Estate and Gift Taxes
The current law imposes three federal taxes on transfers of assets from one person to another. A gift tax is payable by the giver (“donor”) of a lifetime gift. An estate tax is imposed on the estate of a decedent based on the value of the estate’s assets. A generation-skipping transfer (GST) tax applies to lifetime or death-time transfers to a member of a generation more than one generation younger than the person making the transfer.

The estate and gift taxes are unified so that a single graduated tax rate schedule, ranging from 18% to 55%, applies. In addition, a 5% surtax is imposed on cumulative transfers between $10 million and $17,184,000 to phase out the benefits of the graduated rates. The GST tax is imposed at a flat rate of 55% and may be owed in addition to other transfer taxes.

A “unified credit” is available to offset gift and estate taxes. For 2001, the unified credit effectively exempts $675,000 in cumulative lifetime and death-time transfers. This effective exemption amount is scheduled to increase in steps so that it will be $1 million in 2006. The GST tax has a separate exemption for cumulative generation-skipping transfers of up to $1,060,000 (in 2001; subject to future inflation adjustments).

The current law also allows a 100% gift-tax and estate-tax marital deduction for qualifying transfers between spouses. (A special rule applies if the recipient-spouse is not a U.S. citizen.) Other deductions (e.g., for charitable donations) and credits (e.g., a credit for state death taxes) are also available.

Under present law, if the recipient of a gift later sells the gift property, he or she generally uses the donor’s tax basis in determining gain or loss. (Basis typically represents the property’s original cost plus or minus various adjustments required after acquisition.) Thus, essentially, the donor’s basis is “carried over” to the recipient. This carryover basis, however, generally cannot exceed the asset’s fair market value on the date of the gift.

On the other hand, property passing from a decedent’s estate generally receives a “stepped-up” basis. The basis of the asset becomes the fair market value of the asset as of the date of death or the alternate valuation date up to six months after death. This stepped-up basis allows a beneficiary of an estate who sells the property to avoid tax on any appreciation in the value of the property that occurred before the decedent’s death.

The new law overhauls the transfer tax system. Among the changes are a phaseout and eventual repeal of the estate and GST taxes, revision of the gift-tax rates, and a change in the way the tax basis of inherited assets is figured.

Phaseout and Repeal of Estate and GST Taxes. Starting in 2002 and through 2009, the top estate- and gift-tax rates will be reduced, and the unified credit effective exemption amount for estate-tax purposes and the GST tax exemption will increase in steps.

In 2002, the 5% surtax and estate- and gift-tax rates in excess of 50% are repealed, and the unified credit exemption amount will increase to $1 million. (This amount will stay in effect for gift-tax purposes in 2002 and later years.) The state death tax credit will be reduced by 25% and will continue to be reduced annually until it is repealed in 2005 (to be replaced at that time by an estate-tax deduction for state death taxes).

In 2010, the estate and generation-skipping transfer taxes are repealed. The top gift-tax rate will be equal to the highest individual income-tax rate (scheduled to be 35%).

The accompanying table shows the exemption increases and the highest rates.

Basis of Property Acquired from a Decedent. Starting in 2010, the new law repeals the old stepped-up basis rule for death-time transfers and replaces it with a modified carryover basis rule. In general, the basis of property received from a decedent will be the lesser of (1) the decedent’s adjusted basis in the property or (2) the property’s fair market value on the date of death.

Starting in 2010, the new law allows an executor or personal representative of an estate to increase (step up) the basis of assets acquired by the beneficiaries at the decedent’s death, within certain limits. Each estate will generally be permitted to increase the basis of assets transferred up to a total of $1.3 million. Plus, the basis of property transferred to a surviving spouse may be increased by an additional $3 million, so the total step up for assets transferred to a surviving spouse will be as much as $4.3 million. Both the $1.3 million and $3 million figures will be adjusted for inflation occurring after 2010.

Other Transfer-Tax Provisions. The new law contains numerous other transfer-tax and related provisions:

• Donors of gifts and executors of estates will be subject to additional reporting requirements regarding basis of assets.
• Unless otherwise provided in regulations, starting in 2010, transfers to a trust will be treated as taxable gifts unless the trust is treated as wholly owned by the donor or the donor’s spouse under the tax law’s grantor trust rules.
• The special deduction for qualified family-owned business interests is repealed, effective for estates of decedents dying after 2003.
• Where property that qualified for special use valuation or the family-owned business deduction ceases to qualify for those benefits, estate tax may be recaptured even after the estate tax is repealed.
• The income-tax exclusion for up to $250,000 of gain on the sale of a principal residence is extended to estates and heirs.
• The GST-tax exemption allocation rules are amended. One example: The exemption is automatically allocated to lifetime “indirect skips,” such as transfers to generation-skipping trusts.
• The ability to make installment payments of estate tax due to closely held business interests is expanded and modified.

CWEB-L-114

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