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Legislative action in 2001 brought significant changes for many aspects of the federal transfer tax system, with significant effects for individual estate plans. The good news for taxpayers is that the amount that may pass free of federal estate tax at death has increased, and is scheduled to increase further. The bad news is that different aspects of the federal estate tax will continue to change every year for the next eight years, making it virtually impossible to plan for every situation. The changes also have had unpredictable repercussions in the various state death tax systems. As a result, for the near future it is more important than ever to consult expert advisors. On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001, and there began what may turn out to be a decade of uncertainty for individuals wishing to plan their estates. Prior to the 2001 act, the amount of property that could pass free of federal estate and gift tax (the “exemption amount”) was $675,000, and this amount was scheduled to increase to $1 million by 2006. The estate tax and the gift tax were cumulative and the exemptions overlapped completely, so that an individual who used the full exemption to shelter gifts during his or her lifetime would have no exemption remaining at death. The 2001 act accelerated the jump in the amount that could pass free of both the estate and gift tax to $1 million beginning in 2002 and further increased the amount of property that may pass free of federal estate tax only, by increments in 2004, 2006 and 2009. As of Jan. 1, 2004, the estate-tax exemption amount is $1,500,000. However, 2004 brought no change to the gift-tax exemption amount. Thus, lifetime gifts in excess of $1 million will continue to trigger gift- tax liability. This is the result even though the estate-tax exemption, if death were to occur during 2004 through 2009, would permit estate-tax-free transfers of between $1,500,000 and $3,500,000 and, during 2010, there would be no estate-tax liability for such transfers. Thus, an individual who makes cumulative lifetime gifts between 2004 and 2009 in excess of $1 million and who dies within this period will have estate-tax exemption remaining at death. Yet the exemption amounts continue to apply cumulatively to transfers. In other words, a taxpayer who makes aggregate lifetime transfers of $1 million in 2008 and dies in 2009 cannot then transfer $3,500,000 upon death without paying federal estate tax. Rather, such a taxpayer may transfer only $2,500,000 free of estate tax upon death (or the $3,500,000 estate-tax exemption amount less $1 million of lifetime gifts). After 2009, the 2001 act will have repealed the estate tax in full, but only for one year. An individual who dies in 2010 can pass any amount free of estate tax upon his or her death, but, again, the gift-tax exemption remains at $1 million during this time. However, a sunset clause makes the changes in the 2001 act inapplicable to years beginning after 2010. Thus, full repeal of the estate tax lasts only one year and the federal estate and gift-tax laws, as they existed before the passage of the 2001 act, will be reinstated in 2011-that is, unless new legislation either makes the provisions in the 2001 act permanent or provides some new regime. The 2001 act also gradually reduced the top marginal federal estate-tax rate (prior to the application of the federal state-death-tax credit) from 55% (subject to a 5% adjustment for a portion of the wealthiest estates) to 45%. In 2004, the top marginal estate-tax rate is 48%. The top marginal federal gift-tax rate in 2010, when the federal estate tax is repealed, is scheduled to be 35%. The accompanying chart illustrates the amount and timing of the exemption-amount increases and estate tax-rate reductions under the 2001 act, as well as the full repeal of the estate tax during the year 2010. Generation skipping A transfer tax that is all too unfamiliar to taxpayers-until they discover they incur it-is the tax on generation-skipping transfers. The generation-skipping transfer (GST) tax is imposed, in addition to the gift- or estate-tax, generally on transfers of property-made directly or through a trust or similar arrangement-to a “skip person” (i.e., a beneficiary in a generation more than one generation below that of the transferor, such as a grandchild or more remote issue of the transferor). This tax can apply to direct gifts or to distributions from trusts that were created many years earlier. The GST tax is imposed at the top estate- and gift-tax rate on cumulative generation-skipping transfers in excess of an exemption amount (this is known as the GST exemption), which has been $1 million, indexed for inflation occurring after 1997. For 2003, the indexed GST exemption was $1,120,000. Beginning in 2004, the GST exemption is the same as the amount that may pass free of federal estate tax, or $1,500,000 for 2004 and 2005. The GST tax rate for a given year will continue to be the highest estate- and gift-tax rate in effect for such year, falling to 45% by 2009. Like the estate tax, the GST tax is repealed in 2010. For generation-skipping transfers after 2010, the GST exemption will be $1 million, indexed for inflation after 1997. Taxpayers and their advisors alike wonder whether the one-year repeal scheduled for 2010 could arrive sooner, or could become permanent. Following the passage of the 2001 act, there have been several bills introduced in Congress to make the one-year estate tax repeal in 2010 permanent (as well as a number of bills to provide some form of intermediate transfer-tax relief). The acceleration of the repeal by one year has also been proposed. Given the growing deficit, it appears unlikely that a permanent repeal measure will pass Congress in the near future. It appears more likely, however, that the estate tax will be reformed in some manner before the sunset of the 2001 act in 2011. In addition to the changes in the federal estate tax law, ongoing changes to the inheritance and estate taxes imposed in many states (the so-called state death tax) require close attention. Prior to the 2001 act, there was a federal estate tax credit for state death taxes paid by an estate. Many states enacted a death tax equal to the amount of this credit, thereby making the amount of the state death tax entirely dependent upon federal estate tax law. The 2001 act gradually repealed the federal “state death tax credit,” with full repeal to occur as of Jan. 1, 2005. This repeal effectively repeals the state death tax of those states that calculate their death tax based on the federal credit, thereby depriving the states of revenue. Thus, many states are now enacting new state death tax legislation to impose an independent state death tax. However, other states are doing nothing to stop this de facto repeal of their state death taxes-some because any such change requires an amendment to the state’s constitution. Thus, in addition to the numerous federal estate- and gift-tax law changes, individuals must also consider resulting changes in state law in developing and reviewing an estate plan. With so many current and upcoming changes in the law, does every estate plan now need an overhaul? For unmarried individuals, the good news that more value now may pass free of estate tax should not discourage a closer look at state death taxes and the general allocation of the tax burden among planned dispositions. For married couples, an important goal of planning has long been to make maximum use of the gift- and estate-tax savings available to each spouse without disadvantaging either spouse financially. The standard techniques for achieving this result may now have unintended consequences, so it is important to revisit each plan. It has been the case for some time that if the first spouse to die leaves his estate outright to the surviving spouse, no federal estate tax will be payable by virtue of the unlimited federal estate tax marital deduction. However, the estate-tax exemptions of spouses are not cumulative. Upon the surviving spouse’s death, her entire estate (including what she inherited from her spouse) will be subject to federal estate tax; the estate will have an estate-tax liability unless the surviving spouse’s taxable estate does not exceed the estate-tax exemption at the time of death. A surviving spouse cannot use the unused estate-tax exemption of the predeceasing spouse. Tax-sparing planning A mechanism for protecting the predeceasing spouse’s estate-tax exemption amount from federal estate tax is a credit shelter trust (sometimes also referred to as a bypass or family trust) under the predeceasing spouse’s will or living trust. Assets held in a properly structured credit shelter trust will escape federal estate tax in both the predeceasing and surviving spouse’s estates, even if the assets of the credit shelter trust are available to the surviving spouse during her lifetime and regardless of the growth in value of the trust assets during that period. Many spouses are wary of trusts they cannot control. Under certain circumstances, the surviving spouse may be the trustee of the credit shelter trust. In order not to pay a federal estate tax on the portion of the predeceasing spouse’s estate that is not held in the credit shelter trust, it may either be distributed outright to the surviving spouse or held in a lifetime trust qualifying for the federal estate-tax marital deduction for the surviving spouse’s benefit. Most estate planning documents for married couples determine the amount of property passing to the credit shelter trust (or marital-deduction amount) by means of a formula. With the use of a formula, the amount of property passing to the credit shelter trust will likely increase as the scheduled increases in the estate-tax exemption amount under the 2001 act take effect. This could result in the credit shelter trust being funded with an amount that is more than is desired or was anticipated at the time that the will or living trust was signed. In addition, with changes to the state death tax in many states, a fully funded credit shelter trust, while potentially saving future federal estate tax, may cause the estate to incur state death tax in the first estate. Periodic review by counsel of existing documents is advisable to ensure that the estate plan continues to meet the client’s needs and conforms to his or her wishes, as well as to afford the opportunity to make any needed changes. Aen Walker Webster is a shareholder, Carmen Irizarry-Diaz is counsel and Carol A. Kelley is an associate in the Washington office of Pittsburgh’s Buchanan Ingersoll (including the firm of Silverstein and Mullens). Webster chairs the firm’s estate planning group.

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