On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 providing a projected $1.35 trillion tax cut over 10 years. Not since 1986 has tax law undergone such profound change. The centerpiece of the 2001 Tax Act is an across-the-board cut in individual income tax rates. The Act is a sweeping overhaul of the old federal estate tax law, increases the amount exempt from estate and gift taxes, and ultimately eliminates the estate tax. But there is a quirk in the law. To comply with budgetary rules, the Act contains a so-called sunset provision under which the pre-2001 Act rules return after 2010, unless Congress provides otherwise at some future time. This means that the estate tax is repealed only for those who die in 2010. The changes are quite complicated and will require most estate plans to be reevaluated. This Estate Planning Update explains how the 2001 Tax Act's gradual elimination of the estate tax affects estate planning. A number of provisions of the Act could provide taxpayers with significant savings.
Background.
The current estate tax was created in 1916, and the first estate tax dates back to 1797. See the History of the U.S. Estate Tax summary at the end of this update. Under pre-2001 Act law, there is no gift or estate tax on the first $675,000 of combined transfers during life or at death for gifts made and individuals dying in 2001. These two taxes are tied together under a unified system having a top rate of 55%.
Estate Tax Exemption Increases and Rate Reductions.
The new law substantially increases the $675,000 exemption after 2001. Effective January 1, 2002, the amount exempt from estate tax will increase to $1 million for 2002 and 2003, $1.5 million for 2004 and 2005, $2 million for 2006 through 2008, and $3.5 million in 2009. Effective January 1, 2010, the estate tax is repealed in its entirety. There is also a change to the unified system. The gift tax exemption amount remains at $1 million for all years after 2001, and the gift tax is not being repealed during 2010 as the estate tax is. Only the estate tax exemption amounts will rise to more than $1 million. Under the sunset provision, the exemption will go down to $1 million for both estate and gift tax purposes in 2011. The top estate and gift tax rate drops to 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007 through 2009. In 2010, there will be no estate tax and the top gift tax rate will be 35%. The top estate and gift tax rate reverts to 55% in 2011. The table below summarizes the amount of the estate tax exemption and the top estate tax rates under the new Act:
|
Calendar Year |
Amount Exempt from Estate Tax* |
Highest Marginal Estate Tax Rate |
|
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** |
N/A (estate tax repealed) |
N/A (estate tax repealed) |
* Effective January 1, 2004, the exemption for transfers subject to the generation skipping transfer tax is increased to an amount equal to the estate tax exemption.
** Unless reenacted, repeal of the estate tax ceases to apply after 2010, and pre-Act law (including any increases in the amount exempt from estate tax scheduled under pre-Act law) will be reinstated in 2011.
There are differences in the income tax liability of donees (recipients) of lifetime gifts and heirs of estates. A donee generally gets the donor's income tax basis (usually cost) for a lifetime gifted asset (i.e. transferred basis). As a result, if there is a gift of appreciated stock, for example, the donee will have a taxable gain if he sells at the gift's value. Property acquired from a decedent via inheritance, however, generally gets a step-up in basis equal to its value at his death. This means that, on a later sale by the heir, he won't have to pay income tax on the appreciation in the property that occurred while it was held by the decedent.
When the estate tax is repealed in 2010, the basis rules will be changed to a modified carryover or transferred basis system to be similar to the gift tax rules, but with many opportunities for heirs to get increases in basis. For example, it will be possible to increase or step-up the basis of assets received from an individual dying in 2010 by $1.3 million and by an additional $3 million for assets going to a spouse. Under the sunset provision, the old step-up in basis rules return for 2011.
With the scheduled change to a modified carryover basis system in 2010, it is essential that you retain all records of cost or other basis. For purchased items, this means receipts and statements showing the amount you paid for it. For items inherited before 2010, basis ordinarily is the date of death value of the item. For property acquired by gift, the donee's basis usually is the same as the donor's. For depreciable property, basis is reduced to reflect allowable depreciation.
The gift tax has not been repealed. Effective January 1, 2002, the amount exempt from the gift tax assessed on lifetime gifts will be $1 million. Effective January 1, 2002, the top gift tax rate will be reduced to 50%. This rate will gradually be reduced to 45% in 2007. Beginning in 2010, the top gift tax rate will be equal to the top individual income tax rate. The table below summarizes the amount of the gift tax exemption and the top gift tax rate under the Act:
|
Calendar Year |
Amount Exempt from Gift Tax |
Highest Marginal Gift Tax Rate |
|
2002 |
$1 million |
50% |
|
2003 |
$1 million |
49% |
|
2004 |
$1 million |
48% |
|
2005 |
$1 million |
47% |
|
2006 |
$1 million |
46% |
|
2007 |
$1 million |
45% |
|
2008 |
$1 million |
45% |
|
2009 |
$1 million |
45% |
|
2010 |
$1 million |
35% |
The new Act simplifies and reduces the GST tax, which is a special tax that is designed to prevent individuals from avoiding the estate tax by transferring assets to a generation below the next one (e.g., grandparent transferring to grandchild rather than to child). Effective January 1, 2004, the exemption from the GST tax is increased to $1.5 million and will gradually increase to $3.5 million by 2009. Effective January 1, 2010, the GST tax is repealed. Unless reenacted, repeal of the GST tax ceases to apply after 2010 and pre-Act law (including any increases in the GST tax exemption scheduled under pre-Act law) will be reinstated per the sunset provision.
The 2001 Act contains a number of other changes, some of which are retroactive.
· Conservation Easements. The Act expands the availability of the exemption for conservation easements.
· Installment Payment Relief. The Act improves the provision that allows deferral of estate tax on a closely held business. It even creates a retroactive refund opportunity for some estates that had farms that were valued based on actual use rather than highest and best use.
· Family Owned Business Deduction. Effective January 1, 2004, the estate tax deduction permitted for qualified family owner businesses (i.e., $675,000) is repealed.
· State Death Tax Credit. Under the Act, the federal estate tax credit for state death taxes is phased out and is eventually replaced with a deduction for decedents dying after December 31, 2004. When full repeal of the credit occurs, it is anticipated that some states may move to implement a state inheritance tax. This would increase a decedent’s overall tax burden. This could lead taxpayers to consider changing domiciles to a state that does not implement a state inheritance tax.
· Marriage Penalty Relief. The Act phases in limited relief from the marriage penalty.
· Education Incentives. The Act makes qualifying distributions from Section 529 education savings plans tax exempt.
· Pension and Retirement Provisions. The Act increases the amount that may be contributed to IRAs and other retirement plans.
· Individual Income Tax Provisions (Effective Rate Reductions)
· Tax
Benefits Relating to Children and Dependents.
· Alternative
Minimum Tax Relief.
The uncertainty of whether the sunset provision will ever come into play and whether an individual will die during a period of increasing exemption amounts makes planning difficult. Also, the way the law works, when income tax costs related to the change to basis rules are factored in, some heirs will face higher total tax costs if their benefactor dies in 2010 when the estate tax is repealed than they would if he died before 2010. One newspaper columnist wrote in response to the recent estate tax changes “Laughter is the only rational response.” (Washington Post, June 24, 2001).
The Act includes provisions that will significantly affect estate planning and estate administration. These changes provide you with an opportunity to achieve significant tax savings for your family. You should consider the following options in light of the new tax Act:
· Gifting Programs. Because total repeal of the estate tax will not occur until 2010, and may not occur at all, we recommend that you continue making your annual gifts or consider initiating an annual gifting program if feasible.
· The Act’s Impact on Current Estate Plans. You may need to amend your estate plan to avoid unwanted consequences resulting from the increase in the estate tax exemption amount under the Act. In some cases, will and trust language should be altered. In other cases, such language can be simplified. Credit Shelter Trusts (a/k/a Family Trusts) are being rewritten with care not to unintentionally impoverish one’s spouse. Disclaimer and other strategies can also be used.
· Retaining
Flexibility in Your Estate Plan. Given
that multiple Congressional elections and two Presidential elections will occur
between now and 2010, many commentators believe that it is unlikely that
complete repeal of the estate tax will in fact occur in 2010. Even if repeal does occur, history suggests
that repeal would be temporary.
Furthermore, the Act’s sunset provision all but guarantees continuing
changes to the tax law. As a result of
the uncertainty in the estate tax area created by the Act, your estate plan
should be designed to provide as much flexibility as possible.
· Multigenerational
Trusts. As a result of the
scheduled increases in the estate, gift, and GST tax exemptions, greater
amounts may be transferred into multigenerational trusts. If you are interested in establishing a
trust to benefit your descendants, the changes made by the Act provide you with
an additional incentive to do so.
· General Recommendations. Individuals should continue to write wills and revocable trusts and develop estate plans to ensure that their assets will pass as they desire and that special needs of particular heirs will be properly addressed. This is so even if there is a good chance of survival until a year when estate tax won't be owed because of the increasing exemption or repeal under the Act. Even if you feel these new laws do not affect you, it may have been a while since you reviewed your overall estate plan. It is a good idea to review your situation every year.
The inclusion of the sunset provision in the Act all but guarantees that Congress will revisit the changes made by the Act. While many provisions of the 2001 tax Act will probably be extended through 2010, the future of some of the provisions, such as full repeal of the estate tax, is much less certain. While the 2001 Act may well save estate tax to the benefit of your heirs, it has added many new planning complications. I invite you to contact our office with any questions or to set up an appointment so that we can properly reexamine your estate plan to help to keep your estate tax, and income tax for your heirs, to a minimum.
History of the U.S. Estate Tax
The estate tax repeal scheduled for 2010, if actually implemented, will be the fourth such repeal in United States history. Following are some of the highlights in the checkered history of the estate tax.
1797 First federal estate tax imposed. Funds were needed to bolster naval forces due to strained relations with France.
1802 Estate tax repealed.
1862 Estate tax imposed to help finance the Civil War.
1870 Estate tax repealed.
1898 Estate tax imposed to help finance the Spanish-American War.
1902 Estate tax repealed.
1916 Estate tax imposed to replace tariff revenue lost as a result of World War I. An exemption of $50,000 was provided.
1926 Exemption increased to $100,000.
1932 With the advent of the Depression, the exemption was reduced to $50,000 and estate tax rates were increased with a top rate of 45% on transfers in excess of $10 million.
1935 Exemption reduced to $40,000.
1940 In order to help fund World War II, estate tax rates were increased with a top rate of 77% on transfers in excess of $50 million.
1976 Congress overhauls the estate and gift tax, and provides an exemption of $175,625 when fully phased in.
1987 Amount exempt from estate and gift tax increased to $600,000.
1998 Amount exempt from estate and gift tax increased to $625,000, with this amount scheduled to increase gradually to $1 million by 2006.
2001 Effective January 1, 2002, the amount exempt from estate and gift tax is increased to $1 million. Estate tax to be repealed in full in 2010.