is scheduled to be repealed, New York will still impose a 16% top estate tax rate, unless new legislation is enacted. To counteract the loss of the federal credit for the first $1 million, New York would be required to enact a new estate tax statute. Florida’s constitution, in contrast, bars the imposition of death taxes.

Another significant change in estate taxes involves basis at death. After December 31, 2009, when the estate tax is scheduled to be repealed, property within a decedent’s estate will no longer receive a step-up in basis pursuant to Sec. 1014. Rather, the basis of such property will the FMV — or adjusted basis if lower — at the decedent’s death. The character of built-in gain (e.g., recapture) will also carry over to the heirs. However, the new rule is tempered by allowances given to the executor adjust upward (to FMV) the basis of (i) $1.3 million in assets passing to anyone (the $1.3 million is itself increased further by certain capital losses which, but for the decedent’s death, would have been carried over), and (ii) $3 million of “qualified” assets (i.e., nonterminable interests) passing to a surviving spouse.

To prevent manipulation of the basis adjustment rules, no basis increase will be allowed with respect to property gifted to the decedent within three years of death, or with respect to property over which the decedent held a general power of appointment. However, the three-year rule does not apply to intraspousal gifts, unless the spouse making the gift herself received the property by gift within three years of the decedent’s death.

The new basis rules may deter the use of QTIP or general marital deduction trusts. A QTIP election results in the property being included in the estate of the surviving spouse. However, it appears that the basis adjustment rules to not apply to such property. In contrast, property gifted outright to the surviving spouse would be entitled to the basis adjustment. However, since the decedent may insist upon the use of a trust, one way of mitigating the harsh result may be to include a  provision permitting the trustee to distribute appreciated assets to the surviving spouse before her death, thus qualifying the property for basis step-up.

As of 2003, the little-used and inscrutable qualified family-owned business interest (QFOBI) deduction under Sec. 2057 will be repealed. A somewhat ironic twist awaits those brave enough to have utilized Sec. 2057, but whose property ceases to qualify for the QFOBI deduction within ten years after the decedent’s death: the entire estate tax benefit will be recaptured, even though the estate tax itself will have been reduced or repealed.

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Information Desk

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