Gratuitous transfers of property have been subject to tax by the United States government for many years. The federal government first levied a tax on decedents' estates in 1916. It imposed the gift tax in 1932. The Generation-Skipping Transfer ("GST") tax resulted from the Tax Reform Act of 1986. However, on June 7, 2001 President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 ("the Act"). This law changes many provisions of the Internal Revenue Code ("Code"), particularly many of the Code's sections regarding the Gift, Estate and GST taxes. To appreciate the significance of some of these changes, the Gift, Estate and GST tax laws in existence prior to the Act will be briefly summarized. Then the important changes brought about by the Act will be set forth. Finally, the effects of the Act along with the planning opportunities the Act provides will be discussed.
I. Gift, Estate and Generation-Skipping Transfer Tax Laws Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001
As stated above the federal government has subjected gratuitous transfers to three taxes. The Gift and Estate tax systems were imposed separately until they were restructured into one unified tax system in 1976. Since 1977, all gratuitous transfer made by an individual were, and continue to be until the Act is fully implemented, taxed under the same rates regardless of whether made while the individual was alive or after her death. Additionally, every U.S. citizen has been able, since 1977, to give away a limited amount of property free of Gift and Estate taxes during her lifetime and after her death. That cumulative maximum, called the applicable exclusion amount, is currently $675,000 in 2001 and was scheduled to increase to $1,000,000 by 2006.
Furthermore, every decedent is allowed a credit on her federal estate tax return for any estate, inheritance, legacy or succession taxes paid by the decedent's estate to any State or the District of Columbia. Under current law, this State death tax credit cannot exceed a prescribed limit determined by a graduated schedule of rates. At this time most States, including Illinois, have what is called a "pick-up" tax. The death tax imposed on deceased residents of these States is equal to the maximum allowable State death tax credit computed on the decedent's federal estate tax return.
Lastly, the income tax basis of any property transferred subject to the Estate tax is automatically "stepped-up" to the property's fair market value on the date of the decedent's death in the hands of the recipient. The effect of this stepped-up basis rule is less income taxes due from the recipient when she later sells the asset.
The GST tax in its current form is an additional tax imposed on lifetime gifts and post-mortem transfers, but only if the recipient is more than one generation younger than the donor, such as a grandchild. Furthermore, the tax rate applied to GSTs is the highest marginal Gift and Estate tax rate, currently 55%. Also the cumulative maximum amount of GSTs that may be made free of GST tax, called the GST tax exemption, is currently $1,060,000.
II. Changes imposed by the Economic Growth and Tax Relief Reconciliation Act of 2001
As mentioned above, the Act changes the existing Gift, Estate and GST tax laws in several ways. In particular, the Estate and GST taxes, as well as the State death tax credit, are gradually repealed; the Gift tax rates are lowered while the applicable exclusion amount is increased; and the rules for stepped-up basis are significantly modified.
A. Phase-out and Repeal of the Estate and Generation-Skipping Transfer Taxes
Repeal of the Estate and GST taxes does not completely occur until January 1, 2010. However, these taxes, and the Gift tax, are slowly reduced over the next eight years. Beginning in 2002, the top Gift, Estate and GST tax rate is lowered from 55% to 50%. Additionally, the 5% surtax which is applied to cumulative Gift and Estate transfers in excess of $10,000,000 is eliminated in 2002. Also, the applicable exclusion amount for both Gift and Estate taxes is increased to $1,000,000 next year. The GST tax exemption remains at its $1,060,000 level, adjusted annually based on inflation. In 2003, the highest Gift, Estate and GST rate is lowered to 49%. Further reductions are made in 2004. Particularly, the top rate is decreased to 48%, the applicable exclusion amount is increased to $1,500,000 for Estate tax purposes (the Gift tax applicable exclusion remains at $1,000,000), the GST tax exemption is increased to $1,500,000 (and made equal to the Estate tax applicable exclusion amount thereafter until each is repealed in 2010) and the Qualified Family-Owned Business Interests ("QFOBI") deduction is repealed. The QFOBI deduction allowed a certain amount of family-owned business assets to be excluded from the Estate tax, in addition to the applicable exclusion amount. In 2005, Gift, Estate and GST tax rates above 47% are eliminated. The highest rate is decreased to 46% in 2006 and the Estate tax applicable exclusion amount and GST tax exemption increase to $2,000,000. The top rate is lowered to 45% in 2007 and the respective exclusion and exemption amounts are increased to $3,500,000 in 2009.
The new law also provides that one's GST tax exemption will be automatically allocated to indirect skips and one will be able to make allocations on a retroactive basis in certain circumstances. Furthermore, it permits a trustee to sever a trust into sub-trusts for purposes of allocating GST tax exemption even after the trust had been created.
B. Retention of Gift Taxes
The Gift tax remains after 2009. As stated in the previous section the current Gift tax applicable exclusion amount is increased to $1,000,000 in 2002 and its highest marginal rate is lowered to 45% by 2009. After 2009, the top rate is equated to the top individual income tax rate. Additionally, all gifts made to a trust after 2009 will be deemed to be taxable gifts unless the trust is a grantor trust.
C. Reduction and Elimination of the State Death Tax Credit
Between 2002 and 2004 the State death tax credit is reduced until it is completely eliminated in 2005. The reductions are 25% in 2002, 50% in 2003 and 75% in 2004. In its stead will be a deduction for any State death taxes actually paid by the decedent's estate. This means that deceased residents of States with a pick-up tax will not incur any additional death taxes after 2005 because the amount of the pick-up tax is equal to the maximum credit on the federal estate tax return. However, the States with pick-up taxes will lose this source of income.
D. New Modified Carryover Basis Rules
Once the Estate and GST taxes are repealed in 2010 the stepped-up basis rules go away also. New modified carryover basis rules take their place. Generally, these new rules will provide that the income tax basis of all property received from a decedent will be the lesser of the decedent's adjusted basis in the property or the property's fair market value on the date of death of the decedent. However, the Act creates two exceptions to this rule. The first we will call the general basis step-up exception. Every U.S. citizen's estate will be able to increase, up to fair market value, the basis of $1,300,000 of its property. The second exception we will call the surviving spouse basis step-up exception. Under this exception every U.S. citizen's estate may increase the basis, again only up to fair market value, of $3,000,000 of property passing to the decedent's surviving spouse.
The decedent's Executor is given the authority to determine which assets receive the increase in basis. So that the Internal Revenue Service ("IRS") may track the basis of gifted property for income tax purposes the new law requires the Executor to file an information return setting out the specifics of the gifts. Additionally, the executor is mandated to send each property recipient a writing specifying each recipient's adjusted basis in the property received. Penalties will be imposed on Executors who fail to comply with these filing requirements.
E. Back to the Old Rules in 2011
On January 1, 2011 the Act repeals itself. Section 901 of the Act provides that it does not apply after December 31, 2010. Essentially, the laws in effect on May 25, 2001, the day before the Act passed Congress, will go back into effect on January 1, 2011. Thus, the repeal of the Estate and GST taxes and the new carryover basis rules will only last for one year, unless additional legislation provides otherwise.
III. Effects of the Economic Growth and Tax Relief Reconciliation Act of 2001 and Planning Opportunities
Due to the many non-tax reasons for estate planning, the gradual phase-in of the new rules and the repeal of those rules if nothing is done by the Congress and the President in the future, one cannot afford to neglect estate planning at this time. The effects of the new laws are numerous and individuals should review their wills, trusts and other estate planning documents to ensure they take advantage of the new tax breaks and are not disadvantaged by some of the Act's problematic effects.
One effect of the new laws may be that many individuals are now "over-insured," even though some claim that no one is ever "over-insured", but only "over-premiumed." In the past many individuals have purchased life insurance as their taxable estates have grown. This was done to offset the Estate and GST taxes their estates would owe at their deaths with the life insurance proceeds. Maybe insurance coverage can now be lowered, but careful consideration must be given here since these taxes may still be incurred and the cost of later obtaining insurance may be significantly higher. Additionally, the current level of life insurance may be maintained to offset the increased capital gains taxes the property recipients may ultimately realize.
Another ramification of the new Act is that many individuals may need to execute new estate planning documents. Currently, many testamentary documents direct that the residue of the estate be divided in the following way. First, the portion that can pass tax-free pursuant to the applicable exclusion amount will usually go to beneficiaries other than the decedent's surviving spouse. Then the remaining amount goes to the surviving spouse. Since the applicable exclusion amount is increased over the next eight years from $675,000 to $3,500,000 some individuals' current wills and/or trusts may inadvertently disinherit their spouses or result in the spouse exercising his/her spousal rights under state law. Individuals should review their documents and the methods by which they own their assets to prevent this unintended result.
Another result of the new laws, which was alluded to above, is the new filing requirements and accompanying penalties for noncompliance placed on estate fiduciaries. The fiduciaries, and the decedent prior to her death, will need to maintain detailed records in order to complete forms the IRS will require. Based on this additional work, and these increased risks, executors' fees will most likely rise. Similarly, the new Act requires the donors of lifetime gifts, in addition to filing gift tax returns, to notify in writing each recipient on the gift tax return of the donor's adjusted basis in the transferred property. Failure to do so could result in the imposition of penalties.
Problems in determining the adjusted basis of assets will likely be encountered, especially for assets held for a long time or which have been transferred several times by living persons. One possible solution for the owner of such property is to donate the property to a charity. Not only will such action relieve the owner of the burden of determining his basis in the property but he will also be entitled to an income tax deduction.
Under current law, gifts made during life are more appealing than gifts made upon death. The reason being that Gift and GST taxes imposed on lifetime transfers are paid by the donor of the gift from assets other than those transferred, allowing the donee to receive the entire gift. However, Estate and GST taxes imposed on post-mortem gifts are paid from the gift before the donee receives it. That is, the dollars used to pay the tax are themselves taxed. Conversely, the new law makes retention of property more appealing than lifetime gifting. There are several reasons for this. First, the exemption amounts for Estate and GST taxes become significantly higher than the exemption amount for Gift taxes after 2003. In 2009, the exemption for Estate and GST taxes will be $3,500,000 while the exemption for Gift taxes will be only $1,000,000. Additionally, in 2010 the Estate and GST taxes go away while the Gift tax remains.
One strategy that could become popular if the repeal of the Estate tax is made permanent is the use of long-term loans. Pursuant to this strategy one will be able to avoid Gift taxes totally, yet still transfer property to others during his life, if proper planning is done. The individual could use long-term loans which will be forgiven at the lender's death to accomplish this. However, careful drafting of the loan agreements will be necessary to limit Estate taxes while they are still in existence or if they are subsequently re-enacted.
Similarly, one could establish a dynasty trust in 2010, after Estate and GST taxes are repealed. This strategy could benefit one's spouse and decendents for many generations into the future and likely be exempt from Estate and GST taxes forever even if these taxes are re-enacted. Gift taxes on the funding of the trust could be avoided if proper use is made of the Gift tax applicable exclusion amount and the annual exclusions for Gift taxes. However, for clients living in states that still administer a state gift tax additionally planning needs to be done to limit exposure to such tax.
The Economic Growth and Tax Relief Reconciliation Act of 2001 significantly modifies the current Gift, Estate and GST tax laws. Some of the results are very beneficial while others could be detrimental. The ramifications to each individual will be different depending on his/her situation. We highly recommend that your estate plan be reviewed in light of new traps and opportunities resulting from the New Act.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.