On June 7, 2001, President Bush signed The Economic Growth and Tax Relief Reconciliation Act of 2001, which makes many changes in the U.S. estate, gift and generation-skipping transfer (GST) tax rules. This bulletin is intended to briefly summarize some of the changes that will significantly impact estate and tax planning.

The Act reduces the top U.S. estate tax rate from 55% to 50% (applicable to estates of $3 million or more) starting in 2002, and eventually reduces the top rate to 45%. In addition, for years 2002 through 2009, the Act gradually increases the estate tax exemption equivalent (currently worth $675,000) in stages to $3.5 million. Full repeal of the estate tax is scheduled to take effect in 2010. Here are the tax rates and exemption amounts in effect for gift and estate tax purposes during this nine-year period:

	Estate & GST	Gift Tax	Maximum Rate:
Year	Tax Exemption	Exemption	Estate/Gift/GST
2002	$1,000,000	$1,000,000	50%
2003	$1,000,000	$1,000,000	49%
2004	$1,500,000	$1,000,000	48%
2005	$1,500,000	$1,000,000	47%
2006	$2,000,000	$1,000,000	46%
2007	$2,000,000	$1,000,000	45%
2008	$2,000,000	$1,000,000	45%
2009	$3,500,000	$1,000,000	45%
2010	Tax Repealed	$1,000,000	35%

Although the Act would ultimately repeal the estate (and GST) tax in 2010, the gift tax has not been repealed. Thus, lifetime gifts aggregating more than $1 million will continue to be taxed. Beginning in 2010, the maximum gift tax rate will be equal to the top individual income tax rate under the Act (35%).

Upon the repeal of the estate (and GST) tax in 2010, the present system providing for a fair market value (or "stepped-up") basis in property acquired from a decedent’s estate will similarly disappear. In place of a "stepped-up" basis, the Act calls for a "carryover basis" regime that requires estate beneficiaries to take as their basis the lower of (i) the decedent’s adjusted basis in the property or (ii) the fair market value of the property as of the decedent’s death.

To ease the potential capital gains tax consequences to beneficiaries upon their sale of inherited property, the Act includes three provisions for basis increases: First, the executor of a decedent’s estate will be able to increase the basis of the assets transferred by up to $1.3 million. Second, the basis of assets passing to a surviving spouse can be increased by an additional $3 million, making it possible to increase the basis of assets passing to a surviving spouse by up to $4.3 million. Third, for certain types of property, the executor will be able to add to basis an amount equal to the sum of the unused capital losses, net operating losses, and certain other losses held by the decedent at the time of death. In no event may the increased basis of inherited property under the above rules exceed the property’s fair market value at the decedent’s date of death, and property acquired by the decedent by gift (other than from his or her spouse) during the 3-year period ending on the date of death would be entitled to no basis increase.

As to assets held in a Qualified Domestic Trust (or QDOT) for a non-U.S. citizen spouse in order to qualify for the Marital Deduction, the Act will continue to impose the U.S. estate tax on distributions by the trust to the non-citizen spouse prior to 2020. The estate tax will also be imposed on the value of property remaining in a QDOT if the non-citizen spouse dies prior to the scheduled repeal in 2010.

The Act contains a number of modified rules for the allocation of the GST exemption and the severance of generation-skipping trusts into exempt and non-exempt portions. These provisions are effective with respect to transfers after 2000 and, thus, are applicable now.

As the U.S. estate tax exemption amount increases and the top rate drops, the allowable Credit for State Death Tax paid will be phased out and then eliminated entirely in 2005. The estate tax revenue for many states, like New York and Florida, which impose an estate tax equal to the allowable Credit, will fall as this Credit is reduced unless those states act to supplement this decreasing revenue source.

To avoid the requirements of a provision of the Budget Act of 1974, requiring an additional Senate vote when legislation affects revenue for a fiscal year beyond the reconciliation measure, the Act has incorporated a "sunset" provision. This states that none of the provisions of the Act will apply for years beginning (and for estates of decedents dying and gifts made) after 2010. Thus, any provisions of the Act which are not reenacted prior to 2011 will expire in 2011 and the pre-Act tax laws will automatically be reinstated.

The Tax Act of 2001 was designed to reduce Federal tax revenue by an agreed-to $1.35 trillion, rather than to execute a comprehensive plan for overhauling our taxing system. Not surprisingly, a preliminary review of the various provisions which affect individuals, including the income, estate and gift tax provisions and the retirement plan rules, indicates that they are not well coordinated. Many of the questions raised may not be resolved until final IRS Regulations are issued several months (or years) from now, or until court decisions interpret the Regulations.

Because of the wide variety of tax law changes, some of which are phased in over several years and some of which cause existing rules to disappear entirely, and the problematic "sunset" provision, one commentator has characterized the Act as a "shooting gallery of tax breaks that appear and disappear…like pop-up ducks in an arcade." The "wild card," of course, is the "sunset" provision. Avoiding the automatic reinstatement of the pre-Act estate, gift and GST rules will presumably depend on a future President and Congress.

While most of the changes made by the Act are not immediately effective, they will have an immediate impact on the estate plans of some individuals. For instance, taxable lifetime gifts may be less attractive in many circumstances because of the possibility that future law will allow property transfers at death at no transfer tax cost. In light of the new Act, it is important for each client to review their existing estate plan to make sure that it is properly coordinated with the new tax rules.