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Copyright © 1995-2013 Robert L. Sommers, All rights reserved.
< "http://www.w3.org/TR/xhtml1/DTD/xhtml1-transitional.dtd"> The Tax Prophet
Copyright © 1995-2013 Robert L. Sommers, All rights reserved.

July, 2001 Hot Topics

Part 2 of a 2-part series

Estate Tax Changes

          Congress repealed the estate tax for those dying in 2010; however the law has a sunset provision regarding the repeal of estate taxes and unless there is at least 60 Senators voting to eliminate the sunset provision, the estate tax reverts to the 2001 law on January 1, 2011.  Thus, the current Congress has pushed to future legislators the hard decision whether to permanently eliminate the estate tax.

          Prior to the elimination of the estate tax in 2010, there are significant reductions in estate tax.  Starting in 2002, the top brackets for gifts and estates is reduced to 50% (for taxable estates exceeding $2.5 million).  Also, the 5% surcharge for estates over $10 million is repealed.  Gift taxes are not repealed, but the top rate is 35% in 2010.  The maximum rates for estate, generation-skipping transfers and gift taxes are further reduced as follows:


Tax Rate












35% for gift taxes

Increase in Exemption Amounts

          The unified credit for estate tax is equal to the following amounts:











           There is a lifetime exemption for gifts of $1,000,000 beginning in 2002.  The generation-skipping exemption remains the same as under current law through 2003, then it increases in accordance with the estate tax exemption equivalents.  The exemption for a qualified family-owned business is repealed after 2002.

 Comment:  The increase in the estate tax exemption is significant, even though the law expires in 2011which means the current 55% tax bracket and the $1,000,000 exemption equivalent returns.  Increasing exemptions, rather than eliminating the estate tax, is the Democratic approach to fixing the current problem plaguing most estates.  These increases are significant for the following reasons:  Currently, just 2% of all estates pay any estate tax yet estates larger than $5 million (one in 10,000) pay 50% of the estate tax.  By increasing the exemption amounts, the estate tax will be eliminated for the vast majority of estates.

           Estate plans that use a formula to fund an exemption trust (aka credit shelter trust or by-pass trust) and a marital trust, could find that the formula produces odd results, especially if the surviving spouse is not the beneficiary of the exemption trust.  For instance, under current law, if the decedent has a $1,500,000 estate and funds the exemption trust to the maximum estate tax exemption (currently $675,000), the marital trust will contain $825,000.

           In 2002, the exemption trust will contain $1,000,000 and the marital trust will be funded with 500,000.  In 2004, the exemption trust will contain the entire $1,500,00 and the marital trust will not be funded.  If the decedent’s children are the beneficiaries of the exemption trust, the surviving spouse, in this example will receive nothing after 2004.  Thus, estate planners will constantly have to review their client’s estate plans, perhaps on an annual basis, to make sure the plan operates as the client intends, since the scheduled increases in the estate tax exemption will directly affect how the various trusts are funded.

 Termination of Stepped-Up Basis Rules

          When the estate tax is repealed in 2010, the current stepped-up basis rules will also be repealed and will be replaced by the carryover basis rules that apply to gift transfers.  The estate will be permitted to increase the basis of assets by $1.3 million, plus any unused net operating losses, capital losses and certain built-in losses, determined on an asset-by-asset basis.  Property transferred to a spouse either outright or in a QTIP trust or arrangement will be entitled to a $3 million basis step-up.  Therefore, a basis increase to a maximum of $4,300,000 may be made through a transfer of property from the decedent to the surviving spouse.

 Non-resident aliens will be entitled to a $60,000 basis step-up.  The basis in assets cannot be increased beyond the fair market value.

 Special rules will apply to basis computations for jointly-held property, but the decedent is considered owning property of a surviving spouse for community property purposes if the surviving spouse acquires the property from the decedent.  Thus, the $3 million basis adjustment can be applied to both halves of the community property, but the maximum adjustment remains at $3,000,000 under this provision.

 Note: As illustrated below, property held as community property with a $10,000,000 fair market value and a $100 basis will only be entitled to a maximum $4.3 million step-up (if the entire basis increase allotments are used).  Under current law, both halves would be stepped-up $5 million each or $10 million in total.

 The estate and heirs may utilize the decedent’s $250,000 exclusion with respect to the sale of a principal residence.  A technical fix entails recognition of gain involving transfers of property to satisfy a pecuniary bequest; the gain will be determined using the date of death fair market value, rather than the carryover basis in the property.  For example, if a pecuniary bequest (a bequest for a fixed dollar amount) of $100,000 is satisfied by transferring property with a $1,000 basis which is worth $80,000 on date of death, the gain to the estate will be $20,000, not $99,000 (which would be the case if the carryover basis rules applied).   

In addition, gain will be immediately recognized if property is transferred to a non-resident alien; thus in the foregoing example, there will be gain of $99,000 on a transfer to a non-resident alien.

 Comment:  What a mess!  The carryover basis rules were considered unworkable when Congress tried this approach 20 years ago.  This approach will create endless headaches and uncertainty as estates attempt to calculate the basis of property held for generations.  The big winner here will be the IRS since the burden of establishing the basis in an asset falls to the estate.

 Because estate and gift taxes will be treated the same (the donee receives a carryover basis), there is an income tax advantage in making gifts of income-producing assets to those in lower tax brackets.  Under current law, an asset receives a basis step-up on death, meaning that any gain upon the sale of the asset is eliminated.  Because the elimination of estate taxes also eliminates the stepped-up basis rules for property, there is no advantage in holding property until death. To illustrate the lunacy of the estate tax legislation, consider the following examples:

 Example 1:  In tax year 2009, Husband and wife own an apartment building as community property worth $10,000,000.  The adjusted basis is $1,000,000 and there is a $3,000,000 mortgage.  This property is the couple’s sole asset.  The couple would like to sell the property and diversify their holdings.  Assume that the couple has the traditional estate planning set-up in place where an exemption trust (by-pass trust) is funded with the maximum estate tax exemption with the balance to be held in a martial trust.  If  husband dies in 2009; the result will be:

           1.  The building receives a basis step-up to $10,000,000, thus wife can sell the building without paying income taxes and can diversify her investments.

          2.   No estate tax because estates are taxed on their net values ($10,000,000 less $3,000,000 mortgage = $7,000,000; husband’s 50% interest is $3,500,000): The exemption trust is funded with the entire $3,500,000 credit that belongs to husband so there will be no estate tax payable.

3.  Assuming the property does not increase in value after husband’s death, if wife also dies in 2009, her estate will not pay estate tax as well since her share of the community property, $3,500,000, is equal to her estate tax exemption.


4.  Conclusion:   Both husband and wife are better off without the elimination of the estate tax that is scheduled in the tax year 2010.


Example 2:  The same as Example 1, except husband dies in 2010:

           1.  There will be no estate tax since the estate tax is eliminated for those dying in the year 2010.

 2.  There is no longer an automatic basis step-up for community property.  Husband’s executor may allocate a maximum of $4,300,000 in additional basis to the building, thus the building’s basis becomes $5,300,000 (the $1,000,000 adjusted basis, increased by the $4,300,000 adjustment allowed under the new law).


If the building is then sold by wife to diversity her investments, she will have a gain of $4,700,000 ($10,000,000 proceeds, less $5,300,000 adjusted basis) and the combined federal and state tax on the gain (assuming the federal capital gains rate is 20% and the effective California rate is 7.5% or 27.5% combined) will be $1,292,000.  Thus, during the year that estate taxes will be eliminated, the couple will pay $1,292,000 more in taxes!  If the spouse dies in 2010 without selling the property, the heirs will have a $1,292,000 tax bill when they sell the property.


        In this example, the breakeven point between paying an estate tax in 2009 and the elimination of the estate tax in 2010 and the substitution of an income tax, is a net estate of approximately $10,000,000 or higher.  The elimination of estate taxes will benefit those with estates of more then $10,000,000:  The estate tax on $3,000,000 ($10,000,000 net estate less $7,000,000 exemption = $3,000,000 taxable estate), using an average tax rate of 42%, would be $1,260,000.  This compares favorably to the income tax on the building in 2010 of $1,292,000 when the estate tax is eliminated.

 3.  Conclusion:   Husband and wife are better off under the tax year 2009 estate tax rules, even though the estate tax is eliminated in 2010, unless their estate is in excess of $10,000,000.  This is because their estate tax exemption will eliminate any estate tax and they will receive a full basis step-up in their property, measured at the fair market value on the date of the first death.

 Example 3:  Same as Example 1, but husband dies in 2011.  Under the current legislation, the estate tax elimination is repealed for those dying after 2010 and the law reverts to the law as of 2001.  Presumably, husband and wife will each have a $1,000,000 estate tax exemption, so upon the death of husband, his $3,500,000 share of the estate will be divided into an exemption trust of $1,000,000 and a marital trust of $2,500,000.  There will be no tax on the exemption trust, but the assets held in the marital trust will be subject to estate tax upon the surviving spouse’s death.  The wife will receive $3,500,000 of the estate as her community property and will have a $1,000,000 estate tax exemption:

         1.  The property receives a full basis step-up to $10,000,000 so a later sale will not produce income tax on the first $10,000,000.  Thus, wife can sell the building and diversify her investments without incurring an income tax.

        2.  Upon the death of the surviving spouse, there will be an estate tax based on a taxable estate of $5,000,000. ($7,000,000 gross estate, less $2,000,000 in estate tax exemptions) and the estate tax will be approximately $2,500,000.

        3.  Conclusion:  Clearly, a reversion to the 2001 estate tax laws will have an adverse impact to all estates valued more than $2,000,000.  It is doubtful that Congress will let this happen, but as the law is current written, a reversion will occur in 2011.

 Example 4:  Same as Example 2, except the property is worth $20,000,000 and is subject to a $16,000,000 mortgage.  If husband and wife died in 2009, there would be no income or estate tax on the property and the heirs would receive an asset worth $4,000,000.

          1.  If both died in 2010, then there would be no estate tax.   However, there would be a gain of $14,700,000 and the income tax (calculated at a combined 27.5% federal and state) would be $4,025,500.   Thus, if the property is sold for $20,000,000, the heirs would owe $25,500 on the transaction  -- $20,000,000, less $16,000,000 mortgage and $4,025,500 in taxes = $20,025,500 in expenses, or a negative $25,500!

          2.  Consequently, instead of inheriting $4,000,000 in value, the heirs are stuck with a tax liability of $25,500!  One wonders how executors will handle this situation?  Will they abandon the property?  If they distribute it to the beneficiaries, will the beneficiaries have a legal claim against the executor?

          3.  Conclusion.  This example, although extreme, illustrates the pitfalls of converting an estate tax which is based on the net estate, to a system in which gain in assets is preserved and paid by the beneficiaries.

 Miscellaneous Tax Changes

 Reduction in Credit for Estate-type taxes paid to a State

          The credit for estate taxes paid to the states cannot exceed the following percentages of the credit that is currently determined under IRC Sec. 211(b): 









 Starting in the year 2005, there will be a deduction for estate taxes actually paid to a state.

Extension of Time to Pay Estate Taxes

           The right to pay estate taxes in installments will apply to larger-sized closely-held businesses.  The number of partners and shareholders has been increased from 15 to 45.

 IRA Contribution Limitations

Starting in 2002, the annual maximum contribution of $2,000 to an IRA will be raised, as follows: 


Maximum Contribution

2002 – 2004


2005 – 2007




 After 2008, the amounts will be adjusted for inflation in $500 increments. These maximum contribution amounts will be increased for those over age 50 as follows:


Additional Contribution

2002 – 2005




 Comment: IRA limit increases were long overdue and represent another benefit to taxpayers in the lower and middle-income brackets.


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All contents copyright ? 2008 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet(TM) is a trademark of Robert L. Sommers.