Tax Repeal Can Snag Estate Planning

The estate tax may be headed for the graveyard, but estate planning isn’t.

In fact, estate planning may become more, rather than less, complicated for some affluent Americans as they wrestle with the estate tax repeal Congress approved Saturday as part of its $1.35-trillion tax-cut legislation.

Many attorneys and accountants expect a surge in activity as people rework their estate plans, grapple with changes in the way certain property is taxed and attempt to break into trusts set up under the old rules.

All this will be done in a climate of uncertainty, because the estate tax isn’t scheduled to be completely repealed until Jan. 1, 2010--giving Congress plenty of time to change its mind.

“The changes have been stretched out for so many years, you can’t think that [lawmakers are] not going to come back and revisit this,” said Bruno Graziano, an attorney and estate tax expert for CCH Inc., a Riverwoods, Ill.-based tax research firm.

Even if Congress doesn’t reverse course and the estate tax is completely repealed, the relief may not last long. Because of budget rules, the repeal law sunsets--or ceases to exist--Dec. 31, 2010, when current estate tax rates go back into effect.

Still, the bill is expected to significantly reduce the number of people affected by estate taxes starting Jan. 1, 2002, attorneys said.

Under current law, each person can pass $675,000 to heirs free of estate taxes. For estates above that threshold, the tax rate starts at 37%, rising to 55% for estates valued at more than $3 million.

The tax-cut legislation trims the top estate tax rate to 50% next year while increasing to $1 million the amount that can be left tax-free to heirs. The increase in that exemption limit will spare about 40% of the taxpayers who would pay the tax. In 1999--the latest year for which IRS figures are available--49,870 estates were subject to the tax, of which 19,136 were valued at less than $1 million.

The new rules may require people to rethink common estate-planning tactics, however.

Many people, for example, give annual $10,000 gifts to their children, or larger gifts to charities, to reduce the size of their estates and thus save on future estate taxes. (Charitable contributions and gifts of less than $10,000 per recipient don’t incur gift taxes.)

There may be less reason to make such gifts as the estate tax declines and disappears. But if the estate tax is eventually reinstated, people who don’t make such gifts in the intervening years could be missing out on opportunities to shrink their eventual tax bill, experts said.

Complicating the issue is the fact that larger transfers--more than $10,000 per recipient--will still be subject to gift taxes under the repeal law, even as the estate tax disappears. Congress kept the gift tax to prevent wealthy parents from “income shifting”--transferring assets to children in lower tax brackets as a tax dodge.

The new law also may spark more litigation over trusts set up under the old rules, said Elizabeth T. Pierson, an estate-planning attorney with Hoffman Sabban & Watenmakerin Westwood.

So-called credit shelter trusts, for example, typically set aside an amount equal to the tax-free exemption--currently $675,000. The surviving spouse is allowed to tap income from the trust, while the principal goes to the children free of estate taxes after the surviving spouse’s death.

Such trusts often are set up to reduce estate taxes, but also to ensure money isn’t squandered by a spouse, Pierson said. “The evil stepmother might say, ‘It was done for tax planning and we don’t need it anymore,’ but the children might say, ‘Dad wanted it this way--he didn’t want you to have access’ ” to the money, Pierson said.

The bill also significantly changes the way certain inherited assets would be taxed--something that would shift the tax burden onto the heirs of large estates and create new paperwork headaches, accountants said.

Under current law, assets that are inherited get a new value for tax purposes--known as a step-up in basis--when the owner dies. For example, if someone paid $10 for a stock and it grows in value to $100 before she dies, her heirs could immediately sell the stock and pay no capital gains taxes on the $90 increase.

Congress preserved that favorable tax treatment until 2010, when the repeal is scheduled to be fully implemented. After that, only the first $1.3 million of any estate would receive the step-up in basis, and a married person would be allowed to leave an additional $3 million with the favorable tax treatment to a spouse.

For amounts over those limits, heirs would be required to keep track of how much was invested in a stock or other property over time in order to determine capital gains taxes when the asset was sold.

That can be difficult. Congress tried such a system in the mid-1970s by eliminating the step-up in basis for inherited assets, but the experiment didn’t last long, attorneys and accountants said.

“After two years it was repealed retroactively as unworkable,” said William E. Beamer, an attorney with Beamer Lauth & Steinley in San Diego. Keeping track of basis over many years--or several lifetimes if the assets are inherited more than once--could be “a nightmare for accountants, attorneys and everybody else,” he said.

Those who don’t keep good records may end up paying more in taxes, however. Families who can’t prove the cost of improvements over time on a house, for example, may be stuck using the home’s original purchase price as their tax basis and thus face higher capital gains taxes, experts said.

The repeal also limits a special tax break in community property states, such as California. Under current law, assets held by a married couple as community property get what’s known as a double step-up in basis when one spouse dies. In effect, both halves of the property are revalued for tax purposes, rather than just the half owned by the dead spouse.

The new rules preserve that break--to a point. Whereas in the past there was no limit on how much community property could get the double step-up, after 2010 the amount of community property receiving the favorable tax treatment would be limited to $4.3 million.

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Estate Tax Repeal

The estate tax repeal approved Saturday by Congress would gradually lower estate tax rates and increase the amounts that can be passed tax-free to heirs before eliminating the tax entirely in 2010--for one year. In 2011, the repeal expires and the old estate tax rate will be reapplied unless Congress repeals it again.

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Top Tax Exemption Year Rate Amount 2001 55% $675,000 2002 50 1 million 2003 49 1 million 2004 48 1.5 million 2005 47 1.5 million 2006 46 2 million 2007 45 2 million 2008 45 2 million 2009 45 3.5 million 2010 Repealed No limit 2011 55 1 million

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Source: CCH Inc.