Estate And Gift Taxes Under The New Tax Act: A Brighter Future - Maybe

On June 7, 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (the “Act”). The Act is the largest tax reduction package in twenty years (assuming its various phased-in provisions ever actually phase in). The new law lowers individual income tax rates, reduces and eventually eliminates the estate tax, and reduces the so-called marriage penalty, among other things. However, the most beneficial provisions of the Act are deferred for long enough to give Congress time to change its mind (perhaps several times), and the law couples its beneficial provisions with some offsetting negative provisions, creating difficult decision-making dilemmas. The new law thus leaves us in a confusing and uncertain situation.

This Alert will focus on the transfer tax provisions of the Act that have the greatest impact on estate planning. We will discuss some of the most important planning issues that the Act presents and offer a few ideas to consider as you evaluate the adequacy of your existing estate planning documents. In order to keep this Alert relatively short, we must assume that you have some knowledge of the existing transfer tax system and current approaches to tax planning.

Estate Tax Is “Repealed” - Gift Tax Lives On

The new law repeals the estate tax and the generation-skipping transfer (GST) tax for decedents dying after 2009. In the meantime, the maximum rates for estate, gift, and GST tax will gradually fall, and the exclusion amount will gradually increase. The maximum rate will drop to 50% in 2002 and will fall an additional 1% each year until 2007, when the maximum rate will stabilize at 45%. The exclusion amount will rise to $1 million in 2002, to $1.5 million in 2004, to $2 million in 2006, and to $3.5 million in 2009.

Note that the gift tax will not be repealed as of 2010. The lifetime gift tax exclusion amount will rise to $1 million in 2002 and will remain at that level indefinitely, and the maximum gift tax rate for all periods after 2009 will be 35%.

The changes in exclusion amounts and rates can be summarized as follows:

Calendar Year	Estate and GST Exclusion Amount	Highest Estate and Gift Tax Rates
2002	$1.0 Million	50%
2003	$1.0 Million	49%
2004	$1.5 Million	48%
2005	$1.5 Million	47%
2006	$2.0 Million	46%
2007	$2.0 Million	45%
2008	$2.0 Million	45%
2009	$3.5 Million	45%
2010	Repeal	35% (Gift tax only)

Most observers believe that full repeal of the estate and GST taxes will not in fact occur, at least as scheduled under the Act. They note that the date for full repeal will not arrive until two presidential administrations from now and that economic as well as political changes in the interim will likely cause Congress to enact something in place of full repeal sometime between now and 2010. The prospect of such action is enhanced by the fact that the Act provides for an automatic return in 2011 to the law as it existed in May 2001 unless Congress takes further action in the meantime. This “sunset” provision will force Congress to revisit the subject of the estate tax sometime during the next eight years.

Carryover Basis

What Congress giveth with one hand, it taketh away with the other. Along with the repeal of the estate and GST taxes, Congress also repealed, for all decedents dying after 2009, the rules that provide for a date of death adjustment to income tax basis for property acquired from a decedent. Those basis step-up rules have allowed a person receiving non-cash property from a decedent to use as his or her income tax basis the fair market value of that property as of the decedent’s death. (An exception exists for retirement plans and accounts and other assets that are classified as “income in respect of a decedent,” or IRD.) Under the existing basis rules, any unrealized capital gain in a decedent’s property other than IRD simply vanishes upon the decedent’s death.

After 2009, according to the Act, a recipient of property from a decedent will have to adopt the decedent’s income tax basis which, in many cases, will be the original cost of the property. Because capital gain is generally the difference between the amount realized on a sale and one’s basis in the property being sold, the new carryover basis rules will thus result in higher income tax liability upon later sale of appreciated property by the recipient.

The new carryover basis rules are subject to a couple of modifications that will ameliorate somewhat the harshness of the new rule. The Act allows a decedent’s personal representative (executor or trustee) to increase the basis of individual assets above their carryover basis amounts, subject to certain overall maximums. In no event, however, can the basis of any asset be increased above its date-of-death fair market value. The personal representative can decide how the overall basis increases will be allocated among the decedent’s assets. The basis increases will be subject to the following overall limitations:

• For assets that pass to any recipient, regardless of relationship to the decedent, the maximum overall increase in basis cannot exceed $1.3 million (the “general basis increase”).
• For assets that pass to a surviving spouse, the executor can allocate an additional $3 million in increased basis (the “spousal property basis increase”).

These are two distinct, rather than overlapping, step-up provisions. Thus, a personal representative will be able to allocate up to $4.3 million in increased basis to assets passing to a surviving spouse, assuming that no part of the general basis increase is allocated to gifts passing to others.

For purposes of the spousal property basis increase, property will be deemed to pass to the surviving spouse if the gift is either outright or in the form of “qualified terminable interest property” (QTIP). The definition of QTIP property under the Act is very similar to the definition of such property currently in effect for marital deduction purposes.

Fortunately, the Act retains the existing rule allowing the basis of both halves of community property to be increased upon the death of either spouse. Therefore, for example, if a couple owned $6 million of community property at the time the first of the spouses died, and that property had a total basis of $2 million, the deceased spouse’s executor could increase the basis of that property by a total of $4 million (resulting in future basis of $6 million), even though the deceased spouse’s one-half interest alone would warrant a basis increase of no more than $2 million.

Other Significant Provisions

The Act contains a number of other significant provisions that we do not have space to discuss in this Alert. A few of these provisions that could also bear on your estate planning are as follows:

• For decedents dying after 2001, a “closely held business” for purposes of the provisions authorizing payment of estate tax in installments may be owned by up to 45 owners or shareholders rather than only 15, as under current law.
• An individual, personal representative, or trustee who receives a personal residence from a decedent who dies after 2009 will be able to claim the capital gain exclusion available to individuals under Internal Revenue Code section 121 (up to $250,000) so long as the decedent resided in the house for at least two of the five years preceding the sale of the property. Any capital gain excluded under this provision will not reduce the amount of the general or spousal property basis increase otherwise available.
• The GST exemption amount will now automatically be allocated not only to gifts that are direct skips but also to gifts to certain irrevocable trusts whose beneficiaries are both skip persons and non-skip persons. This new rule will avoid a trap for the unwary that has existed in the past.

Planning Implications

It may be premature to give serious consideration to post-repeal planning strategies, both because repeal is still over eight years away and also because it may very well never occur. However, we recommend that you consider a number of steps that will be helpful regardless of whether full repeal of the estate tax ever occurs.

Review the Provisions of Your Bypass Trust. If you are married and have provided in your will or trust that the deceased spouse’s estate tax exclusion amount (currently $675,000) shall pass to a bypass trust (so that it will not be included in the surviving spouse’s taxable estate), you should review the provisions of the bypass trust in light of the increasing exclusion amount. A bypass trust is typically funded according to a formula which causes the deceased spouse’s available exclusion amount, whatever that amount may be at the time of death, to become subject to the bypass trust. Thus, the larger the exclusion amount, the greater the funding of the bypass trust.

If you are like most of our clients, you have probably created your bypass trust for the primary benefit of the surviving spouse. However, you may have provided instead that the trust should benefit other family members, on the theory that the balance of your estate will be sufficient to provide for the surviving spouse. Or, on the same theory, you may have provided that the bypass trust will pay the surviving spouse income only, without giving the trustee authority to invade principal for the survivor’s benefit. Will these provisions still be adequate to provide for the surviving spouse when the exclusion amount - and consequently the bypass trust funding - is $2 million or $3.5 million rather than $675,000?

Unless and until the estate tax is repealed, it will still makes sense in most situations to allocate the deceased spouse’s exclusion amount to a bypass trust rather than to a marital deduction trust so that you can make maximum use of both spouses’ estate tax exclusions. However, if the estate tax repeal ever takes effect, a bypass trust may become a liability. After repeal, property held in a bypass trust will not be entitled to any increase in income tax basis upon the surviving spouse’s death, even if a portion of the surviving spouse’s $1.3 general basis increase would otherwise be available for allocation to the bypass trust assets.

Use Marital Deduction to Defer Estate Tax. For the time being, we will want to continue our usual practice of deferring all estate taxes until the surviving spouse’s death by making optimal use of the marital deduction. The reason for this strategy is obvious: where repeal of the estate tax may occur in the near future, estate tax deferred may be estate tax avoided.

However, if and when the estate tax is repealed, those of you who have provided for everything (other than your exclusion amount) to pass to or for benefit of your spouse - and have done so primarily for estate tax reasons - will be able to give all or some portion of that amount to persons other than your spouse, without adverse estate tax consequences. Given this consideration, a few observers have noted that the biggest “losers” from estate tax repeal may be surviving spouses.

Keep on Giving - But Within the Gift Tax Exclusion Amount. As noted above, the lifetime gift tax exclusion amount will rise to $1 million in 2002 and remain at that level indefinitely. If you are concerned about reducing your taxable estate for estate tax purposes, we recommend that you consider making early use of the $1 million gift tax exclusion - to the maximum extent you are able. This is not a new recommendation; lifetime giving is generally helpful in reducing transfer taxes because it causes future growth in value of the transferred assets to accrue in the estate of the transferee (typically of a younger generation) rather than in your estate. The Act has simply expanded the potential benefit of the gift tax exclusion by increasing its amount.

In the (quite likely) event that the estate tax ultimately remains in force (or your death occurs before 2010), and if your taxable estate exceeds the applicable exclusion amount available at your death, any lifetime rather than in your estate. The Act has simply expanded the potential benefit of the gift tax exclusion by increasing its amount.

In the (quite likely) event that the estate tax ultimately remains in force (or your death occurs before 2010), and if your taxable estate exceeds the applicable exclusion amount available at your death, any lifetime gifts you have made within your gift tax exclusion amount will likely result in significant estate tax savings. However, taxable gifts in excess of the $1 million gift tax exclusion amount are not advisable, because any gift tax you pay will not be refunded or credited to your estate later if the estate tax is subsequently repealed.

If you make lifetime gifts, we recommend that you consider techniques for reducing the valuation of those gifts for gift tax purposes, such as family limited partnerships (FLPs) and grantor retained annuity trusts (GRATs). These techniques, which are not new, continue to be useful options for getting the greatest amount of value out of your gift tax exclusion.

Keep Good Records - Even for Property Already Acquired. The Act represents the third attempt by Congress to adopt a carryover basis regime. Both of the prior attempts - in the 1920s and the 1970s - had to be abandoned because the complexity of the system made it too difficult to administer. The new carryover basis system promises to be even worse than the prior systems because the new law does not include any “fresh start” provision allowing step-up in basis to fair market value as of the effective date of the new law. If and when repeal of the existing step-up provisions takes effect, assets acquired from a decedent will have a basis equal to their original, date of acquisition basis, subject to any adjustments that may have occurred since the date of acquisition (such as for depreciation or for improvements to real property).

In order for a recipient of property after 2009 to compute the amount of capital gain upon any later disposition of the property, the recipient will have to know the property’s basis (and the applicable holding period). In an effort to ensure that recipients have such information, the Act imposes new reporting requirements on the donor or, in the case of a gift at death, on the decedent’s personal representative. Penalties of up to $10,000 are provided for noncompliance.

It is often difficult for the taxpayer who acquired an item of property to establish his or her basis at the time of a sale or exchange. These problems will be compounded where

the party who acquired the property is deceased and good records are not available. So long as the rules for basis step-up at death remain in effect, potential problems created by poor record-keeping can be “cured” by holding onto the property in question until death. Once carryover basis becomes effective, your poor record-keeping will come back to haunt your personal representative. In order to avoid a compliance nightmare for your personal representative following your death, you should consider making good records now of your basis in existing non-cash assets and maintain such records for all future acquisitions. Even if carryover basis never goes into effect, your record-keeping efforts will pay dividends for you if you dispose of any non-cash assets during your lifetime.

Conclusion

Despite its complexity, the Act is basically good news for taxpayers, even if full estate tax repeal never occurs. Unless Congress allows the law to revert to its pre-Act condition in 2011 (which is highly unlikely), you will be able to shelter more value from transfer taxes than you could have under prior law. Most common estate planning document provisions and planning techniques will remain appropriate, at least for the next few years. However, the uncertainty created by the new law will require that you review your existing plan more frequently than you probably have in the past (at least every couple of years) to be sure that changes in the tax law have not caused your plan to function improperly.