The 2001 Tax Act Estate Tax Repeal?

By Alan D. Kahn, Mark H. Levin, and Robert H. Colson

In Brief

Good News, Bad News

The good news is that immediate estate tax relief will take place on January 1, 2002, in the form of a reduction in the estate tax top rate from 55% to 50% and an increase in the lifetime exemption from $675,000 to $1 million. The bad news is that the remaining estate tax rate reductions and the increase in exemptions are phased in slowly until final repeal in 2010. In addition, the entire tax bill sunsets as of January 1, 2011, when the law reverts to the provisions in effect before its passage. In between the good and bad news are plenty of opportunities for estate and gift tax planning: taxpayers should take advantage of increased exemptions, lifetime gift exclusions, and reduced rates before Congress changes its mind.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (Act) significantly modifies aspects of the transfer tax that have been taken for granted for many years. Although the Act does work toward gradual repeal of the estate and generation-skipping transfer (GST) tax by 2010, it uncouples the gift tax from the other two and leaves a modified gift tax in place in 2010. The Act sunsets at the end of 2010, such that all provisions for the estate, gift, and GST taxes revert to what they were before the Act’s effective date.

Major provisions of the Act regarding estate, gift, and GST taxes include the following:

• Beginning in 2002, there will be a nine-year phase-out of the estate and GST taxes through increases in the unified credit and decreases in the maximum rates for the estate and GST taxes.
• The family-owned business deduction will be repealed in 2004.
• The gift tax unified credit lifetime exemption will increase to $1 million in 2002 and remain there through 2010. The gift tax rates will be reduced along the same schedule as the estate and GST tax rates.
• Assets transferred at death will continue to be valued at fair market value until 2010, when a complicated rule that mixes step-up and carry-over bases becomes effective.
• States’ death tax revenues could be zero by 2005 if they are tied to the federal death tax credit. On the other hand, states whose death taxes are not directly tied to the federal death tax credit, like New York, will not see dramatic reduction until full repeal of the federal estate tax in 2010.
• Reinstatement of the pre-Act provisions in 2011 means that the full effect of the repeals will exist for only one year.

Rates and Exemptions

The Act breaks the link between the unified exemption credit for estate, gift, and GST taxes. The estate and GST tax exemption credit at death will increase between 2001 and 2010 from $675,000 to $3.5 million, while the gift tax will have its own lifetime exemption of $1 million from 2002 to 2010. The annual personal gift tax exemption, however, will remain $10,000 ($20,000 for married couples gift-splitting). The tax rates on the three transfer taxes will follow the same schedule, the current top rate dropping from 55% to 45% in 2007–2010. The exemption amounts and top rates will gradually phase in according to the schedule in Exhibit 1 until 2011, when the Act is automatically repealed and the tax provisions in effect before enactment once again become law.

Phase-Out of the State Death Tax Credit

The 2001 Act phases out the state death tax credit over a four-year period beginning in 2002 and replaces it in 2005 with a deduction for state death taxes paid. In order to be deductible, however, the state death taxes must generally be paid within four years of filing the federal estate tax return. The following are exceptions to this requirement:

• If a timely petition for redetermination of a tax deficiency has been filed, payment must occur within 60 days of the final determination.
• If an extension of time has been granted for payment under IRC sections 6161 or 6166, payment must occur within 60 days of the expiration of the extension. If a timely claim for refund or credit for an overpayment of the tax has been filed, the payment must occur within the later of—
• 60 days after the IRS has mailed, by certified or registered mail, a notice of disallowance of any part of the claim,
• 60 days after a decision of a court in which such a refund suit has become final, or
• Two years after a notice of waiver or disallowance is filed under IRC section 6532(a)(3).

The phase-out of the state death tax credit and its replacement by a deduction for state death taxes paid follows the schedule below:

	Reduction	Top rate
2001	N/A	16%
2002	25%	12%
2003	50%	8%
2004	75%	4%
2005–2010	Repealed	State death tax deduction
2011	N/A	16%

Basis of Property Acquired from a Decedent

Assets transferred through the estates of individuals dying before January 1, 2010, will continue to be valued at a step-up in basis to fair market value. During 2010, however, when the estate and GST taxes are repealed, the step-up in basis to fair market value will be limited to $1.3 million; an additional step-up in basis will be permitted for up to $3 million of property bequeathed to a spouse. Any transferred property that exceeds these amounts will be subject to a carry-over basis, which means that the recipients must use the same basis as the decedent, even if this exceeds fair market value. It is up to the estate to determine which assets are measured at fair market value and which at the carry-over basis, except that property given to the decedent within three years of death by someone other than the decedent’s spouse must be transferred at the carry-over basis.

The Act allows an additional step-up in basis for any unused capital loss carryover under IRC section 1212(b) and for any unused net operating loss carryover under IRC section 172 that would (but for death) have been carried from the decedent’s last taxable year to a later taxable year. A step-up in basis is also allowed to the extent of any losses that would have been allowable under IRC section 165 (e.g., losses incurred in a trade or business; losses incurred in a transaction entered into for profit; casualty and theft losses) if the property had been sold at fair market value immediately before the decedent’s death.

The change from a pure step-up to market value system to a mixed step-up and carry-over basis approach will pose special planning problems in 2010 (these provisions will sunset in 2010 unless Congress continues them). If the estate is large enough, the administrator will have to apportion assets between those that receive step-up treatment and those that carry over the decedent’s basis. Because of additional incomes taxes due upon sale, heirs receiving assets with carry-over bases will probably realize less than heirs receiving assets whose bases have been stepped-up to market value. Estate planners must pay careful attention to the ramifications of these asset transfers in order to ensure that decedents’ intentions regarding the distribution of their estates are fulfilled.

Decedent’s principal residence gain exclusion. The Act allows the estates, heirs, and qualified revocable trusts of individuals dying after December 31, 2009, to exclude from income up to $250,000 of gain from the sale of a decedent’s principal residence. This exclusion will be determined by considering the decedent’s ownership and use. If an heir occupies the property as a principal residence, the decedent’s ownership and occupancy is added to the heir’s subsequent ownership and occupancy in determining whether the property was owned and occupied for two years as a principal residence. This provision does not automatically sunset in 2011.

Pecuniary bequest distributions. The Act provides that gain must be recognized when property is distributed to satisfy a pecuniary bequest from estates of individuals dying after 2009. The gain equals the amount that the property has appreciated over its fair market value since the date of death. This provision sunsets on January 1, 2011, reinstating the previous rule that gain be recognized on any increase in value over the estate’s basis.

Gift Tax Provisions

The lifetime gift exclusions will increase to $1 million on January 1, 2002, and remain at that level without sunset. Gift taxes will be paid according to the rate schedule for federal estate taxes when the cumulative gifts exceed $1 million, without regard to the increase in the estate and GST tax exemption from 2002 to 2009. In 2010, the gift tax rate will equal 35%, the highest personal income tax rate. In 2011, the provision sunsets, returning the gift tax rate to 55%.

In addition, the Act calls for every donor required to file a gift tax return after December 31, 2009, to provide a written statement to each donee named in the return. This statement must show the name, address, and phone number of the donor filing the gift tax return, and information about the property received (e.g., the fair market value and basis of the property) by the donee.

A penalty of $50 will be imposed for each failure to provide the required statement unless it can be shown to be due to reasonable cause. Intentional disregard of the disclosure requirements will trigger a penalty of 5% of the fair market value of the gift.

Estate Tax Effect on New York

The New York State Tax Law (NYSTL) incorporates the IRC as of July 22, 1998, in establishing the New York State estate tax. The NYSTL caps the unified credit death transfer exemption at $1 million. Therefore, any increase in the federal unified credit death transfer exemption over $1 million has no effect on New York’s exemption. Additionally, although the New York State estate tax has equaled the state death tax credit since February 1, 2000, its computation for New York State purposes is frozen by NYSTL at the state death tax credit rates in effect on July 22, 1998.

From 2001 through 2004, the New York estate tax will remain equal to the current state death tax credit. Because the state death tax credit is being phased out for federal estate tax purposes, but the New York State estate tax rate remains based on the state death tax credit as of July 22, 1998, the federal and New York effective tax rates will follow the schedule in Exhibit 2. Because the state death tax credit reduces more quickly than the maximum effective federal tax rate on estates and the New York rate remains stable at 16%, the total tax paid by large estates in New York will increase until the state estate tax paid deduction is introduced in 2005 and the maximum federal estate tax rate is reduced to 46% in 2006. Only then will the total estate tax rates paid by New York estates be lower than current rates. When the federal estate tax is repealed in 2010, New York estates will pay only the state rate of 16%.

One of the reasons New York amended its estate tax law in 2000 was to make its taxes more comparable with states such as Florida, whose constitution caps the state estate tax at the state death tax credit. The 2001 Act may cause states to amend their tax laws to recapture tax revenues that they will lose as the state death tax credit phases out. New York may also discover that tax law amendment will be necessary again in order to maintain parity with other states. Nonetheless, the sunset provisions of the 2001 Act, as well as the likelihood that they will be changed before 2010, will have to be considered carefully.

Effect on other states. The changes to the federal estate, gift, and GST taxes will have a dramatic effect on the death tax collections of many states because their estate tax consists solely of the federal estate state death tax credit. These states will collect a decreasing amount as it phases out from 2002 to 2004, and nothing in 2005. If this revenue loss becomes a budgetary issue, some states might amend their tax laws to recover the shortfall. It will be much more difficult for certain states, such as Florida, to adjust, because changing the estate tax will require amending the state constitution.