Fall 2002: DB&M Reports to Clients

Estate and Tax Planning September 2002

In This Issue:
- The Delete/Restore Scenario in Contemporary Estate Planning
- The State Estate Tax Trap
- The Gift Tax Lives!

The Delete/Restore Scenario in Contemporary Estate Planning
The Tax Act of 2001 made a number of important changes in the U.S. estate tax rules, including reductions in the top tax rate and increases in the amount of the applicable estate tax exemption, all gradually phased in between 2002 and 2009. The U.S. estate tax would be repealed entirely starting in 2010 (except for certain terminating Qualified Domestic Trusts for non-citizen spouses). Then, under the "sunset" provision contained in the legislation, the U.S. estate tax would be fully restored again beginning in 2011 and assessed at the higher 2001 tax levels, with a top tax rate of 55% and the exemption reduced back down to $675,000. See DB&M Reports to Clients, Summer 2001 at www.dunnington.com.

The Act, with its myriad of phase-ins and phase-outs and the controversial Delete/Restore scenario in 2010/2011, has made effective estate planning more challenging. Unfortunately, this legislation may also create serious, unintended consequences in some estate plans if Wills are not reviewed in light of the current law. One example would be a Will widely used by married couples to incorporate a plan which first bequeaths to descendants that amount sheltered from tax by the available estate tax exemption, and then leaves everything over and above this amount to or in trust for the surviving spouse. Such a plan is tax-effective in that it combines the exemption and the Marital Deduction to reduce the U.S. estate tax to zero. Yet, with the automatic increases in the estate tax exemption phasing in between now and 2009 (when it will have expanded to $3.5 Million), this plan may inadvertently reduce or even eliminate the assets available for the surviving spouse. To be successful, contemporary estate plans require either flexibility--perhaps the granting of greater discretion to fiduciaries or a structure that will facilitate a disclaimer option--or a commitment to regularly review the plan in light of changing circumstances.

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The State Estate Tax Trap
Various credits may be available to reduce the U.S. estate tax. One such credit that can be very meaningful is the credit allowed for the payment of state death taxes (referred to as the "State Death Tax Credit"). Since the maximum Credit is equal to a percentage of the decedent's taxable estate, it increases as the value of the taxable estate increases. For example, in the case of an estate owner who died in 2001 with a taxable estate of $8 Million, a State Death Tax Credit of $773,200 was allowable, reducing the U.S. estate tax liability from $3,820,250 to $3,047,050.

For years, many states that levy a separate State estate tax chose to collect an estate tax precisely equal to the amount of this allowable Credit. This reduced the need for an elaborate estate tax audit structure at the state level. New York ultimately joined this group of states in 2000 collecting a so-called "sponge tax," meaning that New York would simply collect a tax equal to the Credit allowable in calculating the U.S. estate tax. In the example above, New York would collect an estate tax of $773,200.

Under the restructuring of the Federal transfer tax system in the 2001 Tax Act, the allowable State Death Tax Credit is being phased out. It is reduced by 25% in 2002, 50% in 2003, 75% in 2004 and will be eliminated entirely in 2005. Now, as a result of the evaporating State Death Tax Credit, all those "sponge tax" states that tied their separate estate tax to the allowable amount of the State Death Tax Credit are in a position to lose revenue. By 2005, no estate tax would be payable to such states absent legislative action. Yet this is not the case in New York, Virginia and a few other jurisdictions where the overall estate tax burden would actually increase due to the particular provisions of the statešs death tax rules.

The New York estate tax is specifically tied to the allowable Credit as it existed in 1998. Because the amount of the Credit in 1998 was larger than that allowed under current law, an estate owner who dies a resident of New York can pay less U.S. estate tax by reason of the 2001 Tax Act but, in some cases, a larger amount of New York State estate tax. Unless legislation is enacted to remedy this situation, New Yorkers will be back in the position they occupied prior to 2000 in that dying a resident of New York with a taxable estate may be more expensive than dying a resident of certain other states, such as Florida, where the state estate tax conforms to the reductions in the U.S. Credit. As of this writing, we are not aware of any New York legislation addressing this situation.

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The Gift Tax Lives!

Under the Act, both the rates for the estate tax (applicable to transfers at death) and the gift tax (applicable to transfers made during life) will decline incrementally over the next several years. In 2002, the top gift tax rate is 50%, and will decrease by one percentage point each year through 2007. In 2008 and 2009, the top rate will remain at 45%. Unlike the estate tax, however, the gift tax will not disappear (even briefly) in 2010, but will instead remain in effect at a maximum rate of 35%. Most significantly, unlike the applicable estate tax exemption, the applicable gift tax exemption will be fixed at $1,000,000 beginning in 2002 and will not be staged up to $3.5 Million by 2009.

In executing a lifetime gifting program, donors should be aware that the maximum amount of property they can give away tax-free during life is currently and will continue to be $1 Million. Donors should also recognize that the increase in the gift tax exemption equivalent from $675,000 (pre-2002) to $1 Million (2002 and thereafter) does not necessarily mean they can give an additional $325,000 after 2001 without gift tax consequences. For example, a donor already in the highest gift tax bracket (due to substantial prior gifts) who transfers an additional $325,000 in 2002 will owe $37,250 in gift tax when the donoršs U.S. gift tax return is filed in 2003. This is the result of the interplay between the declining gift tax rates, the Codešs requirement that the aggregate value of all of the donor's lifetime gifts be taken into account, and the graduated tax rate structure. The greater the aggregate value of prior taxable gifts, the greater the applicable gift tax rate for the year in question. To avoid U.S. gift tax surprises after 2001, it is important to tailor the amount of the proposed gift to the donor's prior gift-giving history and the other applicable factors.

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