To Our Clients and Friends:
On June 7, 2001 President Bush signed the new tax bill into law. As you probably know, it includes significant changes in the federal estate tax rules, including a complete repeal of the estate tax in 2010.
Until 2010, the federal estate tax will continue to exist, however, it will be gradually phased out over a nine-year time frame. The estate tax unified credit exemption will be increased in stages between now and 2010, when the estate tax is scheduled for repeal. In the meantime, these increases will completely eliminate the estate tax liability for many and substantially reduce the estate tax for everyone else. In addition, the current maximum estate tax rate of 55% will gradually be reduced until it is eliminated in the year 2010.
The new law will increase the exemption from the estate tax, which is now $675,000 and decrease the estate tax rate. The table below shows the scheduled increases in the exemption amount and the scheduled decreases in the maximum tax rate:
|
Year |
Exemption |
Maximum Rate |
|
2001 |
$ 675,000 |
55% |
|
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 |
Unlimited |
Estate Tax is Repealed |
Estate Planning Considerations
If you have an existing estate plan, it likely includes a bypass trust (also known as an exemption trust) arrangement. This planning tool is intended to ensure that both you and your spouse take full advantage of your respective estate tax exemptions. When the first spouse dies, the will should stipulate that assets with a certain value be used to fund the bypass trust. The ultimate beneficiaries of the trust (typically the children) are named by the decedent and the amount that funds the trust is included in the decedent?s gross estate for estate tax purposes. The decedent?s estate tax exemption then fully shelters the trust fund from any federal estate tax. The surviving spouse can receive distribution of income and some principal from the trust as needed to meet reasonable expenses.
This is excellent tax planning for some people, but not everyone. For some, this type of planning is inappropriate. Most wills call for the bypass trust to be funded with an amount equal to the current federal estate tax exemption without naming a specific figure. Effective the first of next year, the exemption suddenly jumps from $675,000 to $l million. So upon death, the trust might be funded with an amount much greater than the decedent intended, while his or her spouse is left with less than either spouse wished.
For instance, assuming a $1.4 million estate, prior planning would intend for $700,000 to fund the bypass trust. That would leave a comfortable $700,000 to go directly to the spouse. But, if the will stipulates the bypass trust is to be automatically funded with the full estate tax exemption amount, the trust would be automatically funded with $1 million upon a 2002 death. That scenario would leave the spouse with only $400,000. While the spouse can utilize funds in the bypass trust if necessary, he or she may be reluctant to do so, assuming the money is really meant for the kids.
It is important that you review and update your will, if necessary, to ensure that it accommodates your wishes with respect to the funding of bypass trusts and the respective amounts left to your heirs.
Review Your Life Insurance Coverage
A tool in your existing estate plan may be a life insurance policy retained solely to pay the federal estate tax bill that will come due when you pass on. Due to scheduled revisions to the estate tax laws, the amount of coverage that you need will likely decrease effective next January 1st. This is due to the estate tax exemption increasing by $325,000 and the maximum rate decreasing from 55% to 50%. Consider reducing your life insurance coverage accordingly (assuming there are no other reasons to continue carrying an amount which now appears to be excess coverage). You should contact us, or your life insurance professional to determine the amount of life insurance coverage necessary for you under the new law.
You May Need Different Planning for Your Valuable Home
Another common scenario where the new tax law demands a change in your existing estate plan is the transfer of your home upon death. If you own a valuable home, your current estate plan likely leaves the home to your spouse. This could result in a majority of your liquid assets being left to your children in order to utilize the estate exemption properly. The end result: your spouse might be left with one major illiquid asset (your house), while your children receive liquid assets (investments, retirement accounts, life insurance proceeds, etc.). This may be the opposite of your wishes for your wife or husband and children.
The new law allows you to make a change for the better. Beginning next year, you will be able to leave a home worth up to $1 million directly to your kids with no federal estate tax due. You can then generally leave an unlimited amount of other assets (including all the liquid assets) to your spouse estate-tax-free. That way, your spouse will have cash for living expenses and can continue living in the house by renting it from the bypass trust. Meanwhile, leaving the house to your trust (which eventually distributes it to your children) removes an appreciating asset out of your estate and your spouse?s estate too. Finally, the basis of your home will be ?stepped up? to its date-of-death fair market value, which means your children can later sell it with minimal or no capital gains taxes due. The exact same considerations apply if you own a valuable vacation home.
What About Asset Basis Step-Up?
Contrary to what you may believe, the current-law basis step-up privilege for most inherited assets will continue unchanged until the estate tax is completely repealed in 2010. If you pass on before then, your heir?s basis in an inherited asset will generally equal its date-of-death fair market value instead of your lower historical cost basis. The basis step-up is taxpayer friendly; because it means an inherited asset sold shortly after your death won?t result in a substantial capital gains tax bill for your heir, even if your basis was small in comparison to current value. (Tax-deferred retirement accounts are a notable exception to the basis step-up rule).
Once the estate tax is completely repealed in 2010, the basis step-up privilege will be partially repealed. Specifically, non-spousal heirs in total will be entitled to a basis step-up of up to $1.3 million. Spousal heirs will be entitled to a basis step-up of up to $4.3 million (assuming they are allocated the $1.3 million step-up plus an additional $3 million step-up available only to them). So, in 2010 and beyond (assuming Congress actually allows the estate tax to remain repealed), there won?t be any federal estate tax and the partial basis step-up will still wipe out any federal capital gains tax in many cases. Heirs of relatively large estates might owe some capital gains taxes when they sell inherited assts, but generally at only a 20% rate (or whatever the current rate is at that time). That?s a huge improvement over the tax results under the old system.
We hope this letter answers your questions about the new federal estate tax regime. If you are interested in understanding how the new estate law affects your personal situation please call us.
SOUKUP, BUSH & ASSOCIATES, P.C.
