Reviewing the Tax Relief Act of 2001 – Conclusion

April 22, 2004

In the previous issues of this newsletter we have taken a detailed look at some of the changes to the estate and gift tax laws made by the Tax Act of 2001. We have also taken note of the Tax Act’s “sunset” rule, under which the new laws expire and the pre-2001 Act laws return. And, we observed that estate planning has been made more difficult due to (a) the uncertainty of whether the sunset rule will ever come into play, and (b) the uncertainty of whether an individual will die during aperiod of increasing Exemption Equivalents. The focus in this issue is on a topic that has been only touched upon in prior articles, namely: the 2001 Tax Act’s switch from the “stepped-up” basis rule to the “carryover” basis rule.

“Stepped-up” Basis vs. “Carryover” Basis. When a person makes a gift, the donee generally gets the donor’s basis (usually cost). That is, the donor’s basis “carries over” to the donee. As a result, if there is a gift of appreciated stock, for example, the donee will have a taxable gain if he sells at the gift value. By contrast, under pre-2001 Act law, property acquired from a decedent generally got a basis equal to its value at his death – the heir’s basis of the property was “stepped-up” to the date of death value. This meant that, on a later sale by the heir, he or she wouldn’t have to pay capital gains tax on the appreciation in the property that occurred while it was owned by the decedent.

Changes to the Basis Rules. When the estate tax is repealed in 2010, the basis rules applicable to property acquired from a decedent will be changed to be similar to the gift tax rules noted above, subject to some exceptions. In other words, the heir will no longer receive a setpped-up basis; instead, the decedent’s basis will carry over to the heir.

Certain exceptions to Carryover Basis. One important exception to the new carryover basis rule is that each estate will receive $1.3 million of basis to be added to the carryover basis of any one or more of the assets held at death. For example, if an individual dies owning stock worth $5 million for which he paid $3.7 million, the basis of the stock can be increased to $5 million under the Act. Another exception is that estates will be allowed an additional $3 million of basis, to be allocated among the assets passing to a surviving spouse. Under the “sunset” rule, the step-up in basis rules return for 2011.

Record Retention. With the change to carryover basis in 2010, clients must retain all records of cost or other basis. For purchases, this means receipts and statements showing the amounts paid for the items. For items inherited before 2010, basis ordinarily is the date of death value of the item. For property acquired by gift, the donee’s basis usually is the same as the donor’s.

What to do now. While the 2001 Act may well save estate tax, it has also added new planning complications. Clients should continue to have wills and estate plans prepared to ensure that their assets will pass as they desire, taking into account the spec ial needs of particular heirs. This is so even if there is a good chance of survival until a yar when estate tax won’t be owed due to the increasing exemption or repeal. Clients who may have an estate larger than the increasing exemption amount will want to take steps to reduce estate tax, including setting up life insurance trusts, grantor retained annuity trusts, qualified personal residence trusts, and family limited partnerships. Many existing estate plans should be re-examined to keep estate taxes and income taxes to a minimum.