Is It Gone? The Non-Repeal of the Estate Tax
So, it’s finally happened. After years of fighting opposition in Congress and a Presidential veto, the estate tax has been repealed. On June 7, 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001, called EGTRRA (pronounced “Egg Tray”). The bill makes major changes to the United States’ tax system, changing the income tax, gift tax, capital gains tax, and repealing the estate tax. So, now, or at least soon, we won’t have to worry about estate planning, right? Let’s talk about the current estate tax system, and the changes EGTRRA will bring.
II. Changes to the Estate Tax and Gift Tax
Currently, any gifts you make during your lifetime and any property you pass on your death is subject to the unified gift and estate tax. Your estate tax is determined by totaling the value of everything you owned, less anything going to your spouse (the Marital Deduction), and calculating a tentative tax based on estate tax rates from 18% to 55%. Then, your fiduciary (trustee or executor) reduces your estate tax by the unified credit amount (also called a “Coupon”). The current amount of the credit is designed to yield a $0 estate tax on a $675,000 estate.
Another credit that is available is the State Death Tax Credit. Any amount you pay to a state or the District of Columbia for death taxes reduces your Federal Estate Tax dollar for dollar, up to certain limits. In most states, there is an estate tax that is equal to the maximum credit available. This is called a “pickup tax”. So, basically, you calculate your estate tax, then figure out how much goes to your state capital (the maximum state death tax credit) and how much goes to Washington (the rest). Please keep in mind that this is only a summary and your taxes may be adjusted by other credits and deductions.
- Now – the changes to the estate tax include:
- Gradual reductions in the top tax rate;
- Increases in the unified credit; and
A reduction in the size of the State death tax credit and eventually changing it to a deduction; s
This table summarizes some of the changes we will see. Year Estate Tax Exemption Top Rate Gift Tax Exemption State Death Tax Credit Other 2002 $1,000,000 50% $1,000,000 Reduced 25% 5% “Bubble” (on estates over $10 million) eliminated 2003 $1,000,000 49% $1,000,000 Reduced 50% 2004 $1,500,000 48% $1,000,000 Reduced 75% 2005 $1,500,000 47% $1,000,000 Changed to deduction 2006 $2,000,000 46% $1,000,000 Changed to deduction 2007 $2,000,000 45% $1,000,000 Changed to deduction 2008 $2,000,000 45% $1,000,000 Changed to deduction 2009 $3,500,000 45% $1,000,000 Changed to deduction 2010 Estate Tax Repealed 35% (Gift Tax only) $1,000,000 Changed to deduction Full step-up in basis repealed. 2011 $1,000,000 55% $1,000,000 Full Credit Full step-up in basis and 5% bubble restored.
|Top Rate||Gift Tax|
|2002||$1,000,000||50%||$1,000,000||Reduced 25%||5% "Bubble" (on estates over $10 million) eliminated|
|35%(Gift Tax Only)||$1,000,000||Changed to
in basis repealed.
|2011||$1,000,000||55%||$1,000,000||Full Credit||Full step-up
in basis and 5% bubble restored.
As you can see, the repeal does not last very long. In 2011, we wind up right back where we would be without EGTRRA. This result is because of the sunset rule, which makes it very difficult to get large tax cuts or spending increases more than 10 years in the future. It also helped keep the cost of the bill within the $1.35 trillion agreed upon by Congress and the President some time ago.
Even while the estate tax is repealed, there will still be a gift tax. Also, while the estate tax exemption amount goes up, the gift tax exemption remains at $1 million. This is to prevent using gifts to reduce income taxes.
III. Changes to the Step Up in Basis
Currently, when you sell a capital asset (such as a house or an investment), you pay capital gains tax. This tax is at a lower rate than normal income taxes, but can cause great tax pain, because it might be very large in a single year. Much tax planning is designed to avoid paying capital gains taxes, or to time them for minimum impact on your financial goals. The advantage of an IRA, for example, is that you don’t pay capital gains taxes until you withdraw the funds from the account.
The amount of your capital gain when you sell a piece of property is what you received for it, less your basis (for simplicity, what you paid for it). So, if you bought a mutual fund share for $10 in 1985 and sold it for $50 in 2001, you would have a capital gain of $40 in 2001. Your capital gains tax would be based your tax bracket, but would definitely be less than the tax you pay on regular wages.
One of the advantages of dying is that the basis of any property you inherit is not what the decedent (the person who died) paid for it, but its value on the date the decedent died. In the above example, if you inherited that mutual fund share in 2001 when it was worth $50, your basis is $50. If you sell it while it is still $50, then you have no gain, and therefore, no capital gains tax! The downside is that if the decedent paid $50 for it and it’s now worth $10 (think internet start-ups), you get a “step-down” to the value on the date of death of the decedent.
With the demise of the estate tax, the feds thought that the step-up was too big a tax shelter and would cost too much. So in 2010, the step-up rules are changed. You still get a step up of $1.3 million when you die, plus an additional $3 million on property left to your spouse. In other words, if you have property valued at $6 million at your death, with a basis of $1 million, your beneficiaries have a basis of $2.3 million (the old basis plus $1.3 million). If your beneficiary is your husband or wife, then the basis will be $5.3 million (the old basis plus $1.3 million plus $3 million). Under the old rules, your beneficiaries would have a basis of $6 million. Until 2009 and then again in 2011, the full step-up applies.
Notice that this bill has not been called tax simplification?
IV. Cost of the Repeal
A. To the Federal Government
The annual budget cost of the estate tax repeal stays in the range of $5 billion to $15 billion until 2010. In 2010, it jumps to about $24 billion. In 2011, it increases to about $54 billion. Note that the cost seems to lag behind the changes. This is because your estate has 9 months to pay most estate taxes. So, most estates of people dying in 2010 (during the repeal) don’t cause any revenue loss until 2011.
EGTRRA’s income tax provisions will cost about $100 billion in 2011.
B. To the State Governments
The loss of the State Death Tax credit will reduce revenues to those states that use a “pickup” estate tax. A majority of states use a pickup estate tax. If pickup states do reinstate an estate tax in the same size as the current credit, then moderate estates will be harder hit than large estates. Under the old State death tax credit system, moderate estates often paid more to the state than to the federal government. Large estates paid more to the federal government than to the states.
If your state has its own estate tax that is not a pickup tax, keep in mind that even while there is no federal estate tax, you will still have to plan for your state’s estate tax.
C. To Charities
One motivation for charitable giving is to avoid estate taxes. A number of tools are available to take advantage of charitable giving to reduce income taxes, capital gains taxes, and estate taxes. Some of these tools actually leave the family more money than not making the charitable gift. Some charities are concerned that EGTRRA will reduce the tax motivation for making charitable gifts and thus will make it more difficult to raise money. Only time will tell whether this repeal will cause a drop in charitable giving and how big that drop will be.
V. Will there be further changes?
Most observers have concluded that EGTRRA will have to be changed before 2011. Some experts believe that the revenue loss from the tax bill is larger than advertised. In any case, the revenue losses to the states and to charities are not factored in. On the other hand, tax reductions might stimulate the economy to make up some or all of the revenue losses. Again, only time will tell.
States will need to make up the revenue lost by the repeal of the State death tax credit. In 2002, every state that sets its own estate tax as equal to the maximum State death tax credit is going to lose 25% of its estate tax revenue. In 2005, the State’s estate tax revenue will be gone. The majority of states with such a death tax will have to respond through spending cuts; imposition of a new estate tax; or increases in other taxes. A few lucky states may have the financial resources to not need to respond.
The phase-in to repeal, the repeal, and then the cancellation of the repeal leave estate planners with 3 different systems to plan for. Every person could die before 2010, in 2010, or after 2010. We have to plan for all 3! It is quite a challenge. Will Congress and the President respond? It depends on who is in power and the economic situation. Even if most Congressmen think that the estate tax provisions of EGGTRA need to be changed, they have to agree on how to change them before any change will take place.
If you are opposed to estate tax repeal, you might do nothing and let the 2011 reversion to the old rules stand. If you support repeal and you can’t get the votes for full repeal, maybe you’ll make a deal to give up repeal and keep the higher exemption and reduction in estate tax rates. In short, nobody knows what will happen to the estate tax over the next 10 years. Perhaps we’ll see true repeal; perhaps the temporary repeal will never happen; perhaps we’ll get exactly what just passed. Who knows? The problem is that means we have to plan for all possibilities.
Some of you might be thinking that you don’t have to worry about estate planning now that the estate tax has been repealed. This cannot be further from the truth. First, remember that most estate planning is not about reducing estate taxes, it’s about family and personal goals. Saving taxes is only the last piece of the jigsaw puzzle. You and your estate planning attorney need to plan to help you maintain control while you can; provide for you and your dependents should you become disabled or after your death. You need to identify to whom you want to leave your property; when they can get it; and how they can get it. You may want to provide for pets; for parents; for charitable causes that are important to you. None of this is changed by the demise of the estate tax.
Even if your major concern is estate taxes, we still need to plan for them. Can you promise you’ll die in 2010? Or that the real repeal will occur before you die? Even if real repeal happens, will States step in with new estate taxes? Our crystal ball is foggy.
In the meantime, you need to continue planning just like you should be doing already. If you do not have an estate plan, get one. If you do, make sure it is up to date. Most USPA & IRA clients realize the importance of updating your financial plan. It is now especially important to use frequent updating of your estate plan to keep abreast of the rapid changes in this area. Many members of the National Network of Estate Planning Attorneys use formal updating programs that are very effective for keeping your planning up to date. If your estate-planning attorney does not have a formal updating program, ask for a review every year or two years.
Be proactive. Make sure that you adjust your plan to take advantage of the changes in the law. Make sure that you, your friends, and family aren’t fooled into believing that estate taxes are gone or that you don’t need to worry about estate planning anymore. Make sure that your estate plan will work the way you want it to.
The author, Jon Graft, is an estate-planning attorney located in Oakton, Virginia. He has been a USPA & IRA client since 1984. Jon is a member of the National Network of Estate Planning Attorneys and has a law degree and a master of laws in taxation from the College of William and Mary. Jon served in the U.S. Army as a Field Artillery Officer.
Frank McClure contributed to this article. Frank is also a Member of the National Network of Estate Planning