The "Unreal Repeal": A Closer Look at the 2001 Estate Tax Law

by Carrie Seligman, JD, LLM

While the proponents of the 2001 estate tax "repeal" touted the tax bill as great tax relief for those impacted by estate taxes, the reality of the new law falls short of that claim. The extreme complexity and temporary nature of the estate tax "repeal" along with the ongoing advisor consultations seemingly required annually to keep up with the ever changing face of the laws provisions, greatly reduce any relief provided by this new tax law signed by President Bush early this summer.

The changes are part of the massive Economic Growth and Tax Relief Reconciliation Act of 2001 signed by President Bush on June 7th. At first glance, the estate tax provisions in the new law seem like good news. However, the bill contains some less obvious traps that can cost you or your heirs dearly if you don’t take appropriate steps to avoid them.

Fluctuating timing provisions further complicate the bill — some changes are retroactive, some immediate, and still others don’t take effect for five or 10 years. Perhaps the biggest planning problem with the new bill is that it "sunsets" in 2011. This means that in 2011, the estate tax laws will revert back to the 2001 levels. It will literally take an act of Congress to prevent the sunsetting. Add to that the inevitable changing face of Congress (the next election is in 2002), that body’s propensity to tinker with legislation, and the increasing budgetary demands and you’ve got a planning nightmare.

Potential traps

Here are just two common situations that could impact your unsuspecting beneficiaries based on the new tax law:

Repeal of the step-up in basis rule

Let’s assume the bill remains in effect as currently written until 2010. In that year, your wealthy uncle dies leaving you valuable real estate. Because he died in the "best year possible" — 2010 — his estate would not be subject to tax. However, unlike today’s provisions that allow for a step-up in basis to fair market value for inherited property, the basis for the property remains at your uncle’s original basis. That means that if you sell the property, you may be responsible for capital gains on the value of the property in excess of your uncle’s original cost basis.

The tax burden shifts from the estate to the beneficiary — from the estate tax to the capital gains tax. It’s even more complicated because the bill, within limits, allows a modified step up in basis for $1.3 million of assets. The executor must select this and the assets must be specifically identified.

The Unified Credit trap

The Unified Credit is a credit against estate taxes. Property qualifying for the Credit does not incur an out of pocket estate tax. Many estate plans have a provision geared to take full advantage of the Unified Credit. For example, at the death of a spouse, an amount of property equal to the Unified Credit equivalent is transferred to a trust, usually called a by-pass or credit shelter trust (with the balance of the estate transferred to the surviving spouse). The result is no federal estate tax due at the first death. This was, and still is, an effective planning technique depending on the needs and desires of the couple. However, due to the incremental increase in the Unified Credit under the new tax law, depending on the size of your estate, the credit shelter trust may get everything. This would effectively prevent any of the estate from going directly to the surviving spouse if the person died before 2010, which may not be what was intended by the couple when they originally created their estate plan.

Planning can minimize risk

Faced with an uncertain future, shifting timeframes and provisions, and a bill that expires just one year after its full implementation, is there anything you can do to minimize your risks and protect your heirs? Definitely, but you need to design (or possibly redesign) your plan with a great deal of flexibility – now!

Start planning or review your existing plan today

Consult with a trusted advisor to help you sort through the changes and assess their effect on your situation. It’s a good idea to review all of your estate planning documents to determine whether assumptions in place at the time of drafting are still applicable. Planning now will allow you to control the transfer of your assets based upon your values and objectives.

Flexibility is key

Qualified experts can help you make sure the provisions of any trust document allow your trustee(s) to distribute assets as he or she sees fit. Your advisor(s) can also review your holdings, possibly suggesting various options for your assets so your heirs aren’t caught in one of the new bill’s expensive "traps."

Related table and chart below



Gradual increase in the estate and generation-skipping-transfer (GST) tax exemption from $675,000 to $3.5 million by 2009, and a corresponding reduction in the top tax rate from 55% to 45%. The estate or "death" tax disappears completely in 2010.

The exemption amount returns to $1,000,000 and the current gift/estate tax rates are reinstated when the entire bill "sunsets" in 2011.

In 2010, the estate tax disappears.

In 2010, the modified carry-over basis rule replaces the current step-up (current fair market value) in basis. This change shifts the tax burden from the estate to the beneficiary and from the estate tax to capital gains provisions of the income tax. The result? A potentially higher burden for the estate’s beneficiary.

The maximum gift tax rate gradually decreases to 35% by 2010 — a rate equal to the highest income tax rate. The annual $10,000 per donee exclusion (adjusted for inflation) remains in place. The lifetime gift tax exemption increases to $1 million beginning in 2002.

The Gift & Estate Tax exemptions are now separate. While the exemption (Unified Credit) for estate tax purposes increases to $3.5 million, the gift tax exemption remains level at $1 million.

Carrie Seligman, JD, LLM, is the Director of Estate and Business Planning with the Northwestern Mutual Financial Network based in Boston, MA for The Northwestern Mutual Life Insurance Company, Milwaukee, Wisconsin.