Estate Tax Legislation

by Stuart J. Gross, Quincy Cotton, Mark David Rozen
Published: June 07, 2001
Source: R & H Letter to Clients and Friends

Today, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "Act") into law. The Act makes many significant changes to the tax law, most importantly in the estate tax area. Effective January 1, 2010, the Act repeals the estate tax (but not the gift tax). Then, in one of the most audacious examples of political maneuvering, the Act "sunsets" on December 31, 2010. This means: the entire Act is repealed -- and the estate tax comes back -- as of the close of that date! We will leave it to David Letterman to provide the commentary on this irrational legislative process. This letter highlights the major changes to the transfer tax regime effected by the Act.

Rate Reductions

The Act repeals the estate and generation skipping transfer ("GST") taxes for decedents dying (and transfers made) after December 31, 2009. Prior to repeal, the tax rates are lowered, with the maximum rates as follows:













Applicable Credit Amount

The Act makes major changes to the "applicable credit amount" (formerly known as the "unified credit") prior to the repeal of the estate tax in 2010. Currently, taxpayers can transfer $675,000 free of gift or estate tax. This amount, pursuant to legislation previously enacted, was due to increase gradually over time, reaching $1 million in 2006 and thereafter.

The Act accelerates the $1 million exemption into 2002. Then, for purposes of the estate and GST taxes (but not the gift tax, which retains a $1 million exclusion amount), the applicable exclusion amount is increased as follows:


$1.5 million


$2.0 million


$3.5 million

Upon the sunset of the repeal of the estate tax, the exclusion amount would revert to $1 million (for decedents dying after December 31, 2010).

Basis Step-Up

Under current law, property included in a decedent's estate receives a fair market value basis for income tax purposes, such that a sale of the property at its estate tax value results in no gain or loss. Part of the revenue trade-off for the repeal of the estate tax is that this unlimited "step-up" in basis at death provision is repealed, effective with repeal of the estate tax. The general regime of basis being marked-to-market is replaced with a "carryover" basis rule. However, a limited basis step-up of $1.3 million still would be allowed, with an additional $3 million of basis increase being allowed for property passing either outright to a surviving spouse or to a "QTIP" trust for his or her benefit. The executor of the decedent's estate is given the discretion to allocate the basis increase among the decedent's assets.

The elimination of the unlimited basis step-up raises a potentially serious issue regarding the treatment of encumbered property where the amount of the debt exceeds the basis of the property. Without the basis step-up at death, the transfer of such a property by a decedent's estate to the decedent's heirs might result in taxable gain to the extent of the excess of the debt over the basis. This issue was addressed in the final legislation, which specifically provides that neither a decedent nor a decedent's estate recognizes gain when property with mortgage in excess of basis is acquired by a decedent's estate or heirs. However, the estate and the heirs receive the encumbered property with a carryover basis (increased by any portion of the limited step-up allocated by the decedent's executor to the property) and therefore subject to an inherent income tax liability upon its disposition.

The special rule disregarding liabilities in excess of basis is not available for property passing to a tax-exempt or foreign beneficiary. Moreover, transfers to certain foreign recipients, including nonresident alien individuals, will be effectively treated as sales at fair market value.

Reporting Requirements

Under the Act, even though no estate tax is imposed in 2010, it still will be necessary to value all of a decedent's assets; there will be extensive reporting requirements for decedents with assets of more than $1.3 million. Information to be reflected on the required information return, which replaces the estate tax return, includes the basis of each asset in the hands of the decedent and its fair market value, whether the asset would generate ordinary income or capital gain upon sale, the decedent's holding period in the asset, the amount of basis increase allocated to the asset, and the recipient of the asset.

No Repeal of the Gift Tax

Congress was concerned that the repeal of the estate tax and the continued entitlement to a step-up in basis of up to $4.3 million could lead to abusive transactions, such as family members making gifts to elderly relatives in the expectation of receiving the property back with an increased basis. To combat this perceived problem, the Act does not eliminate the gift tax. Instead, effective with the repeal of the estate tax in 2010, the gift tax continues in its present form but with a maximum rate equal to the highest income tax rate (which would be 35 percent under the Act) and a lifetime exemption amount of $1 million. The Act makes no changes (before or after 2010) to the amount of the $10,000 "annual exclusion."

State Death Tax Credit

One of the most shameless aspects of the Act concerns the changes to the credit for State death taxes. Under current law, a credit against the Federal estate tax is allowed for certain death taxes paid to one or more states. The maximum allowable credit reaches 16 percent for each dollar of the taxable estate in excess of $10,100,000. The effect of these provisions is that a death tax imposed by a state that does not exceed the allowable Federal credit results in no net cost to a decedent's estate. Instead of paying 55 percent to the Federal government, an estate pays up to 16 percent to the state and the balance (for a total of the same 55 percent) to the Federal government. Most states, including New York, impose a death tax that is equal to the maximum allowable Federal credit for state death taxes, and thereby collect, in effect from the Federal government, significant tax revenue.

The Act phases out the allowable credit for state death taxes, but the phase out is not in proportion to reductions in the estate tax rate. Rather, for decedents dying in 2002, the allowable credit is 75 percent of the credit that would be allowable under existing law; in 2003, it's 50 percent; and in 2004, it's 25 percent of the currently allowable credit. In 2005 (and thereafter), the credit is eliminated, but a deduction is allowed instead for any state death taxes paid. The result of all of this is that the Federal government, while reducing the maximum estate tax rate for the benefit of taxpayers, will nevertheless collect more money at the margin than it was collecting before, with the burden of rate reductions being borne entirely by the states. It remains to be seen what action the states might take to preserve their revenue stream.

Special Problems for New Yorkers

The state death tax credit shell game has particularly dangerous ramifications for New York taxpayers. For New York constitutional reasons, New York's tax provisions do not automatically conform to changes to the Federal tax law; separate and specific New York legislative action is required. New York now imposes a state death tax equal to the maximum allowable federal credit for state death taxes based upon the Federal tax code as in effect on July 22, 1998. If New York were not to modify its death tax, it would continue to impose a State death tax of up to 16 percent, even though the allowable Federal credit is reduced or entirely eliminated. New York officials have been informed of this problem and are reportedly in favor of seeking legislation to ensure that the New York death tax does not result in any net cost to New York decedents.

GST and Other Changes

The Act makes a number of other significant changes to the estate and GST tax regimes. Most notably, the complicated "qualified family owned business interest" deduction is repealed for decedents dying after December 31, 2003. In addition, some of the rules governing allocation of the GST exemption are made more flexible and forgiving, effective for transfers after December 31, 2000. While doing little to solve the planning horrors posed by the GST, the changes eliminate some traps for the unwary and in certain situations permit retroactive GST exemption allocations to be made with the benefit of hindsight.

* * *

What Congress and the President will do after the current year's legislative dust has settled is unclear. The Act sunsets because, without a sunset provision, a Senate parliamentary rule effectively would have required sixty votes to pass the legislation. This parliamentary rule (informally called the "Byrd rule") applies whenever tax legislation has a negative revenue effect beyond the ten-year budget projection period and, without the sunset provision, the Act would have had such a negative revenue effect. Thus, only by providing for a sunset could the legislation pass the Senate. Next year, the Senate could vote to push back the effective date of the sunset provisions from December 31, 2010 to December 31, 2011, and such a vote would not require 60 votes. Of course, given the recent change in party control in the Senate, any prognostication concerning future legislative action is even riskier than normal.

We will keep you informed of relevant Federal and State legislative activity. In case repeal of the estate tax does come to pass in 2010, taxpayers should be sure to maintain the proper records that a carryover basis regime would require. In light of the changes made by the Act, virtually every estate plan (including every Will) should be reviewed.

If you have any questions about the new legislation or how it affects your planning, please call Stuart J. Gross at 212-903-8723; Mark David Rozen at 212-903-8743; Sanford H. Goldberg at 212-903-8745; Quincy Cotton at 212-903-8739; JoAnn Luehring at 212-903-8731; Lionel Etra at 212-903-8721; Stanley S. Weithorn at 212-903-8687; Debra G. Kosakoff at 212-903-8735; Judith R. Feder at 212-903-8747; or one of our other attorneys at 212-903-8700.