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The Tax Relief Act of 2001
state tax repeal has become a reality. Many proposals lay by the wayside and two previous attempts died on the former President's desk. But even in those defeats was the silver lining of unhoped-for strength. Estate tax repeal had bipartisan support each time and ultimately came respectably close to overriding President Clinton's veto. With a new administration, the question was no longer whether the estate tax would be repealed but when and how it would be accomplished.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (H.R. 1836) was reconciled by the Joint Committee on Taxation on May 25th and passed by both houses of Congress on May 26, 2001. No tax law of such significance has had such a fast track treatment. It will have been signed by President Bush by the time this is published. The new tax law repeals the estate tax entirely in 2010. In the meantime, the tax is gradually phased out with a combination of exemption increases and tax reductions. This phased-in approach opens a whole new universe of estate-planning strategies.
But some things have stayed exactly the same. Because one still has to plan for the eventuality of a death within the next 10 years, all of the current estate-planning strategies are still in play-the QTIP, the credit shelter trust, the QPRT, the FLP, the
NIM-CRUT, etc.-it's all still good, at least for the next decade.
As a practical matter, fewer estates will need to plan for estate tax at all. The current unified credit shields $675,000 that can be transferred free of estate and/or gift tax. This amount will increase to $1 million in 2002, and in a mere 30 months or so, the effective exemption will hit $1.5 million. At that point a couple would be able to pass $3 million to heirs free of transfer tax with the most basic of plans. Larger estates could certainly leverage the unified credit with lifetime gifts.
The Estate Tax Phase-Out
Without the Tax Relief Act of 2001, the estate tax would have been impacted by an increase in the unified credit that would have increased the effective exemption amount from $675,000 to $1 million by 2006. Instead, the amount of the effective exemption amount will increase to $1 million in 2002 for estate and gift tax purposes. It then rises in several steps to $3.5 million by 2009.
The top estate and gift tax rate, currently at 55% plus a 5% surtax to offset the benefits of the graduated rates, are gradually reduced over the next 10 years as well. Here is a chart of how the effective exemption and top estate and gift tax rates look, year by year:
Several major things happen to the transfer tax system in 2010:
The estate tax is repealed.
The generation-skipping transfer tax is repealed.
The top gift tax rate is reduced to the top individual income tax rate of 35%.
The stepped-up basis for assets transferred at death is limited.
The limited stepped-up basis
Once the estate tax repeal is complete in 2010, lifetime gifts will no longer be necessary to reduce the size of the taxable estate. Lifetime gifts will still serve a purpose for reducing capital gains on assets transferred at death. Instead of an unlimited stepped-up basis for all assets passing at death, we will have a carryover basis starting in 2010. However, there will still be a limited stepped-up basis of $1.3 million for assets transferred to an individual and $3 million for assets transferred to a spouse. A number of observations are in order with respect to these limits on the stepped-up basis.
Marriages of tax convenience late in life may become more common.
The status of life insurance in many high net worth households may shift from estate tax to income tax purposes and may be more valuable than ever.
Estates having a high concentration of retirement plan assets, which would contain income in respect of a decedent (IRD) rather than captial gains, would not be in a position to take advantage of the stepped-up basis.
Instead of attempting to minimize the valuation of assets with discounts for marketability and lack of control, executors will have a different focus after 2009. A higher value, up to the new stepped-up basis limits, will generally leave heirs with a higher basis for income tax purposes for future transfers.
Several useful strategies may be employed. For example, a married couple might have an estate plan that calls for assets that have appreciated in value to be transferred. At the death of the first spouse, $1.3 million of gains could then pass to heirs, while $3 million of gains could pass to a spouse. At the death of the surviving spouse, another $1.3 million of capital gains may be transferred free of tax.
That's a total of $5.6 million that a married couple can transfer at a stepped-up basis. However, note that these limits apply to the amount of appreciation, not merely the fair market value of the assets. A married couple might have $5.6 million of appreciation on assets with a market value of, say, $11 million. Moving assets of this size to reduce capital gains may be easier said than done.
Certain assets that will be kept in the family for generations may never be sold, or may be transferred to other family members in the future and can be covered by the limited stepped-up basis at that time. In short, trying to retrofit an estate into a distributional pattern that makes sense for purposes of the limit on stepped-up basis may trigger family frictions, litigation, and may simply not be feasible.
An audit of one's capital gains profile at any given time may reveal more than enough capital gains to require planning, yet there may be no single asset with $1.3 million of appreciation. Many appreciated assets may be earmarked for other purposes-a family home, a business, a painting. With the next 10 years to prepare for the limited stepped-up basis, several strategies may be entertained. First, consider how much appreciation has already accrued. How much is anticipated? What is the likely disposition of each property in the future? In light of the time to prepare, a dedicated fund-a stepped-up basis shelter trust that is needed at the death of the first spouse can be established now with appropriate assets so that $1.3 million or $3 million of appreciation can accumulate over the next 10 to 15 years and be transferred conveniently when the time comes.
YEAR
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EFFECTIVE EXEMPTION AMOUNT
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TOP ESTATE AND GIVE TAX RATE
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2001
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$675,000
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55% +5% surtax
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2002
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$1 million
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50%
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2003
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$1 million
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49%
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2004
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$1.5 million
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48%
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2005
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$1.5 million
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47%
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2006
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$2 million
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46%
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2007
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$2 million
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45%
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2008
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$2 million
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45%
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2009
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$3.5 million
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45%
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2010
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[tax repealed]
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[gift tax only]
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Other Key Provisions
As the estate tax becomes less of a threat to more Americans over the next decade, other financial-planning efforts will take on greater priority. Many other important changes were made by the Tax Relief Act of 2001 as well.
STATE CREDIT: The state death tax credit has enabled the majority of states to collect estate tax revenues from estates without adding to the overall burden that taxpayers face. All states impose a tax equal to the amount of the credit that can be used to offset federal estate taxes. This credit is being phased out by 25% in 2002, 50% (below present amounts) in 2003, 75% in 2004, and is repealed entirely in 2005. At that time, a deduction will apply to any state estate tax, inheritance tax, or succession tax which is paid to any state.
A greater consciousness of state death taxes will be needed because this is likely to be one of the most dynamic areas of change over the next few years. States have relied upon the federal state tax credit as a simple way to siphon tax revenues from the federal estate tax collection efforts. However, about 17 states currently impose their own estate, inheritance, generation-skipping and/or gift taxes. As the new tax reform calls for the state credit to be phased out by 2005, more states will enact their own transfer taxes.
CONSERVATION EASEMENTS: Effective for estates of decedents dying after December 31, 2000, qualified conservation easements will no longer have to be within a specific distance of a metropolitan area, national park, wilderness area, or Urban National Forest.
IRA CONTRIBUTIONS: The contribution limit for IRAs will increase from $2,000 to $3,000 in 2002, then $4,000 in 2005, and $5,000 in 2008. It will be indexed for inflation thereafter.
TAX RATES: A new 10% tax bracket is retroactive to apply to 2001 and will provide savings of up to $600 for married couples. Instead of a top tax rate of 39.6%, the top rate will drop to 38.6% for the 2001 through 2003 tax years, then drop to 37.65% for 2004 and 2005, and finally drop to 35% for 2006 and later.
MISCELLANEOUS: During its remaining existence, modified rules will affect the generation-skipping transfer tax. The alternate minimum tax (AMT) will continue to affect an increasing number of people, perhaps affecting some 35 million taxpayers in ten years unless it is modified.
More To Follow
We are entering a dynamic period of change. Strategists are considering their options. Congress will make adjustments. The economic context is shifting as well. Will the estate tax repeal be accelerated? Postponed? Will a carryover basis work out where it previously failed? Will states enact dozens of new estate and inheritance taxes? What new income tax techniques will influence planning? Estate tax repeal is not the end of estate planning ... it is the beginning.
© 2001 R. Moshman
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Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
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