The unfortunate truth about estate tax "repeal" under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) is that it doesn't really repeal the estate tax. Not immediately anyway, and not permanently either. And the odds are it may not happen at all.

Under prior law, if your taxable estate (which basically means the value of your assets plus life insurance proceeds) exceeded $675,000, then estate taxes beginning at 37% and increasing to a maximum rate of 55% would apply. This $675,000 exemption amount (technically known as your "applicable exclusion amount" or your "unified credit exemption equivalent") was scheduled to increase gradually to $1,000,000 by 2006.

Estate Tax Changes Under the New Law.  The new law accelerates the increases in the applicable exclusion amount and decreases the top marginal rate based on a nine-year phase-in, with a temporary repeal scheduled for 2010, as follows:

Estates of persons dying in Applicable Exclusion Amount Top Marginal Estate Tax Rate Top Marginal Rate Starts At
2001 $675,000 55% $3,000,000
2002 $1,000,000 50% $2,500,000
2003 $1,000,000 49% $2,000,000
2004 $1,500,000 48% $2,000,000
2005 $1,500,000 47% $2,000,000
2006 $2,000,000 46% $2,000,000
2007 $2,000,000 45% $2,000,000
2008 $2,000,000 45% $2,000,000
2009 $3,500,000 45% $3,500,000
2010 Unlimited 0% N/A
2011 and later $1,000,000 55% $3,000,000

The figures for 2011 and later are not a misprint!  Because of the "sunset" provision contained in Section 901 of the Act, all of the tax cuts under the Act expire in 2011.  This means that barring further legislation, the estate tax repeal is just a one-year repeal that only applies to persons dying in 2010!

It is also important to note that the gradual reductions allow Congress to halt the repeal at any point along the way without it being a "tax increase."

Click here for a graphical representation of the maximum estate tax rates that will apply over the next 20 years under the new law, in Adobe Acrobat PDF Format.  Click here for a handy chart showing all of the applicable exemption amounts and tax rates for each year under the Act, also in PDF format.

These are the estate taxes that will be imposed on taxable estates of $2,000,000, $3,000,000, $5,000,000 and $10,000,000 each year under the Act:

Estates of persons dying in Taxable Estate of $2,000,000 Taxable Estate of $3,000,000 Taxable Estate of $5,000,000 Taxable Estate of $10,000,000
2001 $560,250 $1,070,250 $2,170,250 $4,920,250
2002 $435,000 $930,000 $1,930,000 $4,430,000
2003 $435,000 $930,000 $1,905,000 $4,355,000
2004 $225,000 $705,000 $1,665,000 $4,065,000
2005 $225,000 $695,000 $1,635,000 $3,985,000
2006 $0 $460,000 $1,380,000 $3,680,000
2007 $0 $450,000 $1,350,000 $3,600,000
2008 $0 $450,000 $1,350,000 $3,600,000
2009 $0 $0 $675,000 $2,925,000
2010 $0 $0 $0 $0
2011 and later $435,000 $945,000 $2,045,000 $4,795,000

If there was ever a time when a full and permanent repeal of the estate tax was possible, early 2001 was it. When was the political will greater? We had record-breaking projected government surpluses and Republicans pledged to eliminate the estate tax in control of the White House, the House and the Senate. And yet they still couldn't do it.

We urge our clients to keep a healthy skepticism about the future of estate tax repeal and to take prudent steps to disinherit the IRS.

Moral #1: Single individuals and married couples whose assets (after including the proceeds, not just the cash value, of any life insurance) exceed $1,000,000 may be well advised to take reasonable and prudent steps to minimize estate taxes, notwithstanding the new tax law.

Married couples who have existing Wills and/or Living Trusts that provide for bequests to their children based on the applicable exclusion amount available on the death of the predeceasing spouse should have their documents reviewed to ensure that the surviving spouse is not effectively disinherited because of the increasing amounts under the new law! Instead, consider establishing a "bypass" or "credit shelter" trust that can primarily benefit the surviving spouse (and also the children as you wish) without being subject to estate taxes on the death of the surviving spouse.

Reduction and Elimination of State Death Tax Credit. The second hidden truth about estate tax repeal is that to a large extent the states, not the federal government, are paying for it! Because of the state death tax credit under prior law, a significant portion of the federal estate tax didn't go to the federal government at all, but to the states, many of which, including Florida, have "sponge" or "pickup" state estate taxes that only impose a tax to the extent creditable against the federal tax. Florida alone was collecting almost $800,000,000 per year, and this amount was expected to exceed $1 billion annually in future years. The 2001 Act reduces the credit to 75% of its current level in 2002, 50% in 2003, and 25% of 2004. Beginning in 2005, the credit is replaced with a deduction for state death taxes.

This means that Florida and other states with only a "sponge" or "pickup" estate tax will suffer a drastic and immediate reduction in revenues, and will receive nothing after 2004. These states will likely have to increase other state taxes to compensate. Many states which currently have a "sponge tax" may impose their own independent estate or inheritance taxes. Some states only recently changed from their own estate/inheritance tax systems to a "sponge tax" so they only need to reinstate their prior law!

The net effect may be a balkanization of death tax systems across the country, a potential disaster for families of decedents with real property and other assets in multiple states and/or other indications of unclear domicile.

May 2003 Update:  This prediction has already started to come true.  Several states, including New York, Massachusetts, Wisconsin, Rhode Island, Virginia, North Carolina, New Jersey, and Illinois have either already enacted or are considering enacting "decoupling" legislation to stop this tax revenue hemorrhage, in many cases freezing the applicable exclusion amount for state estate tax purposes at the $675,000 amount.

Moral #2: If you moved to Florida from another state and consider yourself a Florida resident, you may be well advised to have a Florida attorney review your estate plan and personal situation to ensure that you haven’t given your state of origin an excuse to claim that you never really "left" and try to impose its own inheritance/estate tax and, just as importantly, back state income taxes, on your estate.

Florida cannot enact a standalone estate tax under its state Constitution, which means that the deficit will probably be made up in increased property and sales taxes. It may also impede Governor Bush's efforts to reduce and eventually repeal the Florida intangibles tax.

Retention of Federal Gift Tax.  The third hidden truth is that federal gift tax was not repealed at all. The applicable exclusion amount for gift tax purposes will be $1,000,000 in 2002, but will remain at that amount, notwithstanding later increases in the applicable exclusion amount for estate tax purposes.  In 2010, when the estate tax is repealed, the gift tax will be a flat 35% on all amounts transferred over the $1,000,000 exclusion amount.

Congress' stated purpose for retaining the gift tax is to prevent transfers of income-producing assets to friends and relatives in lower tax brackets, with a later return of the assets to the donor. Congress' probable unstated purpose is to discourage lifetime transfers for estate planning purposes, so that estate taxes can still be collected from the estate of anyone who dies before or after 2010, or if the repeal is itself halted or repealed at some point in the future.

Moral #3: Those seeking to make substantial transfers to reduce their estates for estate tax purposes should consult the appropriate tax professionals to ensure that the contemplated transfer will not result in the imposition of gift taxes.  

More adventurous clients want to consider sophisticated "leveraged" transactions to make such transfers to minimize use of their applicable exclusion amounts.  

The fourth hidden truth is that the new tax law contains a major income tax increase. Under prior law, assets owned by a decedent received a "step-up" in basis to fair market value as of date of death under Internal Revenue Code Section 1014. This important tax benefit applied to all taxpayers, not just those subject to estate taxes.

For example, if you bought shares of stock many years ago for $100 and as of the date of your death, the shares were worth $1,000, your heirs would receive the stock with an income tax basis of $1,000, and would only pay capital gains taxes on any subsequent sale of the stock to the extent that the amount received exceeded $1,000. Thus, $900 of capital gain permanently escaped ever being subject to federal income taxes.

To help pay for estate tax "repeal," the new law limits the availability of the step-up in basis to only the first $1,300,000 in assets. For example, if you die with assets worth $3,000,000 and the pre-death tax basis of these assets is $1,000,000, then after allocating the $1,300,000 step up the combined basis of all assets passing through the gross estate would be $2,300,000.

The personal representative or executor of the estate would have the power to manually allocate this limited step-up to estate assets of his or her choice.

In addition to the $1,300,000 basis step-up that all estates will be entitled to, assets left outright to a surviving spouse or to a trust qualifying for the estate tax marital deduction can be entitled to an additional $3,000,000 of basis allocation.

However, to the extent that these $1,300,000/$3,000,000 amounts are exceeded, new carryover basis rules will apply, under which the basis of inherited assets will be the lesser of the decedent's basis or date of death fair market value (which means that your heirs will be taxed on the gains but won’t benefit from the losses).

Happily, this new law will not take effect until 2010, and there is a good chance that it may never take effect, particularly if the planned estate tax reductions are halted at some point in the future. Carryover basis at death was considered such an administrative nightmare the first time it was enacted in 1976 that it was repealed retroactively in 1980. The argument surrounding the basic unfairness of carryover basis at death is that family members receiving property upon your death will have to rely on the records of a person unavailable for consultation (you!) to prove the basis of the property. Otherwise, the IRS will win because your heirs will be unable to meet their burden of proof, keeping basis low and capital gains high.

Moral #4: If your assets now exceed or may in the future exceed $1,300,000, keep good records of the tax basis of all of your investments, including your home, marketable securities and investment real property, even those you never intend to sell. Your family may need them! It would be a good idea to have a reputable CPA maintain these records for you.

The new carryover basis law is actually more complex than the 1976 law because of the manual basis step up allocation. Because this allocation is discretionary and will greatly impact the after tax value of your beneficiaries’ inheritances, failure to give your executor/personal representative guidance in your documents as to how you wish to allocate this basis increase may result in potentially bitter family squabbles and even costly litigation.

Moral #5: If your assets exceed or may in the future exceed $1,300,000, you may also want to consider adding provisions to your estate planning documents which indicate how you wish this basis increase to be allocated.

Not only is the amount of the basis step-up restricted, so are the types of assets to which the step-up will apply. The new law is much more restrictive with respect to the availability of the step-up for assets held in trust. While assets held in a living trust that you establish for yourself will qualify for the step-up if you die, the ability of your family members to obtain a basis step up on their deaths for assets held in a trust established by you is uncertain. This includes assets held in a QTIP marital deduction trust for a surviving spouse.

Moral #6: If you have established trusts under a Living Trust or your Will for your family members (which is generally a good idea), you may want to have these trusts reviewed by an attorney to ensure that the provisions of these trusts permit distributions of low-basis assets to take advantage of the basis step-up.