On June 9, 2001, President Bush signed into law a widesweeping tax reform bill, the Economic Growth and Tax Relief Reconciliation Act of 2001. Because many of our clients are already asking about the effect of the Act's changes to estate and gift taxes upon current planning, we thought it timely to provide you with the following highlights of the Act in this area.
ESTATE TAX REDUCTION AND REPEAL
The new law repeals the estate tax and the generation-skipping transfer tax, but not the gift tax, for persons dying after December 31, 2009. However, the "sunset" provision of the Act restores the estate tax, with a top bracket of 55% and an exemption of $1,000,000, as of January 1, 2011, unless Congress affirmatively extends the repeal. In the meantime, the maximum estate tax rates, which are also the flat generation-skipping transfer tax rates, will drop as follows:
For deaths
in:
|
The Maximum
tax rate is:
|
| 2001 |
55% |
| 2002 |
50% |
| 2003 |
49% |
| 2004 |
48% |
| 2005 |
47% |
| 2006 |
46% |
| 2007-2009 |
45% |
| 2010 |
0% (tax repealed) |
| 2011 |
55% (unless repeal is extended) |
Some immediate good news is that the law repeals, as of January 1, 2002, the additional surtax of 5% that applies to estates over $10,000,000. Prior to the Act, this surtax reduced the benefit of the lifetime exemption and the lower estate tax rate brackets for estates over $10,000,000, and eliminated these benefits for estates over $21,000,000.
The lifetime exemption from estate tax and the exemption from the generation-skipping transfer tax (GSTT) will each rise over time, as follows:
Year
|
Exemption Amount
|
| 2001 |
$675,000 for estate tax,
$1,060,000 for GSTT |
| 2002-2003 |
$1,000,000 for estate tax,
$1,100,000 for GSTT' |
| 2004-2005 |
$1,500,000 |
| 2006-2008 |
$2,00,000 |
| 2009 |
3,500,00 |
| 2010 |
$-0- (tax repealed) |
| 2011 |
$1,000,000 (unless repealed is extended) |
1 The exemption of the generation-skipping transfer tax will be indexed to inflation in 2002 and 2003, as it was for 2001, when it was raised from $1,000,000 to $1,060,000. The amount shown here is an approximation.
Prior to the Act, the federal estate tax laws allowed a specific credit against the federal estate tax for estate and/or inheritance taxes paid to a state. In 1982, California repealed its inheritance tax and instituted an estate tax equal to the federal credit for state death taxes. The state death tax credit available for federal estate taxes will be reduced under the new Act to the following percentages of the amount available under prior law:
Year
|
Percentage Available
|
| 2002 |
75% |
| 2003 |
50% |
| 2004 |
25% |
After 2004, the state estate and/or inheritance taxes actually paid will be allowed as a deduction, not a credit, in determining the taxable estate for federal estate tax purposes. Interestingly, for larger estates, the deduction allowable after 2004 will save more federal estate taxes than will the credit available in 2004, but, of course, the combined federal and state death taxes will be more.
GIFT TAX CHANGES
Although the federal estate tax and gift tax have been "unified" since 1976 so that total transfers, whether made during lifetime or at death, result in the same total transfer tax, Congress chose not to extend the estate tax repeal to lifetime gifts. Purportedly, this was done out of concern that the lack of a gift tax would allow taxpayers in high income tax brackets to make tax-free gifts to their children, who generally pay income taxes in lower brackets and, therefore, would reduce the national revenue from income taxes. Instead, the lifetime exemption for taxable gifts will rise to and remain at $1,000,000 on January 1, 2002. After that date, the maximum gift tax rate will be equal to the maximum estate tax rate (and will follow the changes listed above), except that for gifts made in 2010, the maximum gift tax rate will be the highest income tax rate (35% in 2010, under the new law). Unless Congress acts affirmatively, on January 1, 2011, the sunset provision of the law will restore the 55% maximum gift tax bracket.
The Act also restricts the availability of the gift tax annual exclusion (currently $10,000) for gifts to certain trusts, effective January 1, 2003. After 2002, the only trusts eligible to have gifts excluded for gift tax purposes will be those which, by reason of income tax laws, require the trust income to be taxed to the donor. Other rules permitting gift tax-free payment of other persons' medical and education expenses, and direct gifts of $10,000 to individuals, remain unchanged.
SAVING FOR COLLEGE
As described in our Winter 2001 Legal Update, effective January 1, 1998, Congress introduced "Section 529 Plans," which are state-run trust funds to which donors may make gifts on behalf of a family member or friend, to be applied later for college education costs. Although earnings on these funds did not incur current income tax, the donee was taxed on those earnings as they were withdrawn (presumably, a full-time college student would be in a very low income tax bracket). The Act adds an additional advantage to this vehicle: withdrawals will be income tax-free if applied to college education expenses.
REDUCTION IN THE STEP-UP IN BASIS
The income tax basis of assets included in a person's gross estate for estate tax purposes generally is adjusted to the assets' fair market value at the date of death. For example, if a person purchases real property for $500,000 in 1975 and still owns the property at his or her death in 2001 when it is worth $1,700,000, that person's heirs may sell the property as if they'd bought it for $1,700,000. They would thereby avoid income tax on capital gain except for the sales proceeds above the date of death value. In our normal inflationary times, this is called the "step-up in basis." Of course, if the property has decreased in value from its original cost, there would be a "step-down" in basis.
With certain exceptions described below, the Act provides that property received from a person dying after 2009 will have an income tax basis equal to the lower of (1) the decedent's basis and (2) the fair market value at the decedent's death. However, each person dying after 2009 will be permitted to pass up to $1,300,000 of property (valued at date of death) selected by the executor or trustee that will have a step-up in basis. In addition, up to $3,000,000 of property passing to a surviving spouse and qualifying for the federal estate tax marital deduction will receive a step-up in basis, provided that the spouse survives for at least six months.
PLANNING CONSIDERATIONS
While all of us need more time to digest the provisions of the new law, and the Treasury Department needs to interpret the law, we believe that the most prudent advice we can give at this time is to avoid any immediate changes to your current estate plan, simply because the changes to the estate tax will be slow in coming. Therefore, we do not recommend that you discontinue your gifting programs, life insurance maintenance or other activities geared to reduce the estate tax liability which your heirs may face.
We do recommend that you:
1. Review your current estate plan in order to ensure that it takes advantage of the growing lifetime estate tax exemption. If we prepared your estate plan, in most cases our formula clauses will adjust to take full advantage of this change in the law.
If your surviving spouse is not a beneficiary of your so-called "bypass" trust (also known as the "exemption" trust, the "credit shelter" trust and the "Deceased Trustor's Trust"), which is sometimes the case in second marriages, the increasing exemption may materially reduce or even eliminate a formula marital deduction, leaving the surviving spouse with insufficient income or assets for his or her well-being.
These estate plans should be reviewed before the increased exemptions begin to take effect in 2002.
2. Revisit with us, during 2001 or 2002, your current gift program to existing irrevocable trusts, including those created solely to hold life insurance policies.
If you have questions regarding your estate plan and the changes created by this new law, please contact Marvin H. Lewis (310.281.6302) or Reeve Chudd (310.281.6308) of our Estate Planning Department.
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