ESTATE TAX LAW OVERVIEW

The purpose of this memo is to acquaint you with some of the provisions in the law of federal estate and gift tax and how this may affect your estate plan. We cannot overstate the importance of periodically reviewing your estate plan to insure that your objectives are being met.

Overview of Federal Estate and Gift Tax Law

The estate and gift tax is a “unified” system. Under this system, all property transfers either during an individual’s life or as a result of death are subject to a tax. The value of lifetime taxable transfers are added to all property transferred at death to obtain the value of the individual’s gross estate¹. Certain deductions are subtracted from the gross estate to obtain the value of the individual’s taxable estate. An unlimited deduction is available for any property passing to a surviving spouse or to a charity. A graduated tax rate is then applied to the taxable estate to obtain the “tentative estate tax.” The tentative estate tax less the applicable credits (discussed below) results in the estate tax due.

Certain credits are applied against the tentative tax, including the amount of any gift tax paid on lifetime taxable transfers. The largest credit against the estate tax is known as the “unified credit.” The effect of the unified credit is to allow every individual to transfer the applicable unified credit amount at death and not be subject to federal estate tax.

The applicable unified credit amount for individuals dying in 2006 through 2008 is $2,000,000. This means, with proper planning, including a proper allocation of assets, a husband and wife can combine their unified credits to pass a total of $4,000,000 to their children without incurring a federal estate tax. In addition to the annual exclusion against gift tax (see footnote 1, below), an individual may make gifts of up to $1,000,000 in the aggregate during his or her lifetime and not be subject to the federal gift tax.²

¹Annual lifetime transfers of $12,000 or less to any single individual are excluded from the gross estate. This $12,000 annual exclusion is not cumulative and may be made to an unlimited number of individual donees each year. In the case of married donors, the donor’s spouse may elect to join in with the gift effectively doubling the amount that may be transferred under the annual exclusion by the gifting spouse.

²Beginning in 2004, the unified credit against estate tax (for transfers made at death) increases, as set forth herein. However, the unified credit against gift tax (for transfers made during life) shall continue at $1,000,000.

The Credit Shelter Trust

One of the most common estate planning techniques is to draft wills for a husband and wife which, upon the death of the first spouse, establishes a “credit shelter trust.” The concept of the credit shelter trust is illustrated by the following example:

Wills without Credit Shelter Trusts. H and W each have $2,000,000 in assets. H dies in January 2006 leaving all of his assets to W. There is no estate tax in H’s estate because of the unlimited “marital” deduction for all assets passing to a surviving spouse³. W, who now has $4,000,000, dies in November 2006 leaving all of her assets to C, the child of H and W. Since W’s estate is in excess of $2,000,000 it pays $1,071,416 in federal ($791,016) and New York (($280,400) estate tax, leaving C with a net inheritance of $2,928,584.

Wills with Credit Shelter Trusts. Assume the same facts as above except that H’s will leaves his entire estate ($2,000,000) to a credit shelter trust which pays income to W for her life. There is no federal tax on H’s transfer to the trust because of the unified credit. Upon W’s death, the $2,000,000 passes to C from the trust and is not subject to estate tax in W’s estate since W had no ownership of the trust assets. W’s estate ($2,000,000) passes to C free of federal estate tax because of the unified credit. C’s inheritance will be $3,800,800 (accounting for $99,600 in NY estate tax in each of H and W’s estates as the New York unified credit is only $1 million - see below), $872,216 more than if H and W did not have credit shelter trust planning.

Scheduled Changes to the Estate and Gift Tax Laws

The unified credit amount against federal estate taxes is scheduled to increase to $3,500,000 in 2009. This may have a significant impact on wills with credit shelter trust planning in place.

In 2010, the federal estate tax will be eliminated entirely. The current estate tax law, however, has a “sunset” provision which provides that the changes enacted in 2001 to the estate tax structure will expire in 2011 unless Congress acts before that time. If Congress does not act, the pre-2001 provisions would become effective again at that time. Under the pre-2001 law, in 2011, the unified credit amount would be $1,000,000.

Even with the increase in the federal unified credit against estate taxes, the federal gift tax will remain for lifetime taxable gifts in excess of $1,000,000. New York has repealed its gift tax.

³The marital deduction against estate tax is only unlimited when the surviving spouseis a United States citizen. The marital deduction is greatly reduced and different rules apply when the surviving spouse is not a United States citizen.

Federal Changes Affecting the Calculation of New York Estate Tax

In February 2000, New York State repealed its separate estate tax in favor of receiving the maximum statutory credit for state death tax⁴. New York law provides that the maximum applicable unified credit used to calculate New York estate tax is as defined by the Internal Revenue Code, as amended, through July 22, 1998. The result of this language in the New York Tax Law is that since New York’s estate tax law is based on the 1998 Internal Revenue Code, New York’s unified credit against estate tax will not increase above $1,000,000. In estate plans which employ a credit shelter trust, this may have the unintended consequences of the estate paying significant New York estate tax where none was contemplated. For example, for decedent’s dying in 2006, 2007 and 2008, where the taxable estate is $2,000,000, no federal estate tax will be due. However, there will be a New York estate tax of $99,600. Most estate plans never contemplated the unintended and unanticipated effect of the changes in federal law on the New York estate tax law. New York may enact laws to ameliorate the unintended consequences, but if not, your estate plan may need revision to carry out your objectives so that no New York tax, as well as federal tax is paid by the estate of the first spouse to die.

Estate Tax Brackets

Prior to 2002, the lowest federal estate tax rate was 18% and estates in excess of $3,000,000 were taxed at 55%. Taxable estates in excess of $10,000,000 lose the benefit of the graduated tax rate scheme. Beginning in 2002, the highest federal estate tax bracket was set at 50% and was thereafter reduced by 1% each year. For persons dying or gifts made in 2007, the highest federal estate tax bracket will be 45% but that rate will not be further reduced until the estate tax is eliminated in 2010. In 2011, unless Congress acts, the highest federal estate tax bracket will revert to 55%.

Although federal law eventually eliminates the estate tax, the gift tax on transfers during life is retained with a $1,000,000 lifetime exemption. After 2009, the maximum federal gift tax rate will be 35%. This maximum was retained to prevent people from shifting assets to family

⁴Prior to February 2000, New York State maintained a separate estate tax law which applied its own deductions and credits to a decedent’s gross estate. Estates less than $300,000 were not subject to tax. The New York estate taxation scheme existed in parallel with the federal estate tax system. The federal tax system gave a credit for estate tax paid to New York, although since the federal credit had a ceiling (which increased or decreased depending on the size of the estate), it was possible to pay more in New York estate tax than the decedent’s estate received as a credit against federal estate taxes. After February 2000, New York adopted a rule which simply said that the New York estate tax is equal to the maximum federal credit for state estate tax paid for any given estate. This is commonly known as the “sop” tax or “pick-up” tax as it was simply designed simplify New York’s estate tax by “picking up” the federal credit as its estate tax.

members in lower income tax brackets without any penalty on the transfer itself.

Estate Tax Changes Affecting Capital Gains Tax

In 2010, certain rules for the calculation of capital gains on the sale of assets will be changed. If you purchase an asset, the price at which you purchase it becomes your “cost basis.” If you later sell that asset, your capital gain is determined by subtracting your cost basis from the sale price. The difference is subject to the capital gains tax. When an asset is gifted, the donee retains the cost basis of the donor (and not the value of the asset on the date of the gift) for purposes of determining capital gains when the donee later sells the property. However, if an individual inherits an asset from a decedent, that individual’s cost basis becomes the value of the asset on the date of the decedent’s death. In essence, all of the accumulated capital gain of the decedent is eliminated at death. This is commonly known as the “stepped-up basis” rule.

The stepped-up basis rule is to be modified when the estate tax is scheduled to be eliminated in 2010. Instead of receiving a stepped up basis on all of a decedent’s assets, the heirs will receive the decedent’s cost basis. An exception to this rule is that $1,300,000 of a decedent’s assets will be eligible for stepped up basis treatment, and $3,000,000 for assets passing to a surviving spouse (This likely will result in bookkeeping problems as it is usually difficult and time consuming to determine a person’s original cost basis for a stock, particularly where it was purchased many years prior to death and may have been subject to multiple splits and dividend reinvestment).

IRA/Pension Distributions

In 2001 the IRS proposed new regulations governing distributions from, and beneficiary designations for, retirement accounts which purport to make it simpler to determine what you are required to withdraw from a retirement account during your life, and what your designated beneficiaries are required to withdraw after your death. People dying today have an increasingly larger percentage of their assets in retirement accounts. These proposed regulations also may effect your estate plan.

Your Estate Plan

These issues may significantly impact your existing estate plan and may well have consequences for your family that are unintended. The current federal estate tax law phases in and changes from year to year, and you need to be familiar with such changes. We encourage you to review these matters with us if you are uncertain if your estate planning objectives will continue to be met as the laws change.

PLEASE NOTE THAT THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE ADVICE. EVERY SITUATION IS UNIQUE AND WE ENCOURAGE YOU TO MEET WITH US SO THAT WE CAN GIVE YOU ADVICE SPECIFICALLY TAILORED TO YOUR NEEDS.