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by Richard D. Weber, J.D.
MDA Legal Counsel
Published in the September 2001 issue of the Journal

Question: What are the estate- and gift-tax provisions of the new federal tax act, and what should dentists do to protect themselves and their families.

Answer: My partner, Curtis J. DeRoo, is an expert on estate planning. I asked him to provide the answer.

The following is a summary of the salient provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("the act") as they relate to estate and gift taxes. The act is complicated. Most of the provisions are phased in over the next 10 years.

Estate Tax. The estate tax is repealed, but not until 2010. In the meantime, the exemption for estate tax rises and the top marginal rate drops between now and repeal. This is summarized in the chart below:



Gift Tax. The gift tax annual exclusion remains at $10,000 per year, but the lifetime exemption increases from $675,000 to $1 million on Jan. 1, 2002. Unlike the estate tax exempt amount, it stays at $1 million. The top gift tax rate is the same as the estate tax rate, and will gradually drop to 45 percent over the next nine years. When the estate tax is repealed in 2010, the gift tax will still remain, but will then revert to the top income tax rate, currently scheduled to be 35 percent.

New Basis Rules Starting in 2010. Under the existing estate tax law and the new act, property acquired from a decedent will continue to have a stepped-up basis until 2010. This means that if the beneficiaries sell the assets the capital gains for tax purposes will be the difference between the sale price and the value at the date of death, rather than the cost to the decedent. When the estate tax is repealed in 2010, the stepped-up basis rules will also be repealed and replaced with a complicated set of new carryover basis rules:

General Rule: Starting in 2010, property acquired from a decedent will have basis equal to the lesser of the decedent's basis or the fair market value of the asset at the time of death.

  • Exception #1: Each decedent will have a stepped-up basis on assets valued up to $1,300,000. The executor of the decedent's estate will presumably chose which assets obtain a stepped-up basis and which assets pass under the carryover basis rule.
  • Exception #2: Each decedent will also have an additional stepped-up basis of $3 million, but only for transfers to a surviving spouse. Thus, the first spouse to die will be entitled to a stepped-up basis on assets valued up to $4,300,000; the second spouse to die will be limited to a stepped-up basis on assets valued up to $1,300,000, unless that spouse remarries.

Although the new basis rules do not take effect until 2010, if and when they actually do take effect it will be chaotic. Beneficiaries will pay capital gains tax on the difference between the sale price and the cost to the decedent, except for the assets that would retain the stepped-up basis. In addition to the substantial taxes that will be paid by beneficiaries, the record-keeping will be a nightmare. Decedents or their family members will have to keep track of the cost of assets that may have been purchased decades prior to the decedent's death.

State Death Tax Credit. Michigan modified its inheritance tax system in 1994, dropping the inheritance tax and replacing it with the so-called "pick up" tax. This results in the state collecting its allowable share of the federal estate tax as calculated under the state death tax credit rules. For example, on a $5 million estate the top Federal rate is 55 percent; the state death tax credit at that level is 12 percent, so the state collects 12 percent while the IRS keeps 43 percent (a total rate of 55 percent). The act repeals the state death tax credit, by dropping it by 25 percent per year for the next four years, until it is repealed by 2005. This is likely to cause states such as Michigan to re-enact some type of inheritance tax to replace the lost revenue.

Sunset Provisions. The law has a sunset provision effective Dec. 31, 2010. Read literally, the estate tax will be repealed for calendar 2010, but resurrected on January 1, 2011. This is apparently a technical quirk that was required by the Congressional Budget Act of 1974.

Future Revisions. Because of the sunset provision, the complexities involved with the carryover basis, the repeal of the state death tax credit, and the fact that we have two presidential and five congressional elections between now and 2010, it is likely that many of the provisions in the act will be modified, some substantially, before they ever take effect.

What Dentists Should Do. Dentists should review their estate plan with their attorneys to determine how their individual estate plans are impacted by this act. Most dentists will continue to use revocable living trusts and the standard exemption equivalent trust. These trusts avoid probate, save estate taxes when properly funded, and give substantial freedom and control to a dentist in disposing of his or her assets. In order to take advantage of the increasing exemption under the act, careful consideration must be given to the requisite funding amounts in the name of each spouse. Failure to carefully consider a revocable trust and the proper funding could result in significant tax costs to the decedent's estate and beneficiaries.

Qualified retirement plans, which are protected from judgment creditors in malpractice cases, are often a dentist's largest asset. Therefore, dentists may consider making their retirement plan assets payable to their trusts as a means of efficiently and adequately funding their trusts. This is tricky, and will take an estate-planning lawyer who is familiar with retirement plan intricacies.

Expanding the lifetime gift tax exemption from $675,000 to $1 million will also provide additional options to dentists who wish to transfer assets to their children or other beneficiaries prior to their death.

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