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Special Topic: Estate Tax Repeal Adds Uncertainty to Estate Planning
By Roxanna Hammett and Professor John H. Skarbnik


© Copyright 2001 by Professor John H. Skarbnik and Roxanna E. Hammett, Esq. Professor Skarbnik, LLM, JD, CPA, is a Professor of Taxation at Fairleigh Dickinson University and is tax counsel to Walder, Hayden & Brogan, Roseland, New Jersey. Ms. Hammett is a senior attorney at Wolff & Samson, Roseland, New Jersey.


On June 7, 2001, President George W. Bush signed into law the "Economic Growth and Tax Relief Reconciliation Act of 2001," hereinafter referred to as the "Act." This broad piece of legislation contains 85 major provisions, with 441 changes to the Internal Revenue Code (sometimes referred to hereinafter as the "Code"). This article will examine the Act's estate and gift tax provisions.

As will be discussed below, although certain taxpayers and their families may receive immediate estate and gift benefits from the Act, the truly substantial benefits may not occur for a number of years.- The actual repeal of the estate tax and the generation skipping tax occurs for estates of decedents dying after December 31, 2009. The current step-up in basis rules for property passing from a decedent are also repealed, with some significant exemptions, as of January l, 2010, taking back some of the total benefit of the repeal.

Such repeal is transitory. The pre-Act estate tax laws, including the higher estate tax rates, are resurrected for estates of decedents dying after December 31, 2010. This means that the estate tax repeal, absent future Congressional action, is effective only for the estates of decedents dying during the year 2010.

For those of us who believe estate planning is better accomplished without the help of Dr. Jack Kevorkian, these proposed changes have created uncertainty, but also some excitement. As will be discussed, individuals should continue to actively seek methods under the current rules to reduce their possible estate tax burdens.

Before discussing the specifics of the Act, it may be interesting to review the stated reasons for the proposed changes. The Senate Committee Report on the Act states, "The Committee finds that the estate, gift, and generation-skipping taxes are unduly burdensome on affected taxpayers, particularly decedents' estates, decedents' heirs, and businesses, such as small business, family-owned businesses, and farming businesses. The Committee further believes it is inappropriate to impose a tax by reason of the death of a taxpayer."1 Before this Senate report was issued, the language contained in a House Ways and Means Committee Report accompanying a prior version of the Act stated, "The Committee finds the estate, gift, and generation-skipping taxes are unduly burdensome on all taxpayers"2 (emphasis added).

Discussed below are some of the key estate and gift tax changes with special emphasis placed on the issue of how estate and gift tax planning considerations may now be altered. Notwithstanding the proposed repeal of the estate tax in the year 2010, and the resurrection of the current estate tax laws in the year 2011, individuals subject to estate taxes should take the Act into account in planning their estates.

I     REDUCTION OF ESTATE AND GIFT TAX RATES, AND INCREASE IN THE EXEMPTION EQUIVALENT

Under the law in effect prior to the Act, an individual's lifetime transfers were subject to tax to the extent they exceeded the exemption amount. Since the Tax Reform Act of 1976, the estate and gift tax have been unified, meaning that the same tax and credit systems apply to both. At the time of a decedent's death, all prior taxable transfers are taken into account in determining the estate tax due from the decedent's estate.

For tax years prior to 2010, when the estate tax is repealed, the unified estate and gift tax laws continue to apply. The unified rules will not apply after 2010, at which time the gift tax will remain in existence while the estate tax will be repealed.

In 2002, the top estate and gift tax rate will be reduced to 50 percent. The 53 percent and 55 percent brackets will be eliminated.3 Additionally, the Code provision which phased out the benefits derived from the lower brackets by imposing a 5 percent surtax on both taxable gifts and estates exceeding. $10 million is eliminated in 2002.4 For the years 2003 through 2007, the highest gift and estate tax rates are reduced ,1 percent each. year. Thus, the rate is decreased from 49 to 45 percent, and the lower rate remains in effect until repeal in 2010.

The unified credit amount is being increased substantially. Under prior law, the credit amount effectively exempted $675,000 of taxable transfers in 2001 and was gradually increasing until 2006, when it would exempt $1 million of taxable transfers.

Under the new law, $1 million is being exempted starting in 2002, and the exemption is being increased to $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2006. Based upon the new exemption, a married couple can now transfer $2 million to their beneficiaries without any estate or gift taxes after 2002, or $4 million in 2006 by taking advantage of both spouses' credits.

The unification of the estate and gift tax systems is eliminated following repeal of the estate tax. Although the original House version of the Act repealed the gift tax as well, in conference the House agreed to the Senate version of the bill. which retained the gift tax, in order to prevent taxpayers from engaging in income tax avoidance under the new carryover basis rules, discussed below. However, the maximum gift tax rate will not exceed the maximum individual income tax rate.

From 2002 through 2010, the estate and gift tax rates and unified credit exemption are as follows:

Calendar Year Exemption Highest Estate and Gift Tax Rate
2002 $1,000,000 50%
2003 $1,000,000 49%
2004 $1,500,000 48%
2005 $1,500,000 47%
2006 $2,000,000 46%
2007 $2,000,000 45%
2008 $2,000,000 45%
2009 $3,500,000 45%
2010 not applicable estate tax repealed, gift tax at top individual rate


The repeal of the estate tax in 2010 will not relieve the estate of a decedent who died before January 1, 2010, from its obligation to pay its estate tax in installments, if a qualified election was made. Under current law, if the value of a closely-held businessexceeds 35 percent of adjusted gross estate, the executor may elect to pay the estate tax attributable to such interest over 14 years. The Act also expands the definition of a closely-held business to include certain lending and financial businesses.5

Notwithstanding the general repeal of estate taxes, taxes still may be levied upon distributions from qualified domestic trusts (QDOTs). Transfers to a non-US citizen spouse do not qualify for the marital deduction unless the property is placed within a QDOT.6 The estate tax will continue to be levied upon distributions occurring prior to January 1, 2021, from a QDOT to a surviving spouse. However, there will be no tax upon the distribution of the assets from a QDOT following the death of the spouse after December 31, 2009.7

II     ELIMINATION OF FAMILY OWNED BUSINESS DEDUCTION AND STATE DEATH TAX CREDIT

Some of the benefits of the lower rates have been offset by the elimination of certain tax benefits that were formerly available to taxpayers. The state death tax credit will be phased out gradually until January 1, 2005, when it will be completely repealed. In addition, the additional exemption given to certain family-owned businesses will be repealed for the estates of decedents dying after December 31, 2003.

Prior to the Act, a decedent's estate could partially offset a portion of the federal estate tax with the death taxes - estate or inheritance taxes - paid to a state. The credit was based upon a statutory rate computed upon the taxable -estate of a decedent, reduced by $60,000. However, the state death tax credit could not exceed the actual state death taxes paid.8 Pursuant to the new Act, the state death tax credit will be reduced 25 percent per year from 2002 through 2004, and completely eliminated effective for estates of decedents dying after December 31, 2004. However, for estates of decedents dying after December 31, 2004, a deduction is granted for the actual death taxes paid to any state.9 Due to this phase-out of the state death tax credit, the total estate tax savings in certain states may not be very significant.10

An estate currently is granted an additional deduction from the gross estate for the value of a qualified family-owned business. However, the deduction is limited to $675,000. To be eligible to claim the deduction, the following criteria must be met:
(1) The decedent was a US citizen or resident.
(2) The value of the qualified family-owned business, together with the amount of the decedent's gifts to his family, including the value of gifts which were sheltered by the gift tax annual exclusion, must exceed 50 percent of the adjusted gross estate.
(3) During at least five of the eight years preceding the decedent's date of death, the decedent or a member of his family materially participated in the business.
(4) The decedent and his family owned a significant percentage of the business - 50 percent if owned by the decedent and his family, and 30 percent if owned by two or three families.
(5) The stock in the family-owned business was not publicly traded within three years of the decedent's death.
(6) Thirty-five percent or less of the income of the family-owned business would be classified as personal holding company income.
(7) The executor elects to obtain the benefits of this provision and files an agreement providing for certain recapture of the benefits if the family members fail to remain active within the business for 10 years after the date of the decedent's death.11
Under the Act, the family-owned business deduction is repealed for estates of decedents dying after December 31, 2003.

     III MODIFICATION OF THE CARRYOVER BASIS RULE

Under current law, which remains in effect for the estates of decedents dying before January 1, 2010, the decedent's -estate and the beneficiaries thereof acquire a basis in the decedent's property which is equal to the fair market value of the property as of the date of the decedent's death.12 (This is known, of course, as "stepped-up" basis.) An estate may elect to value assets as of the alternate valuation date, provided that the value of the gross estate (and, consequently, the estate tax levied) is decreased as a result of such election. The alternate valuation date is the earlier of the date such property is sold, distributed or exchanged, or six months after the decedent's date of death. If the estate elects to value its assets as of the alternate valuation date, the basis of all property will be the value as of the alternate valuation date.13

By acquiring property which has a basis equal to the fair market value as of the date of the decedent's date, the beneficiary, in effect, acquires a "clean slate." All gain and loss associated with the property is eliminated. This result should be contrasted with the current rules governing the basis of property acquired by gift. The basis of gifted property generally is equal to the lesser of the fair market value of the property or the donor's basis, adjusted by a portion of the gift taxes paid upon the transfer.14 (This is known as "carryover" basis because the donee carries over the basis of the donor. Thus, in general, property acquired from a decedent by reason of death is entitled to a stepped-up basis, while property acquired from a donor by reason of a gift receives a carryover basis.)

In estate planning, it is extremely important to factor in these basis rules. Before gifting significantly appreciated property, one should consider whether it would be better for an individual to retain ownership of the property and pass it at death rather then gift it away during life. This is an especially important decision where, for example, an individual's estate would not be subject to tax.

Example 1: Mark is married to Sue and they have one child, Amanda. Mark owns a piece of real estate that he purchased for $100,000 and which is currently worth $675,000. In addition to the real estate, Mark owns other assets having a value of $2 million. Mark advises you that he intends to give the property to Amanda during his lifetime and pass the remainder of his estate to Sue upon his death. If Mark thereafter gifts the property to Amanda, there will be no current gift taxes due, since the applicable credit amount will shelter the transfer from tax. However, if Amanda sold the property, her gain would be equal to the difference between the amount realized and her basis. So, if she sold the property for $700,000, her taxable gain would be $600,000. Additionally, there would be no tax at the time of Mark's death, since all of his other property passed to Sue, and it would qualify. for the unlimited estate tax marital deduction. Alternatively, if Mark dies in 2002 and makes a testamentary - bequest of the property to Amanda, there still would be no estate tax due, but Amanda would now acquire a basis equal to the fair market value of the property. If we assume the value of the property was $675,000 at the time of Mark's death, then Amanda would recognize a $25,000 gain upon her subsequent sale . of the property, as contrasted with the $600,000 gain she would recognize if she acquired the property by gift.

The current step-up in basis rules contained in IRC Section 1014 are scheduled for repeal for property inherited from decedents dying after December 31, 2009, the same effective date as the repeal of the estate tax. Generally; subject to certain exemptions, carryover basis rules, similar to those applicable to donees of gifted property, will then apply. New IRC Section 1022 states that except as otherwise provided, the basis of property acquired from a decedent will be the lesser of the fair market value of such property or the adjusted basis of the decedent. As a result of this change, the income tax benefits which were obtained by inheriting appreciated property at the donor's death, rather than by a gift, will be eliminated.

Example 2: If Amanda inherited the property from Mark, who died in 2010, Amanda's basis in the property will be Mark's basis of $100,000. If she thereafter sold the property for $700,000, she would recognize a $600,000 gain, the same as if she received the property by gift.

Any tax benefit that the decedent could have derived from selling depreciated assets is eliminated both under current law and under the carryover basis rules.

Example 3: Amanda inherited X stock from Mark in 2010. Mark paid $100,000 for the stock and it had a value of $70,000 at the time of his death. If Amanda later sells the stock for $80,000, she will have a long term capital gain of $10,000 which must be reported on her income tax return.

For gift tax purposes, a donee of property that is depreciated at the time of transfer will have a dual basis for the purpose of determining gain or loss. Similar to the basis rules that apply to property acquired from a decedent, in determining the loss recognized upon the disposition of the gifted property, the donee's basis will equal the fair market value of the property at the time of the gift. However, for the purpose of determining whether a donee recognizes a gain upon such donee's disposition of depreciated gifted property, the donee. may utilize the donor's basis.15

Example 4: Assume the same facts in Example 3 above, except that Amanda received the property by gift from Mark, and later sold the property for $80,000. Amanda would recognize no gain or loss. Her basis for determining loss would be the fair market value as of the date of transfer, which was $70,000. Upon the sale she does not have a loss, since the amount received, which was $80,000, exceeds her basis. Nor does she have a gain. The amount realized exceeds her basis for gain, which is Mark's carryover basis of $100,000.

In certain situations the foregoing may create an incentive for individuals to gift depreciated property. However, as will be discussed below, since the gift tax remains in effect after the repeal of the estate tax, the gift tax may be a disincentive for making such a transfer of depreciated property. Indeed, this was the motivating factor in Congress's decision to retain the gift tax after 2010.

Notwithstanding the general rule that there will not be a step-up in the basis of property acquired from a decedent who died after December 31, 2009, there are potentially significant exemptions. Without taking into account the exemption granted to transfers to spouses, any estate can allocate up to $1.3 million to increase the basis of property inherited from a decedent by any unrealized gain.16 The estate of a nonresident alien decedent is limited to a $60,000 allocation. Additionally, any estate can allocate up to $3 million to increase the basis of appreciated property which passes to the decedent's surviving spouse. The allocations cannot increase the basis of any property in excess of the property's fair market value. Additionally, as is the case under current law, no basis increase is permitted for items classified as income in respect of decedent (IRD).17 Such allocations will be made by the executor on the estate tax return for the estate.

The basis of property acquired by a decedent for less than full and adequate consideration within a three-year period preceding the decedent's date of death may not be adjusted. However, the foregoing rule does not apply to property acquired from the decedent's spouse, unless such spouse acquired the property for less than full and adequate consideration within the three-year period preceding the decedent's date of death.

Certainly, it will be necessary to carefully plan how assets are held in dealing with these new basis rules. Taking into account all tax and nontax factors, spouses may want to consider making certain property transfers. It should be noted that, for the purposes of this section, if property is held jointly with a right of survivorship by the decedent and a spouse, it is treated as being owned 50 percent by each.18

Example 5: Barbara and Tony have been married for 20 years and have three children. The only asset which they own jointly is their home, which has a fair market value of $800,000 and a basis of $200,000. Barbara owns stock in a closely-held business that is worth $8 million..'Barbara's basis in the stock is $1 million. Her husband, Tony, has liquid assets worth $6 million, which are not appreciated. If Tony predeceases Barbara, the total potential basis increase of $4.3 million will go unused. Barbara should consider transferring some of her assets to Tony, so that he will own some of the appreciated stock as well.

In addition to the foregoing adjustments to increase the basis of property acquired from a decedent, the exclusion for gain upon a sale of a residence has been extended to apply to a sale by an estate, a qualified revocable trust, or the beneficiary of the decedent's residence. Under current law, due to the step-up in basis rules, the estate or a beneficiary would not recognize the gain to the extent of the appreciation which occurred prior to the decedent's death. After the repeal, the estate or the beneficiary will now be eligible to exclude up to $250,000 of the gain recognized upon the sale of the residence.19

As a result of the carryover basis rules, it is more likely that an estate will recognize gain upon a distribution of property to satisfy a pecuniary bequest. An estate will recognize gain or loss upon the distribution of property to satisfy a specific bequest.20

Example 6: Fred owned 1,000 shares of X Company stock. Fred's basis in the stock was $250,000. At the time of Fred's death the stock had a value of $900,000. Pursuant to Fred's Will, $1 million is to pass into a trust for the benefit of his granddaughter, Stacy. Assume Fred's executors transfer the securities to. the trust at a time when the securities were worth $1 million. Under current law, the estate would recognize a $100,000 gain, the fair market value at the time of transfer, minus the estate's basis, $900,000.

Due to the adoption of the carryover rules, the amount of gain that would be recognized upon the distribution of appreciated property to satisfy a pecuniary bequest would be increased substantially. Based upon the facts in Example 6, the executor would recognize gain of $750,000.

Congress adopted a rule limiting the amount of gain recognized upon the transfer of appreciated property to satisfy a pecuniary bequest. Gain will be recognized to the extent that the fair market value of the property at the time of distribution exceeds the fair market value of the property at the time of death. The basis of the property in the hands of the legatee will be increased by the amount of the gain recognized.21

Thus, based upon Example 6, the gain recognized would be limited to $100,000, and the basis of the property to the trust would be $350,000 (the carryover basis of $250,000, plus the gain recognized, $100,000).

IV     GIFT TAX

Unlike its estate tax counterpart, the gift tax is not being repealed. Prior to the repeal of the estate tax, the estate and gift tax rates remain unified. However, taxable gifts made after December 31, 2009, which is the effective date for the repeal of the estate tax, are subject to gift taxes. The maximum gift tax rate is reduced to 35 percent, which is.the highest individual income tax rate. The value of all property transferred to trusts after December 31, 2009, is treated as a .taxable gift unless the trust is considered a grantor trust.22

The applicable exclusion amount is being increased for both the estate and gift tax for property passing from a decedent who dies after December 31, 2001, and for transfers made after December 31, 2001. After such date, $1 million of assets will be effectively sheltered from tax. However, unlike the increase in the amount of the applicable exclusion for estate taxes over the next several years, the applicable exclusion amount is not being increased for gift tax purposes; it will remain at $1 million, but gifts in excess of the gift tax credit after 2002 will still continue to offset the larger estate tax credit. Thus, for the first time since the estate and gift taxes were unified in 1976, individuals will be able to transfer substantially more wealth upon their deaths without the imposition of any tax than during their lifetimes.

V     REPORTING REQUIREMENTS

Many estates will still be required to file a return after the repeal of the estate tax, which becomes effective for estates of decedents dying after December 31, 2009. Estates having a value greater than the aggregate basis increase that an executor is permitted to allocate to the basis of property included in the decedent's estate, pursuant to newly enacted IRC Section 1022, will be required to file a return. However, for purposes of the filing requirement, the additional basis increase allocable to assets passing to the decedent's spouse is not taken into account. Any estate of a decedent dying after December 31, 2009, in which the fair market value of property acquired from a decedent exceeds $1.3 million, will be required to file a return. The estate of a nonresident alien decedent will be required to file a return if the fair market value of the tangible assets owned by the decedent and other property acquired from the decedent by a United States person exceeds $60,000.23

Under the new rules, the estate tax return must be filed with the decedent's final individual income tax return, i.e., by April 15 of the year following the year of death. This is contrasted with current law where the estate return must be filed separately within nine months of the decedent's date of death.24

The return must contain the following information specified by the Act:
(1) the name and taxpayer identification number of the recipient;
(2) an accurate description of. the property;
(3) the decedent's adjusted basis of the property and the fair market value at the time of the decedent's death;
(4) the decedent's holding period for such property;
(5) sufficient information to determine whether any gain on the sale of the property would be treated as ordinary income;
(6) the amount of the allocated basis increase to such property;
(7) additional information as the regulations may prescribe.25
The executor of the estate is also required to furnish to each beneficiary acquiring property from the decedent a written statement of the decedent's basis in the property and holding period in the property, the fair market value of the property, whether any basis adjustment is being made to the property, and whether the gain upon disposition of the property would be treated as ordinary income.26

This is an incredible burden that Congress will be placing upon taxpayers. Taxpayers will be required to maintain records not only for investments and significant purchases, but they will also be required to maintain their purchase records for` all assets which will be reportable in their estates, including. all tangible personal property. Amazingly, taxpayers will be required to keep a record of their purchases of household furnishings. Due to the practicalities involved, one might expect some exemptions from this recordkeeping nightmare will eventually be added to the law. Hopefully, a technical corrections act is coming- down the pike that will relieve us of these record-keeping requirements.

Generally, the obligation to file a gift tax return to report taxable gifts remains unchanged. The returns will continue to be filed by April 15th of the year subsequent to the year of the taxable gift.27

Unless reasonable cause is shown, a penalty of $10,000 is imposed upon the failure to provide the estate tax information on the date prescribed by law, i.e., the due date of the decedent's final return, including extensions. A $50 penalty is imposed upon the executor for each failure to provide the applicable statement to a person receiving property from the decedent.28

VI     GENERATION-SKIPPING TRANSFER TAX

The generation-skipping transfer ("GST") tax is a separate tax in addition to the estate and gift taxes. Its purpose is to ensure that property passing to remote generations in excess of the exempt amount 'is taxed in a manner similar to how the estate or gift tax would have been applied had a generation not been "skipped." Under the law in effect prior to the Act, the GST tax was a flat tax imposed at the rate of 55 percent (the highest possible estate tax rate). The amount which was exempt from the GST tax, called the "GST Exemption," was $1,060,000 for the year 2001, and was indexed for future inflation.29

Since the GST tax corresponds to the maximum estate tax rate, the rate reductions imposed by the Act will also reduce the amount of the GST tax. For decedents dying or for gifts made in 2002, the GST tax will be imposed at the rate of 50 percent; 49 percent in 2003; 48 percent in 2004; 47 percent in 2005; 46 percent in 2006; and 45 percent in each of 2007, 2008 and 2009. Furthermore, the Act provides that the amount of the GST exemption will remain at its current level of $1,060,000 as adjusted for inflation until 2004, when it becomes equal to the exemption for estate taxes. Thus, the GST exemption will equal $1.5 million in 2004 and 2005; $2 million in 2006, 2007 and 2008; and $3.5 million in 2009.

Lastly, under the Act, the GST tax will not apply to generation-skipping transfers made after December 31, 2009, i.e., the GST tax is.repealed for the year 2010. However, because of the "sunset" provision of the Act required under Congressional budget rules, on December 31, 2010, the entire Act fades into the sunset, and the GST tax rate will return to 55 percent the next day, with an exemption of $1,060,000 indexed for inflation, unless new legislation is enacted by a future Congress.

The Act also modified the rules regarding deemed and retroactive allocations of the GST exemption. There are three types of skip transactions which are subject to the GST tax. These are "taxable terminations," "taxable distributions" and "direct skips."30 Of these, a direct skip is a transfer subject to estate or gift tax that is made to a "skip person," who is either an individual two or more generations below that of the transferor, or a trust for the sole benefit of skip persons. Under the rules in effect prior to the adoption of the Act, if an individual makes a lifetime direct skip, any unused GST exemption was deemed to be allocated to the property transferred in an amount necessary to eliminate any GST tax. There was no deemed allocation of GST exemption for lifetime transfers made to a trust which is not a direct skip.

The Act provides for a new deemed allocation rule applicable to lifetime "indirect skips," which are defined as any taxable transfer to a GST trust which is not a direct skip. The purpose of this new rule is to alleviate the problems caused when a taxpayer inadvertently fails to allocate GST exemption to an indirect skip. Thus, transfers from a trust which are likely to be GSTs will now be covered by the automatic allocation of GST exemption. A taxpayer may still opt out of the new deemed allocation rule for lifetime indirect skips.

In addition to the foregoing, a taxpayer will now have the ability under the Act to retroactively allocate unused GST exemption to any previous transfer made to a trust, on a -chronological basis. The purpose of such retroactive allocation is to allow a taxpayer to allocate GST exemption where there has been an "unnatural order of death," i.e., the taxpayer's child has predeceased him prior to the termination of a trust which was intended to ultimately benefit the child rather than the child's children. A retroactive allocation may be made where: (1) a non-skip person has .in interest in the trust; (2) such person is a lineal descendant of a grandparent of the transferor or of a grandparent of the transferor's spouse or former spouse, and such person is assigned to a generation below that of the transferor, and (3) such person predeceases the transferor.31 The retroactive allocation needs to be made in the calendar year within which the death of the non-skip person occurs.

An example of the new rule regarding the retroactive allocation of the GST exemption is as follows:
Example 7: Assume that in 1999, a taxpayer ("T") creates an irrevocable trust for the primary benefit of his child ("A"), who is then age 21. The trust agreement provides that the trustees have discretion to distribute income to A, and principal distributions will be made to him at ages 25, 30 and 35, at which time the trust will terminate. If A should die prior to age 35, the trust agreement states that A's children will receive the trust assets. T makes gifts to the trust in 1999 and 2000, but does not allocate any GST exemption to the gifts on the federal gift tax returns (Forms 709) filed to report the gifts. In 2001, A dies, and the assets of the trust pass to A's children in a generation-skipping transfer. T may retroactively allocate his unused GST exemption to the 1999 and 2000 gifts and thereby exempt the assets passing to A's children from the imposition of the GST tax. Such a retroactive allocation of the GST exemption was not permitted prior to the Act.

Other provisions of the Act which relate to the GST tax allow severance of GST trusts, called a "qualified severance," thereby eliminating the need to include complicated severance provisions in a Will or trust agreement. In addition, the valuation rules applicable to the allocation of the GST exemption have been modified with regard to the date the allocation becomes final; the doctrine of substantial compliance for GST exemption allocations has been .codified; and the Internal Revenue Service has been directed to allow relief in situations where the taxpayer intended to allocate the GST exemption but inadvertently failed to do so in a timely manner.

Example 8: Assume a taxpayer ("T") transfers $1 million of stock to a GST trust for the benefit of his grandchild. Although a federal gift tax return (Form 709) is filed to report the gift, no allocation of T's GST exemption is made thereon. If such an allocation had been made, the transfer would be fully exempt from the GST tax regardless of the amount of any future appreciation. The. value of the stock later appreciates to $1.5 million by the time T makes an allocation of his GST exemption to the transfer. Under the old law, $500,000 of the stock, and any appreciation thereon, would not be sheltered from the GST tax. The Act provides that a late election under new IRC Section 2642(g)(1) can be made, which would allow T to allocate his GST exemption based on the value of the stock on the date of the original transfer ($1 million), as opposed to its appreciated value at the time of the. late allocation.

VII     THOUGHTS FOR FUTURE ESTATE PLANNING

A. Revisions to Existing Estate Plans

The increase in the exemptions for the estate tax and the GST tax necessitate the reviewing and possible revising of many existing wills in order to ensure that the testator's goals will be met. Most wills for married individuals with estates in excess of the current exemption amount of $675,000 use a formula to divide the decedent's estate into two parts, one equal to the exemption amount then in effect (often called the "credit shelter amount") and the other equal to the balance of the decedent's residuary estate and passing to or for the benefit of the surviving spouse (the "marital deduction" portion).

Given the increase in the estate. tax exemption through 2009, the assets funding the credit shelter amount will be significantly increased through the application of the formula contained in the will. As noted above, the estate tax exemption will increase to as much as $3.5 million in 2009. For those individuals whose wills bequeath the credit shelter amount solely to or for the benefit of their children, rather than surviving spouses, the change in the law may result in more assets than desired benefiting the children at the expense of the spouse. Even if the will provides that the credit shelter amount will be held in trust for the spouse's benefit, depending upon the size of the decedent's estate, the spouse could be the beneficiary of all of the assets, contrary to the decedent's intent. All wills should be reviewed to make sure that the testator's intent is met. Consideration may be given to limiting the amount passing into an applicable credit shelter trust or to beneficiaries other than the spouse. For example, a testator's will might state that "an amount equal to the lesser of the applicable credit amount or $1.5 million shall pass as follows. . . ."

In a situation where a married couple wants their assets to be utilized essentially for the benefit of the surviving spouse, it may be increasingly attractive to use a disclaimer will. A disclaimer will provides that all of a decedent's assets pass to the surviving spouse. However, the will has provisions which further provide that if the spouse makes a timely disclaimer, the disclaimed assets may pass into a trust which provides for income distributions to the spouse. Such a will also grants the trustees liberal invasion provisions for the benefit of the spouse. Depending upon the particular circumstances, and the estate tax laws then in effect, a spouse can determine up until nine months after the decedent's death whether he or she wants to place the assets into a disclaimer trust. If an individual makes a qualified disclaimer, the federal tax laws are applied as if the disclaimant is .deceased and the assets never passed to him or her.32

A spouse's qualified disclaimer must meet the following three conditions:
(1) It must be in writing.
(2) The disclaimer must be received by the -personal representative of the estate within nine months of the date of death of the decedent.
(3) The spouse must riot have accepted the benefits prior to the disclaimer.33
The assets passing into a trust following a disclaimer by the spouse can avoid taxation in both spouses' estates, assuming that the spouse does not disclaim assets having a value in excess of the applicable exclusion amount. Based upon the current estate tax applicable exclusion, the spouse may see no benefit to creating a credit shelter trust. The use of the disclaimer trust permits the spouse to decide, nine months after the date of the other spouse's death whether he or she wants to take advantage of the deceased spouse's applicable credit amount.

Example 9: Steve and Kathy have been married for 30 years and have three children and five grandchildren. They hold all of their assets separately in their respective individual names. They each own assets having a value of $1.5 million. Steve has executed a will providing that all of his assets shall pass to Kathy. However, if Kathy disclaims any portion of the assets, they will .pass into a. trust which gives Kathy all of the income during her lifetime. The trustees also have the right to invade the principal of the trust for Kathy's benefit. Steve dies in 2002, when both his and Kathy's assets are still worth $1.5 million. Kathy should seriously consider making a disclaimer of $1 million of assets. By making the disclaimer, the assets included in Kathy's taxable estate will not include the assets within the trust. If Kathy dies in 2003 when her assets and the trust assets each has a value of $1.5 million, then Kathy's gross estate would be $2 million. If she did not make the disclaimer, her gross estate would be $3 million. By making the disclaimer, the estate, tax on Kathy's estate would be reduced by approximately $490,000 ($1 million times 49 percent). If Steve died after December 31, 2008, there would be no estate tax savings achieved as a result of a disclaimer. This assumes that the value of Steve and Kathy's assets each remained at $1.5 million. Since the applicable exclusion amount is increasing to $3.5 million as of January 1, 2009, then Kathy's estate will not be subject to estate tax because the gross estate is less than the applicable exclusion amount. Thus, in this situation it is not necessary to create a disclaimer trust.

This use of either a disclaimer will or a "cap" on the amount of assets passing under the formula clause in the will will build flexibility into the estate plan, in light of the. uncertainty as to whether the estate tax repeal will ever become permanent. Furthermore, it is also important that each spouse own sufficient appreciated assets in his or her own name to take advantage of any available basis adjustments.

In addition, in those estates where it has been contemplated that a tax will be incurred on the death of the first spouse, i.e., where there is a second marriage and the decedent has children from a prior marriage whom he or she wishes to benefit in an amount in excess of the estate tax exemption, revisions may be needed. Given the contemplated repeal of the estate tax in the future, it may make sense to make full use of the marital deduction on the first spouse's death so that the payment of any tax could be completely eliminated.

In this situation, a testator may want to consider creating a qualified terminal interest property trust, more commonly referred to as a "QTIP" trust.34 The testator can create a trust which provides income to the spouse for life, with the remainder to the children of.the first marriage. The testator can, if he chooses, prohibit any invasion of the corpus by inserting a provision to that effect. The property passing into the QTIP trust will qualify for the marital deduction. However, the value of property included in a QTIP trust will be included in the spouse's estate upon his or her demise. If the spouse dies after the repeal of the estate is in effect, there will be no tax.

There is a disadvantage to using a QTIP trust for the spouse's benefit - rather than an outright disposition to the spouse - when it comes to the new carryover basis rules. As noted above, the Act provides for a basis step-up for $3 million of assets passing to a surviving spouse, including assets passing to a QTIP trust. However, upon the spouse's subsequent death, it does-not appear that the QTIP property which is includible in the spouse's estate is eligible for any further basis adjustment if such property is then still held in trust. Thus, planners must balance the possible income tax benefit of an outright disposition to the spouse with the other benefits of having the assets held in a QTIP trust, especially in second marriage situations.

Often, estate planners have focused exclusively on transfer tax, i.e., estate and gift, considerations. Given the new carryover basis rules which are scheduled to go into effect in 2010, income tax planning will become much more significant. As noted above, detailed records of purchase prices of all assets must be kept.

B. GST Planning under the Act

The amount of the GST exemption will also be increasing after 2004 so that it is equal to the estate tax exemption, as described above. Individuals whose wills incorporate GST planning may or may not be comfortable with an increased amount of assets (up to $3.5 million) ultimately passing to their grandchildren, rather than their children. On the other hand, with the repeal of the GST tax in 2010, there will no longer be any limit on the amount of assets which can pass to grandchildren free of tax, and some individuals may wish to take advantage of the ability to pass their entire estates to their grandchildren.

C. Life Insurance

Life insurance can play an important role in estate planning. In order to. preserve. a decedent's assets, it is often recommended that the testator purchase insurance on his own life in order to assist the beneficiaries of his estate with the payment of the estate tax. If a testator is married and anticipates avoiding the estate tax on the death of the first spouse due to the use of the marital deduction, it may be prudent to purchase an insurance policy that provides benefits only upon the death of both spouses, i.e. second-to-die life insurance.

Notwithstanding the possible repeal of the estate tax in 2010, life insurance will still play an important role in estate planning. It is risky to assume that a decedent's estate will not be subject to tax. Why? Because there still is approximately eight years until repeal will become effective and there's political uncertainty as to whether repeal. will ever become a reality. Even if repeal occurs, the purchase of life insurance in appropriate situations will provide additional benefits to the decedent's beneficiaries.

Therefore, life insurance will still play an important role in estate planning for the foreseeable future. To avoid having the insurance proceeds included in an individual's estate, an individual should consider having the insurance policy owned directly by the individual's beneficiaries or by an irrevocable insurance trust. The gross estate of a decedent includes the value of all life insurance proceeds received by the decedent's executor or by any other beneficiary if the decedent possessed at the time of his death any incident of ownership over the policy. Incidents of ownership include the power to change the beneficiary, to surrender or control the policy, to assign the policy, to revoke an assignment, and to obtain from the insurer a loan against the surrender' value of the policy.35

D Gifts to Family Members and Charities

Given the possible repeal of the estate tax in the future, there would seem to be little incentive for individuals to make gifts to family members which result in the payment.of a gift tax. However, there may be significant non-tax reasons for gifting to occur, such as to transfer control of a family-owned business to children and grandchildren during an individual's lifetime. Gifts need to be planned, carefully to ensure that the $1 million gift tax exemption will be leveraged to the extent possible by using available discounting methods.

Query the impact of the Act on charitable gifting, both during lifetime and upon death. With the proposed repeal of the estate tax, individuals who would not otherwise be charitably inclined may be reluctant to make testamentary bequests to charity - whether an outright bequest or a charitable trust - because the estate tax deduction resulting from a charitable bequest will no longer be relevant. For those individuals who wish to benefit a charity after the Act, they are likely to be better served by gifting assets to charity during their lifetimes so that they receive an income tax benefit (a charitable deduction). It remains to be seen whether the Act will have a significant impact on charitable giving.

VIII     CONCLUSION

The only certain thing about the Act is that it has caused a great deal of uncertainty among estate planners. How can one properly plan for the repeal of the estate and GST taxes when it is unclear whether such repeal will actually come into effect? Only time will tell whether the "sunset" provisions of the Act will take effect at the end of 2010, or if a future Congress will take action before that time. It would seem that four factors will be. important in determining whether the repeal of the estate tax will become permanent: (1) the state of the economy and the likelihood of budget surpluses or deficits in the future; (2) the 2002 Congressional elections, in which significantly more Republican U.S. Senators will be up for reelection than Democratic U.S. Senators; (3) the response of the states to the loss of revenue stemming from the elimination of the state death tax credit; and (4) the length of time before Congress decides to address the issue of repeal.36 Of the foregoing factors, it would seem that the first, the state of the economy and whether the predicted budget surpluses materialize, will be of utmost importance. Should the economy take a down= turn and tax revenues not meet expectations, it will be difficult for a future Congress to- make the _ repeal permanent. It should be noted that the estimated revenue loss resulting from changes to the estate, gift and GST taxes for the years 2003 through 2011 has been estimated to be $1-33.2 billion.37 It is impossible to know, without the luxury of a working crystal ball, what the economic climate will be like in 2010, after two Presidential elections have occurred and the "baby boomer" generation begins to reach age 65. Thus, the best advice for those engaged in estate planning in the future is simply to proceed with caution.

ENDNOTES

1. Senate Finance Committee Report, S Rep No 107-30.
2. House Ways and Means Committee Report issued on July 16, 1999, and accompanying the Financial Freedom Bill. of 1999, HR 2488.
3. Under IRC §§ 2001 and 2502, the 53% bracket applies to taxable transfers aggregating between $2.5 million and $3 million. The 55% bracket applies to taxable transfers in excess of $3 million.
4. In 2001, an additional 5% tax is levied upon lifetime and death taxable transfers exceeding $10 million in order to eliminate the benefits from the lower brackets. The benefit of the lower brackets is totally eliminated once estate or lifetime taxable transfers exceeded $17,184,000. In effect, such an individual's or a decedent's taxable estate would be subject to a flat 55% rate. IRC §§ 2001(c)(2) and 2502.
5. IRC § 6166.
6. In addition to meeting the general requirements for a qualified terminable interest trust (periodic income distributions to spouse, - invasion of corpus solely for spouse's benefit), the trust must provide that at least one trustee must be a US person or a domestic corporation, and that the trustees have the right to withhold estate tax from the distributions. IRC §§ 2056A, 2056.
7. IRC § 2210.
8. IRC § 2011.
9. IRC § 2058.
10. A number of states have tax laws stipulating that the state death tax shall, at a minimum, equal the amount of the state death tax credit given for the purpose of computing U.S. estate tax. As a result of the elimination of the credit, a number of these states will also find a decrease in state tax revenue. However, some states, such as New York, based their estate tax upon the credit available as of July 22, 1998. Unless the New York legislature amends this provision, the State of New York will continue to impose a death tax even though there may be no U.S. estate taxes. NY Tax Law § 951.
11. IRC § 2057.
12. IRC § 1014.
13. IRC §§ 2032 and 1014(a)(2).
14. IRC § 1015.
15. 1RC § 1015.
16. The limitation is increased by the amount of the decedent's unused carried-over capital losses and net operating losses, and the amount of the losses that a decedent could have claimed if he sold depreciated assets before his death. IRC § 1022.
17. See IRC § 691.
18. IRC § 2040.
19. IRC § 121(d)(9).
20. Reg § 1.1014-4(a)(3).
21. IRC § 1040.
22. IRC § 2511(c).
23. IRC §. 6018(b).
24. IRC § 6075.
25. IRC § 6018(c).
26. IRC. § 4018(e).
27. IRC § 6075.
28. IRC § 6716.
29. IRC § 2641.
30. IRC § 2612.
31. IRC § 2632(d)(1), as added by the Act.
32. IRC § 2046, and Reg § 20.2046-1(a).
33. IRC §§ 2046 and 2518. Assets passing into a trust in which the spouse receives the income rights can still be deemed to be made pursuant to a qualified disclaimer. See IRC § 2518(b)(4) and Reg § 25.2518-2(e)(2). A disclaimer will not be deemed to be qualified if the disclaimant receives future benefit from the assets. 34. See IRC § 2056(b)(7).
35. IRC § 2042.
36. See Aucutt, "Still Debating the Prospects for Estate Tax Repeal," 28 Estate Planning 383, 389 (Aug 2001).
37 Id.



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