US estate taxes in transition: new national legislation to slash the inheritance tax on personal estates won't go into effect until 2010, and it isn't even passed yet. Here's what you need to know in the meantime - Chief Executive Opinion

South Florida CEO, Dec, 2003 by Michael E. Kauoukjian

On June 18, the U.S. House of Representatives voted to permanently repeal the estate tax as of 2010. The House bill (H.R. 8) is currently under consideration in the Senate, where its fate is uncertain. Some commentators believe that rather than a total repeal, the final legislation will result in a substantial increase in the amount that taxpayers can transfer on death without paying a tax.

Whatever the final outcome, it appears that the US estate and gift tax will continue to create complex problems for highnet-worth individuals, at least through the end of the decade. Here, in my opinion, is what you need to know for now.

Under current law, the US imposes taxes on the gratuitous transfer of assets held anywhere in the world by a US citizen or domiciliary, subject to applicable treaties. The gift tax applies to lifetime transfers and the estate tax to transfers at death. The law provides five principal means of relief:

* Annual Exclusion. A donor may make lifetime transfers of up to $11,000 each year to any number of people without paying gift tax. This figure, known as the "Annual Exclusion Amount," is indexed for inflation and may rise in subsequent years.

* Exclusion for Educational and Medical Expenses. A donor may make direct payment of specified tuition and medical expenses for any person without paying a gift tax.

* Charitable Deduction. Transfers during life and at death to qualified charities are fully deductible for both gift and estate tax purposes.

* Marital Deduction. Transfers during life and at death to a spouse who is a US citizen are fully deductible for both estate and gift tax purposes. Transfers to a properly structured Marital Trust for the benefit of a US citizen spouse also qualify for the deduction. The spouse must receive all of the trust income for his or her life; principal distributions to the spouse are authorized.

Transfers to a non-citizen spouse, even if a US domiciliary, do not qualify for the marital deduction (though annual lifetime transfers to a non-US citizen spouse of up to $112,000 are excluded from the gift tax). Transfers at death to a properly structured Qualified Domestic Trust for the benefit of a non-citizen spouse, however, do qualify for the marital deduction. The required terms are similar to those of the Marital Trust described above, except that distributions of principal to the non-citizen spouse are subject to tax, and a US Trustee is required.

* Applicable Exclusion Amount. Each US citizen or domiciliary can make cumulative transfers of up to $1 million, during life or at death, without paying gift or estate tax. This "Applicable Exclusion Amount," is in addition to the other exclusions and applies to transfers to children, non-US citizen spouses and any other person. The Applicable Exclusion Amount for estate tax purposes gradually increases to $3.5 million by 2009, while the Applicable Exclusion Amount for gift-tax purposes remains at $1 million. In other words, by 2009, a US citizen or domiciliary may transfer a cumulative $1 million during life or at death without paying gift or estate tax, with an additional $2.5 million available for tax-free transfers at death.

Rates

The current top gift and estate tax rate is 49 percent. The top rate for both taxes is scheduled to gradually decrease to 45 percent by 2007. In 2010, the top gift tax rate is further reduced to 35 percent.

Under current law, the estate tax (but not the gift tax) is repealed as of 2010, but for that year only. Absent new legislation, the tax will return in 2011, with a top rate of 55 percent and a cumulative Applicable Exclusion Amount for both estate and gift tax of $1 million. In other words, the estate of a person dying on December 31, 2010 will pay no estate tax, while the heirs of someone dying a day later may see their inheritance cut in half. It is this absurd result which H.R. 8 seeks to avoid by making the 2010 repeal permanent.

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And for the Next Generation

The US imposes a generation-skipping transfer tax (GST tax) on gratuitous transfers during life or at death to grandchildren and others who are two or more generations younger than the transferor, and to certain trusts for their benefit. This tax is in addition to the estate and gift tax. The GST tax rate is equal to the top estate tax rate: currently 49 percent, with scheduled reductions to 45 percent by 2007.

Each person has a "GST Exemption Amount" that he or she may use to protect assets from this tax. The GST Exemption Amount is currently $1.12 million. Beginning in 2004, the GST Exemption Amount is scheduled to track the Applicable Exclusion Amount and will gradually increase to $3.5 million by 2009. The GST tax is also scheduled for repeal in 2010. Absent new legislation, it will return in 2011 with a top rate of 55 percent and a GST Exemption Amount of $1 million, as adjusted for inflation from 1997.

Michael E. Kavoukjian heads White & Case's Private Clients group in the law firm's Miami office.