INTRODUCTION

Opportunities and Pitfalls

Don't Wait. The cause for the urgency in contacting your estate planning advisor is threefold.

Why Estate Planning Takes on Added Importance

Before discussing some of the specifics of the Tax Relief Act, and what new estate planning strategies you should implement as a result, you should consider some factors involved in the bigger picture.

At first blush, one might conclude that estate planning is a thing of the past; no estate tax, therefore, no estate planning. In fact, this conclusion could not be further from the truth. Why?

A significant estate tax continues to exist. The new law does not repeal the estate tax until 2010; until that relatively distant date, the entire estate tax system stays put. There will be 2 presidential elections and 4 congressional elections between the date of enactment of the Tax Relief Act and 2010. A future Congress might delay the repeal date or "repeal the repeal". In fact, built into the new law is a "sunset" date of January 1, 2011, that automatically reinstates the estate tax to its full 2001 level (unless Congress acts in the meantime) with a $1,000,000 exclusion and a top tax bracket of 55% to 60%.

Many experts, including myself, believe that total repeal of the estate tax will never take place, and certainly there is no guarantee of repeal. This means that all estate plans need to be flexible. Your estate plans should be able to twist and turn as quickly as the law will during the next 10 years.

Most estate tax rates do not budge from their present, high levels until their scheduled repeal in 2010. Although the highest estate tax rate is gradually reduced by 10 percentage points over nine years (plus 5 percent attributable to the surtax for estates over $10 million), the rest of the rates, which are the rates that apply to the bulk of taxable estates, will not change. These rates range from 18 percent for taxable amounts from $0 to $10,000, to 43 percent for amounts between $1.25 million and $1.5 million mark.

Although it is a positive step, the increase in the estate tax exemption (the amount of assets automatically freed from any estate tax liability) is not substantial until 2009. In 2002 and 2003, for example, only $300,000 more in assets are exempt from estate tax than would have been under the old rules. Add to the equation what inflation will do to the value of these exemptions during the next 10 years, and it is clear that the new exemptions will not provide the level of estate tax relief many estate owners had hoped for.

The gift tax will not be repealed. This means that you may continue to encounter problems in giving a son or daughter substantial funds for a first home or an emergency, or passing a family business along to the next generation gradually as a reward or incentive to continue your business. Additionally, the amount of the exemption for gifts to a non-citizen spouse is limited. In 2002, that exemption is only $110,000.

You will now need to contend (or, more accurately, your heirs will have to contend) with additional income tax, scheduled to appeal on the scene when (and if) the estate tax is phased out. Any individual with an estate with a potential value exceeding $1.3 million (in post-2010 dollars) should anticipate that the heirs may have to pay additional tax down the road as a result of the new "carryover basis" rules.

State tax authorities will be pressured to continue a significant estate tax on the state level to maintain much needed revenues. "Piggybacking" state taxes to federal taxes, which many states now do, will become less common. This means additional complexity for your total estate planning strategy, as states begin to reach for a means to replace their "pickup taxes," which will expire when (and if) the federal estate tax repeal becomes effective in 2010.

As you can see, estate planning has gotten more complex and, for many taxpayers, more important than ever.

HIGHLIGHTS OF THE NEW ESTATE AND GIFT TAX CHANGES

It is helpful as you more forward with your revised estate plans to be familiar with the major provisions in the new law that drive the need to make these changes.

Reductions in Estate and Gift Tax Rate

After December 31, 2001, the top marginal estate and gift tax rate starts to fall gradually. In 2002, it falls to 50 percent, applicable to amounts in excess of $2.5 million. After 2002, the top rate drops more slowly (by 1 percent each year), until it levels off at 45 percent for the 2007 to 2009 period for amounts in excess of $1.5 million. However, as noted above, the other estate tax rates (from 18 to 43 percent) and the corresponding bracket amounts, do not change. They remain the same over the entire nine-year phase-out period.

Here is how the estate tax rates look after the highest rate bottoms out at 45 percent:

Increase in Amount Excluded from Estate Tax

Every estate is allowed a deduction against the estate tax. This excludes some of your assets from the estate tax liability. In 2001, the amount excluded was $675,000. (This means that an estate of $675,000 or less will not be taxed). Starting in 2002, the exclusion amount for estate (but not gift) tax purposes gradually increases until topping off in 2009 under the following schedule:

Increase in Amount Excluded from Gift Tax

The new law affects the amount of gifts you can make without being taxed. Starting in 2002, the lifetime exclusion amount for gift tax purposes increases to $1,000,000. This exclusion is in addition to the $10,000 annual exclusion of which you probably are aware and which is increased to $11,000 in 2002. Unlike the gradual increase in the estate tax exclusion, however, the gift tax exclusion is set to remain at $1,000,000, with no further adjustments.

The gift tax rate will be phased down but not completely out. Initially it falls to 50 percent and continues to drop together with the estate tax rate until the estate tax repeal in 2010. In 2010, the gift tax does not end; instead, it will be fixed to the highest income tax rate operative at that time (scheduled to be 35 percent), with a $1,000,000 lifetime exemption continuing.

Carryover Basis

Under current tax law, the assets which an individual owns as of the date of death receive a "stepped-up basis" to the fair market value of those assets as of the date of death. As a result, assets which appreciated in value between the date of purchase and the date of death escape forever the capital gains tax which otherwise would have been levied upon such appreciation. The stepped-up basis rule has been a pillar of estate planning.

Starting in 2010, a system called "carryover basis" will replace today's "stepped-up basis" for property that passes to another person after you die. Basically, it replaces the estate tax with a modified income tax system of taxing assets of a decedent. Carryover basis means that if your heirs sell the property they inherit from you as soon as they receive it, they will have the same amount of taxable gain that would have resulted if you had sold the property during your life. Every estate (except for estates of nonresident aliens) will be entitled to increase, by a maximum of $1,300,000, the basis of assets to their date-of-death value. Thus, if you have noncash property worth $6,000,000 on the date of your death, in which you have a basis of $1,000,000, using this basis step-up provision, the basis of this property can be increased to $2,300,000. If a surviving spouse receives the assets beginning in 2010, either outright or in a qualifying trust, an additional $3,000,000 in basis step up is available.

Under current tax law, assuming that certain residency and ownership requirements are met, an individual may exclude $250,000 of gain upon the sale of the individual's primary residence. Under the Tax Relief Act, beginning in 2010, in addition to the carryover basis rules, the $250,000 exclusion from gain which was available to you from the sale of your personal residence is also available to the person who inherits your house, but only if certain conditions are met.

Generation-Skipping Transfer Tax

The generation-skipping transfer tax (GST) is a tax on the transfer of property to a person who is more than one generation younger than you (for example, your grandchild). Under the new law, the GST will be on the same schedule for reduction and repeal as the estate tax. Also, the GST exemption in 2002 will be $1,100,000 and beginning in 2004, the GST exemption will equal the estate tax exemption. This means similar problems will exist, and demonstrates the need to coordinate solutions with the estate tax phase-out and gift tax reductions.

Credit for State Death Taxes

The credit for state death taxes paid will be repealed over a four-year period, from 2002 through 2005. Starting in 2005, you will instead be able to deduct state death taxes paid.

Family Owned Business Deduction Eliminated

The qualified family owned business interests deduction disappears after 2003. However, if the heirs of an estate that took that deduction thereafter breach certain "continuity" requirements (for example, by using the property for fewer than the required 10 years), the estate will be subject to recapture of the tax benefit that the deduction generated.

Installment Payment Provisions

Generally, an estate tax liability must be paid within nine months of death. However, if the decedent's gross estate includes an interest in a closely held business, subject to certain restrictions, the executor may elect to extend the time to pay the estate tax liability attributable to that interest for up to 14 years.

The Tax Relief Act increases from 15 to 45 the maximum allowable partners and shareholders that a business can have and still qualify as a closely held business interest for purposes of the installment payment rules. As a result of expanding the definition of a closely held business interest, an increased number of estates will be eligible to take advantage of paying estate taxes in installments.

MAJOR PLANNING TRAPS HIDING IN THE CHANGES

At first glance, the new law looks like a windfall for taxpayers.

True, the federal estate tax is slated for repeal; however, the reduction is slow, "off the top" and occurs only in small bites during the nine year phase-in period. From 2001 until 2010, the maximum estate tax rate goes down only 10 percentage points, from 55 percent to 45 percent. This is not terribly generous. Most estate holders will be just as interested in avoiding a 45 percent estate tax as a 55 percent estate tax. Estate planning continues to be necessary, particularly because after 2010, if Congress does nothing further, the old rules return, and the tax reverts to its 2001 levels with a top rate of 55 percent and an exemption of $1,000,000, figures that are very close to the old top rate and exclusion.

At the same time the estate tax is scheduled to end as a revenue generator, the "carryover basis" system (as explained earlier) is poised to replace it. This means that your heirs take ownership of your property with the same basis you had, subject to certain permitted increases explained above. Effectively, the tax savings your estate received from repeal will be partially offset by increased income tax your heirs will have to pay because of the change in the way their basis in inherited property will be calculated.

The Practical Implications

How will the new law impact how you plan your estate, and will you even need estate planning?

The short answer to the last question is "yes." In fact, given the many aspects of the changes (repeal, rate reductions, exemption increases), estate planning is more critical, and more complex, now than at any time in the past.

Your estate planning strategies now, more than ever before, depend on your age and health, and your spouse's age and health:

If you are relatively young and in good health, your strategy may be based on an expectation (but not the guarantee) that there will be no estate tax in 2010 and perhaps thereafter. However, the ultimate fate of the estate tax is uncertain. Legislation is not carved in stone, and the repeal could be repealed before it ever even takes effect, or Congress could keep the repeal in effect after 2010.

Individuals who are older or whose health is precarious should assume that their estates will be subject to estate tax at one of the phase-out rates and their property will have a stepped-up basis in the hands of their heirs.

In order to escape estate tax, many estate plans provide for the maximum amount available through the full use of the unified credit to pass tax-free to nonspouse heirs and the remainder to go to the surviving spouse or in a trust for the surviving spouse, who takes an unlimited amount estate tax-free. This is designed to use the unified credit to shelter assets that will pass to heirs other than the spouse or in a trust for the spouse, while taking advantage of the unlimited marital deduction. The balance of the estate goes to the spouse estate tax-free.

In a one marriage situation, the result might be that the surviving spouse has less control over assets than the spouses originally intended. In a second or subsequent marriage situation where the exclusion amount passes to heirs other than the spouse, as the exclusion amount increases (from $1,000,000 this year to $3,500,000 in 2009), an automatic provision in your estate planning documents maximizing the use of the credit for nonspouse heirs may give those heirs more than you had intended. Depending on the size of your estate, you could unwittingly cut out your spouse altogether!

You could place a limit on the amount covered by the exclusion that will pass to your heirs or use a schedule that corresponds to the changing exclusion amounts.

During the next nine years, as the estate tax rates go down, the gift tax rates also fall, but when the estate tax disappears in 2010, the gift tax will still be there for transfers you make during your lifetime. Congress decided to continue the gift tax, but at a rate equivalent to the highest income tax rate.

Why would you want to transfer assets during your lifetime if lifetime transfers will always be taxed, but death transfers may occur tax free starting in 2010? Giving continues to have its advantages:

You may want to shift income to a relative in a lower tax bracket by giving away an income-producing asset. (But keep in mind that if a child is under age 14, income in excess of $1,500 is taxed at the parents rates.)

You may wish to move forward on a gift-giving program that takes advantage of the annual $11,000 gift tax exclusion per donee (increased from $10,000 to $11,000 in 2002), especially if your estate eventually may be subject to the carryover basis rules.

You may, because of your age or health concerns, expect to be hit with an estate tax.

You may expect the estate tax to return at a comparable (or higher) level after 2010.

You may want to provide financial help to family members now.

You may want to encourage your children to take over the family business by giving them equity interests before you die.

Measuring Tried and True Estate Planning Techniques Against the New Law

In cases where a lifetime transfer remains a good tax strategy, will the techniques used by estate planners under the old laws and rates need to be changed or discarded? Set forth below are a few of the popular estate planning arrangements and methods, most of which are principally intended to lower your estate taxes.

GRATs

Grantor retained annuity trusts (GRATs) will remain useful as long as the estate tax exists. A GRAT enables you to set up a trust that pays you an annuity for a term of years, with the remaining assets going to your beneficiaries. The amount of the gift (the remainder interest) is calculated when the trust is set up and consists of the amount you contribute to the trust less the value of the annuity payments. Assuming that investments are successful, the amount remaining in the trust when the annuity payments are completed will be substantially greater than the remainder that was initially calculated. Because the gift was completed when the trust was set up, no additional gift tax is imposed on the extra amounts that pass to the trust beneficiaries. The tax laws that specifically govern GRATs are not changed by the Tax Relief Act, and GRATs should continue to be an effective way to make lifetime transfers.

Defective Grantor Trusts

You may want to set up a trust in order to ensure that your assets pass according to your wishes while at the same time taking advantage of individual tax rates as long as they are lower than the tax rates assessed against trusts. One way to do this is to deliberately set up a trust which, though valid under state law and for federal estate tax purposes, "fails" the federal income tax test, causing the income from the trust to be taxed to you. With the decrease in individual tax rates under the new law, this may be a desirable option for many taxpayers.

Family Limited Partnerships

As long as there remains a combined estate and gift tax, family limited partnerships will be an effective way to take advantage of appropriate discounting, and maximize your use of both your annual and lifetime gift tax exemption.

Life Insurance

Life insurance and life insurance trusts are useful sources of funds to pay estate taxes and avoid tapping assets. They will continue to be useful through at least 2009. Then, in 2010, life insurance can serve as a source of funds to pay the income tax resulting from the change from stepped-up to carryover basis.

Qualified Terminal Interest Property

Although transfers of terminable interests such as life estates or annuities generally do not qualify for the unlimited marital deduction, an exception exists if the spouse is entitled to receive the income from the property for life and certain other requirements are met (a "QTIP trust"). QTIP trusts continue to provide a valuable means of transferring property under the broad umbrella of the marital deduction as long as an estate tax exists.

Transfers at Death

Planning for transfers upon your death is challenging. The phased-in decreases to the estate tax alone will not generate substantial shifts in your estate plan, but repeal, if it lasts, will. Even a repeal that lasts for only one year, 2010, will warrant significant revisions in your plans. To ignore a one year repeal because of its limited application is to court disaster.

In some situations, the addition of provisional language to your will or trust will be sufficient to cover the one year repeal of the estate tax. In others, it may be necessary to prepare one set of documents and devise one strategy to cover the year 2010, and adjust your estate plan for the years before and after.

New Carryover Basis and Need for Records

At the same time the estate tax is scheduled to disappear in 2010, the basis for the properties your beneficiaries inherit from you will change from fair market value on date of death to the basis you had in the properties on that date, subject to certain adjustments explained above. This is an extremely important change. Under the old rules, any problems with your recordkeeping vanished when the property passed at death to your heirs, because the basis was automatically stepped up to its date of death fair market value.

Under carryover basis, how will you, and the IRS, determine what the basis is? Without adequate records, the IRS may prevail in a contest involving basis. Estate planning should now include determining what your current basis is in your assets and establishing a system to track future adjustments.

Example: Your grandmother purchased a vacation condo in Hawaii in 1950 for $20,000. Through the next 50 years, she made improvements to the property that cost her an additional $15,000. When she dies in 2010, her condominium, which she leaves to you in her will, is valued at $250,000. Because her basis in the property is carried over to you, your basis in the property is $35,000. If you sell the condo for $250,000, you will have taxable gain of $215,000, unless the basis of the property is designated to be increased as part of the $1,300,000 carryover basis increase amount. In that case, your basis will be the fair market value of the condo at the time of her death, $250,000. Similarly, if your grandmother dies in 2007, and the property is valued at $250,000, you will automatically have a basis in the property of $250,000, because the step up rules will still be in effect.

Estate planning documents should be modified so as to specify who will determine the manner in which basis should be allocated.

Complete Elimination of Tax Under Repeal

Of course, for the period of time that the estate and GST taxes are repealed, your estate planning strategy will not revolve around the payment or avoidance of taxes but will focus instead on how your estate is distributed and what strategies will best accomplish your goals. You will be able to retain control of assets you might have previously had to relinquish control over in order to reduce your tax bill; you will be able to plan direct transfers to beneficiaries you might once have had to arrange circuitous transfers to in the past. Except for the continuing tax on lifetime transfers (the gift tax), you will be able to arrange bequests and transfers according to the direction and schedule you and your estate planner determine is best.

RETIREMENT PLANS AND ESTATE PLANNING

Estate planning is not limited to positioning your assets in anticipation of your death. The size, nature and handling of your estate also depend on how you arrange your finances both preparing for, and during, your "golden years." Consequently, another important aspect of estate planning involves taking steps to maximize your income and enhance your financial security after your retirement.

Not surprisingly, the new tax law also makes significant changes to the rules affecting the assets you put aside for your retirement, or for your heirs if you die before "spending down" those savings. The rules governing these arrangements, both under the new law and its predecessors, are complex. Obstacles line the path of retirement planning in the form of restrictions on how much you can save; when you can take optional distributions; when you must take distributions, where you can put your contributions, and that is the short list. The good news is that the changes made by the new law are generally to your benefit.

Retirement Plan Tax Changes

You will be allowed to make larger contributions to, and take greater benefits from, qualified plans, such as those maintained by your employer. Contributions may take the form of deposits that your employer makes for you, or they may be deferrals that are taken out of your pay and held in an account, as in the case of 401(k) plans.

You also will be able to contribute more to your IRA, whether it is a traditional IRA or a Roth IRA. If you are 50 or older, you may be able to make "catchup-up" contributions to your IRA or your qualified IRA.

You will be able to reduce the distributions you must take from your qualified plans when you reach your required withdrawal date, and you and your heirs may stretch the payments out for a longer period of time.

You will have more flexibility in determining how and to whom your IRA or plan assets will be paid after your death, and in moving them among various types of accounts while you are alive. The options available to you in terms of where you can focus and what you can use for your retirement savings will expand, even permitting you to set up a Roth IRA in your 401(k) plan.

The changes made to the rules governing IRAs and employer-sponsored retirement plans are intended to encourage retirement savings. As a result, it will be possible to capitalize your retirement benefits so that in addition to making up a larger dollar portion of your estate than ever before, they can also be distributed in ways that will make funds available not only for your own needs but also to your heirs as part of your estate. The retirement plan provisions of the new act offer strategies and opportunities that can be an important part of your estate planning.

Sheltering Retirement Plan Assets

In order to ensure that your assets that have been put away on a tax-deferred basis will be used to support you in your retirement rather than simply provide an inheritance for your heirs, the law requires that you begin taking distributions from your retirement savings after you reach age 70-1/2. Two recent developments, proposed regulations issued by the IRS, and Congress' order to update the mortality tables used to calculate IRA payments, will reduce the size of the payments you are required to receive during your lifetime. This means you can plan on keeping more money in your estate to pass to your heirs.

More Variety in IRA Options

One of the important goals of estate planning is providing for comfortable retirements years. IRAs are a valuable tool in this endeavor, and they can be a valuable asset in your estate as well. The new law increases the current $2,000 maximum annual amount you can contribute to your IRA (depending on your level of income) starting in 2002, according to the following schedule:

Another change in the law enhances the "portability" of your retirement assets. You will be able to roll over amounts from IRA into another IRA or employer-offered retirement plan and your after-tax contributions from one employer plan to another or to an IRA. This permits you to preserve your retirement benefits if you switch jobs among employers, and it also allow you to design a more efficient "package" for your estate.

More Money in Retirement Plans

Under the new law, the contributions you make to your retirement plans, or that your employer makes on your behalf, may end up composing a larger portion of your estate. If you are at least 50 years old, you will be able to make "catch up" contributions to your IRA or 401(k) plan or $500 each year from 2002 through 2005 and $1,000 each year from 2006 and thereafter. The limit on the regular contributions you and your employer can make to your defined contribution plans (such as profit sharing and 401(k) plans) also will rise. The maximum amounts you will be able to contribute to your 401(k) plan, for example, will increase according to the following schedule:

ESTATE PLANNING TODAY: CONCLUSIONS

Estate tax "repeal", far from eliminating estate planning, may actually help focus more attention on this comprehensive financial undertaking. Estate planning involves more than avoiding payment of estate and gift taxes. It also involves developing strategies to preserve and enhance the assets that compose your estate and to ensure that you have implemented the best approach not only to structuring the inheritance you will leave behind but also providing for your enjoyment of the estate your earned.

During the nine year phase-in period, what we will see more closely resembles estate tax reform than estate tax repeal, but that does not mean the changes in the law and in your estate are any less significant. The new law is complex, its implications are vast and you should start planning now.

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