New Rules for 2004

ere we are at the start of a new year and Congress has cooked up a whole new stew of phase-ins, phase-outs, temporary rules, cost-of-living adjustments, and other assorted improvements in the tax code. What might one call such a stew?¹

It is a transitional time with taxation evolving as a result of social and economic changes. Dividends, only recently considered passé in a culture that sought only fast growth, are now in demand. Let's review all of these changes as well as the sudden appearance of dividends in every discussion. But first, let's tackle the main question on everyone's mind: Is the estate tax repeal for real? More legislative adjustments in this area now appear inevitable.

Tax Evolution

As society, wealth, and tax rules change, our financial-planning strategies must evolve as well. The current evolutionary context has been manifested in the most recent tax laws.

Obviously, we would not be discussing tax evolution without the Economic Growth and Tax Relief Reconciliation Act of 2001. Besides repealing the estate tax by 2010, EGTRRA '01 severed the unified estate and gift tax system, phased out the state death-tax credit that had unified state death taxation, and established a modified stepped-up basis for appreciated assets being transferred at death after 2009 (to the extent they exceed $1.3 million or $3 million for transfers to a surviving spouse).

In 2003, the Jobs and Growth Tax Relief Reconciliation Act added another layer of change. Lower tax rates on income, capital gains, and dividends will mean new approaches to planning. It was no coincidence that Microsoft announced that it would no longer rely upon stock options for employee incentives. In another announcement, Microsoft indicated that it would begin sharing its wealth with investors in the form of dividends. In the wake of corporate accounting scandals and stock market volatility, there is a strong appetite for having a dependable dividend.

In truth, for most people, their estates will never be large enough to face taxation. In that respect, tax evolution is already complete. In this brave new tax paradigm, income taxation, including capital gains and the alternative minimum tax, takes on greater significance. The dividend age has begun.

Alternative Endings

In 2001, Congress overhauled the transfer tax system but budget rules forced Congress to impose a sunset on the new law. During 2002 and 2003, Congress lacked the 60 votes needed in the Senate to make the repeal permanent after 2010.

In 2004, we find ourselves once again facing the repeal of the estate tax…or perhaps not. If Congress takes no further action over the next eight years, the estate tax would phase out, be gone entirely in 2010 and then re-emerge in 2011 looking exactly as it had in its heyday, with a top rate of 55%, a 5% surtax for certain larger estates, and an exclusion amount of $1 million. If you like science fiction, you have to love our tax code.²

What are the odds of repeal actually happening? Let's put it all in context. True reform was attempted in 1976 when Congress created a unified transfer tax system, yet waves of tax legislation continued to follow at shorter and shorter intervals. Before long, every new session of Congress had to have its own tax reform. Tax reforms focused on "simplification" in the 1980s, social goals or fairness during the '90s, and last year's legislation is intended to improve our economy.

Conclusions: Improvements in the tax code may one day result in a fair and simple system that Congress can stop tampering with…and we should all live so long to see such a thing. But it appears highly unlikely for the tax-reform factory in Washington to leave well enough alone or to follow through on a 2001 plan by the time 2010 arrives. By 2010, society's periodic "tax the rich" attitudes may have swung back into place just when the repeal is to be implemented.

Moreover, the financial basis for repeal is already very much in doubt. The United States is no longer in the same tax-surplus posture we had when the estate tax repeal was enacted in 2001. The surplus days are gone. There is a large budget deficit and increased costs for health care, Social Security, and our international endeavors. The tax revenues that once flowed from capital gains during the bull markets of the 1990s have dried up; many portfolios still carry heavy losses. With lower income tax rates, lower capital gains rates, and lower estate tax rates, something has to give if there are going to be more tax revenues.

One alternative ending involves the retention of an estate tax with a relatively high exemption of $3 million following one of several Democratic proposals. Congress may also allow the phase-out of the estate tax to proceed but stop the process on the eve of repeal, December 31, 2009. That would put the top rate at 45% with an exemption amount of $3.5 million.

New Numbers for 2004

The largest and most obvious change for 2004 is the increase in the applicable exclusion amount. The exclusion amount is being increased by 50%, from $1 million to $1.5 million. It will remain at $1.5 million during 2004 and 2005 before continuing on upward to $2 million in 2006. A higher exclusion will mainly help a small number of estates that are the right size and which fall into this window of time.

Of greater significance to more estates are those changes affecting capital gains. And the final phase-out of the state death tax credit could have major planning ramifications down the road.

Estate and GST Tax: The exemption amount for estate and GST tax purposes increases from $1 million in 2003 to $1.5 million in 2004. The top tax rate for estates, gifts, and generation-skipping transfers drops one percentage point, from 49% to 48%.

Gift Tax: The lifetime exemption for gift tax purposes will remain at $1 million. The annual gift tax exclusion remains at $11,000 per donee, per year ($22,000 with spousal gift splitting). Significantly, the increased exemption only applies to estates and generation-skipping transfers. For gifts, the exemption remains at $1 million and is not adjusted for inflation. This represents a parting of the ways for estates and gifts, which had been coordinated in a unified transfer tax system for 28 years.³

State Death Tax Credit: The credit is in the final year of its phase-out. It was reduced by 25% in 2002, 50% in 2003, and is reduced by 75% in 2004. Next year it will be gone entirely. As more states adopt differing estate and/or inheritance taxes, the need for a federal credit to unify this area of law becomes more apparent, further weighing against the estate tax's repeal being implemented.

Capital Gains: Under the 2003 JGTRRA, the maximum capital gains rate was reduced from 20% to 15%. Taxpayers in the 15% tax bracket who had paid 10% tax on long-term capital gains now pay 5%. In 2008, the 5% rate drops to 0%. In 2009, the rates return to pre-JGTRRA levels, i.e., 20% and 10%. (The five-year rate of 18% was eliminated.)

Dividends: Under JGTRRA, dividends are taxed much like long-term capital gains, i.e., at 15% and 5% with pre-JGTRRA levels, i.e., being taxed as ordinary income, after 2008. Early tax proposals would have reduced the tax on dividends even further.⁴

Retirement Plans: Contribution limits are also adjusted under EGTRRA of 2001. The exclusion for elective deferrals increases from $12,000 to $13,000. The limit for SIMPLE accounts increases from $8,000 to $9,000.

Looking Ahead to 2005: We are only twelve months from now from the next phase of the estate tax's repeal. In 2005, the top estate, gift, and GST tax rate will drop to 47%. The applicable exclusion for estate and GST purposes will remain at $1.5 million and the gift tax exclusion will remain at $1 million. The state death tax credit will no longer exist but will become a deduction.

Inflation Adjustments

Based on the Consumer Price Index, the following cost-of-living adjustments were released by the IRS in Rev. Proc. 2003-85 and will apply in 2004:

GIFT TAX: The annual gift tax exemption under §2503(b) will remain at $11,000.

INSTALLMENT PAYMENTS: Installment payments under §6166 utilize a dollar amount for calculating interest regarding the 2% portion of the estate tax payable in installments. This increases from $1,120,000 in 2003 to $1,140,000 in 2004.

SPECIAL USE VALUATION: The limit under §2032A increases from $840,000 to $850,000.

NONCITIZEN SPOUSES: The exemption under §§2503 and 2523(i)(2) for gifts to noncitizen spouses increases from $112,000 to $114,000.

GST: The generation-skipping transfer tax exemption increases based on the applicable exclusion amount of §2010(c) and is not adjusted for inflation after 2003. The GST exemption is $1.5 million in 2004.

ATTORNEY FEES: Attorney fees under §7430 remain at $150 per hour in 2004.

PENSION PLANS: The limit on annual benefits under a defined benefit plan increases from $160,000 to $165,000 in 2004. For defined contribution plans, the limit increases from $40,000 to $41,000. The annual compensation limit increases from $200,000 to $205,000. The limit for key employees in top-heavy plans remains at $130,000, while the limit for highly compensated employees under §414(q)(1)(B) remains at $90,000.

Technical References

¹ The recipe for "son-of-a-gun beef stew" posted on FabulousFoods.com calls for 2 lb. beef; 6 potatoes; 1 can stewed tomatoes; l lg. onion; 1 clove garlic; 2 cups carrots; 1 cup celery; 1 cup whole kernel corn; 1 cup peas; 1.5 lb. mixed vegetables; 3 quarts water ; 1/2 cup pearl barley; 3 tsp. salt; 2 tsp. black pepper; 3 whole bay leaves; 4 tsp. parsley; 1/4 tsp. oregano; 1/4 tsp. basil, corn starch. The site describes the stew as "a mainstay for many chuck wagon cooks of the early cattle drives," and describes visitors bringing a variety of ingredients.

² Hyper-space jumps on Battlestar Gallactica can't compare with the sophisticated mojo of the Joint Committee on Taxation. Submitted for your approval: The estate tax disappears in 2010, but when we wake up on January 1, 2011, the estate tax will not only reappear but we will find ourselves back in 2001 with high estate tax rates, a $1-million exemption and a stepped-up basis. But even if this retro scenario takes place, Congress may witness the resulting fiasco and whisk us back to the future in 2012, retroactively, nunc pro tunc, i.e., as if it had never happened.

³ Prior to 1976, there were 25 federal estate tax brackets ranging from 3% to 77% and gift tax rates were 75% of the estate tax rates. The Tax Reform Act of 1976 combined estate and gift tax rates into a single, unified schedule with 21 brackets that went up to 70%. TRA '76 also provided the unified estate and gift tax credit instead of separate exemptions of $60,000 for estate tax and $30,000 for gift tax. The unified credit was initially $30,000 and was increased in annual increments. Annual gift tax exclusions were increased from $3,000 to $10,000 by 1981 tax legislation.

⁴ Responding to a proposal to make dividends 50% tax free in 2003 and 100% tax free in 2004 through 2006, Warren Buffett called the proposal "voodoo economics" that uses "Enron-style accounting." Writing in the Washington Post, Buffett illustrated how the plan would "further tilt the tax scales toward the rich," with an example of what would happen if his company, Berkshire Hathaway, began paying $1 billion in dividends. As 31% owner, Buffett would receive $310 million tax free. His effective tax rate overall would be 3% while his secretary would be paying tax at a 30% rate. President Bush had supported last January's proposal to eliminate the tax on dividends paid on already taxed corporate profits. He said, "it's not fair to double-tax by taxing the shareholder on the same profits."

© R. Moshman 12/03