Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the U.S. federal estate-tax exemption is increasing each year, with the tax itself being phased out completely in 2010. However, it is scheduled to return in 2011, and what will happen between now and then is anyone's guess. Politicians are divided on the best way to deal with this tax: some want to keep it as a way to make the rich pay, while others want it abolished because of the hardship it places on certain groups. Caught in the middle are Americans who have become complacent when it comes to estate planning. They may think that the phase-out of the federal estate tax means no taxes will be due when they die. This assumption could lead to expensive mistakes that will affect their heirs.

Regardless of the debate among politicians on this issue, one thing is almost certain: even if there is a permanent repeal of the federal estate tax, a tax in one form or another will replace it. You need to understand why this is and how you can protect your estate from excessive taxation.

New Limits on the Step-Up in Basis
When the estate tax is phased out, the unlimited step-up in basis provision for inherited property will disappear as well. Beginning in 2010, the regulations will allow an executor or a personal representative of an estate to adjust the cost basis of assets acquired by the estate's beneficiaries.

Each estate will generally be permitted to increase the basis of assets transferred up to $1.3 million. Plus, the basis of property transferred to a surviving spouse may be increased by an extra $3 million. Therefore, the total step-up for assets given to a surviving spouse will be no more than $4.3 million. After 2010, both the $1.3 million and $3 million figures will be adjusted for inflation.

This change in the step-up in basis provision could negatively affect the estates of farmers and small business owners who hold a significant amount of their wealth in the form of business assets. Recipients of highly-appreciated real estate would feel the hit as well when they sell and have to pay capital gains taxes.

How States Will Recover the Money
Until recently, most states did not impose their own estate tax; instead, they received credits from the federal government for a portion of the estate taxes paid by residents with large estates. (This is called a "pick-up" or "sop" tax.) This had been the case since 1926, but now, under EGTRRA, that is gone. Consequently, a number of states have taken steps to offset, in whole or in part, the $4-billion annual loss caused by the federal estate-tax credit phase-out.

To recover at least some of what they're losing, some states now have a stand-alone estate tax that incorporates the previous estate-tax credit as a minimum tax or supplemental tax. So far, almost half the states have changed their laws so they can keep collecting estate tax. (Some states already had their own estate tax, which was charged in addition to federal taxes due at death.) Each state is free to set its own definition of an estate-tax base, exemption amounts and rate schedules.

A number of states also have an inheritance tax that could go up. This is a tax on the beneficiary's right to receive your property. The amount of tax a beneficiary pays depends on the value of the property he or she receives and his or her relationship to you. Generally, transfers of assets to a spouse are exempt from the tax. In some states, transfers to children and close relatives are also exempt.

As you can see, the states are seeking to make up for billions of dollars in lost revenue, so you will very likely encounter changes in the future to the estate and inheritance taxes paid by you and your relatives. Where you live and die can make a big difference in terms of how much of your estate beneficiaries lose to taxes.

What You Can Do
Moving to a more tax-friendly state is one way to help lower estate taxes. But there are no assurances that your new home state won't pass additional tax legislation if it gets into a budget crunch situation.

Reducing the size of your estate while you are alive is another way to lower estate taxes. Individuals can give away up to $11,000 a year to as many people as they wish without using their lifetime gift-tax exemption. Therefore, you and your spouse could give away $22,000 annually. Also, you can give unlimited amounts to your spouse, to a charity or for someone's tuition or medical care. However, you should be careful with gifting because you might need the money yourself in the future.

Finally, you need to think about the change in the step-up in basis provision. Your heirs will receive assets as if they were the original purchasers. When they sell the assets, the capital gains tax will apply to the difference between the original price and the sales price. The modified carryover basis ($1.3 million and $3 million, as described above) will be added to the transfers. Thus, you may not want highly appreciated assets in your estate.

There are many proposals to modify the path currently set in law. Until this debate comes to a conclusion, it is not possible to determine the impact of an estate tax beyond 2010. Even then, there's a likelihood of further changes. For these and other reasons, you should remain flexible, keep abreast of legislation changes and be prepared to revise your estate-planning strategy. (To learn more, see Getting Started On Your Estate Plan.)

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