ESTATE TAX CHANGES 2001: TAX PLANNING AND TAX TRAPS

Case affects internet and international tax planning

By Richard S. Lehman, Esq., of Richard S. Lehman P.A.; Boca Raton, FL
Published: August 17, 2001
South FLorida Business Journal

The new tax law reduces the estate tax in stages, repealing it fully in the year 2010 and resurrecting the repealed estate tax in 2011 exactly as it stands today. This schizophrenic approach leaves both estate tax planners and clients in a position that will require new thinking for estate and gift tax planning and the periodic review of plans. This will be important if one is to avoid costly tax traps and inter-family litigation necessary to decide what a decedent really intended amid all of the tax language.

Before considering the actual changes in the law it is helpful to review the issue of whether the complete repeal of the estate tax law will in fact occur. The new law gradually reduces the estate tax through 2009 leading to a full repeal in the year 2010. However, as of now the repeal does not apply to estates of decedent's dying after 2010 and without further legislation continuing this repeal, the full estate tax in its present form will return and apply to individuals dying in 2011 and thereafter.

While one can only guess at whether the repeal will continue, the facts point to the conclusion that it may not. Principally, in the year 2011, when continued repeal must be voted on again, the first of America's baby boomer generation will turn 65 and the country's price of retirement and related services will begin a costly climb. At the same time, it is estimated that a continued estate tax repeal continuing from 2011 until 2020 will cost an estimated $1.5 trillion. Keep in mind that continued repeal will benefit only America's 10,000 wealthiest families. Consequently estate planning documents will need to take into account the very real possibility that repeal will not happen.

That being said, in this first of a series of two articles we will briefly review several of the changes in the law and look at a major tax trap that one must be cognizant of. In the second article we will consider several of the tax planning concepts that will shape our minds to accommodate to the new law.

The major change is that the estate tax is scheduled for complete repeal in 2010 while the gift tax is being retained. Between now and 2010 the estate tax will continue to exist; but with an expanding amount that will be exempt from estate tax (the "Exclusion Amount") and at reduced rates.

The Exclusion Amount will increase to $1 million in 2002, $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009. In addition, the highest estate and gift tax rates will decrease to 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006 and 45% in 2007. The gift tax will not be repealed, although the gift tax exemption amount will be increased in 2002 to $1 million (but will not be increased beyond that amount) and the gift tax rate will drop in 2010 to the top individual rate (currently set to be 35%). The gift tax annual exclusion will remain at $10,000 (indexed for inflation).

Several significant changes in addition to the above include:

The Generation Skipping tax will not apply to generation skipping transfers after December 31, 2009 and the increasing estate tax Exclusion Amounts will also apply to gradually reduce taxable generation skipping transfers.

There is a major change to the law does not come into effect until the actual repeal of the estate tax. This change has to do with the cost basis of property inherited from a decedent. These changes will replace the estate tax to some extent with an income tax and are covered in Part 2 of this article.

Having covered some of the major highlights of change, let's look at a major tax trap that one of these changes pose for surviving spouses in many of today's existing wills.

Generally, there are two main concepts that govern estate tax planning in the typical married couple's situation. The first is the use of the Exclusion Amount that permits a portion of a decedent's estate to pass free of tax to any recipient. The second is the unlimited Marital Deduction which permits transfers to be made free of tax to a surviving spouse, thus deferring the federal estate tax until the surviving spouse's death.

The goal of protecting the spouse and minimizing estate tax is often accomplished with an "A-B estate plan". Under this plan a formula provides that one portion of the plan leaves the Exclusion Amount in a trust (the "Part B") in a manner that will avoid inclusion of this trust in the surviving spouse's estate. The Part B trust will generally provide the surviving spouse with rights during her lifetime but will often have severe restrictions on the surviving spouse's full use of the funds in Part B. The balance of the Estate is then left for the benefit of the surviving spouse either outright or in trust (Part A).

The formula that establishes the amounts available to each of Parts A and B is dependent first upon the Exclusion Amount available. This amount which presently stands at $675,000, was to grow to a maximum of $1,000,000 prior to the new law. The significant and rapid increases in the Exclusion Amount under the new law may have serious unintended consequences. As the Exclusion Amount increases, the result to many wills and trusts will be a substantial reduction in what the surviving spouse receives under Part A and may inadvertently disinherit the spouse.

This is best shown by way of example.

Assume Husband's will, drawn in the year 2000 and unchanged to accommodate the new law, provides for a Part B trust for the maximum Exclusion Amount with the balance of his estate to pass to wife outright and free of trust. Assume that the Part B trust leaves the wife only the income from the trust during her life and requires that it be shared with another family member. Assume husband intended a maximum of $1,000,000 to be included Part B as provided under prior law; with the other $1,000,000 to pass to wife with no restrictions whatsoever. Assume further that the husband's estate at date of death has a value of $2,000,000 and husband dies in the year 2006 when the applicable Exclusion Amount is $2,000,000. Based on the formula in place in husband's existing will, all $2,000,000 will go to Part B leaving the wife only a shared income interest in the $2,000,000 and nothing in Part A except her right of election under state law.

Richard S. Lehman, Esq. (LL.M in Taxation) is the managing partner in the Boca Raton law firm of Richard S. Lehman P.A. The firm specializes in tax law focusing on tax and asset protection planning, document drafting and litigation strategy in the areas of income, estate, trust taxation and probate litigation.

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