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Waiting For Repeal
t is hard to remember a tax law that sped through the legislative endgame faster than the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The Senate approved the tax package on May 23. Negotiators from the House and Senate reconciled the House and Senate versions of the bill in a single day, May 25, 2001. The House and the Senate remained in session on May 26, the Saturday of Memorial Day weekend, to take a final vote. President Bush made his immediate approval clear.
The impetus for this express train was the need to bring income tax relief to the public swiftly enough to lift the economy. By contrast, it has taken more than three years to get an estate tax bill through Congress and signed by the President. And though the income tax relief has sped off on its way, the estate tax caboose seems to have come uncoupled from the rest of the train and remains standing on the tracks.
In fairness, many of the proposals that fell short would have phased out the estate tax over just as long a period. Yet there were also less ambitious proposals that would have reduced the estate tax burden on more estates a lot sooner.
But now that the law has taken shape, estate planners can finally see how it will affect actual estates. And from the very outset, there are novel issues relating to phasing out of the estate tax over time. The next eight and a half years will be a very long goodbye indeed. What strategies will leave the estate in the best tax posture once the repeal of the estate tax is in place in 2010? Will there ever be an estate tax repeal…or will we all just be left waiting for Godot? What strategies can hedge against the possibility that the estate tax repeal fails to be implemented? Let's examine our options.
Basic Planning for Smaller Estates
Under the new law, more small and moderate estates will escape estate tax as time goes by. By next year, a married couple could, with minimal planning, pass a $2-million estate free and clear just by having each spouse take full advantage of the applicable credit amount. Realistically, another $500,000 of additional lifetime gifts, charitable gifts, and other deductions could avoid taxation. Thus, a $2.5-million estate will probably be in good shape with the most basic of tax plans during 2002 and 2003.
As the applicable credit amount rises to $1.5 million in 2004, the "safe marital estate" will rise to about $3.5 million (i.e., the $1.5 million exemption for each spouse for a total of $3 million plus $500,000 of the miscellaneous deductions for a total "safe marital estate" of $3.5 million-not to be confused with the $3.5 million applicable credit amount for 2009.) As the applicable credit amount rises thereafter, the "safe" estate does as well.
Consider the estate of a couple dying in 2009 when the applicable credit amount will be 3.5 million. If each spouse is able to utilize $3.5-million exemption, a total of $7 million will be shielded from tax.
Along with the increase in applicable credit amounts, the rate of tax will simultaneously begin dropping. Note, however, that the biggest drop in rates will arrive up front. In 2002, the 5% surtax and the 55% and 53% estate tax brackets will be eliminated. A new 50% rate will apply to transfers exceeding $2.5 million.
Limited Relief for Larger Estates
The unified credit, which is now referred to obliquely as the "applicable exclusion amount," currently shields up to $675,000 of gifts or estates from transfer taxes. Instead of being increased gradually to $1 million by 2006, the EGTRRA increases the amount to $1 million starting in 2002. During the next 8.5 years, larger estates will continue to face high estate taxes.
Example: An estate worth $20 million under tax rates that apply during 2001 would generate an estate tax in excess of $10 million. By 2009, with an applicable exclusion amount of $3.5 million and a top estate tax rate of 45%, the tax savings would be more than $3 million, yet there would still be a considerable amount of estate tax-more than $7 million-which is a lot to pay considering the sharp drop-off to zero estate tax for transfers made during 2010.
Consider where most of the tax savings are concentrated, i.e., during the earliest portion of the phase-in process that takes effect in 2002, slightly less than seven months from the date the law was signed. For the $20-million estate of an individual dying during 2002, the estate tax liability would drop by about $1.3 million. Considering the total savings to be had for the estates of those dying in 2009, it appears that approximately 38% of the tax savings would arrive during the first year.
But there is a wild card in that state death taxes may be increased by 2009. Under EGTRRA, the state death tax credit under §2011 was phased out by 2005 and converted to a deduction. As of July, 2001, Commerce Clearing House reports that 37 states and the District of Columbia have only a "pick-up tax" that is designed to piggy back on the state death tax credit. Many of these states will enact their own estate and/or inheritance taxes. That may further reduce the "savings" available by 2009 and will certainly create ongoing transfer tax issues beyond the effective date of the repeal of the federal estate tax.
Capital Gains Strategies
After the repeal of the estate tax, the carryover basis will make capital gains one of the major concerns of estate planning. Knowing that larger estates will have only a limited stepped-up basis of $1.3 million for transfers to individuals and $3 million for transfer to a spouse, several strategies may be contemplated.
For the estate of a married couple, some thought may be devoted to designating specific assets that have appreciated enough in value to take advantage of the $1.3- and $3-million limits at the death of the first spouse and an additional transfer of $1.3 million at the death of the second spouse. Additional strategies may concentrate on specific types of assets.
At first blush, retirement assets would appear to have a downside in the new scheme of things. Income in respect of a decedent (IRD) won't qualify for the stepped-up basis limits that will remain after 2009. However, assets from a qualified retirement plan will continue to be beneficial insofar as they provide rapid tax-deferred growth and a dependable source of relatively liquid assets at death. Reducing existing retirement plans would therefore not be advisable. But having other assets that can be transferred using the stepped-up basis limits would be desirable.
Life insurance would appear to be a highly desirable asset to have after 2009 since it will not trigger capital gains. Life insurance proceeds would also be useful as a source of liquid assets to pay state inheritance taxes. Irrevocable life insurance trusts remain a favored strategy for the immediate future and beyond. However, shifting too much emphasis toward life insurance is certainly not advisable. Life insurance isn't free-it is one useful investment strategy among many.
In an estate that has assets that have appreciated more in value than the available $1.3-million and $3-million limits, appreciated assets that have declined in value or which have poor prospects for future growth no longer need to be held in anticipation of a stepped-up basis after the owner's death.
The Gift Tax Goes Solo
In 1976, the estate and gift taxes were combined in a unified transfer tax system, with a single unified credit that could be applied to transfers whether they occurred during life or at death. The unified system has held up for a quarter century. However, as the "applicable exclusion amount" phases in over 8.5 years, we are actually witnessing the end of that unified estate and gift tax system.
Both the estate and gift tax exclusion amounts will rise to $1 million in 2002 and will remain at that amount during 2003 as well. But when the applicable exclusion amount for estate tax rises to $1.5 million in 2004, it will part company with the applicable exclusion amount for gift tax, which will remain at $1 million. By 2009, the applicable exclusion amount for estate tax will reach $3.5 million.
The amount exempt from the generation-skipping transfer (GST) tax is currently $1,060,000. It will remain at that level until December 31, 2003. Starting in 2004, the GST tax exemption will be the same as the applicable exclusion amount for estate tax purposes.
Will There Be a Repeal?
The concept of living past December 31, 2009 to reach the effective date of the repeal has given rise to some awkward discussions about amending living wills-should a life be sustained an extra few days if that would eliminate $1 million of estate tax liability? The ethical and practical considerations exceed what most practitioners are prepared to deal with.
But there is no guarantee that estate tax repeal will arrive on schedule or even take place at all. Over the next 8.5 years, the membership of Congress will turn over several times. New occupants may come and go at the White House. The economy may change drastically.
A postponement of the final repeal would be comparable to the delay of the 50% estate tax rate. Originally, that tax was 70% and, under ERTA '81, was supposed to be phased down to 50% by 1987. However, under the TRA '86, the top estate tax rate was frozen at 55% for five years. When that time expired, it was refrozen and has remained at 55% to the present day.
It has become fashionable for the most prominent experts in the field of estate planning to go on talk shows and warn that we may never actually see a repeal of the estate tax. Several reasons are given. One initial concern is a sunset provision that is built into EGTRRA which would automatically reinstate the estate tax in 2011 unless Congress takes action before then. Most observers feel this is not a significant possibility. The provision was based on compliance with the Congressional Budget Act of 1974.
It is simply unrealistic to think EGTRRA will go eight and half years untouched by tax writers and legislators. Difficulties with the carryover basis and numerous state inheritance taxes may make a modified federal estate tax more appealing. The last attempt at a carryover basis was the one enacted by the Tax Reform Act of 1976. After several postponements, that attempt was repealed retroactively by the Crude Oil Windfall Profit Tax Act of 1980.
A shortfall in federal revenues over the next eight years may also be influential in shifting the pendulum of public opinion back toward the "tax the rich" sentiments that have prompted the imposition of estate taxes in the past.
Repeal Is So Simple...
Tamper with an elaborately interrelated transfer tax system and you can quickly end up with a train wreck. A change of this magnitude can't be expected to come off without leaving unanswered questions. And with so much time for the various changes to phase in, there will undoubtedly be technical and substantive adjustments. Ultimately, the orphaned vestiges of the transfer tax system may be more costly to administer than the revenues or social benefits they produce.
© 2001 R. Moshman
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