OMB Watch analysis of the significance of the estate tax repeal language signed into law as part of President Bush's June 2001 $1.35 trillion tax cut. The tax bill the President will sign next week will represent only a symbolic victory with regard to repealing the estate tax. (Read the full text of the bill, H.R. 1836 Conference Report) Because Congress was limited to a $1.35 trillion tax cut, and full repeal of the estate tax will be very costly, it delayed repeal of the estate tax until January 1, 2010. Prior to full repeal, the tax rates drop to 45% and the "exemption" level increases to $3.5 million. Since the tax bill expires in 10 years - at midnight on December 31, 2010 - on January 1, 2011 all the provisions in the bill sunset and revert to current law. Thus, the estate tax repeal will last for only one year! This leads to the bizarre effect that if a person dies before midnight on December 31, 2009, the heirs will be liable for an estate tax under the bill's reduced tax rates and higher exemption level. If the death occurs from January 1, 2010 to midnight on December 31, 2010, there will be zero estate tax liability. But, if the death occurs on January 1, 2011, estate taxes under current law will be owed (unless additional legislation is passed extending repeal or making it permanent). At best this is a rhetorical victory for those opposed to the estate tax. (See the OMB Watch statement released on behalf of the Nonprofits to Preserve the Estate Tax coalition.) At worst, the changes in the estate tax and the year of full repeal will have a negative effect on federal and state revenues, as well as on the amount of charitable giving. In addition, this "repeal" of the estate tax is enormously complicated, does not quickly address concerns of small businesses and family farms, and will make estate planning as well as the capital gains liability of heirs incredibly difficult as well as subject to evasion. Here are the main changes:

• The estate/gift tax rate drops from 55% to 45% by 2007. The chart below provides the details.
• The wealth exemption (under the unified credit) goes up from $675,000 to $1 million in 2002. (It was already scheduled to rise to $1 million by 2006.) It rises to $3.5 million by 2009, the year before full repeal. (These figures are double for couples.) The chart below provides the details.
• In 2004, the family-owned business deduction, currently at $1.3 million, is repealed (presumably because the general exemption will have increased to $1.5 million in 2004).
• The state tax credit phases out by 2005. In 2002 it is reduced by 25%, in 2003 by 50%, in 2004 by 75%, and the state tax credit is completely repealed in 2005. If payment is made for a state inheritance or estate tax liability, that amount can be deducted as an expense from the estate assets (thus reducing the taxable amount). This will have considerable negative impact on state revenues, most of which benefit from a pick-up tax based on the federal state tax credit.
• The estate and generation-skipping transfer tax is repealed effective January 1, 2010. The gift tax will continue after repeal, with the top tax rate equal to the maximum individual income tax marginal rate. In other words, while there is no estate tax, and any inheritance will be untaxed, there will be a gift tax during the year of repeal.
• After repeal, a modified carryover basis for property acquired from a decedent will be implemented. Currently, capital gains taxes are only assessed on the appreciation from fair market value when an asset is inherited (when the owner of the estate dies) until it is sold. (This step-up in basis works because the estate pays a tax on its holdings. However, with repeal of the estate tax, appreciated property would remain untaxed until the heir sells it. At that point the tax would only be on the step-up in basis.) The change to carryover basis will require taxation on the appreciation from the time the asset was acquired by the decedent to sale by an heir. In other words, capital gains taxes will be charged on the appreciation in value of an asset from its original worth rather than its worth at the time of death, requiring complicated record keeping and reporting requirements. (A change to carryover basis was enacted once before, but dropped before it was implemented because of the difficulty in executing it.) However, only assets over a $1.3 million exemption (with an additional $3 million exemption for a surviving spouse) will be taxed in this new way. The executor of the estate is allowed to determine which assets will be included in the exemption amount.
• The conservation easement is extended so that any property in the United States or any possession of the US can now be set aside for the purpose of conservation and, thereby, reduce the total value of the estate. (Current law requires that land be within a certain distance of a national park or wilderness area or Urban National Forest to be considered.) This provision is retroactive to January 1, 2001. This is perhaps the only really positive change in the estate tax.
• The limit on the number of shareholders in order to qualify for installment payments of an estate tax has been increased from 15 to 45, thus allowing larger businesses or farm operations to benefit from paying estate tax liability on an installment plan. This provision starts on January 1, 2002.
• Eligibility for special treatment as a family farm or business are expanded to include lending and finance businesses. This provision starts on January 1, 2002.
• All of these changes expire on January 1, 2011 and the estate tax provisions will revert to those under law before this tax bill passed.

Estate Tax Phase-Out 2002-2010 Year Wealth Exemption Highest Tax Rates 2002 $1 million 50% 2003 $1 million 49% 2004 $1.5 million 48% 2005 $1.5 million 47% 2006 $2 million 46% 2007 $2 million 45% 2008 $2 million 45% 2009 $3.5 million 45% 2010 NA (Repealed) Top individual rate (Gift tax only) Cost of Estate Tax Changes Year Cost (in $ millions) 2002 $105 2003 6,993 2004 5,990 2005 7,594 2006 4,570 2007 10,186 2008 12,358 2009 13,201 2010 23,523 2011 53,904 During the first five years (2002-2006), the estate tax changes will mean that the federal government loses $24.9 billion. In the second five years (2007-2011), these changes will cost $103.1 billion with more than half of the cost coming in 2011 when repeal of the estate tax is in full swing. 2011 gives a sense how the cost of estate tax repeal explodes in the second decade. The fact that repeal of the estate tax lasts only one year suggests that Congress will need to revisit these issues. Indeed, opponents of the estate tax are likely to be unhappy when they discover these provisions sunset on January 1, 2011 and revert to law before this tax was enacted - thus, a $1 million wealth exemption and a marginal tax rate of 55%. People who need to plan their estates will find this bill confusing and frustrating because they will not know what will happen in 2011. All of this said, Congress may find it impossible to support repeal of the estate tax. The Joint Committee on Taxation scored immediate repeal of the estate tax as costing $662 billion over 10 years. Thus, Congress will need to find an offset equal to the cost of estate tax repeal such as increasing income tax marginal tax rates (which were just reduced).