Sunset Provision

It is very important to note that the repeal of the estate tax may never become a reality. The 2001 Act has a built in sunset provision 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 this does not occur, the estate tax is scheduled to return January 1, 2011 and will revert back to the estate tax law that existed prior to the 2001 Act with a maximum exemption of $1,000,000. Additionally, many changes can occur over the next six years with shifts of power to new Presidents and legislative players so we will continue to monitor the horizon for future changes in the law.

Capital Gains Tax and Carryover Basis

Under current law a person incurs a tax on capital gains earned upon the sale of a capital asset. The amount of gain that a person realizes is determined by subtracting their adjusted cost basis in the property from the proceeds received from the sale of the property. Under current law and until the estate tax is repealed, a person who receives an asset as the result of a transfer upon death receives a step-up in basis so that their cost basis in the property received is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. On the other hand, if a person receives an asset as a lifetime gift, his or her basis in the property is the same as the transferor’s cost-basis. This is referred to as carry-over basis.

The 2001 Act imposes a carry-over basis on heirs who receive property from a decedent after January 1, 2010. This means that 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. Also, 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 gift tax on transfers made during lifetime is not repealed by the 2001 Act. Instead the gift tax rates are set to decrease with the reduction in the highest marginal estate tax rates. Beginning in 2010 the highest marginal gift tax rate will be equal to the highest income tax rate (probably 35%).

The amount exempt from gift taxes has also increased with the estate tax exemption, however, it is capped at $1.0 Million. This means that a donor can now exempt up to $1.0 Million from gift taxes. Please be aware 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. Additionally, 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. However, as previously stated, if a person receives an asset as a lifetime gift, his or her basis in the property is the same as the transferor’s cost-basis.

Additional Estate Tax Changes on the Horizon?

The United States House of Representatives and the United States Senate have recently sought to make additional changes to the Federal estate tax law.

In each of the last two years, 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 in 2002 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 by a vote of 51 to 48 to accelerate the date of repeal of the estate tax by one year to January 1, 2009. This move 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

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. Like Federal gift tax law, North Carolina does recognize unlimited charitable and marital deductions.

With regard to the estate 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. It is a relatively simple calculation. 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

From an estate planning perspective the 2001 Act has made some significant changes that will impact how we plan for the future. A significant number of people will no longer be subject to the tax simply because of the increase in 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.

In short, the need for a comprehensive plan, developed by an attorney who specializes in the area of estate planning, will remain well into the future and taxpayers should not be lulled into a false sense of security by the headlines and sound bites in the media touting a repeal of the death tax.

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