Estate Tax Advisory: A 2010 Odyssey

Congress has passed  the Economic Growth and Tax Relief Reconciliation Act of 2001.  Under the Act, estate and generation-skipping transfer (GST) taxes will be reduced from 2001 through 2009 via a complex mechanism, with outright repeal of both taxes in 2010.

The following  chart sets forth the  phase-in  schedule for the  new  estate and gift tax  provisions:

* Linked to individual income tax rates of 15% to 35%.

Long-range planning  will take on a new dimension, especially in view of the fact that the Act's changes are not "permanent."  Because of Congressional budget recon­ciliation rules, all of the Act's provisions sunset. Thus, only if you die in the year 2010 will there be no federal estate tax.  If you die on or after January 1, 2011, the old estate tax is revived with a top rate of 55% and a $1,000,000 exemption!

In any event, you should develop a flexible strategy for dealing with the new law.  The repeal of the estate and GST taxes will impact many different areas of personal financial planning with which you should become familiar in order to develop the most rewarding financial plan in the short and long-term.  The following are a few of the more important changes and our recommendations for dealing with them:

New Adjusted Basis Rules

Basis is the "cost" of an asset to you for purposes of determining capital gain on sale.  Along with the repeal of the estate and GST tax, the basis-step-up rules under current law (which allowed us to increase basis to fair market value at death)  will be replaced with a modified carryover basis rule that limits the recipient's basis to the lesser of the decedent's adjusted basis in the property or its fair market value on the date of death.  Numerous exceptions, however, will permit executors to increase the basis of a significant amount of assets.  This change will effectively trade an estate tax on the entire value of the asset for an income tax on the appreciation in the asset.

Recommendation:  Retain all records of your tax basis in assets.  For purchases, this generally means the original cost.  But basis can get complicated when, for example, improvements are made to real property.  Planners will need to distinguish between improvements that add to basis and repairs and other expenditures that do not.  Records also will be needed for items acquired as gifts or from the estates of parents or others. 

Gifting Program

Gift taxes are not repealed, but the rates are lowered.  The maximum gift tax exemption will be $1,000,000 in 2002 and will NOT increase even though the estate tax exemption will eventually increase to $3.5 million.  This means that there will be greater limits on the amount that can pass tax-free during your lifetime.

Under the new law, it would not usually make sense to make gifts that would bring an individual's total cumulative lifetime taxable transfers in excess of the exemption amount ($1 million for 2002), causing gift tax to be payable currently.  In most cases, it would make better sense to hold off and make transfers at death.  Such an approach could result in less or no transfer tax being payable on additional transfers either because of the higher estate tax exemption during the phase-out years or because of the repeal of the estate tax in the year 2010 (and possibly thereafter). 

Note that there will be some situations in which it will make sense to pay gift tax.  The phase-out of the estate tax takes place over such a long period that some will not live long enough to take advantage of the repeal.  A current gift removes both the post-transfer appreciation in the gifted assets and the gift tax itself from the donor's estate tax base.  In addition, utilizing valuation discounts will sub­stantially decrease the value of the inter vivos gifts.

An individual who has exhausted his or her $1 million exemption may continue to make gifts each year free of gift tax up to the amount of the inflation-adjusted annual exclusion ($10,000 in 2001 for each individual to whom a gift is made).  An individual also may make unlimited transfers to his spouse free of gift tax.  A spousal donee, in turn, would be free to make gifts to others to take advantage of the annual exclusion and his or her own $1 million exemption.  Alternatively, a spouse without sufficient assets can double the annual exclusion available to the other spouse by consenting to gift-splitting.

Recommendation:  With so much uncertainty in the ultimate repeal of the estate tax, a review and maximization of your current Will and gifting program is important.  You should review your gifting program to ensure that you have maximized the use of your available exemption amount and that you are fully utilizing the annual exclusion amounts available to you each year.

The new law did nothing to eliminate or undercut the use of qualified personal residence trusts, grantor retained annuity trusts or family limited partnerships.  These are excellent techniques to make gifts on a discounted basis.  Although we do not recommend a gift that would trigger a substantial gift tax payment, (after all, it is pos­sible that the repeal will be made permanent) people with substantial assets should still be considering the above techniques to transfer assets to their descendants.  For example, a husband and wife could transfer assets valued at $5 million to a family limited partnership and, with a strong discount appraisal, make gifts to children and grandchildren of limited partnership units which would be valued between $1 and $2 million for gift tax purposes.

Credit Shelter Trusts/Asset Allocations

Most families have Wills with a credit shelter trust, i.e., a trust for the benefit of descendants and/or the spouse to use the maximum federal exemption.  As the exemption amount increases to $3.5 million over the next several years, you must now consider whether this standard formula clause will place too many assets in that trust and leave the residuary estate (usually given outright or in trust for the surviving spouse) with too little. 

In addition, to make maximum use of the new exemption amounts, each spouse should have in his or her name an amount equal to the federal exemption.  This allows each spouse to utilize fully his or her exemption amount.

Recommendation:  During the period from 2002 to 2009 when the estate tax exempt amount will increase periodically, couples should review their asset allocations on at least an annual basis to make sure they each have sufficient assets to fund the credit shelter amount and enough left over to make the survivor comfortable.  For individuals who do not want to fund the credit shelter trust with the maximum amount of the exemption, a revision to the Will would be required. 

State Death Taxes

A state death tax credit is allowed against the federal estate tax for estate or inheritance taxes paid to a state on property included in a decedent's gross estate.  Most states impose a "pick-up" or "soak-up" estate or inheritance tax that exactly equals the maximum state death tax credit allowed against the federal estate tax.

 For estates of individuals dying after 2004, the state death tax credit will be repealed and replaced with a new deduction for state death taxes.  The deduction will be allowed in computing the federal taxable estate.

Before repeal and the change to a deduction, the state death tax credit will be reduced by:

• 25% from the amount allowed under pre-Act law, for estates of individuals dying in 2002,
• 50% from the amount allowed under pre-Act law, for estates of individuals dying in 2003, and
• 75% from the amount allowed under pre-Act law, for estates of individuals dying in 2004.

Observation:  If a state only imposes a death tax equal to the Federal state death tax credit, the reduction in, and later repeal of, the state death tax credit will not affect the total of the federal and state estate and inheritance taxes that have to be paid by the estate of a decedent  dying in that state.  This change only means that a larger percentage of the gross estate tax after applying the unified credit will go to the federal government, and less will go to the state.  For decedents dying after 2004, the entire tax will go to the federal government (unless the states revise their estate tax to recover the lost revenues in response to the federal law changes). 

On the other hand, if a state's estate or inheritance tax is not pegged to the state death tax credit, then part of the benefit of lower federal estate taxes will be lost when the state retains its current rates and a lower (or no) state death tax credit is available.  For example:

New York.  New York became a "pick-up" tax state on February 1, 2000.  While most "pickup" tax states impose a tax equal to the amount of the federal credit for state death taxes, New York imposed a tax equal to the amount of the federal credit for state death taxes under the federal law as in effect on July 22, 1998.  Thus, beginning January 1, 2002, the New York State estate tax will exceed the amount of the credit for state death taxes.  This "additional" New York State tax will increase as the new law reduces the credit for state death taxes and increases the estate tax exempt amount in excess of $1,000,000, which is the maximum allowable for New York State purposes.  For example, a person dying in New York in 2004 with $10.1 million will pay 48% to the IRS and an additional 12% to New York State for a total of 60%!  The maximum rate of tax is 55% in 2001.

Connecticut.  The Connecticut Succession Tax has been phased out for bequests to spouses, parents and descendants.  It will be phased out for collateral relatives and non-relatives between now and 2005.  For estates not subject to the Succession Tax, an estate tax is imposed equal to the federal credit for state death taxes paid.  Thus, for those who leave their property to members of their immediate family, Connecticut is a true "pick-up" tax state.  As the new law reduces the federal credit for state death taxes, the Connecticut estate tax will be reduced.  Thus, a person dying in Connecticut in 2004 with $10.1 million will pay 48% to the IRS and an additional 4% to Connecticut for a total of 52%.

New Jersey.  The New Jersey Inheritance Tax is no longer applicable to bequests to spouses, parents, or descendants.  Transfers in excess of $1,075,000 to collaterals are taxed as well as transfers in excess of $500 to non-relatives.  There is a New Jersey estate tax equal to the amount of federal credit for state death taxes.  The New Jersey tax on each estate will be the greater of the Inheritance Tax or the estate tax.  For those who leave their assets to members of their immediate family, there will be no inheritance tax but they will pay New Jersey the amount of the applicable federal credit.

Florida.  The Florida estate tax is equal to the federal credit for state death taxes, regardless of whether you leave your assets to relatives or non-relatives.

Observation:  Under current law, Connecticut (for transfers to immediate family), New Jersey (for transfers to immediate family) and Florida (for all transfers) will have no state death tax beginning on January 1, 2005.  The legislatures of all "pick-up" tax states will have to address this issue between now and 2005.  If New Jersey and Connecticut do not reimpose an estate tax, New York will once again be out of step, estate tax wise, with its neighbors.  This will again put pressure on Albany to conform.

Recommendations:  If you are a New York resident, for planning purposes, your Will should insure that you utilize the federal $1.5 million exemption available in 2004 in your credit shelter bequest even though such action would trigger a New York estate tax because of the New York limitation of $1,000,000 for the estate tax exempt amount.

Generation Skipping Transfer tax

The new law reduces the GST tax rate from 55% to 50%.  However, there is still a flat tax on transfers that skip a generation until January 1, 2010, when the tax is repealed.  It is also subject to the sunset provision and will be in effect again on January 1, 2011.

The Act also makes certain modifications to the generation-skipping transfer tax provisions including (1) automatic allocation of the generation-skipping tax exemption to lifetime trusts, (2) retroactive allocation of the generation-skipping tax exemption and (3) relief from late allocations.  This is important for clients who have made GST transfers (e.g. transfers to a trust that will extend beyond the life of a child and pass to grandchildren) and the election to cover the value of the transfer by your GST exemption was not made on the initial gift tax return or was made on a later return. 

Recommendations:  Have your gift tax returns reviewed for GST allocation.  Also, you should still consider the establishment of trusts to utilize your $1,000,000 exemption ($2,000,000 for couples).

Individual Retirement Accounts

The Act revises a number of the rules relating to individual retirement accounts.  The annual contribution limit will increase from $2,000 in 2001 to $3,000 for 2003 and 2004, $4,000 for 2005 to 2007, and $5,000 for 2008.  The limit will be increased annually for inflation after 2008 in $500 increments.  For individuals over age 50, the maximum contribution limit is increased by an additional $500 for 2002 to 2005, and by $1,000 for 2006 and later tax years.  It should be noted that the new law did not change the phase-out rules for deduction of IRA contributions by individuals who are active participants in an employer-sponsored retirement plan (e.g., 401(k) plan or profit sharing plan).  Consequently, taxpayers whose adjusted gross income exceeds $43,000 ($63,000 for married filing joint returns) in 2001 (subject to increases in later tax years) will not be able to deduct any of their IRA contributions if they participate in an employer-sponsored retirement plan.

Planning Note:  Remember that IRA benefi­ciaries are determined by the terms of your IRA agreement and not by your Will.  It is important to consider and designate your IRA beneficiaries appro­priately in the context of your overall estate plan to achieve the maximum tax savings.

Summary

The phase-in provisions of the Act can significantly affect a person's estate plan, especially married couples.  The increasing estate tax exempt amount will require a constant review of asset allocation of spouses to insure that the unified credit of both spouses is fully utilized.

The fact that the Act repeals the "death" tax for only one year, 2010, means there must be further federal legislation to keep the repeal after 2010 or to override the repeal before 2010.  Which way the political wind will blow is anyone's guess.  However, under the present law, estate planning after 2010 will be very different from what it is now.  Because of the limited step-up in basis, income tax (capital gain) considerations will replace estate tax considerations.  Consideration will also have to be given to the possibilities of a future reimposition of an estate tax.  Thus, the planning to minimize the tax effects of death after repeal will be as complex at that time as it is today.  Although the so-called experts predict that repeal will never happen, it would be foolish to wait until the last moment to review your testamentary plans.  Everyone should review his or her estate plan in light of the changes in the Act.  The only exception would be for an unmarried individual or a married couple with assets that would be less than the increased estate tax exempt amount of $1,000,000.