See the 2019 update at the end of this article.
On June 7, 2001, President George W. Bush fulfilled his campaign promise to reduce taxes by signing a much ballyhooed $1.35 trillion tax cut package known as the Economic Growth and Tax Relief Reconciliation Act of 2001. The good news is that the new law amounts to the largest tax cut in more than 20 years. The bad news is that some of the changes may expire or may not take effect at all. One change that might not take place has to do with the estate tax. So even though the President might boast that the new law has killed the so-called death tax, reports of its death might be premature.
The new tax package does include a repeal of the estate tax, but it doesn’t kick-in until the year 2010. In the meantime, the estate tax exemption increases from $675,000 in 2001 to $1 million in 2002 and 2003, $1.5 million in 2004 and 2005, $2 million for 2006 through 2008 and $3.5 million in 2009. When the year 2010 rolls around the estate tax is gone. Too bad this isn’t the end of the story.
If you are “lucky” enough to die in 2010, then perhaps your heirs will sidestep the estate tax. However, the repeal is temporary. That is, if you make it to 2011, the entire tax is scheduled to be back with just a $1 million exemption. You see, in order to meet budgetary restrictions; the new act contains a so-called “sunset” provision that brings the current estate tax rules back in force in 2011. As such, this sunset provision will keep the debate on the estate tax brewing for the next decade. It will no doubt be a key issue in the two presidential and four congressional elections between now and 2010. In the meantime, the taxpaying public will be left questioning the final outcome as they struggle to plan their affairs.
Once the estate tax is fully repealed in 2010, heirs will be faced with a new rule on assets they inherit. Under the current law, when you die, your heirs receive your assets with a “stepped-up” basis equal to the value of the asset on the date of your death. For example, assume you bought your Google shares at $100 per share, but they are trading at $500 per a share when you die. Your heirs get to use the $500 value when they sell the shares, so that the $400 gain escapes tax. After the estate tax is repealed, this “stepped-up” basis will apply to $4.3 million in assets passing to a spouse and to $1.3 million in assets inherited by non-spouses. However, your heirs will be stuck using your original cost on all assets over those limits. Just imagine the paperwork nightmare as you try to keep track of those assets that get a new basis and those that don’t. Somehow tax simplification got lost in this part of the tax cut.
If things weren’t complicated enough, even though the estate tax is phased-out, the gift tax is set to stay on the books. Congress was concerned that without a gift tax, wealthy taxpayers would make large gifts to family members in lower income tax brackets. To prevent this, even after the repeal of the estate tax, the law retains the gift tax with a $1 million exemption.
2010-2012 UPDATE: While most thought that Congress would revisit the estate tax before the end of 2009, they did not. As such, effective January 1, 2010, there was no federal estate tax. However, in December 2010, Congress did take action to reinstate the estate tax. For those who died in 2010, there was an option. 2010 estates were subject to the estate tax with a $5 million exemption or they could opt out of the estate tax and be subject to the modified “carryover” basis rules discussed above. For those who died in 2011, the federal estate tax applies with a $5 million exemption. In 2012, the exemption increases to $5.12 million. However, without further action, the federal estate tax will revert to a $1 million tax exemption in 2013. As such, the future of the federal estate tax is still very uncertain. Stay tuned.
2013-2017 UPDATE: On January 2, 2013, President Obama signed the American Taxpayer Relief Act which averted the so-called “fiscal cliff.” One part of this new act made the 2010 estate, gift and generation skipping changes permanent. This means that the federal estate tax exemption remains at $5 million per person. This amount will be adjusted for inflation each year. Based on this inflation adjustment, the exemption has increased as follows: 2013 was $5.25 million; 2014 was $5.34 million; 2015 was $5.43 million; 2016 was $5.45 million and for those dying in 2017 the exemption is $5.49 million. If your estate exceeds this threshold, the tax rate on the value of your estate in excess of the threshold is increased from 35% under the 2010 act to 40% under the 2013 American Taxpayer Relief Act.
2019 UPDATE: Part of President Trump’s tax package was to increase the federal estate tax exemption through the year 2025. In 2019, the federal estate tax only applies if the value of the decedent’s estate exceeds $11.4 million. Because of this significant increase in the exemption, it is extremely important to review “old” estate plans.
The important message is that those who made an estate plan based on the federal estate tax law as it existed prior to 2010 should have those plans reviewed immediately as they may not have anticipated the changes that have occurred and the plan they have in place may yield unanticipated results. And those with estates in excess of the $11.4 million exemption still need to plan to avoid a 40% tax on the excess.