The Economic Growth and Tax Reconciliation Act of 2001 was enacted by Congress and signed into law by President Bush in June of 2001. The Act changes the rules that govern estate and gift taxation and will have an impact on how we draft estate plans for our clients in the years to come. Despite the media concerns voiced about the repeal of the "death tax", estate and gift tax will likely remain a major factor in how people structure and plan for their families' futures for years to come.

This Memorandum is not intended to be a form of legal advice and you should always seek the opinion of a qualified tax professional who has reviewed the facts and the circumstances of your individual case. Instead, this Memorandum is provided to give a basic outline of the changes in the tax code scheduled to take effect over the next seven years.

Estate and Generation-Skipping Tax

The 2001 Act increases the amount exempt from estate tax from $1,000,000 in 2003 to $1,500,000 effective January 1, 2004.

The 2001 Act increases the amount exempt from estate tax from $1,000,000 in 2003 to $1,500,000 effective January 1, 2004. The exemption amounts are then slowly increased over the next six years until January 1, 2010 when the estate tax, as it is known today, is repealed. The highest rate of tax will continue to be reduced from now until 2009. The table below outlines the new exemption amounts and highest estate and gift tax rates under the new law.

The repeal of the estate tax may never become a reality. A sunset provision was built into the 2001 act which was required to comply with the Congressional Budget Act of 1974. This means that all provisions of the 2001 act sunset for years beginning after December 31, 2010, right after the Congressional elections of November 2010. Continued repeal of the estate tax will require Congress to re-enact the legislation to keep the repeal alive. If the legislation is not re-enacted, the estate tax is scheduled to return January 1, 2011. It will revert back to the estate tax law that existed prior to the 2001 Act with a maximum exemption of $1,000,000. With changes in Presidents and legislative players, many changes can occur over the next years. We will continue to keep a close watch on the laws so that we can stay on top of any future changes.

Capital Gains Tax and Carryover Basis

Current law states that a person incurs a tax on capital gains earned upon the sale of a capital asset. The amount is calculated by subtracting their adjusted cost basis in the property from the proceeds received from the sale of the property. Until the estate tax is repealed, receiving an asset as the result of a transfer upon death receives a step-up in basis so that the cost basis in the property received is generally equal to the fair market value of the property at the time of the decedent's death. The value is calculated differently if it is handled on a carry-over basis. This means if a person receives an asset as a lifetime gift, their basis in the property is the same as the transferor's cost-basis.

The 2001 Act imposes a carry-over basis on heirs who receive property from a decedent after January 1, 2010. Heirs will inherit a decedent's property with a cost basis equal to the lesser of the decedent's adjusted cost basis or the fair market value of the property on the date of the decedent's death. While the estate will not pay estate tax on the assets, the heirs will likely incur capital gains tax if and when they sell the assets.

However, a decedent's executor will be permitted to increase the adjusted cost basis in a decedent's property to the lesser of $1.3 Million or the actual value of the property. The cost basis of certain property transferred to a surviving spouse may be increased up to $3.0 Million. Certain property like retirement plan assets would not qualify for this cost basis adjustment.

Gift Tax

The 2001 Act does not repeal the gift tax on transfers made during lifetime. The gift tax rates are set to decrease with the reduction in the highest marginal estate tax rates. In 2010, the highest marginal gift tax rate will be equal to the highest income tax rate.

The amount exempt from gift taxes has also increased with the estate tax exemption but it is capped at $1 million. A donor can now exempt up to $1 million from gift taxes. Be aware, however, that the exemption does not increase like the estate tax exemption. Payment of tuition or medical expenses paid directly to the school or health care provider on behalf of another person is not taxable regardless of the cost of such services. Also, the current annual exclusion amount from gift tax for gifts directly to a person other than your spouse has increased to $12,000 and is indexed for inflation. As previously stated, if a person receives an asset as a lifetime gift, their basis in the property is the same as the transferor's cost-basis.

Additional Estate Tax Changes on the Horizon?

In 2002, the House has passed a bill that would eliminate the sunset provisions of the estate tax causing the 2010 estate tax repeal to be permanent. This measure was defeated in the Senate and is not likely to pass the Senate in 2003 due to the fact that 60 votes are required for passage.

On March 20, 2003, the Senate voted to accelerate the date of repeal of the estate tax by one year to January 1, 2009. This was done as part of the Senate's effort to establish a budget for Fiscal year 2004. Once completed, the Senate budget resolution must then be reconciled with the House budget resolution. Even if the repeal of the estate tax does not get moved up as part of the 2004 budget, this recent move by the Senate indicates a desire by a majority in the Senate to accomplish the repeal of the Federal estate tax before January 1, 2010.

Of course, any changes to the law of taxation are subject to further change and are dependent on who holds office, the state of the economy and a number of other factors.

North Carolina Gift and Estate Tax

Like the Federal gift tax law, North Carolina does recognize unlimited charitable and marital deductions. While the Federal gift tax exemption increased to $1,000,000 effective for gifts to non-spouse/non-charity beneficiaries occurring on or after January 1, 2002, the North Carolina gift tax exemption remains at $100,000, and this $100,000 exemption applies only to gifts to direct descendants (known as Class A beneficiaries). In particular, North Carolina taxes lifetime transfers to nieces and nephews and unrelated beneficiaries (including in-laws) at a much higher rate than children or other descendants, and non-descendants are not entitled to any gift tax exemption beyond the $12,000 annual exclusion. The result is the first dollar over $12,000 of property transferred by gift to non-descendants is subject to North Carolina gift tax.

North Carolina eliminated its separate inheritance tax in 1999 and has since been dependent on a portion of the Federal estate tax known as the state death tax credit. The state death tax credit is the amount states such as North Carolina receive from the Federal estate tax. Under the 2001 Federal Act, the state death tax credit will be reduced by 25% for estates of decedents dying in 2002, 50% for estates of decedents dying in 2003, 75% for estates of decedents dying in 2004, and 100% for estates of decedents dying in 2005 and beyond.

North Carolina has decided not recognize this phase out of the state death tax credit. This further complicates the estate tax predicament for North Carolina residents since the amount of estate tax paid to the North Carolina Department of Revenue as part of the state death tax credit is determined by reference to Federal law as it existed prior to the 2001 Act. Further, given our state's growing deficit, it is possible that North Carolina could re-introduce its own inheritance tax, which would be completely independent of Federal law.

Planning Under the 2001 Act

Due to the significant changes brought about by the 2001 Act, there will be a continued need for a comprehensive plan developed by an attorney who specializes in the area of estate planning. Taxpayers should not be lulled into a false sense of security by the headlines and sound bites touting a repeal of the death tax.

A significant number of people will no longer be subject to the tax simply because of the increase of the exemption. However, with repeal not scheduled to occur until 2010, many people are going to be faced with the same estate and gift tax issues with a slightly lower net tax liability. The likelihood of additional changes further complicates the planning process. Even if the Federal estate tax is repealed, there may be new issues as far as capital gains tax and the carry-over basis provisions that will become effective.

What to Do Now

Reviewing and possibly revising plans that currently fund the credit shelter trusts to the maximum available exemption amount is now an appropriate course of action. That particular funding formula may no longer be appropriate if the combined family assets do not exceed the higher exemption amounts. Termination of certain trusts designed to avoid tax at the second death of the husband and wife and the elimination of the administration burden and expense associated with those trusts may also be appropriate. The review of insurance policies that were purchased to pay estate tax is also recommended.