This report is merely a follow-up to our commentary last month on the status of Connecticut and federal estate and gift tax legislation.

I. The Federal Estate Tax Situation --- July, 2002

A. Last year, in June 2001, Congress passed a new law that calls for a phase-out of the federal estate tax over the next 8 years. During this period, the tax law would gradually increase the exemption (the allowable exclusion) for property passing by reason of death, while it would at the same time lower the maximum estate tax rate on such property. Ultimately, there would be no federal estate tax for people dying in 2010. However, the law includes a "sunset" provision, which causes the entire phase-out and repeal to go out of existence at the end of 2010, unless Congress does something before then to confirm or modify the law. In other words, unless Congress does something, (a) estates of people dying after 2010 would be subject to the same rules that exist today, as established by pre-2001 law; (b) the allowable exclusion from estate taxes would be $1,000,000, and (c) estates are likely to be larger because of market appreciation and asset accumulation, etc.

Last month, the House of Representatives passed HR 586, a bill that would remove the sunset provision and make permanent the estate tax repeal and all other tax cuts that were included in the 2001 legislation. But, the divided Senate could not be expected to pass such a sweeping measure. Instead, the Senate Majority Leader agreed to consider a bill that had been passed by the House in April, 2001. That bill dealt with repeal of only estate, gift, and generation-skipping transfer taxes, with no apparent jeopardy to other tax cuts, energy policy, or other important economic issues. By mid-June, however, after considering the matter, the Senate turned down a bill calling for permanent repeal of estate and gift taxes. The subject is likely to languish for some time now; some forecast no action likely before the next Presidential election.

B. Among the issues involved in this debate is that of taxing appreciation or capital gains incurred on property passing by reason of death. Until now, heirs and beneficiaries who receive a decedent's property benefit from a "step-up" in basis (or tax-cost), so that they do not pay capital gains tax on any of the appreciation in value that occurred before the decedent's death. That feature of old law has existed partly as a matter of avoiding double-taxation, so that the inherited property is not subjected to both an estate tax and a capital gains tax. But, since the new tax law passed in 2001 would repeal the estate tax, this concern about double-taxation will vanish. The need to allow a step-up in basis will no longer exist, and the 2001 law will eventually replace it with a "carryover" basis. So, a decedent's heirs would receive the property with the same tax-cost basis that their decedent had. They, ultimately, would pay a capital gains tax on all appreciation in value of the property from the time it was initially acquired by the decedent.

This concept of "carryover" basis is not a new one. The federal government tried to implement such a technique before, in 1976. It did not work, because very few people actually knew the true tax-cost basis of assets that were received from decedents. Practically speaking, the decedents' records of purchase prices and securities exchanges were too often unavailable or incomplete. The government tried to presume a zero tax-cost basis unless the taxpayer could substantiate a higher basis. That met with overwhelming opposition, and the law was repealed within six months. Whether people today are any better at keeping records is open to question. In debating whether to confirm or to modify the 2001 tax law, Congress will have to determine whether or not re-implementing carryover basis will be any more successful in producing revenue than it was the first time it was tried. This fundamental change to an elaborate carryover basis system is scheduled to start in 2010, and to go away in 2011. It seems quite clear that Congress will be obliged to make a decision before then.

II. Connecticut's Inheritance and Estate Taxes --- July 2002

A. Connecticut's Inheritance Tax (called a "succession" tax, imposed on the right of heirs to receive or to succeed to property owned by a decedent) has also been in the process of phase-out and repeal, for several years. The tax was never the easiest for decedents' families to contend with. Governed by statutes, but with no written regulations, and involving some oversight or interrelated reporting to probate courts, many saw this frustrating tax as unfair to families of modest means, and a cause for Connecticut's loss of retirees, who seemed to be leaving the State in part as an effort to avoid both the tax and probate expenses at death. Ultimately, Connecticut gave in and, following the trend in what was by then a majority of other states, began its phase-out or repeal of the tax. Although slow in coming, the move was a good one, we think.

Unfortunately, the State deficit (which arose in 2001 and has grown to more than a reported $750 million) caused the State to freeze the further phase-out of this tax for one year. So, presently, property passing from a decedent to a spouse, ancestors or descendants is exempt from tax, i.e., still reportable, but not taxed. But, property passing to siblings remains subject to the tax until January 1, 2004, and property passing to more remote relatives or unrelated parties remains subject to tax until 2006. Moreover, until the tax is completely gone, a decedent's survivors still have to file at least a short-form Succession Tax return, even if the property is exempt. That return gets filed in the probate court, and the court's fee is based upon the greater of probate property or the total amount of property reported for tax purposes. (That has caused more than a few widows to ask, "Why am I receiving a bill from the probate court when my husband had no probate estate and there is no tax due?")

B. In addition to its succession tax, Connecticut has long had its own Estate Tax upon the value of property passing by reason of death. Sometimes called a "pick-up" tax, this one is equal to the amount of a credit that is allowed by the federal government against the Federal Estate Tax. So, the taxpayer-estate really doesn't feel it: instead of being paid to the federal government, the credit causes the taxpayer to pay a portion of the federal tax to the State.

Connecticut, like the majority of States, made the decision to repeal its succession and inheritance taxes based upon the ability to collect this less-costly-to-administer "pick-up" tax. But, remember, now the Federal Estate Tax is being phased out. So, by 2005, whether or not the repeal of the federal tax is made permanent by Congress, there will not be any credit for the states to pick up. Once the States realize this, they may - in their search for revenue to cover growing deficits - turn again to something like an inheritance or succession tax which, despite some complexity of administration, makes for "easy pickins'" when a taxpayer dies, compared to confronting voters with an increase in income taxes. So far, Minnesota, Rhode Island, and Wisconsin have already taken action to preserve their estate tax without relying upon revenue from the federal credit. But, Connecticut's penchant for allowing current budget needs to drive long-term tax planning probably means we won't see the issue addressed for awhile.

III. Gift Taxes - State and Federal.

Unlike other states which repealed their gift tax on lifetime transfers of property when they repealed their inheritance taxes, Connecticut remained firm - no repeal of the State's gift tax. In part, Connecticut saw its gift tax as a means of deterring people from making lifetime transfers in order to impoverish themselves and become eligible for Medicaid or public assistance. (Health care costs are a major factor in the state's budget crisis). Such reasoning leaves one wondering whether or not the gift tax has in fact had any such deterrent effect. People of modest resources seem to continue to make transfers, motivated by an expressed desire to benefit their families and "protect" their hard-earned property from the State, whereas wealthier individuals are least likely to have need or desire to join the rolls of Medicaid recipients. Eventually, the State agreed to phase-down the tax, so that it would apply only to gifts of $1 million or more. But, now, in light of the State's budget deficit, legislators twice proposed a freeze on the scheduled phase-down of the gift tax. Although the initial two efforts failed, the freeze was finally enacted as part of a final budget compromise. The effect of the freeze is to delay the scheduled gift tax rate reductions for two years, starting with gifts made in the year 2002.

The freeze may help the State's current budget situation, but it does nothing to improve the State's handling of long-term tax policy. One of the problems with Connecticut's gift tax is that, despite the phase-down, there is no $1,000,000 exemption. That is, tax on gifts under that amount is being phased out completely; but, gifts over that amount appear to continue to bear a tax assessed from the first dollar of every gift. So, the tax on a gift of $1,000,001. is not 6% of $1., as a quick look at the rate schedule might suggest; nor is it 6% of $1,000,001., but 10.7%. Eventually, the legislators may figure out the lack of equity, if they make a sincere effort to address estate and gift taxes on a comprehensive basis. Until then, Connecticut remains unique as the only State to repeal its inheritance tax but to keep its gift tax.

The Federal Gift Tax, on the other hand, remains squarely in place and, under the current law, allows a $1,000,000 exemption as well as an annual $11,000 per donee exclusion. Unfortunately, the exemption is not scheduled to increase like the federal estate tax exemption is. However, the annual exclusion (which had been $10,000 per donee) is indexed, so that it will continue to increase with inflation, and the maximum rate of gift tax is slated to be reduced eventually to the maximum income tax rate.