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Congress passed a new comprehensive tax act on May 26, 2001. Formally known as the Economic Growth and Tax Relief Reconciliation Act of 2001 (hereafter the "Tax Act"), this legislation made a number of changes in both income tax and transfer tax rules. An individual must consider whether these transfer tax (estate, gift and generation-skipping transfer taxes) changes impact his or her written estate plan, and if so, what changes to the estate plan should be made.

The changes in transfer tax rules. Both the estate and generation-skipping transfer ("GST") taxes are scheduled to die a slow death. In year 2010, no estate tax or GST tax will be imposed on the estate of an individual who dies in that year. Between now and 2010, the exempted amount applied against a person's gross taxable estate (the "Applicable Exemption Amount, or AEA"), which is currently $675,000, will increase in stages. The AEA will be $1,000,000 in years 2002 and 2003, $1,500,000 in years 2004 and 2005, $2,000,000 in years 2006, 2007 and 2008, and $3,500,000 in year 2009. The highest estate tax bracket, currently 55%, will drop to 50% in year 2002, and then decrease in stages until it reaches 45% in year 2007. The GST tax exemption will remain at $1,060,000 and continue to adjust for inflation until January 1, 2004, when it will become equal to the AEA.

The gift tax has not been repealed. Instead, the gift tax exemption will increase to $1,000,000 in year 2002, and remain unchanged thereafter. The gift tax bracket rates will be the same as the estate tax rates. The estate of a person who dies in 2007, leaving $2,000,000 to his children, will not be subject to estate tax. If this same person had given $2,000,000 to his children prior to his death, $1,000,000 of his estate will be subject to gift tax.

The old tax law - rises like a Phoenix in year 2011. On January 1, 2002, the entire Tax Act is revoked. The estate tax repeal is repealed. The old tax law rises from its ashes. The transfer tax rules that would have been in effect under the old tax law become the transfer tax law of the land. The AEA will be $1,000,000. The highest tax bracket will be 55%. Most commentators feel this will never happen because Congress will pass yet another tax bill before 2011. Given that two more presidential elections and five more Congressional elections will occur between now and 2011, and that the first wave of 75 million baby boomers will become eligible for social security in year 2008, the pressure to reinstate some type of transfer tax system will be great. It is likely that a revised system which incorporates a large exemption ($2,000,000 or higher) against estate, gift and GST taxes will be installed. One study has shown that only .4% of the wealthiest people in America would have taxable estates if the AEA were $3,500,000.

Loss of income tax basis step up - the trade off. The old tax law on income tax basis remains effective until year 2010. That law says that property passing to another person or entity at the death of its owner receives a new income tax basis - equal to the estate tax value (generally date of death value) of the property - in the hands of the new owner. This is called the "stepped up" or in some cases, the "stepped down" income tax basis rule. "Income tax basis" is the bottom line figure used to compute gain or loss on a sale of property.

For example, if Mary purchased a residence in 1975 for $100,000 (which established the beginning tax basis), and then sells this property in 2009 for $1,800,000 (net of commissions), she will incur $1,700,000 of gain, which will be taxed at the long term capital gains rate. If Mary dies shortly before she sells the property, and her son Stephen, the beneficiary of her residence, then sells the property for $1,700,000, he will incur no capital gain because his income tax basis in the property will be $1,700,000. At the moment of Mary's death, all potential gain in the property is eliminated. Stephen benefits mightily from the stepped-up basis rule.

The Tax Act changes this result. Beginning in 2010, a beneficiary now will receive the decedent's old income tax basis, which is called "carry-over" tax basis. Each decedent's estate will be entitled, however, to a partial step-up in basis of $1,300,000 for all property in his estate. In our scenario, Stephen will receive the carry-over basis of $100,000 plus an additional $1,300,000 of step up basis, for a total basis of $1,400,000. Upon selling the property for $1,700,000, he will have a capital gain of $300,000.

Any transfer of property at death from one spouse to another spouse will entitle the decedent's estate to an additional $3,000,000 basis step-up. A decedent spouse, therefore, is entitled to a total tax basis step-up of $4,300,000 for any property passing to his spouse. Basis step-up can not be greater than the fair market value of the property.

The Tax Act now allows a beneficiary or the estate of a decedent's residence to benefit from the $250,000 income tax exclusion on the sale of an individual's residence. The decedent must have lived in and owned his residence for two of the five years prior to the date of his death. In our second scenario, Stephen can exclude $250,000 of the $300,000 capital gain incurred because Mary's residence qualifies for this principal residence exclusion.

The cash flow benefit of not paying estate taxes in 2010 could partially be taken away by forcing a beneficiary to recognize capital gains tax on the sale of appreciated real estate received by succession or inheritance.

In year 2011, the Phoenix brings back the old income tax basis adjustment rules.

How can one reasonably plan an estate without knowing what the rules will be when he, she or they die? With the new Tax Act, planning an estate now is like shooting at a moving target. For now, the estate planning attorney can only advise his client with different degrees of certainty on different issues. The probability of Congress amending the Tax Act, the client's present written estate plan (specific language used in the documents), the age and health of the client, the type and size of the client's estate portfolio, the client's marital and family status, and more, must be factored into the attorney's advice.

Let's slow the moving target down as much as possible so we have a better chance of hitting it. The following suggestions are an attempt to do this.

Any estate plan that has not been reviewed for three years should be. It may be that non-tax considerations need to be addressed. Beneficiaries may have married, died, and/or had children. Beneficiaries may have developed developmental, physical or addiction problems. Growth in a client's estate may require a change in plan to meet the client's wishes. IRAs and other retirement plans may have grown considerably, and beneficiary designations on these plans may need to be amended in order to coordinate the value in these plans with the client's overall estate plan.

Life insurance considerations should be made. While the need for life insurance for the purpose of paying an estate tax may wane with the increase of the AEA, it may become useful in 2010 in order to cover capital gains tax that may be incurred. decade. Future growth in the value of estate assets can increase liquidity demands, possibly when the client's health has deteriorated and the cost of additional insurance has increased. It may be better to borrow against permanent policies that now seem to be larger than necessary, thereby decreasing the coverage and increasing the assets available for other investments.

Gifting Strategies

Gifts that incur a tax (i.e. are not covered by the new $1,000,000 gift tax exemption in 2002 or are not within the $10,000 per year per beneficiary exception or the payment for the donee's medical or educational expenses exception) should not be made. However, taxable gifts by a donor with an estate significantly larger than the available AEA and with slight chance to live until 2010 can still be made. Such gifts incur a transfer tax approximately 33% less than the estate tax, which makes this taxable lifetime gifting a more economical way of leaving an estate than incurring estate tax at death.

For a client who has a large estate, it still makes sense for him to make leveraged non-taxable gifts. Gifts of limited partnership interests, Grantor Retained Annuity Trusts, Qualified Personal Residence Trusts continue to provide substantial benefit in the appropriate circumstances. Other advanced planning techniques still have merit for this type of client. An installment sale to a Defective Grantor Trust, especially when combined with discounted assets such as limited partnership interests, remains a good estate planning technique. Converting increasingly larger Bypass Trusts into multi-generational Dynasty Trusts is an idea to consider in case some form of transfer tax system is invoked by law. These plans will continue to be a viable way of reducing client's estate without gift tax cost.

The incentive to make charitable gifts (outright or in charitable Trust form) for estate tax reduction reasons will reduce with the growing AEA and then total estate tax repeal. However, charitable gifting will continue to be important for income tax deduction purposes and the non-tax desire to benefit the charity.

Build Flexibility into the Estate Plan

Beginning no later than January of 2004, flexibility should be drafted into a client's plan to account for the Tax Law, whether changed or not, and in case of other changed circumstances. The client should consider giving a trusted person the power to amend his plan in the event he becomes incompetent and can not change the plan in the light of changes. Establishing the criteria in a durable power of attorney for when and how an attorney in fact may change an estate plan is important.

Flexibility should also be provided to allow a neutral party to amend or revoke an irrevocable Trust created upon the client's death. A prime example of such Trust is the Bypass Trust. A scenario for change might be this: The first spouse dies in 2005, and the Bypass Trust is funded with $1,500,000 of assets. The surviving spouse dies in 2010 with the Bypass Trust now holding $2,500,000 of assets. Estate tax repeal has become permanent by new tax law. The income tax basis adjustment limitations are also now permanent.

Flexibility in the above scenario can be created by a provision in the estate planning document which appoints a Trust Protector who has the power to revoke the Bypass Trust and the QTIP Trust, and distribute the Trust estate outright to the surviving spouse. The Trust Protector could be appointed by the client in the estate planning document, or by some other mechanism in the document, including by the court.

The estate plan could be drafted to show the express intentions of the client so that subsequently changed circumstances (e.g. a change in the transfer or income tax law) might be relied upon to invoke provisions found in many states's probate codes which allow a modification or revocation of an irrevocable Trust. Typically any spendthrift clause should be removed to make it easier to obtain court approval for a modification or revocation.

Other techniques for providing flexibility include the use of powers of appointment for withdrawing assets from an irrevocable Trust and disclaimers by a beneficiary beneficial interests in a Trust.

Income Tax Basis Planning

The ramifications of the new income tax basis adjustment limitations must be considered. Any survival period requirement for a surviving spouse should be removed from the estate planning document. Otherwise, if the second spouse does not survive the death of the first spouse in 2010 by the required amount of time (5 days, 30 days, whatever), the deceased spouse's estate will not receive the extra $3,000,000 tax basis step-up amount.

It is now more important than ever to keeping records of capital expenditures for real estate. This documentation of capital expenditures, which increase income tax basis, will be critical beginning in 2010 when the full tax basis step-up rule no longer applies. Accurate record keeping remains important if an individual sells real estate or makes a gift of real estate (with the donee taking carry-over basis).

In separate property states, or in community property states where one spouse has a large amount of separate property, it may be appropriate for the spouse with the larger estate to gift a sufficient amount of his estate to his spouse. If his spouse should predecease him in year 2010, her estate then could fully benefit from the new tax basis rules.

Considerations of fairness to beneficiaries of property and avoidance of beneficiary fights should be considered in the drafting process. In 2010, decedent dies, leaving a Will which says that Albert is to receive Property A and Barney is to receive Property B. Both properties are worth $1,800,000 and both have an income tax basis of $500,000 at the time of death. The Will is silent on how decedent's $1,300,000 basis step-up is to be allocated. The Executor allocates all of the basis step-up to Property B. Albert and Barney both sell their properties. Albert realizes a capital gain. Barney does not. Albert is very unhappy. If the Will had provided for a prorata allocation of basis step-up between the two properties, a fight could have been avoided.

Property in a Bypass Trust is not eligible for tax basis step up when the surviving spouse dies. Therefore it may be better to revoke this Trust for income tax reasons using one of the flexibility tools discussed above.