The Economic Growth and Tax Relief Reconciliation Act of 2001, signed into law by President Bush on June 7, 2001, could fundamentally change the way wealth passes from one generation to another. But then again it may not change anything at all.

According to Stephen Leimberg, author of Tools and Techniques of Estate Planning and a recognized authority on the subject, the new law doesn’t impact whatever estate planning you’ve done. “It’s business as usual,” he says. Confused? You’re not alone.

Much of the confusion derives from the fact that the new law repeals the estate tax in 2010 but then brings it back from the grave in 2011. All the tax cuts that became law will expire on December 31, 2010 unless they are renewed by Congress. No one expects that to happen, but uncertainty abounds as to just what Congress will do.

Chris Cooper, a certified financial planner (CFP) based in Toledo, OH, says, “What’s not in the law, you can’t plan for.” And since the estate tax is repealed for only one year, conservative planners are treating the new legislation as a non-event. But there are things you can and should do that will be discussed shortly.

The entire tax bill expires on December 31, 2010, because of a “sunset” provision. Under congressional budget rules, certain legislation that decreases revenue must cease to be effective 10 years after passage. But the real reason this was done was to limit the projected cost of the bill — a little bit of chicanery that Congress is very adept at.

Though it’s extremely unlikely that all of the law’s provisions will be allowed to expire, estate planning for small-business owners has been made extremely complicated by this legislation, so consult your estate planner as soon as possible.

Current Law

Under the current system, a coordinated system of gift and estate taxes has imposed a tax with a marginal rate of 18% to 55% on the value of wealth transfers, whether the transfers took place during a person’s lifetime (gift tax) or at death (estate tax). In addition, a generation-skipping transfer tax (GST) with a flat rate of 55% had been imposed on cumulative transfers of over $1 million to “skip persons,” such as grandchildren, during the donor’s lifetime.

The present system of estate and gift taxes applies only to transfers in excess of an “applicable exclusion amount.” Prior to passage of the bill, the exclusion amount for 2001 was $675,000; $700,00 for 2002 and 2003; $850,000 for 2004; $950,000 for 2005; and $1 million for 2006 and succeeding years. Estates with a value below the exclusion amount owe no taxes.

Qualified family-owned business exclusion: Family-owned businesses that were transferred on death to family members were permitted an estate tax exclusion of $1.3 million if the decedent or a member of the decedent’s family owned and materially participated in the business for at least five of the eight years preceding his/her death.

In addition, at least one heir (a relative of the deceased) is required to materially participate in the business for at least 10 years following the decedent’s death.

Unified system: This system meant that people could dispose of a total of up to $675,000 (in 2001) in the form of taxable gifts during their lifetimes and bequests at death without having their estates subject to the tax. In addition, an annual $10,000-per-recipient gift tax exclusion ($20,000 for joint gifts) was allowed for additional distributions of wealth without incurring any federal gift taxes.

The old law also contained a 100% marital exclusion for transfers of wealth (gift or estate) between husband and wife.

Asset sales: Under present law, if a recipient of a gift subsequently sells it, he/she uses the donor’s tax “basis” in the property to determine a gain or loss. Basis generally represents a taxpayer’s investment in property (i.e., what he/she paid for it).

On the other hand, property transferred at death generally receives a “stepped-up basis,” which means its value for tax purposes is established as the fair market value of the property when the donor died.

Changes in the Law

The estate tax and GST are phased out and eventually repealed, the gift tax rules are changed, and the way the tax basis of inherited assets is figured is changed.

Exclusion and rate: First, the exclusion amount will be raised and the top estate tax rate will be lowered over the course of the next eight years. The exclusion amount jumps to $1 million in 2002, $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009. Meanwhile, the highest estate tax rate decreases to 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007. It will then stay at 45% until 2010, when the estate tax is repealed.

The qualified family-owned business exclusion is repealed on January 1, 2004.

Gift tax: The link between the gift tax and estate tax is severed. The lifetime exclusion for the gift tax increases to $1 million in 2002 and remains at that level. The annual $10,000 gift tax exclusion remains. The gift tax rates will decline in step with the estate tax rates, but when the estate and GST taxes are repealed in 2010, the maximum gift tax will be 35% — the top individual income tax rate.

Basis: After 2009, the tax basis of assets received from a decedent will not be “stepped-up”; it will equal the basis of the decedent at death. However, a decedent’s estate is permitted to increase the basis of appreciated assets transferred by up to a total of $1.3 million. The basis of appreciated property transferred to a surviving spouse can be increased by an additional $3 million.

Steps to Take

Keep documents up-to-date:According to Dennis Filangeri, a CFP in San Diego, CA (, “Many estate plans have to be reexamined and rewritten, so see your planner or attorney each year to make sure your planning documents are up-to-date and your assets are properly titled.”

Gifting: Currently, one estate planning strategy is to transfer assets that are likely to appreciate, like stocks or shares in a Family Limited Partnership (FLP), through lifetime gifts. The idea is to pay little or no gift tax on these transfers when their value is lower, instead of having them taxed as part of your estate years later, after they have increased in value.

The separation of the gift tax and estate tax makes this strategy questionable for estates whose value is close to the current thresholds. Why would you want to pay a gift tax if no tax would be due after your death, assuming you survive until your estate is no longer taxable?

Curt Weil, a CFP based in Palo Alto, CA, says the new law favors structuring a family business as a FLP if it’s worth less than $2 million. That allows the owner to gift the limited partnership shares to his/her children while alive, but still remain within the $1 million gift tax exclusion.

Weil explains that even though all the limited partnership shares of a business valued at under $2 million are being transferred, their value (for tax purposes) is not $2 million because the shares aren’t readily marketable and the shareholders have no say in the business’ management.

“When the parent (the general partner) dies,” says Weil, “the value of his/her estate has been substantially reduced and it’s very unlikely that there’ll be any estate tax liability under the new law.”

Another view on gifting: “I agree that there will be changes in many planner’s minds about gifting, says Cooper, “But the sunset provisions make any planning dangerous if there isn’t planning for the return of the estate tax in 2011, or otherwise people will be committing suicide in 2010.”

Capital gains: In 2010, the estate and generation-skipping taxes will disappear altogether, but assets that are transferred will only be entitled to a limited step-up in basis totaling no more than $1.3 million ($4.3 million for a spouse) for the whole estate. Beyond that, the decedent’s original basis applies to transferred assets and when these assets are sold, capital gains taxes are due on any appreciation in value.

Jim Barnash, a CFP in Chicago, IL, says, “If you want to help your kids, keep good records of your basis in all your assets. Your kids will need them when they get ready to dispose of these assets.”

“Dividing up an estate between a surviving spouse and other heirs to take maximum advantage of various deductions and exclusions is at the heart of many estate plans. But now, you have to look carefully at the basis of assets being allocated to optimize use of the basis step-up,” Filangeri adds.

Timing: “Nine years is an eternity in the world of tax legislation,” says Filangeri. “And any number of reasons might cause Congress to slow or halt the progress toward total repeal.” Leimberg reminds us that Congress passed stepped-up basis legislation in 1978, only to rescind it a few years later because it was unwieldy.

If you’re worried that the estate tax is never going away, or if you have a realistic fear that you might die before 2010, Barnash says, “Make sure you have enough cash in your estate to cover the tax. Otherwise, you should buy enough life insurance to cover the bill. Make sure the life insurance is placed in a trust so the proceeds aren’t included in the estate.”

Zall is a freelance writer who specializes in taxes, investments, and human resource/business issues. He is a certified internal auditor and a registered investment advisor. He can be reached at (e-mail).

Publication date: 06/25/2001