There has been much written about the recent changes in the Federal estate, gift, and generation skipping taxes. There are, however, some surprises and consequences of the changes which are only beginning to be understood. We want to give you what we believe are the most significant changes.

Before the enactment of the 2001 statute there was a $675,000 exemption from the estate and gift taxes and a $1,000,000, plus inflation adjustments, for the GST. Under the new statute the estate tax exemption increases to $1,000,000 in 2002, $1,500,000 in 2004, $2,000,000 in 2006 and $3,500,000 in 2009. The GST exemption will be the same as the estate tax exemption. In 2010 the estate tax and GST are repealed.

Before the 2001 Act, the maximum estate tax bracket on amounts over $3,500,000 was 55%. The GST rate is 55% on any generation skipping transfer. Under the new statute the estate tax maximum rate is reduced to 50% on amounts over $2,500,000 in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007 with repeal in 2010. The GST rate will be the same as the maximum estate tax rate from 2002 through 2009.

The 2001 statute increases the gift tax exemption to $1,000,000 in 2002 and there are no further increases. The gift tax is not repealed in 2010. The maximum gift tax rate is reduced the same as the estate tax rate and in 2010 is reduced to 35%, the maximum income tax rate.

Apparently, the gift tax was retained to discourage transfers to persons in lower income tax brackets.

The Federal estate tax has always had a credit for death taxes paid to a state, up to certain amounts, provided that the amount is actually paid to a state. As a result, every state but one has an estate tax equal to the credit amount allowed on the Federal estate. These state death taxes do not increase the total death taxes paid but allocate part of the tax to be paid to a state.

Under the 2001 Act, the state death tax credit is reduced by 25% in 2002, 50% in 2004, 75% in 2004 and is eliminated in 2005 and thereafter. For many states this will result in a significant reduction in revenue. The elimination of the state tax credit is much faster than the repeal of the Federal estate tax.

The impact on state revenues is only beginning to be understood. Many states will have to adopt their own death tax or some other revenue raising tax.

Before the 2001 Act the basis for income tax purposes of any asset subject to the estate tax was changed to the estate tax value of that asset. This was the major difference between the estate tax and the gift tax. When a person makes a gift the donee takes the donor’s basis in the gift asset which is referred to as a carryover basis.

Beginning in 2010, the 2001 Act eliminates the change in basis at death and imposes a carryover basis so the estate and beneficiaries of the estate will use the decedent’s basis. This change from an estate tax at death with rates as high as 55% to a capital gains tax at 20% when an asset is sold is a favorable change from a tax viewpoint.

From an administration standpoint, carryover basis at death will be a nightmare. It will be impossible to determine the basis of some assets and yet the Act requires an executor to file with the IRS the basis of every asset in the estate.

It is not speculation that there will be severe problems with this change. In 1976 a carryover basis at death system was adopted. It caused so many problems it was repealed in 1978 retroactive to 1976 as if it never existed.

The only significant difference between the 1976 change and the 2001 Act is important. This is that every estate can increase the basis of its assets by $1,300,000 and for transfers to spouses by another $3,000,000. If, however, you don’t know the decedent’s basis in an asset how do you know what it is increased to?

People involved in this may have to improve their record keeping.

To the surprise of many, the 2001 Act provides that all of its provisions do not apply after December 31, 2010. For the estate tax and GST this means that for deaths after 2010 or generation skipping transfers after 2010, the 2001 Act will not apply but rather the law before enactment of the Act will apply. Another Congressional vote by 2010 would be necessary for any part of the 2001 Act to survive.

If you wish to discuss further the 2001 Act please call Martin J. Dever or Robert A. Hetherington of our Trusts and Estates Department at 201-487-3800.

Robert A. Hetherington, Esq.