TAX
INSIGHTS:
ESTATE AND
CHARITABLE PLANNING UNDER THE ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT
OF 2001
by
John R. Price
Byrle M. Abbin
Jerry J. McCoy
Part One–Estate Planning Under the Economic Growth and Tax
Relief Reconciliation Act of 2001
Introduction -
General Description of 2001 Act
Miscellaneous
Changes Made by the 2001 Act
Planning
Implications of the 2001 Act
Conclusion
Part Two–Changes Affecting Individuals, Estates and Trusts
The Technical
Provisions
Avoiding Taxable
Gifts
Other Planning Aspects
Part Three–Charitable Giving Under the
Economic Growth and Tax Relief Reconciliation Act of 2001
Overview
The 2001 Act
Itself
The Incredible
Disappearing Tax Act
Other Charitable
Provisions
Practical
Implications for Charitable Planning
The Bottom Line
I. Introduction
- General Description of the 2001 Act
From an estate planning
perspective the most important provisions of the 2001 Act are the significant
ones that will, or are most likely, to take effect. They are the direct and indirect reductions in the estate, gift
and generation-skipping transfer (GST) taxes. The reductions, which extend from
2002 through 2009, take two forms: (1)
decreases in the maximum tax rates, which only benefit taxpayers with estates
of $2.5 million or more, and, (2) staged increases in the amount that can be
passed free of tax (the credit equivalent).
The increases in the estate tax credit equivalent will relieve the
estates of an increasingly large number of individuals from the obligation to
pay any federal estate tax. The 2001
Act also makes a number of generally helpful changes in a variety of
areas—including deferred payment of the estate tax under Section 6166 and
the GSTT. Those miscellaneous changes are summarized in Part II, below.
Unfortunately, the 2001 Act
partially reverses the unified gift and estate tax system that has been with us
since 1976. In particular, while the estate
and gift tax credit equivalent will both increase to $1 million on January 1,
2002, the gift tax credit equivalent will remain at that level
indefinitely. In contrast, the estate
tax credit equivalent and the GST exemption will increase in tandem at
irregular intervals until they cap out at $3.5 million on January 1, 2009.
The scheduled changes made by
the 2001 Act culminate in a repeal of the estate and GST taxes effective
January 1, 2010. However, the gift tax
will remain in effect after 2009 with a $1 million credit equivalent and a
maximum rate of 35 percent. The gift
tax was retained in order to discourage individuals from making sham gifts for
the purpose of shifting income to lower-bracket family members. If the estate and GST taxes are repealed on
January 1, 2010, they may be reinstated a year later by the Sunset provision of
the 2001 Act. Act
Section 901. Under the Sunset
provision, which was added for procedural reasons, none of the changes made by
the 2001 Act will have any effect after December 31, 2010. Future revenue needs, changes in the makeup
of Congress, the program of future presidents, and a host of other events will
determine the extent to which the scheduled tax cuts and repeal will actually
take place. Many commentators, including
this author, believe the scheduled estate and GST tax repeal will not take
effect.
Importantly, the 2001 Act has
relatively little present impact on existing estate planning strategies and
plans. Of at least equal importance,
the changes made by the 2001 Act do not have any significant adverse impact on
estate planning. Specifically, the 2001
Act does not impose any of the limits on existing estate planning strategies
that were proposed by the Clinton administration (e.g., limiting discounts in the
valuation of family limited partnerships and limited liability companies that
hold financial assets, eliminating the gift tax annual exclusion for gifts to Crummey
trusts, and ending the preferential gift tax treatment of transfers to Qualfied
Personal Residence Trusts (QPRTs)).
The prospective repeal of the
estate and GST taxes confirms that survival continues to be the best estate
planning strategy. The uncertainty of
the tax picture makes that even more true now.
In assisting our clients, we have never known when they would die, but
we have usually known the general nature of the federal transfer tax provisions
that would apply to them and their estates.
The repeal and Sunset provisions of the 2001 Act put a greater premium
on creating and maintaining estate plans that are as flexible as possible.
Under the 2001 Act, the estate
tax credit equivalent will increase in irregular stages, beginning in
2002: In 2002 and 2003, the estate and
gift credit equivalent will both be $1 million, in 2004 and 2005, the estate
tax credit equivalent and the GST exemption will increase to $1.5 million, in
2006-2008 to $2 million, and in 2009 they are scheduled to reach $3.5 million. The increased estate tax credit equivalent
will allow a married couple to make deathtime transfers of double the amount of
the credit equivalents (i.e., $2 million in 2002-2003, $3 million in 2004-2005,
$4 million in 2006-2008 and $7 million in 2009).
The GSTT $1 million exemption
(as adjusted for post 1997 inflation–$1,060,000 in 2001) will continue in
effect, with adjustments for post-1997 inflation until December 31, 2003. Beginning in 2004 the GSTT exemption will be
an amount equal to the estate tax credit equivalent (i.e., $1.5 million in
2004-2005, $2 million in 2006-2008, etc.).
B. Cuts in Tax Rates
In 2002, the maximum estate and
gift tax rate will drop from 55 to 50 percent.
The rate will drop an additional 1 percent per year for the next five
years before stabilizing (temporarily) at 45 percent in 2007. The GST tax rate,
which is pegged at 50 percent of the maximum estate tax rate, will decline
correspondingly. Thus, the present GSTT
rate of 27˝ percent (.50 x .55) will decrease by half the cuts in the estate
tax rates, until it reaches 22˝ percent (.50 x .45) in 2007. While the estate and GST taxes are scheduled
to expire at the end of 2009, on January 1, 2011, they may be revived by the
Sunset provision of the 2001 Act.
The gift tax will continue in effect
after 2009, but at somewhat reduced rates.
On January 1, 2010, the rate on taxable gifts of $250,000 to $500,000
will drop from 34 to 31 percent, and a flat rate of 35 percent will apply to
taxable gifts in excess of $500,000.
Prior to 2010, taxable gifts between $250,000 and $500,000 were subject
to a 34 percent rate and gifts above $500,000 would have been subject to rates
of between 37 and 45 percent. Under the
2001 Act, the maximum gift tax rate on post-2009 gifts is the same as the
maximum income tax rate applicable to individuals. Tying the maximum gift tax rate to the maximum income tax rate is
justified on the ground that the gift tax is retained after 2009 in order to
preserve the integrity of the income tax.
The credit equivalents
and maximum rates under the prior law and the 2001 Act are set forth in the
following table:
|
Calendar Year |
Estate and GST* Tax Deathtime Credit
Equivalents Prior Law 2001 Act |
Gift Tax Credit Equivalent 2001 Act |
Maximum Estate and Gift Tax Rates Prior Law 2001 Act |
||
|
2002 |
$700,000 |
$1 million |
$1 Million |
55% |
50% |
|
2003 |
$700,000 |
$1 million |
" |
" |
49% |
|
2004 |
$850,000 |
$1.5 million |
" |
" |
48% |
|
2005 |
$950,000 |
$1.5 million |
" |
" |
47% |
|
2006 |
$1 million |
$2 million |
" |
" |
46% |
|
2007 |
$700,000 |
$2 million |
" |
" |
45% |
|
2008 |
$700,000 |
$2 million |
" |
" |
45% |
|
2009 |
$850,000 |
$3.5 million |
" |
" |
45% |
|
2010 |
$950,000 |
Taxes
Repealed |
" |
" |
Gift Tax at Top Individual Income Tax Rate |
|
2011 |
Sunset provision of 2001 Act restores prior provisions of all taxes. |
||||
* Until January 1, 2004,
the GSTT exemption is fixed at $1 million, adjusted for post 1997 inflation
(i.e., $1,060,000 in 2001). Beginning
in 2004, the same amount will be allowed as the GSTT exemption and the estate
tax credit equivalent (i.e., $1.5 million in 2004-2005, etc.).
C. Winners
Under the 2001 Act
The big winners under the 2001
Act are wealthy individuals who survive until at least 2002, when upper estate
tax rates are cut by 3-5 percent. In
2001, amounts between $2.5 million and $3 million are subject to a 53 percent
estate tax rate and a rate of 55 percent applies to amounts above $3
million. In 2002, the rate on amounts
above $2.5 million is cut to 50 percent.
Thus, in 2002 the estate tax imposed on a taxable estate of $20 million
will be almost $900,000 lower than if the tax were imposed at the present
(2001) rates. The wealthiest taxpayers,
of course, also benefit the most from the income tax changes. The maximum income tax rate is scheduled to
drop from 39.6 percent to 35 percent.
In contrast, the 36 percent bracket will only drop to 33 percent, the 31
percent bracket to 28 percent and the 28 percent to 25 percent.
The 2001 Act does not cut the
estate tax rates that apply to taxable estates of $2.5 million or less. However, taxpayers with estates in that
range will benefit from the scheduled increases in the amount of the estate tax
credit equivalent that begin in 2002.
As explained below, later scheduled increases in the estate tax credit
equivalent will eliminate the estate tax for estates of $1.5 million in
2004-2005, $2 million in 2006-2008, and $3.5 million in 2009.
D. Losers Under the 2001 Act—States and
Charities
Curiously, the states are the
big losers under the 2001 Act—most of which will suffer substantial revenue
losses beginning in 2002 when the state death tax credit begins to phase
out. In 2002, the credit shrinks to 75
percent of the present amount, in 2003 it slips to 50 percent, in 2004 to 25
percent, and in 2005 it is replaced by a deduction. Is this the Bush administration's approach to revenue sharing?
Charities may also turn out to
be big losers under the 2001 Act—as a result of changes made, and not made, by
the 2001 Act. First, by reducing income
and transfer tax rates, the 2001 Act correspondingly diminishes the tax
benefits of making charitable gifts. Of
course, the extent to which tax cuts will discourage charitable gifts, if any,
is unknown. In addition, the 2001 Act
disappointed many charitable organizations and individual taxpayers who hoped
it would include changes that would further encourage an increase in charitable
giving by individuals. One hoped-for
change would have allowed taxpayers who do not itemize their deductions to
deduct the full amount of charitable gifts.
(From 1982 through 1986, taxpayers who did not itemize deductions were
allowed to claim a limited deduction for charitable contributions.) Another change sought by charities would
have allowed donors a charitable deduction for contributions of interests in
IRAs and qualified plans without including any amount in their income.
II. Miscellaneous
Changes Made by the 2001 Act
The 2001 Act changes many other
provisions, some of which are more important than others. While some of the changes are relatively
minor, even those are generally beneficial, including ones that affect the
exclusion for contributions of qualified conservation easements, the election
to defer payment of the estate tax for up to 15 years, and the use of the GSTT
exemption and the division of trusts for GSTT purposes. On the negative side, effective January 1,
2004, the 2001 Act repeals IRC Section 2057, the deduction for qualified
family owned business interests (QFOBI).
A. Qualified
Conservation Easements, IRC Section 2031(c)
The 2001 Act expands the scope
of the estate tax exclusion for gifts of conservation easements by eliminating
the requirement that the land subject to the easement be within specified
distances of a metropolitan area, national park, wilderness area, or urban
national forest. Under the amended provisions
of IRC Section 2031(c), which applies to decedents dying after 2000, the
exclusion is allowable for qualified conservation easements with respect to
land located anywhere in the United States or its possession. The maximum amount of the exclusion remains
unchanged by the 2001 Act, at $400,000 in 2001 and $500,000 thereafter. Some planners and environmental advocates
were disappointed by the failure to increase the maximum allowable amount of
the exclusion.
B. Deferred
Tax on Business Interests, IRC Section 6166
Effective with respect to
decedents dying after 2001, the 2001 Act extends the estate tax deferral
benefits of IRC Section 6166 to businesses with an increased number of
shareholders or partners (from 15 to 45).
Act Section 571(a). The
extension can be of substantial benefit to estates that will now be able to
satisfy the requirements of IRC Section 6166.
In a bit of special legislation,
Act Section 571(b), amended IRC Section 6166(b) to allow the
estate tax on interests in qualifying lending and finance businesses to be paid
in five equal installments.
C. GSTT
Changes
The 2001 Act made several welcome
changes in rules affecting the GSTT exemption and the division of trusts. Act Section 561(a) adds new subsections
(c) and (d) to IRC Section 2632.
Deemed Allocation of GST Exemption. New IRC subsection 2632(c), which applies to transfers
made after December 31, 2000, helpfully provides for the deemed allocation of a
grantor's unused GST exemption to a defined class of trusts called "GST
trusts"—which are ones to which deemed allocations would previously not
have been made. As defined, the term
GST trusts appropriately excludes trusts that provide for specific types of
distributions or are charitable lead annuity trusts or charitable remainder
trusts. The specific types of
distributions that will cause a trust to be excluded, and no deemed allocation
made to them, include ones, (1) with respect to which more than 25 percent of
the corpus must be distributed to or may be withdrawn by (a) one or more
nonskip persons before attaining age 46, or (b) one or more persons who are
living at the time of the death of another person who is their senior by 10
years or more; (2) any portion of which is includible in the estate of a
nonskip person other than the transferor if he or she died immediately after
the transfer. Under subsection (c)(5),
an election against the deemed allocation may be made on a timely filed gift
tax return. Consistent with other
provisions, a deemed allocation under the new rules will only occur at the end
of the estate tax inclusion period as defined in IRC
Section 2642(f)(3).
Retroactive Allocation of GST Exemption. New IRC subsection 2632(d) allows a transferor
retroactively to allocate his or her GST exemption to trusts to which an
allocation or deemed allocation had not previously been made. The allocation can be made upon death, in
2001 or later, of a nonskip person who was a lineal descendant of the
transferor's grandparent (or of the grandparent of the transferor's spouse or
former spouse), and who had an interest or future interest in a trust to which
the transferor had made a transfertypically the transferor's
child. The transferor's GST exemption
may be allocated on a chronological basis to any or all transfers made to the
trust on a gift tax return that is timely filed for gifts made in the year of
the nonskip person-descendant's death.
For purposes of the allocation, the value of the transfers are
determined as if the allocation had been made on timely filed gift tax returns.
Division of Trusts. An
addition to IRC Section 2462(a) recognizes the effect of a post-2000
division of a trust into two or more trusts that is a "qualified
severance." Importantly, the
amendment allows a qualified severance to be made at any time. A qualified severance means the division of
a single trust on a fractional share basis into two or more trusts that
provide, in the aggregate, for the same succession of interests of
beneficiaries as in the original trust.
If a trust has an inclusion ratio greater than zero and less than one, a
severance is a qualified severance only if it is divided into two trusts, one
of which receives a fractional share of all trust assets equal to the
applicable fraction of the single trust immediately before the severance. In such an allocation the trust that
receives the fractional share will have an inclusion ratio of zero and the
other trust will have an inclusion ratio of one. The amendment is most welcome—the existing regulations only
recognize the effect of divisions that were made at the inception of a
trust.
D. Qualified
Family Owned Business Interest Deduction, IRC Section 2057
Under IRC subsection 2057(a) of
existing law, estates that include a family owned business may benefit from
both the credit equivalent and the qualified family owned business interest (QFOBI)
deduction. In combination, the QFOBI
deduction and the unified credit allow as much as $1.3 million to pass tax-free
to a decedent's qualified heirs.
The 2001 Act repeals the QFOBI
deduction in 2004 when the credit equivalent reaches $1.5 million. In effect, the present combined benefit of
$1.3 million remains in effect until January 1, 2004, when the estate tax
credit equivalent becomes $1.5 million and the QFOBI deduction is repealed. The repeal will be hard to justify to the
owners of small businesses: Over the
next three years, the estate tax credit equivalent for ordinary taxpayers will
increase by $825,000 (from $675,000 in 2001 to $1.5 million in 2004). Over the same period, the combined benefit
of the credit equivalent and the QFOBI deduction will increase by only
$200,000. While the QFOBI deduction is
complex and recapture provisions require payment of some of the tax benefit if
the business interest is disposed of within ten years, it has been of
substantial benefit to the owners of many farms and small businesses.
E. Income Tax
Changes, IRAs, and Carryover Basis
The income tax changes made by the
2001 Act, including reductions in income tax rates and increases in the amount
of allowable contributions to IRAs and qualified plans, are of relatively
little significance to most estate planning clients. Section 601 of the 2001 Act amends IRC Section 219(b) to
increase the basic deductible amount for contributions to IRAs to $3,000 in 2002-2004,
$4,000 in 2005-2007, and $5,000 in 2008 and later. In addition, persons over age 50 may contribute an additional
$500 in 2002-2005 and $1,000 in 2005 and later.
Carryover Basis. Income tax considerations will have a major impact on
estate planning if the estate tax repeal takes effect as scheduled in
2010. If it does, the basis rules of
IRC Section 1014 are repealed, and the new rules of Section 1022 will
determine a recipient's basis in assets acquired from a decedent. Under the new rules, an aggregate basis of
up to $1.3 million could be allocated to assets that are included in a
decedent's estate and an additional $3 million in aggregate basis could be
allocated to assets that pass to a surviving spouse or to a qualified
terminable interest trust for his or her benefit. To the extent the basis in assets in community property assets is
stepped up by those provisions, the surviving spouse's basis in the other half
of those assets will also be stepped up.
A decedent's basis in all other assets would carry over and be adopted
by the recipients.
III. Planning Implications of the 2001
Act
The following analyses,
observations and suggestions are generally relevant to all clients—whether they
have, or do not have, estate plans in place.
The suggestions are, of course, particularly relevant to clients who are
in the process of planning their estates.
A. Overview
As indicated above, existing
estate planning strategies and techniques—and the existing plans of most
clients—are unaffected by the 2001 Act.
Accordingly, clients may adopt or continue sound estate planning
techniques, all of which remain available.
B. Review
Existing Plans
Existing estate plans should be
reviewed, particularly to determine whether the existing form of credit
shelter, marital deduction, and other formula gifts remain appropriate in light
of the increases in the estate tax credit equivalent that will take effect
beginning in 2002. It is also important
to determine whether trust documents or local law allow the qualified severance
of trusts—which could be important for GST purposes. The holdings of clients in closely held businesses should be
analyzed to determine whether they qualify, or could be modified to qualify,
for the deferred payment of estate taxes under the amended provisions of IRC
Section 6166.
C. Review
and Possibly Revise Formula Gifts in Wills and Trusts
Existing estate planning
documents should be reviewed, and new ones prepared, in light of the scheduled
increases in the amounts that can be passed free of tax and changes in the tax
rates. Thus, the formulas usually give
as much as possible to other beneficiaries—often outright to the children of a
prior marriage or to a credit shelter trust for their benefit. Accordingly, a formula gift could result in
too much passing to beneficiaries other than the surviving spouse.
The problem of unintentionally
passing too much property to the credit shelter trust does not arise, or at
least is not so intense, if the surviving spouse is also the sole, primary
lifetime beneficiary of the credit shelter trust. The problem also does not arise if the testator's entire estate
is left to a QTIP trust, of which the surviving spouse is necessarily the only
lifetime beneficiary, and with respect to which the decedent's executor could
make a partial QTIP election. (The
benefit of the decedent's remaining credit equivalent could be preserved by
making a partial QTIP election). Of
course, even in the case of a QTIP trust, the surviving spouse may need
additional protection if the trustee is, or may be, hostile to her interests
(possibly one or more of the decedent's children who are also the remaindermen
of the trust). In such a case the
surviving spouse could be given a 5 or 5 power of withdrawal—which could be
limited to the amount by which 5 percent of the principal value of the trust
exceeds the amount of income she received from it.
Some clients may wish to pursue
another alternative if the surviving spouse, or another person whose interests
will not be adverse to the surviving spouse, will have power to make a QTIP
election. Under it, the amount of
property passing to a QTIP and to a credit shelter trust (or to others) is
determined by the QTIP election itself.
The surviving spouse could have an interest in the credit shelter trust
and a special power of appointment over it. (The regulations allow the QTIP
election to control the extent of the property over which the surviving spouse
has the necessary qualifying income interest for life.[1]) The approach is akin to ones in which any interests in
a QTIP trust that the surviving spouse disclaims will pass to a credit shelter
trust or to others. However, in the
latter case the surviving spouse cannot retain a special power of appointment
over the property unless it is limited by an ascertainable standard.
Possible Solutions—Limits or Caps on Gifts to Others. In some cases, a husband or wife may wish to limit the
extent to which property would pass to or for the benefit of persons other than
the surviving spouse, who may be children of the testator by a prior
marriage. A client might choose to
resolve the matter in a variety of ways.
A testator might, for example, wish to make the children and the
surviving spouse beneficiaries of fixed separate shares of the credit shelter
trust. For example, the testator's
children might be the beneficiaries of a fractional share of the trust. The share might be determined by a fraction,
the numerator of which is $675,000 (the credit equivalent in 2001), and the
denominator of which is the estate tax credit equivalent allowable at the time
of the testator's death ($1 million in 2002-2003; $1.5 million in 2004-2005, $2
million in 2006-2008, and $3.5 million in 2009). The surviving spouse would be the beneficiary of the balance of the
trust. Some testators might, instead,
prefer to forego the full use of the credit equivalent by "capping"
the amount that would pass to the children or to a credit shelter trust. A cap might also be desirable if a
substantial part of the testator's estate consists of assets that fluctuate widely
in value (e.g., shares of high tech, bio-tech, and .com companies).
Formula gifts are usually tied to
the amount of the deceased spouse's remaining unified credit. They typically take the form of either: (1)
an upfront gift to the surviving spouse or to a trust for his or her benefit of
the required minimum amount; or (2) an upfront gift of the maximum amount to a
credit shelter trust. Whichever
approach is used, the scheduled increases in the credit equivalent will
allocate increasingly larger amounts to the nonmarital beneficiaries (i.e., the
credit shelter trust, the children of the deceased spouse, or others). The point is illustrated by the following
example.
Example: H's
will makes a formula gift to a credit shelter trust (the beneficiaries of which
are his children by his first marriage) of the maximum amount that can pass
without incurring any tax liability and leaves the balance of his estate to a
QTIP trust for his wife W. If H dies in
2001 the credit shelter trust will be funded with property worth $675,000; if
he dies in 2002 the trust will receive $1 million; if H dies in 2009 it will
receive $3.5 million, etc. The trust
for W will receive a correlatively smaller amount.
The
status of a client’s closely held business interests should be reviewed in
light of the increase from 15 to 45 in the number of shareholders or partners
allowed under IRC Section 6166(b).
Act Section 571(a). The
amendment is effective with respect to decedents dying after December 31,
2001. Because of the increase, the
estates of more owners of interests in family owned businesses may qualify, or
may be planned to qualify, for the 15 year deferred payment of the estate
tax. Few businesses will qualify for
the new provisions of IRC Section 6166(b)(10), Act Section 571(b),
that allow installment payment of the estate tax attributable to interests in
qualifying lending and finance businesses.
Businesses only qualify if they meet specific requirements regarding the
number of employees, amount of gross receipts, and sources of income.
E. Freeze
or Reduce the Tax Value of Assets
Clients should be encouraged to
consider ways in which the gift and estate tax value of assets may be frozen or
reduced. The outright gift is the
simplest way to freeze the gift and estate tax value of an asset. Of course, the tax value of more valuable
assets can be frozen by selling them to family members in an installment
sale. Value reduction techniques
include the formation of family limited partnerships, or LLCs, interests in
which usually qualify for substantial gift and estate tax discounts, and the
creation of grantor retained annuity trusts (GRATs), or irrevocable trusts of
other types. Gifts of fractional
interests in real property also qualify for discounts—most often in the 15-20
percent range. Thus, a gift of a
one-half interest in a parcel of real property worth $100,000 may have a gift
tax value of less than $50,000, quite possibly only $40,000. The value of the donor's retained interest
would be similarly reduced.
F. Gifts
and Other Basic Strategies
Most clients whose estates are
in a taxable range (i.e., more than $2 million per couple) should consider
making, or continuing to make, annual exclusion gifts. Doing so will remove from a donor's estate,
the value of the gift, including its future growth in value and any income it
generates. Annual exclusion gifts may
be made in various forms, most often outright or to discretionary trusts with Crummey
withdrawal provisions. Annual exclusion
gifts in trust may, of course, be made to the custodians for minor
beneficiaries under the Uniform Transfers to Minors Act or to trusts for minors
that meet the requirements of IRC Section 2503(c).
Clients with the capacity to
make substantial additional gifts should consider doing so early in 2002 in
order to take advantage of the $325,000 increase in the credit equivalent (from
$675,000 to $1 million). The same class
of clients should consider funding GSTT exempt trusts with all, or the
remainder, of their credit equivalent and their unused GST exemption. From the federal transfer tax perspective,
the potential benefit of such trusts is enhanced if the grantor is treated as
its owner for income tax purposes and, thus, remains taxable on its
income. Note, in this connection that
under the 2001 Act, post-2009 transfers made to a trust are not treated as
taxable gifts if the grantor is treated as the owner of the trust for income
tax purposes. Act Section 511,
amending IRC Section 2511(c).
The elements of a gifting plan
should, of course, take into account relevant nontax factors including the age,
health, experience, and capacity of a client and the client's dependents and
other intended donees or beneficiaries.
Somewhat different planning considerations will apply to clients who are
not likely to survive until 2009 (when the credit equivalent is scheduled to
become $3.5 million) or 2010, when the estate tax repeal may take effect. For example, in the latter case, it may be
appropriate to recommend making substantial taxable gifts. The gift tax paid with respect to taxable
gifts is not included in the donor's estate tax base if he or she survives for three
years or more following the gift.
Consider Making Use of Increased $1 Million Credit Equivalent in 2002. Clients who can afford to make substantial additional
gifts should consider doing so early in 2002 in order to take full advantage of
the $325,000 increase in the gift tax credit equivalent that becomes effective
on January 1, 2002. Depending on the
circumstances, a client might make additional gifts in various ways. Some might choose to make additional outright
gifts to adult children, while others would transfer larger amounts to grantor
retained annuity trusts (GRAT).
Significant overall tax benefits can result from transferring property
to a GRAT that is likely to appreciate substantially. Gift planning will be somewhat simpler in 2002 when the estate
and gift tax credit equivalent and the GST exemption will be at essentially the
same levels.
Consider Creating GSTT Exempt Dynasty Trusts. As suggested above some wealthier clients may wish to use
some or all of their gift tax credit equivalent and GST exemptions by creating
one or more GSTT exempt trusts. In
2002, a couple could transfer up to $2 million to a trust without incurring any
out-of-pocket gift or GST tax cost.
Clients can, by creating such a trust, provide benefits to their
descendants and insulate the trust property from the reach of the beneficiaries
creditors—and would be predators. In
the states that have repealed or modified the Rule Against Perpetuities (e.g.,
Alaska, Delaware, Florida, and South Dakota), a dynast trust could last for
many generations.
The trust could be defective for
income tax purposes, as a result of which the grantor would be treated as the
owner of the trust for income tax purposes and would be required to pay the
income tax attributable to the trust.
Such an approach is desirable in part because the income tax rates
applicable to estates and trusts were not reduced by the 2001 Act and, hence,
will be higher than the rates applicable to individual taxpayers.
A variety of techniques can be
used to cause the grantor to be treated as the owner of the corpus and income
of a trust. One popular approach is to
include a power that allows the grantor to reacquire the property of the trust
by substituting property of equal value.
See IRC Section 675(4).
Another is to give a nonadverse party, such as the trustee, the power to
add beneficiaries. The power to add
charitable beneficiaries is sufficient for this purpose. See Bernard Madorin, 84 T.C. 667
(1985) and PLR 199936021. The trust
would be more flexible if the trustee could terminate the status should it
become desirable to do so. Thus, the
trustee might be given the power to terminate the grantor's power to substitute
other property or to release the trustee's own power to add charitable beneficiaries. Under a slightly different approach, the
trust could allow the trustee later to amend the trust in ways that would give
the grantor a power that would cause the grantor thereafter being treated as
its owner for income tax purposes.
Again, the power might be subject to later termination by the
trustee. Inclusion of such a power is
also important because, after 2009 (i.e., after estate tax repeal), transfers
to a trust will be subject to the gift tax unless the grantor is treated as the
owner of the trust for income tax purposes.
Making Taxable Gifts in Excess of $1 Million Credit
Equivalent May be Hazardous to a Client's Wealth. Although the scheduled repeal of the estate and GST taxes
may not take place on January 1, 2010, clients should be reluctant to make
gifts that will require the payment of any gift tax. The reason is simple—Why should a client pay a gift tax at a
marginal rate of 41 percent on gifts in excess of the $1 million gift tax
credit equivalent, when the property might pass to the intended donees free of
any tax if the owner dies after 2009?
In some cases, making taxable
gifts could produce unfortunate results—particularly depending on whether the
donor dies before or after 2009.
Consider the following example:
Example: In 2002, Mr. Gotrocks, who had previously made no taxable
gifts, made taxable gifts of $1.5 million to his children. In April 2003, he paid a gift tax of
$210,000. Mr. Gotrocks made no more
taxable gifts and died in 2009, leaving a taxable estate of $2 million.
Combining the value of his taxable estate and his taxable gifts yields a total
of $3.5 million. As a result of the
increase in the estate tax credit equivalent to $3.5 million no estate tax is
due from Mr.Gotrock's estate.
Unfortunately, the gift tax he paid will not be refunded to his estate
or his beneficiaries.
In limited instances making
taxable gifts in excess of the credit equivalent may be appropriate. For example, taxable gifts may be of tax
benefit to a client who is expected to survive for three or more years and to
die before 2010, leaving a taxable estate that exceeds the amount of the
allowable estate tax credit equivalent.
Make Incomplete Gifts, Perhaps to Income and Gift Tax
Defective Trusts. Wealthier
clients may wish to make incomplete (i.e., nontaxable) gifts to an unusual type
of trust. The transfers would be
attractive, in part, as a low cost gamble that the estate tax will be
repealed. The approach is also
attractive because it has little, or no, downside tax risk.
The plan involves transferring
property to an irrevocable trust that is intentionally defective for income and gift tax purposes. Transfers to such a trust do not constitute
completed gifts. The desired tax status is achieved if the grantor retains a
special testamentary power of appointment and an independent trustee has
discretion to distribute income and principal to a class that includes the
grantor. Gifts to irrevocable income
and gift tax defective trusts may be attractive because of the scheduled repeal
of the estate tax. Transfers to such a
trust would be incomplete gifts that are not subject to any present gift tax
liability. The 2001 Act also amends IRC
Section 2511(c), to provide that post 2009 gifts to a trust are incomplete
if the trust is treated as wholly owned by the donor under IRC
Sections 671-677. In combination,
these rules mildly encourage clients who have already used their $1 million
credit equivalent to make transfers to trusts that would be treated as
incomplete and of which they are treated as the owner for income tax purposes. The latter feature also allows sales to be
made between the grantor and the trust without being subject to the capital
gains tax.
Most distributions of income or
principal to persons other than the grantor would be treated as gifts by the
donor. However, distributions that
constitute qualified transfers (i.e., the direct payment of tuition or the
medical care insurance or other medical expenses of children, grandchildren, or
others) are excludible for gift tax purposes and are not subject to the GSTT. IRC Sections 2503(e) and 2611(b). Thus, distributions from the trust could be
made to meet educational and medical expenses of the grantor's family. Taxable gifts would occur if the trustee
could make other distibutions to persons other than the grantor. Of course, if it appears desirable to do so,
the trustee could unwind the trust in whole or in part by making distributions
to the grantor. Because of the
grantor's retained interests, the trust would provide little, if any,
protection against the grantor's creditors.
Under existing law, no gift
would take place when the trust was created or when the donor dies and the
power of appointment is exercised or lapses.
Historically, the gift tax has not been applied to gifts that become
complete when the donor dies. If the
estate tax is no longer in effect when the grantor dies, the trust property
will pass to the appointees of the grantor or designated takers in default
without having been subject to any federal transfer tax.
Overall, the downside tax risk
of the trust is limited. Gifts to such
a trust would only be reached by the estate tax, which is scheduled to expire
on January 1, 2010. If the estate tax
is in effect at the time of the grantor's death (i.e., either the grantor dies
before 2010 or the estate tax is not repealed), the property of the trust would
be included in the grantor's gross estate.
However, the property would have been fully includible in the grantor's
estate if the trust had not been created.
In addition, the grantor's estate would not include the amount of income
tax that he had paid with respect to the trust and amounts of qualified
transfers (i.e., direct payments of tuition and medical care). On the other hand, if the gifts to the trust
had constituted completed gifts and were made more than three years prior to
the grantor's death, the tax base would not include: (1) the income generated
by the trust; (2) any subsequent appreciation in value of the trust assets; and
(3) the amount of the gift tax paid.
However, the effect of inclusion could be blunted if the grantor
exercised his retained power of appointment by appointing the trust property to
a trust for which the estate tax marital deduction is allowable.
G. Charitable
Gifts and QPRTs and Other Trust Plans
Although the tax cuts made by
the 2001 Act slightly diminish the tax benefits of making charitable gifts,
incentives remain, including all of the nontax reasons for doing so. Accordingly, clients may wish to consider
and implement a charitable gift plan, perhaps one including a charitable
remainder trust. Clients may also wish
to consider the advantages of creating Qualified Personal Residence Trusts
(QPRTs) and, possibly, other forms of irrevocable trusts. A form of irrevocable trust that is
incomplete for gift and income tax purposes may be of interest to some
clients. See Part III.
H. Hedging
Estate Tax Repeal; Term Life Insurance
A client whose estate may face a
liquidity problem may wish to consider making gifts to fund the acquisition of
term life insurance. Many clients would
be reluctant to purchase more expensive cash value policies in view of the
scheduled repeal of the estate tax.
Gifts for the purpose of buying life insurance on a client's life are
most often made to the client's adult children or to an irrevocable life
insurance trust (ILIT). In either case,
the insurance proceeds would not be included in the client's estate. If the estate tax is repealed the client
might cease making gifts and allow the insurance to lapse. If the estate tax remains in effect, gifts
and the term insurance coverage might be continued.
The changes made by the 2001 Act
provide good reasons for most clients to review their estate plans, including
their choices of executors and trustees. In addition, clients with the capacity
to do so should consider making annual exclusion gifts and gifts up to the
limit of the gift tax credit equivalent ($1 million in 2002 and
thereafter). As discussed above in Part
III F, care should be exercised in selecting the form of gifts. Some clients
may wish to make gifts in excess of the credit equivalent by making incomplete
gifts to trustswhich could be particularly beneficial if the estate tax
is ultimately repealed. Against the
possibility of death before repeal, or no repeal, clients should also be
encouraged to consider other estate planning techniquesparticularly
ones that may reduce the tax value of their estates. Finally, clients whose estates may have liquidity problems should
consider funding the purchase, by adult children or ILITs, of insurance on
their lives. Despite tax reform and
medical progress, it seems almost certain that both death and taxes will remain
with us indefinitely.
I. The Technical
Provisions
A. Tax Rates
Section 101(a)(i)(2) of the
Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Act) provides
that for calendar year 2001 the top rate applicable to estates and trusts will
be 39.1 percent instead of the 39.6 percent under the pre-2001 Act Internal
Revenue Code. This means that for
Electing Small Business Trusts (ESBTs), the flat rate applied to the ESBT
portion will be 39.1 percent for 2001.
The top rate then is reduced for subsequent years as follows: years 2002 and 2003, 38.6 percent, 2004 and
2005, 37.6 percent, 2006 and thereafter, 35 percent. Currently existing nondeductible amounts involving: (a) the
phaseout of the personal exemption(s) and (b) the limitation on itemized
deductions will be inapplicable after 2009 (Act Sections 102 and 103). These nondeductible provisions are retained
as under current law through 2005, the reductions will be only two-thirds in
2006 and 2007 and one-third in 2008 and 2009.
Although the 2001 Act carves a
new 10-percent tax bracket out of a portion of the current 15-percent bracket,
it is clear that the new tax bracket is applicable only to living persons since
Act Section 101(c)(1) excludes estates and trusts; therefore, estates and
trusts will not gain the benefit of the new lower brackets. Similarly, the tax credit for 2001 that is
refundable and anticipated to be distributed in late summer/early fall to
“human” individuals is not applicable to estates and trusts, and they will not
receive the $300 credit refund check ($500 for head of household and $600 for
married couples filing joint returns).
B. Carryover Basis
Act Section 541 terminates the step up in basis to fair market
value for property acquired from a decedent
at death, and Act Section 542 provides a new
Internal Revenue Code Section 1022 that
applies to decedents dying after December 31, 2009, by treating property
transferred at death as if transferred by gift for determination of heirs'
basis, e.g., such basis will be the lesser of the
decedent's tax basis or fair market value at date of death. To mitigate complete application of
carryover basis to all assets of a decedent, new IRC Section 1022(b) provides
that the executor of an estate can increase the basis in assets owned by the
decedent by up to a total $1.3 million (that will be indexed for
inflation). In addition, this new
section allows the tax basis to be increased by the amount of decedent's
capital loss and net operating loss carryovers. Moreover, basis will be increased by the amount of any losses
that would have been allowable under Section 165 of the Internal Revenue Code
had property acquired from a decedent been sold at fair market value
immediately before the decedent's death (e.g., built-in losses). For non-resident aliens, the $1.3 million
step-up is reduced to $60,000, and the special basis increases for unused
built-in losses and loss carryovers are not applicable. Of significant consequence is a special additional
basis increase under new IRC Section 1022(c) for property acquired by a
surviving spouse. The basis of qualified
spousal property (QSP) that is bequeathed by a decedent to a surviving
spouse can be increased by up to $3
million (in addition to the above-described $1.3 million per estate step-up in
basis). QSP includes outright transfer
property and qualified terminal interest property. For this purpose, outright transfer property is defined to mean,
"any interest in property acquired from the decedent by the decedent's
surviving spouse." Certain
limitations apply denying basis step up for property passing through third
parties between the decedent and the surviving spouse. Transfers by the decedent to spouse that are
returned back to the decedent within three years of death also are denied basis
step ups. Interests in foreign personal
holding companies, DISCs, and Passive Foreign Investment Company (PFICs) are
also excluded from step up in basis.
New IRC Section 1022(d).
Consistent with prior law, property that constititutes income with
respect to a decedent (IRD), as defined under IRC Section 691(a), will not
qualify for stepped-up basis. New IRC Section 1022(f). Property deemed owned in a revocable trust,
one half of joint tenancy property, and community property will qualify for step
up in basis, subject to the above rules of "capping" limitations and
exceptions. New IRC Section
1022(d). Property subject to a power of
appointment by the decedent will not qualify for basis step up. All of the dollar amount special tax basis
increases noted above (e.g., the $1.3 million and $3 million-surviving spouse
allowance) relate to the subject estate consisting of at least those amounts as
appreciation, i.e., excess of fair market value over decedent's basis at date
of death. In other words, the special
step-up provisions are effective only to reduce otherwise unrealized, potential
taxable gain existing at decedent's date of death. Basis cannot be increased to more than the fair market value of
the property at the date of death of the decedent.
Sale of Principal
Residence Gain. The exclusion of gain on sale of a principal residence
that currently is applicable to individual homeowners will be extended to heirs
who acquire such residence(s) from a decedent.
New IRC Section 121(d)(9). Also,
a qualified revocable trust, as defined under IRC Section 645(b)(1), that has
title to a residence will be able to take advantage of the principal residence
gain sale exclusion (now $250,000).
Pecuniary Beneficiary
Exception. If "appreciated carryover basis property" is
used to satisfy pecuniary bequests under will or by controlling trust document,
the appreciation element as of date of
death will not be taxed as a result of such funding; thus, the only gain
recognized will be the excess of fair market value at date of funding over the
fair market value at date of death. Act Section 542(d), amending IRC Section
1040(a) and (b).
Inherited Art is a Capital
Asset. Lastly, the definition of capital asset under IRC Section
1221(a)(3), where the exceptions to capital asset treatment are listed, has
been amended so that property subject to carryover basis under new IRC Section
1022 will be treated as a capital asset.
This section of the 2001 Act is Headed "Capital Gain Treatment for
Inherited Art Work or Similar Property," so sales or exchanges of
inherited property that falls within the step-up basis provisions of new IRC
Section 1022 will be treated as capital gain rather than ordinary income. Act Section 542(e)(2).
Transfers to
Non-Residents. Gain will be recognized for testamentary transfers by a
U.S. (citizen or resident) decedent to a non-resident alien, measured by the
appreciation element that is the excess of fair market value at death over
decedent's tax basis. Lifetime gifts
are exempt and excepted from this treatment (Act Section 542(e)(1) and (2)
amending IRC Section 684.) Also
excepted are transfers into trust by a U.S. person to the extent any U.S.
person is treated as owner of the trust under IRC Section 671. Act Sections 542(e)(1)(A) and (B).
Relevance of Grantor Trust
Income Tax Status to Treatment of Trust Transfers as Gifts. Unless
excepted by regulations to be issued under amended IRC Section 2511, transfers
in trust shall be treated as taxable gifts under IRC Section 2503, unless the
trust is treated as wholly owned by the donor or donor’s spouse under the
grantor trust deemed ownership provisions of Subchapter J. Act Section 511(e), amending IRC Section
2511(c), effective for gifts after December 31, 2009. This will place more importance on structuring a trust as a
"pure" grantor trust, i.e., one deemed owned solely by the grantor or
the grantor's spouse. Today, such grantor trusts are often created
with a Crummey draw down power to enable a transfer, which is
complete for gift tax purposes, to qualify for the $10,000 annual per donee
exclusion. It is uncertain whether
these trust transfers subject to draw down will continue to meet the gift
exception discussed above, once the estate tax is repealed in 2010. Thus, trusts that have been drafted with Crummey
provisions create no current concerns, but conceivably could become a problem
after 2009, because someone other than the donor (the person with the draw down
power) would also be considered a deemed owner in part. Until clarifying explanation and/or
regulations are issued, this uncertainty will continue.
Qualified Tuition Plans –
Income Tax Free. The 2001 Act provides a number of new and improved tax
breaks for education expenses. The
major education change is that qualified tuition plans (Act Section 402
amending IRC Section 529) are significantly improved. Beginning in 2002, amounts
distributed from a qualified state tuition
program (popularly called Section 529 plans) are excluded from the recipient
beneficiary's taxable income to the extent used to pay qualified higher
education expenses. These special
education plan treatments are also extended to programs established by eligible
educational institutions. Income earned
by such trust plans will be deferred in 2002 and tax free distributions may
commence in 2004. These changes should
provide incentive to parents, as well as grandparents, to fund second and third
generation education requirements with a very income tax favorable treatment to
all involved generations. The limit for
annual contributions to educational IRAs is increased from $500 to $2,000 in
2002. Contributions can be made to both
forms of education plans.
Retirement Savings
Liberalization. Both traditional IRA and Roth IRA plans are more
enticing, because annual contributions limitations will be increased from
$2,000 a year to $3,000 in year 2002, $4,000 in 2005 and $5,000 in 2008 (New
Act Section 601(a) amending IRC Section 219(b). Similarly, the annual 401(k)
and other retirement plan contributions limitations will be increased from
$10,500 currently to $11,000 in 2002, and thereafter by another $1,000 annually
until it reaches $5,000 in 2006.
Individuals over age 50 are entitled to special catch-up contributions
to IRAs, 401(k)s, and other retirement plans that permit deferral of
salary. Lastly, provisions for greater
portability of pension benefits allow a participant to transfer or "roll
over" benefits from one retirement plan to another, as well as between
IRAs and employer sponsored retirement plans. (Act Sections 602, 641-645). Act Section 611 increases the limitation on
defined benefit plans from $90,000 to $160,000, indexing for COLAs, and the
limitation on defined contribution plans from upon $30,000 to $40,000, again
subject to COLA indexation. The 2001
Act makes myriad "other" modifications and liberalizations to
retirement plan rules.
II. Avoiding
Taxable Gifts
It is likely there will be accelerated use of grantor retained annuity
trusts (GRATs) that by their terms leave little, if any, remainder interest
subject to gift tax by using the Walton
case (115 TC No. 41) approach. This
involves a short term, high rate payout and investment predictions about future
appreciation that go with that. The
income tax elements arise from: (a) the
fact that GRATs are grantor trusts and the transferor is liable for income tax
on income and/or gains generated by the GRAT, while the transferor is also an
annuity beneficiary, and (b) subsequent planning desires, such as a sale of the
annuity interest to further freeze value from gift tax or a sale of the
remainder by children to generation skipping or other entities, where future
appreciation may pass to other family or chosen non-family beneficiaries and
not be subject to gift tax. Both of these transactions do carry with them
considerations for the income tax treatment i.e., the nature of the gain and a
determination of what basis would be allocated to those interests.
Despite certain commentators'
views that the 2001 Act provision that subjects all forms of trust, except for
grantor trusts, to gift tax will inhibit installment sales to grantor trusts,
they should gain more attention, as just noted above for GRATs, because they
are very comparable in nature. It is beyond the scope of this text to discuss
all the intricacies of installment sales to a grantor trust, and in a limited
($1 million) gift tax exemption system, many will argue that ("zero
out") GRATs are better, since they generate very little or no gift tax
liability. Whereas in a sale to a
grantor trust, a certain amount of principal or corpus value must be funded in
that grantor trust to make the purchase a recognizable event from the point of view of the IRS (Cf: PLR
9535026). Since the transferor may be
concerned that the creation of such a trust with a large sale to it might be
subject to excessive gift tax, it is likely that under the new transfer tax
regime, the initial installment sale will be of a smaller amount than perhaps
it might have been previously.
Furthermore, just as GRATs will be created on a short-term
"roll-over basis," re-instituting them every two years or so, the
same approach is likely for installment sales grantor trusts, where initially a
moderate amount will be sold and once that hoped-for appreciation is realized
(not necessarily recognized in the tax context), the additional value will
support subsequent purchases. So this
approach will be the equivalent to a GRAT "rollover," e.g., a serial
sale by the grantor over a period of time to the grantor trust or as a
"rolling sale" as the trust value increases. There likely will be attempts to reduce the
amount of taxable gift in funding the grantor trust, whether it is a lower
percentage of the purchase price or use of guarantees, as some commentators
have suggested, to accomplish the initial purchase by the grantor trust. It is to be noted that continuation of the
grantor trust becomes more interesting to the grantor himself under the new
law, since gift tax free transfers can be accomplished by the grantor(s)
through payment of income tax on income realized by the trust. Thus, the grantor trust will likely be even
more alluring than it has been under the law prior to the 2001 Act.
There likely will be increase in
aggressive attempts to use "opportunity arrangements" that include
methods that allow the senior generation to direct investment by second and/or
a third generation based upon contacts, knowledge, abilities, etc. of the
senior generation. This allows gift-tax-free transfer of future investment
success, since the best planning avoids creation of an asset that is owned by
the senior generation.
Use of charitable lead trusts
will gain more attention as a means to diminish the value of the remainder
gifts, while simultaneously allowing the transferor donor to accomplish his
charitable giving desires. It may be accompanied by what was considered in
Private Letter Ruling 200107015, an "unplanned" gift of the remainder
interest by donor’s children to their children at a highly discounted value to
accomplish second to third generation estate planning at an insignificant gift
tax cost. Thus, the discount to the
remainder interest for the charitable lead income trust can be a very
interesting and important planning device.
The above described transfers
will be accompanied by a continued, if not increased, use of valuation
depressants to reduce gift tax exposure for all of the above type of transfers,
such as entity wrappers, including family limited partnerships (FLPs), limited
liability companies, (LLCs) and combinations thereof. In all of these transactions, more emphasis is likely to be put
on both leveraging and layering of entities.
Probably, more emphasis will be
placed on redemption of interests of senior generation minority shareholders of
S corporations or partners of family limited partnerships through a realization
of market rate discounts for minority interest that result in creation of
non-taxed gifts to the remaining family member shareholders or partners. Similarly, sophisticated entity ownership of
options that are sold to lower generations to accomplish discounted or gift tax
free transfers are likely to be used more frequently.
B. Loss Realization
More attention probably will be
paid to proactive planning; taxpayers will want to realize losses inherent in
assets during lifetime when gains exist to provide a tax-free offset. In addition, testators will pre-plan the
nature of assets that will be stepped up in basis should carryover basis
actually be implemented, such as tax shelter partnership interests and other recaptured
type investments. Drafters will have to
include directions in the controlling documents, so that less experienced
executors and/or trustees will do mechanically what serves the family best in
the circumstances. It seems likely that
what appeared first to be a temporary use of bequests to surviving spouses,
(especially step up in basis that in reality will become a permanent step up in
basis extended to the $3 million spousal allowance) should be a mandatory
requirement of almost every transfer document.
.
If implemented, the rules
requiring use of decedent's tax basis, not fair market value at date of death,
as the heirs' tax basis will cause significant changes in will and trust document
drafting, disposition planning, and additional record keeping. Note that carryover basis will be applicable
only to decedents dying in year 2010, unless Congress deigns to extend or make
permanent the estate tax repeal.
Meanwhile, taxpayers must maintain
accurate records regarding tax basis; this will be easier to do for asset
acquisitions made in year 2001 and thereafter.
A provision in a will or controlling document will be needed in case:
(a) a prospective decedent becomes legally incompetent in the near future, and
(b) repeal actually stays in the law, specifically if it is made
permanent. It is premature, however, to spend significant time and money to
reconstruct as much as possible evidence of tax basis for assets acquired a
long time ago. Likewise, many
uncertainties exist in the new law that likely will be clarified by the Joint
Committee "Blue Book," Treasury regulations, notices, etc., so
extensive current drafting of documents for carryover basis is not only
difficult to accomplish with certainty, but is unwarranted under current
political conditions, since the new Democratic leadership of the Senate has
announced its interest to "repeal the estate tax repeal," while
Republican members of the Senate and House of Representatives, and perhaps the
President as well, indicate a desire to make the repeal permanent.
Over the years, taxpayers have
often attempted to move money or assets between generations without gift tax
consequences, but the reviewing courts have not accepted the viability of these
methods. Particularly suspect are attempts to make intra-family loans that are
not repaid during lifetime and are bequeathed back to the obligor at
death. Based on a number of cases, it
is clear that the Tax Court, as affirmed by appellate courts, can determine
that a debt instrument, legally recognized under state law, still may not meet
the "bona fide" test for tax purposes, when there is an implicit or
explicit intent not to collect the debt by the lender. Thus, intra-family loans made
contemporaneously with trust or will documents that bequeath that note back to
the obligor are likely to be void for tax purposes and thus treated as an up
front gift during the transferor's lifetime. Moreover, even if the transferor
overcomes the gift tax hurdle, the heir/obligor may face a problem with income
realization on cancellation of debt under IRC Section 108. It is not certain that income tax exceptions
in IRC Section 102 will control. These
rules should be considered most carefully before intra-family loans are
completed. Other situations, such as
borrowing fair market value in excess of basis and then transferring the
property to charity or taxable entities confront provisions that deem
realization of the debt as sales proceeds.
The applicable Code sections are as follows: (a) if a partnership is
involved under IRC Section 752(d); (b) the part gift/part sale provisions of
Regulations Section 1.1011(b) for charitable transfers, (c) Regulations Section 1.1001-2 that
consider sales proceeds have been received to the extent that any debt relief
is accomplished in discharge by transfer.
Moreover, in many of the proposed planning approaches, if the planning
events are challenged, the IRS and/or the courts may apply the integrated, step
transaction doctrine to assess income tax.
It would appear that all of the
above discussion applies equally to: (a) estates already planned; (b) estates
in the process of being planned; or (c) to those estates yet to embark on
overall estate planning. Likewise, all
of these elements are applicable to moderate wealth —$2 to $5 million,
significant wealth $5 to $xx million, and the wealthiest estate owners (fill in
your sum definition of that amount!!)
The possible repeal of the estate tax has been discussed
and debated in charitable planning circles for some time, usually in terms of
the adverse impact it might have upon charitable giving in general, and
charitable planning devices in particular.
Surprisingly, the actual enactment of the Economic Growth and Tax Relief
Reconciliation Act of 2001 (2001 Act) is more anticlimactic than really calamitous
for charities and charitable planners.
Certainly, some charitable planning devices will be
affected, and some clients may even choose to forego charitable transfers they
had been contemplating. These
developments are probably inevitable, for some charitable transfers are
motivated in part by tax benefits, and the elimination or reduction of those
benefits will necessarily change the mix of planning considerations. On balance, however, the situation with
respect to charitable transfers is far less grave and demands less immediate
attention than might initially have been thought. True, as discussed elsewhere in this Special Alert, there are
estate planning considerations to be addressed in light of the 2001 Act, and
these may be serious in some instances.
Particularly in the case of medium-sized estates, perhaps in the $1
million to $5 million or so range, the changing exemption amounts can pose an
immediate and potentially serious threat to the client’s objectives. It will be necessary for many, perhaps most,
of the existing wills in this category to be reviewed to prevent unintended and
unexpected consequences.
The charitable transfers in these wills may also need to
be modified, but those changes will result more often from changes in the client’s
plans and intentions than from any need to act quickly to avoid undesired
consequences. In fact, the new law
actually does not include much that relates directly to the charitable
provisions of the Internal Revenue Code.
Earlier versions of the legislation, and the Administration’s tax
package that led to the 2001 Act’s passage, included several additional
charitable incentives, but these did not appear in the final bill passed by
Congress.
Unless a
testator’s will contains an outright mistake of some sort, there will be plenty
of time to think through any charitable changes that must be put into place,
for the effect of the 2001 Act on charitable planning is one of gradual change
rather than a sudden and exciting alteration of existing rules. True, the repeal of the estate tax, much
feared by some and hotly debated by all, is at least technically enacted in the
2001 Act. Repeal, however, will not
occur, if at all, until 2010, some nine and a half years (or just over 114
months) from the date of enactment.
Even then, the estate tax will spring back to life in 2011 unless some
future Congress repeals it again.
So, in the end, the 2001 Act is a much less important
event for charitable gift planners than it seemed while it was in
progress. True, there are some
significant changes and, as legislators are so fond of telling us, this is the
largest tax cut in 20 years and one of the largest ever. Most of the changes, however, are either in
other areas, where gift planning concerns are not directly involved, or have
such a long lead time that they are not really a factor yet. As a result, planners will have time to deal
with the changes at their own pace, without the sort of frantic, last minute
burst of activity that has marked most tax changes in recent history.
II. The
2001 Act Itself
According to official estimates, the 2001 Act is slated
to reduce government revenues by at least $1.35 trillion over the next ten
years. The true loss may be even
greater, since the effective dates of most provisions are delayed to reduce
their impact in the critical ten-year period used for budget and revenue
estimation purposes. Many big-ticket items, including the repeal of the estate
tax, come in only at the end of that period, so their cost would be much larger
if they continue. Aside from the sheer
size of the 2001 Act, however, most of its changes are neither sweeping nor
ingenious. From a charitable planning
standpoint, the principal changes include the following.[2]
Income tax rates will be reduced by a half percentage
point in each bracket this year and next, then a full percentage point in 2004
and 2006, to produce an eventual top bracket of 35 percent. A new ten percent bottom bracket is created
as well, and to reflect the effect of this change, all taxpayers will receive a
tax rebate of $300 ($600 for joint return filers) later this year. Lower rates have historically been viewed as
discouraging charitable gifts, since they reduce the tax savings produced by a
contribution and thereby increase the after-tax cost of the contribution. In
the case of the 2001 Act, however, the rate declines are probably too small and
too gradual to have a discernible effect in this area. Of course, a person contemplating a
deductible charitable transfer in December of a year during the period of
declining rates will always be ahead if he makes it immediately before the year
ends, rather than delaying it into the following year. There are two separate reasons for
this. First, as just described, the
deduction will produce a somewhat larger tax saving in the earlier year, when
rates are higher. In addition, the
deduction will be realized a year earlier, so that the time use of money factor
also will come into play.
In what may be the most significant direct charitable
change, the 2001 Act provides a gradual phaseout of the overall limitation on
itemized deductions – including charitable deductions. Under that rule, the
total itemized deductions otherwise allowable (other than medical expenses,
investment interest, and casualty, theft, or wagering losses) is reduced by
three percent of the amount of the taxpayer's adjusted gross income in excess
of $132,950 in 2001 ($66,475 for married couples filing separate returns).[3]
These amounts are adjusted annually for inflation. This rule is often referred to as the “Pease rule” after the
Congressman who invented this as a way to increase federal tax revenues
quietly, without the political stigma of actually “raising taxes.”
The
effect of this rule is to disallow some of a taxpayer’s total itemized
deductions. Since charitable
contribution deductions are included in this category, it has been viewed as
harmful to charitable giving. In
practice, however, it is usually not a factor, since most taxpayers already
have sufficient other itemized deductions (such as state and local taxes and
mortgage interest) to exceed the reduction amount; in this case, additional
deductions would not be affected.
Accordingly, under these conditions, the Pease rule would not disallow
deductions for any additional contributions the taxpayer might be
considering.
The Pease rule will disappear under the 2001 Act, but the
disappearance will not start for five years – beginning in 2006 – and will not
become fully effective until 2010.
The 2001 Act repeals the estate tax, effective for
persons who die after 2009. The 2001
Act then brings it back into effect (in its unamended 2001 version) the
following year. Until the eventual
repeal takes effect, the top estate tax rate will drop and the exemption amount
will increase as follows:
Estate Tax and GST Tax
Year Exemption Amount Top Rate
2001 $
675,000 (no change) 55% (no change)
2002 1,000,000 50%
2003 1,000,000 49%
2004 1,500,000 48%
2005 1,500,000 47%
2006 2,000,000 46%
2007 2,000,000 45%
2008 2,000,000 45%
2009 3,500,000 45%
2010 [estate tax is repealed]
2011
675,000 55%
[Of course, repeal proponents anticipate that the final
change in the table above will not occur, but more on that later.] Several other estate tax amendments also
take effect during this phase-out period.
The special deduction for family-owned business interests is repealed as
of 2004. The credit for state death
taxes is phased out between 2002 and 2004, and converted into a deduction
beginning in 2005. Moreover, the 2001 Act
clarifies the rules governing the estate tax exclusion for land subject to a
conservation easement. These changes are discussed elsewhere in this Special
Alert.
From the standpoint of charitable planning, the effect of
repeal is primarily the obvious one. To
the extent charitable transfers are motivated by estate tax savings, such
transfers will no longer be necessary.
A more difficult question is the extent to which such tax savings are an
indispensable factor, without which the transfer would not take place. The available research, including a landmark
study sponsored by National Committee on Planned Giving in 2000, suggests that
estate tax savings are an important factor for donors but not a controlling
motivation. People have been making
charitable bequests since long before there was an estate tax, and they will
certainly continue to do so if the repeal of the tax actually takes
effect.
Predictably, observers who predict that repeal would
spell serious declines in overall revenues for charitable organizations often
approach the issue from a primarily tax-oriented viewpoint. Others, who work primarily with charities
and donors making charitable transfers, tend to take a different view – based
upon a belief that people give to charities primarily because they wish to
support the work of those charities.
Only time will tell which camp is correct, but charitable giving in the
United States has generally increased year by year, despite tax changes that
are predicted to have an adverse impact.
Consider the fact that a charitable bequest, while it
does reduce estate taxes, does so at a cost of 100 percent of the amount
transferred. It would be somewhat
illogical to transfer one’s entire estate to charity solely to eliminate estate
taxes, for there would be nothing thereby saved for other, noncharitable
beneficiaries.
More important, elimination of the estate tax would leave
people with more property to dispose of as they wished. Consider the case of a person who has an
estate of $100 million and desires to leave as much as possible to family
members. Under present law, that person
would have $45 million net after taxes to dispose of as desired. If the estate tax repeal actually takes
effect, she would then have the full $100 million available. Can one conclude with any certainty that
none of that additional disposable property is likely to go to charity? Your author’s experience suggests that even
this person who places family beneficiaries first would be more willing to
include a charitable bequest in her estate plan with the extra $55 million for
distribution. For this reason, repeal
of the estate tax could even produce a sizable net gain for charity.
Unlike some earlier versions of the estate tax repeal
legislation, the 2001 Act does NOT repeal the federal gift tax. Top gift
tax rates are reduced (identically with the reductions shown above for the
estate tax) and a flat $1 million lifetime exemption is imposed beginning in
2002. That exemption will not increase
with the estate tax exemption, but continues at $1 million indefinitely, even after the estate tax is
repealed. In addition, when the estate
tax repeal finally does take effect, the top gift tax rate would drop to a rate
equal to the top income tax rate at that time (35 percent under the 2001 Act,
but it is fair to expect that future Congresses will change that).
Continuation of the gift tax injects a new factor into
the estate planning picture for persons contemplating action between now and
2010. For example, a person making a
lifetime transfer of $2 million in 2007 might incur a gift tax on at least $1
million of that amount (more if earlier taxable gifts had been made) and the
transferee would definitely take the transferor’s basis for income tax
purposes. On the other hand, if that
transfer were made instead by will at the transferor’s death, the exempt amount
would be at least $2 million, rising to $3.5 million if death occurred in 2009,
and no tax would be incurred if the transferor had the good (or bad) fortune to
die during the period when the estate tax is repealed. Moreover, despite the carryover basis rule
discussed below, the transferor’s executor might be able to provide the
transferee with a full fair market value basis for income tax purposes. This makes for a radically changed planning context
and, while these are noncharitable factors, they would have an impact on
charitable transfers as well.
Also, the existence of a gift tax during the period of
repeal would preclude the creation of large charitable or noncharitable trusts
during that period as a hedge against a future return of the estate tax. One appealing planning tactic during a time
when there were no transfer taxes (estate tax or gift tax) would be a
discretionary trust holding the bulk of a persons wealth, from which the trustee
could make transfers to charitable or noncharitable beneficiaries. Alas, the continuation of the gift tax makes
that impractical. Any charitable
transfers would have to be made in conformity with the gift tax charitable
deduction as we now know it.
Under the 2001 Act, a carryover basis regime would begin
in 2010 with the repeal of the estate tax.
Current law grants property passing from a decedent a new basis for
income tax purposes in the hands of the recipient, equal to its fair market
value at decedent’s death. Under carryover
basis, the decedent’s basis in property will carry over to the recipient. If the fair market value is lower than the
decedent’s basis, the recipient takes a basis equal to fair market value. Thus, some of the benefit realized from
repeal of the estate tax is likely to be offset by increased capital gains
taxes in the future. The first $1.3
million in an estate (as selected by the executor) would continue to receive a
stepped-up basis, as would the first $3 million passing to a surviving
spouse. These dollar amounts will be
increased to reflect post-2009 inflation.
Property received by gift within three years of death would not be
eligible for a step up under these provisions.
As
discussed below, imposition of carryover basis would create a number of new
charitable tax planning opportunities.
By creating a new category of estate asset that would be subject to
added tax in the hands of a legatee (much like an item of income in respect of
a decedent under present law), the 2001 Act would encourage charitable bequests
of such property. Also, it seems likely
to anticipate that the familiar charitable remainder trust would provide a
logical solution to the problem that would arise when property acquired by a decedent
would have to be sold and a capital gains tax incurred. Such an approach is often used now for
dealing with appreciated property, and carryover basis would increase the
amount of appreciated property in general circulation.
III. The
Incredible Disappearing Tax Act
For charitable gift planners, all of the most important
changes will be slow to arrive and are phased in gradually when they finally do
begin to take effect. The most profound
changes here by far are the repeal of the estate tax and the accompanying
imposition of carryover basis, and both of these are delayed until 2010. As if that were not enough, due to an
obscure procedural quirk, all the changes in the new law will disappear
eventually (in 2011) unless extended by some future Congress.
This is
referred to as a “sunset” provision, and here is how it operates (and why it
was included). The Congressional Budget
Act of 1974 (Budget Act) includes a number of rules governing Congressional
consideration of budget reconciliation legislation such as the 2001 Act. One such rule is the so-called “Byrd rule,”
named after its principal sponsor, Senator Robert C. Byrd of West
Virginia. The Byrd rule generally
permits Senators to raise a point of order against extraneous provisions (i.e.,
those which are unrelated to the goals of the reconciliation process). Under the Byrd rule, a provision is
considered to be extraneous if it falls under one or more of six specific
definitions. In the case of the 2001 Act,
this could occur if the bill increased the deficit for a fiscal year beyond the
ten-year budget period covered by the 2001 Act. Such a point of order could only be overcome by a 60-vote margin,
and the close split in the present Senate made that exceedingly difficult.
Accordingly,
to ensure compliance with the Budget Act, the 2001 Act simply provides that all
provisions of that Act, and all amendments made by it, will not apply for years
beginning after December 31, 2010. The estate, gift, and generation-skipping
provisions of the 2001 Act therefore do not apply to estates of decedents
dying, gifts made, or generation skipping transfers, after that date. So the changes in the 2001 Act have no
effect outside the budget period, because the old law will spring back into
place on that date. Voila! Problem solved!
True,
this gambit leaves these important tax rules in some peril – and they will
disappear into the sunset at the end of 2010 unless some future Congress
extends them. Furthermore, that is not
the only such clever trick in the 2001 Act.
On several occasions, once this year and again in 2004, installment
payments of corporate estimated tax otherwise due on September 15 are delayed
to October 1.[4] What’s behind this? In other contexts, this might be referred to
by the technical term “cooking the books.”
The federal government operates on a September 30 fiscal year, so this
tiny adjustment in due dates shifts significant amounts of tax revenue into a
later fiscal year, where it can moderate the effects of changes that reduce tax
revenues.
As a
result of this legislative legerdemain, only persons with a lucky streak and a
superb sense of timing will be in a position to garner the full benefit of
estate tax repeal under the law as it now stands. To achieve this, a person would first have to live until 2010,
when the repeal is scheduled to take effect.
He would then have to time his death to fall within the year 2010,
before the repeal expires. And he would
have to hope all along the way that the next five Congresses do not find it
necessary to delay or repeal the repeal!
Beyond the simple wonder that Congress would actually do this, it is
important to note that, except for people who are lucky (or unlucky) enough to
die in 2010, estate tax repeal is still today, after the 2001 Act, something
that will occur only if Congress acts again.
Thus, unless one views continuing federal budget surpluses as inevitable
and future government spending as unlikely, permanent repeal is far from
certain.
IV. Other
Charitable Provisions
A number of charitable provisions were discussed in
connection with the Administration’s tax proposals that formed the basis of the
2001 Act. None of these were included
in the final version of the Act, but they are still positioned for future
consideration by Congress. These
include the following:
·
The Charitable IRA. Charitable representatives have invested much effort in
urging consideration of a charitable IRA provision, which would allow taxpayers
to withdraw amounts from an IRA free of tax to fund charitable gifts. One version of this was passed by Congress
last year but vetoed by President Clinton.
Hopes were high for its passage in the 2001 Act, since the measure had
widespread support in Congress and was endorsed by the new President. Despite an encouraging last-minute
development, this did not materialize.
The
final Senate version of the 2001 Act would have allowed taxpayers over age 70˝
to make withdrawals from an IRA to fund charitable gifts, including both direct
charitable transfers and gifts made through planned giving vehicles such as
charitable remainder trusts, charitable gift annuities, or pooled income
funds. That provision would not have
taken effect until 2010, but the House-Senate conferees chose not to include it
in the final version of the Act.
·
Charitable deduction for
nonitemizers. Under present law, taxpayers who claim the standard deduction
rather than itemizing their deductions have no tax incentive to make charitable
contributions. This proposal would
allow them to deduct their contributions up to some amount (usually $500). This change is more controversial than it
might appear, since: (1) it is very expensive in revenue terms, (2) it seems
unlikely to increase giving since most nonitemizers already give to charity in
amounts that approach or exceed the $500 amount generally proposed, and (3)
this would be quite difficult for the Internal Revenue Service to enforce, since nonitemizers’ returns are
seldom audited anyway. Some observers
have suggested this change is more accurately characterized as an increase in
the standard deduction than a charitable deduction provision.
·
Increased percentage
limitation for corporate donors. The Administration proposes raising the
percentage limitation on corporate charitable contributions from 10 percent of
taxable income to 15 percent thereof.
Since few corporations now give as much as 10 percent, this change is
not too sweeping, but this is part of a package aimed at encouraging more
corporate donations.
·
Limited liability for
corporate donors. Another change proposed by the Administration
would limit the potential liability of a corporate donor for injuries suffered
by a person as a result of his use of contributed property. [One hopes the
Administration is equally concerned about the liability of the donee of this
property, but that point has not yet been raised publicly.]
·
State tax credit for
certain programs. Although the details have not yet been fully
described, the Administration proposes to make federal funds available in some
fashion to support the allowance of credits on state income tax returns for
contributions to certain specific types of human services programs.
All of these provisions are now expected to be considered
separately during the remaining year-and-a-half of the 107th
Congress.
The Senate version of the 2001 Act included two other
charitable provisions that were omitted from the final bill. First, it would also have corrected a
long-disputed charitable tax problem for artists. Under present law, an artist making a contribution of his works
is entitled to deduct only the cost basis of the works. This is merely one application of the
ordinary income rule applicable to all taxpayers, but artists have felt
particularly disadvantaged because these same works are taxed in their estates
at full fair market value for estate tax purposes. The Senate bill would have created a special exception for
artists, giving them a full fair-market-value deduction for charitable
contributions of their works of art.
Another
Senate provision would have given an enhanced charitable deduction for
contributions of book inventory to certain categories of educational
organizations – schools, charities supporting elementary and secondary
education, and charities organized primarily to provide free books to the
public or to operate literacy programs.
This too failed to survive the House-Senate conference.
V. Practical
Implications for Charitable Planning
What does all this mean for charitable gift planners
today? Except as a backdrop to what may
occur in the future, the answer is probably that they should continue to do
largely what they are accustomed to doing.
The biggest changes are nearly ten years off at present, and even then
will not take permanent effect unless and until some future Congress decides
that should happen. Many observers feel
that will not ever materialize in light of the lost revenue from other changes in the 2001 Act. Only time will tell whether the estate tax
will actually be repealed.
One certain aftermath of the 2001 Act will be the boom
for estate planners. Also, whenever
clients revisit their estate plans, they are likely to reconsider their
charitable dispositions as well, making this a time of potential opportunity
for charities.
Most existing estate plans and their planning documents
will have to be reviewed to determine what changes are appropriate to take the
new law into account. In particular,
the increasing exemption amounts over the next few years will require careful
reconsideration of family dispositions.
This may be particularly important for persons with medium sized
estates. Smaller estates were not
estate tax sensitive originally, and they will continue to be unaffected. Likewise, larger estates that far exceed the
exempt amounts are less likely to need restructuring, although they will need
to be reexamined for other reasons, including the various generation-skipping
transfer tax changes in the 2001 Act.
All of
these considerations suggest that virtually all existing wills and trusts
should be reexamined to determine how they would be affected and whether they
still carry out the intentions of the persons who made them. This represents a rare opportunity for
charities to present their case to their constituencies and suggest an added or
increased bequest. Organizations that
have not mounted a serious bequest program should consider this option for the
period that lies ahead, as the changing estate tax picture for the 2001 to 2011
period promises to be a very active time for estate planning activity.
Individuals
who redraft their estate plans to reflect this changing tax picture should be
reminded to reconsider their charitable objectives as well. Board members and major donors represent a
logical initial focus for such an effort, but charities will be well advised to
cast a wider net during this period when many individuals will be revising
their wills and trusts, sometimes more than once.
If the estate tax actually is repealed in 2010, it will
be supplanted by a new income tax rule that has significant implications for
charitable planners as well as estate planners. Under the 2001 Act, property acquired from a decedent dying after
2009 will take a carryover basis in the hands of the recipient. The rule of present
law whereby such property takes a fair market value (i.e., stepped up) basis is
repealed as of that date. However,
there are three important exceptions to this new carryover basis rule:
·
Basic Exemption. The first $1.3
million of a decedent’s property (as selected by the executor of the estate)
would continue to receive a stepped-up basis.
·
Spousal Exemption. Up to $3 million
of property (as selected by the executor of the estate) acquired from the
decedent by a surviving spouse, provided that such property is “qualified
spousal property” (i.e., either an outright transfer to the spouse or qualified
terminable interest property such as a QTIP trust). Note that this definition differs from the present marital
deduction in that it fails to include the spouse’s interest in a charitable
remainder trust.[5] Thus, planners may find it advisable in some
cases to abandon the CRT as a marital trust vehicle.
·
IRD Exception. The new carryover
basis rules would not apply to “income in respect of a decedent,” such as IRAs
and other retirement plan assets.
The $1.3 million basic exemption and the $3 million
spousal exception would be indexed for post-2010 inflation. The sheer size of these exceptions will
remove most estates from the operation of the new rules. As a result, most Americans will be
unaffected by the carryover basis rule, just as most are presently unaffected
by the estate tax.
Nevertheless,
many new issues will have to be addressed in wills, and the likely result will
be a new set of complications in will drafting. The planning necessary to
facilitate the carryover basis rules will require some very basic retooling of
accepted planning and drafting approaches. In Addition, that retooling itself
will create some new charitable planning approaches. Here are some likely examples of how charitable planning may be
useful under the carryover basis regime:
·
Charitable Bequests of
Low-Basis Property. The carryover basis rules will impel estate
planners to assign a decedent’s low-basis property wherever possible to one of
the categories that qualify for a basis step-up. In larger estates, or estates of unmarried persons, this may not
be feasible for all of the decedent’s property. One useful allocation of low-basis property in such a situation
would be a bequest to a charitable entity, which will not be adversely affected
upon selling the property. Under
present law, planners frequently arrange to allocate IRA and retirement plan
assets and other items of income in respect of a decedent to charity for a
similar reason. The donor’s favorite
charity, as a tax-exempt entity, would offer a ready recipient for property
disadvantaged under the carryover basis regime. By allocating a decedent’s
lowest-basis property to charity, the planner could thus optimize the overall
tax position of family beneficiaries.
·
New Emphasis on
Charitable Remainder Trusts. The carryover basis rules will bring about an
overall increase in the amount of substantially appreciated property in the
hands of the public, as inherited property becomes an entirely new class of
appreciated property. Charitable remainder trusts (CRTs) and charitable
contributions are classic devices for dealing with such property on a
tax-advantaged basis, and they will continue to serve this function. The 2001
Act lowers income tax rates, but otherwise leaves the income tax largely
unaffected. As a result, the present
income tax incentives for charitable giving not only survive, but they become
more significant.
·
Estate Distribution and
Administration. Estate beneficiaries receiving low-basis
property will also find the CRT an attractive means for selling such property
without incurring an immediate capital gains tax. In fact, estates themselves might be structured to use CRTs to
dispose of low-basis property.
Particularly in larger estates, where the $1.3 million and $3 million
exemption amounts are insufficient to step up sufficient property to meet
overall needs, it may prove useful to include a testamentary charitable
remainder trust in the estate plan and allocate low-basis property to it for
resale free of capital gains tax. [6]
·
Notice to Charitable
Beneficiaries of Inter Vivos CRTs. An
obscure amendment to the gift tax return requirement may fulfill part of an
objective that has long been sought by charitable organizations.[7] Under that new rule, effective for transfers
after December 31, 2009, a person required to file a gift tax return will be
required to furnish “to each person whose name is required to be set forth in
such return” (other than the donor) a written statement of the name, address,
and phone number of the donor (or other person required to make the return) and
the information in the return regarding the gift property. This is presumably to assure that donees
have the basis and value information they will then need to deal with the
property under the carryover basis rules.
In the case of a CRT, however, this will apparently require for the
first time (under federal law) that the charitable beneficiaries be notified
about the formation of the trust. As a
result, a beneficiary receiving the notice will be in a better position to
enforce its rights under the CRT. This
may not necessarily be the case where the donor retains the right to change the
charitable beneficiary of a CRT, but it does reflect a significant, though
unintended, change in the law for the cases where an irrevocable charitable
beneficiary is named.
·
New Trust Formats. As estate planners begin to cope with the new
carryover basis regime, they are likely to adopt new approaches in their use of
trusts. Standard practice today often
results in a two-trust approach, with the tax-free amount in one trust and the
balance in another trust (the marital trust in the case of a married testator). Under carryover basis, there may be reason
to use a three trust approach as the new standard – a marital trust for the $3
million of property qualifying for the spousal step up, another trust for the
$1.3 million of exempt property, and a
third trust for the carryover basis property that cannot receive a stepped-up
basis. Likewise, drafters will
certainly develop ordering rules for determining which types of property are
assigned to each of these categories.
Even with no estate tax to worry about, planners will have tax problems
to anticipate and resolve, and (as discussed below) it is likely that some of
those new problems will have charitable solutions.
C. Income Tax Incentives Continue
In the dramatic context of the estate tax repeal debate,
it has been easy to lose sight of the fact that income tax factors generally
create a more potent incentive to charitable giving than estate tax
factors. One incentive that is likely
to become more important in the post-estate-tax era is the charitable remainder
trust (CRT). Future donors will
continue to find such trusts attractive for the same reasons that donors today
create them. As pointed out above, the
arrival of the carryover basis rules in 2010 will make the CRT even more
attractive as a means of avoiding or deferring capital gains taxes. Also, other charitable transfers that
produce an income tax charitable deduction will likewise continue to be viable.
The gradual phaseout and eventual repeal of the “Pease”
rule, also described above, will remove one psychological disincentive to
charitable giving by ending the cutback of a taxpayer’s overall itemized
deductions. This widely misunderstood
provision did operate to cut back some deductions, especially for upper income
donors. Its repeal is gradual, starting
in 2006 and finally removing the limitation in 2010. No new planning on the part of donors or donees will be required,
but both will welcome the demise of this provision (assuming the repeal
survives the phase-in period and is eventually extended or made permanent).
The repeal of the estate tax, coupled
with the retention of the gift tax and the advent of carryover basis, changes
the dynamics of gift planning. Some
familiar planning devices – those used to achieve estate tax savings – will no
longer be needed for that purpose and will thus be less useful.
For example, charitable lead trusts
have long been a classic planning device for minimizing transfer taxes on large
estates and gifts, but with fewer transfer taxes to minimize, they may lose
some of their appeal. Of course, they
will still be useful for other purposes, such as avoidance of the percentage
limitations on income tax charitable deductions. Moreover, lest we forget, the gift tax is still with us and will
be even if the estate tax repeal takes effect.
The charitable lead trust will continue to be an effective way to make
lifetime gifts to children and grandchildren while avoiding federal gift taxes. Indeed, the pre-repeal period might be a
time for some donors (particularly the elderly and infirm) to consider a
charitable lead trust for their grandchildren as a means of hedging against
possible death before the estate tax and the generation skipping transfer tax
are repealed.
Similarly, private
foundations would not be needed to reduce estate tax burdens under a
post-repeal system. However,
foundations are proving increasingly popular among younger donors for whom the
estate tax has never been an important planning factor, so this effect is hard
to evaluate.
More interesting and exciting is the potential effect of
estate tax repeal on present estate planning patterns. Many estate plans are focused primarily upon
noncharitable considerations, such as the marital deduction. A typical plan under present law often
leaves the bulk of the first spouse’s estate in some fashion that qualifies for
the marital deduction, with the principal nonspousal distribution delayed until
the second spouse’s subsequent death.
This sort of arrangement will not be necessary in an estate-tax-free
environment, so the estate planner will be free to utilize other approaches –
including plans that are not possible under present law, because they would
violate estate tax marital and/or charitable deduction principles. Inevitably, some of those new possibilities
will include new forms of charitable transfers.
For
example, a testamentary trust might be created to run for the surviving
spouse’s life with discretionary distributions sprinkled among a group
consisting of the spouse, other family beneficiaries, and charity. This would be unthinkable under present law,
but could be a useful model in the absence of the estate tax.
Likewise,
it might be possible to use a new type of foundation. At present, some foundations are created (or receive their major
funding) at death in order to provide an estate tax charitable deduction for
the founder’s estate. The price of that
deduction has been the qualification of the private foundation as a charitable
organization under IRC Section 501(c)(3), which in turn has required the
foundation to comply with all of the private foundation restrictions. Unless the foundation complies with the
prohibitions on self-dealing, excess business holdings, etc., it will not
produce an estate tax charitable deduction for its creators. Removal of the estate tax, however, would
liberate a new, post-2009 foundation from these rules and enable it to operate
outside the private foundation limitations.
Although
this might make the foundation a taxable entity, at least in theory, it could
readily avoid or at least minimize its income tax liability in several
ways. First, it might be able to
qualify as a social welfare organization exempt from tax under IRC Section
501(c)(4). Its contributors would not
qualify for income tax charitable deductions, but that would not be necessary
if it were created by bequest, and it would be subject to a much less rigorous
standard of supervision. [8] Even better might be to operate as a
testamentary trust, so that its charitable distributions would be deductible
without limitation and it could avoid tax simply by distributing all of its
income, either to charity or to other beneficiaries. At least under current dividend conditions, this could enable it
to distribute far less than the five-percent minimum required of private
foundations.
Of
course, the gift tax would remain in effect under the 2001 Act, even after
repeal of the estate tax, so these new planning approaches could not be
undertaken via lifetime transfers.
Thus, any transfers made during the transferor’s lifetime must continue
to be arranged in a manner that will qualify for the gift tax charitable
deduction. Despite this limitation, a
wide array of new charitable devices will doubtless be proposed should the
estate tax wind down to its final exit as the 2001 Act provides.
Not many people have made any plans yet for meetings,
vacations, and the like in 2010. Many
of us are content simply to hope we will still be alive, active and healthy
nine years from now. Repeal of the
estate tax, if it occurs at all, will be phased in over a period of nearly ten
years. As a result, the impact of
repeal on charitable plans and charitable planning will be a long time
coming. Even if a client is convinced
that permanent repeal will occur, he or she should be slow to abandon a
charitable disposition on this basis alone.
Although the new rules must be anticipated, and transition period will
require a considerable amount of estate planning effort for noncharitable
reasons, the estate tax will remain a fact of life for a considerable
period. Accordingly, the true effect
upon charitable transfers is a long way off.
And it is important to remember that nothing in the 2001 Act requires
charitable donors and their planners to change their charitable plans in the
immediate future.
One final point is the issue of
whether the estate tax repeal provisions of the 2001 Act will ever take
effect. As described above, without
more Congressional action, the 2001 Act will phase the estate tax out of
existence by 2010 but bring it back again in its present (2001) form a year
later. Without rehashing the honesty,
advisability, or effectiveness of this, how likely is this to occur?
It is worth noting that the repeal
provisions included in the 2001 Act differ significantly from those in earlier
repeal measures, and the differences invite a conclusion that even the present
Congress must have been equivocal about repeal. First, the retention of the gift tax can be viewed as evidence
that the repeal is seen as temporary at best.
By precluding lifetime transfers during the temporary repeal period, the
2001 Act sets up an effective defense against transfers that would otherwise be
made in order to avoid application of some future estate tax levy. More importantly, the 2001 Act brings
substantial rate reductions and increased exemptions in the years leading up to
repeal. This will serve to alleviate
the pressures for extension or reenactment of the repeal in 2009 or 2010, since
only a small percentage of estates at that time will be subject to tax. Indeed, repeal proponents fought against
such measures as alternatives to repeal.
By the time this issue comes up in Congress again, the case for repeal
is likely to seem much less compelling.
Finally, the likelihood of complications and public dissatisfaction with
the carryover basis rules may cause repeal with carryover basis to look
less attractive than a continuing estate tax at lower rates affecting fewer
estates.[9]
Proponents of repeal have stated that they view the 2001
Act provisions as the best they could achieve under current conditions, and
that they expect future Congresses to finish the job by making the repeal
permanent. That is certainly one
possible scenario, but that would not occur unless two other things also
occur. First, the budget surpluses now
projected would have to materialize more or less as predicted and continue on
past 2010. Second, it also would be
necessary that intervening Congresses from 2002 to 2010 determine that they
have no more pressing need for the large amounts of revenue the repeal of the
estate tax would extinguish. People’s
views on this vary, but your author, for one, sees this as unlikely.
Historical
Note: The last epic tax cut bill, the
Economic Recovery Tax Act of 1981, was billed as “the biggest tax cut bill ever
passed.” Just a year later, federal
deficits were ballooning so rapidly that Congress had to step in with “the
biggest revenue-raising bill ever passed” – the Tax Equity and Fiscal
Responsibility Act of 1982.[10]
What seems far more likely is that
economic reverses, a national emergency, or some other occurrence not
specifically predictable right now will intervene sometime in the next nine or
ten years to make it necessary for the federal government to become concerned
again about revenues. If that should
occur, the excess revenues that propelled the 2001 Act may prove to have been
illusory. Congress would then have to
do again what they did in 1982 – reexamine the priorities in the tax cut
package that would then be phasing in and determine whether elimination of the
estate tax is sufficiently high on the list to justify its retention.
Alternatively, if the surplus
projections prove to be right on the money, Congress must face a similar task –
to determine whether the automatic reenactment of the estate tax under the 2001
Act should be undone so that the estate tax will stay repealed. That decision would have to be justified
under revenue estimates, competing national priorities, and political
realities, as they then exist.
Which is the more likely
scenario? Regardless of personal
opinions, one would have to admit that the facts required to keep the estate
tax away permanently would represent an unprecedented period of American
prosperity. Any number of things could
ultimately be blamed if the repeal is ultimately undone. Possible scapegoats would include an
economic slowdown, future military action,[11] unnecessary
government spending, necessary government spending, or simple miscalculation by
the revenue estimators. Whatever the
cause, complete and permanent repeal certainly cannot realistically be viewed
as a sure thing from today’s vantage point.
VI. The
Bottom Line
On balance, the 2001 Act and the repeal of the estate tax
seem unlikely to injure charities, and it is easy to see how charities could
ultimately benefit. Particularly in the
short run, it will become necessary for most Americans to visit their estate
planners for a review and update of their wills and/or trusts. The opportunity this presents for increased
bequest expectancies is obvious and significant. Additionally, income tax rates will decline gradually in most
brackets 2001 through 2006. Although
lowered rates may be viewed generally as discouraging charitable gifts, there
are two offsetting factors in this context.
First, the declines are both small and gradual, so that this effect is
unlikely to be substantial. Second, and
more important, the rates under the 2001 Act continue to decline throughout
this period, thus facilitating year-end campaigns in which donors may be
reminded on several occasions that a deductible gift will save more tax NOW
than if it is postponed until next year.
So, in
the final analysis, this author’s conclusion is that charitable planners will
have to make some adaptations to the new law, but that their basic work will
continue undiminished and largely unchanged.
The repeal of the estate tax may or may not survive the next ten
years. And even if it does, many
traditional incentives will continue without diminishment while other, new
incentives will emerge from the repeal legislation itself and the carryover
basis rules it will impose. Either way,
planners will still be called upon to help donors achieve their non-tax goals
most effectively under a changing legal structure. This may not be an easy job, but then an easy job would really be
something new and different, wouldn’t it?
Copyright © 2001 by PANEL PUBLISHERS
A Division of Aspen Publishers, Inc.
[1] Reg. § 20.2056(b)-(7)(d)(3).
* Byrle M. Abbin, author of Income Taxation of Fiduciaries and Beneficiaries, is a retired partner and a consultant to the firm of Andersen in Washington, D.C. He received his B.B.A. with distinction from the University of Michigan and his J.D. from Harvard Law School. In 1959, Mr. Abbin was awarded the Elijah Watt Sells Gold Medal as well as the Illinois Gold Medal for the best paper submitted on the national CPA exam.
He has had extensive experience in tax policy matters through congressional testimony, written analyses in tax journals, and as a member of various committees of the American Institute of Certified Public Accountants (AICPA) that have proposed legislative and regulatory recommendations. He is a former Director of the American Council for Capital Formation, The Tax Council, and a former Director and Chairman of the Institute for Research on the Economics of Taxation. He served as Chairman of the AICPA Fiduciary Income Tax Task Force and serves on the AICPA Transfer Tax Task Force. He is a member of the program and policy committee of the Tax Foundation, and the Advisory Board of numerous tax journals. He is a past member of the AICPA National Conference of Lawyers and CPAs and a former Director of the National Association of Estate Planning Councils, and he continues membership in numerous professional associations.
* Jerry J. McCoy, author of the Family Foundation Handbook, is an independent attorney in Washington, D.C., specializing in charitable tax planning, tax-exempt organizations, and estate planning. He holds degrees from Duke University and New York University.
A member of the American Law Institute and a fellow of both the American College of Trust and Estate Counsel (ACTEC) and the American College of Tax Counsel, Mr. McCoy is listed in Who’s Who in America, Who’s Who in American Law, and The Best Lawyers in America. A frequent presenter at planned giving, tax, and estate planning seminars, he serves on the adjunct faculties at the Georgetown University Law Center and the University of Miami Law School. He is Chairman of the Charitable Planning and Exempt Organizations Committee of ACTEC.
Mr. McCoy is co-founder and co-editor of Charitable Gift Planning News, a monthly newsletter.
[2] For a complete summary of the 2001 Act, the reader is referred to <http://www.house.gov/jct/x-50-01.pdf >,where the official summary prepared by the Staff of the Joint Committee on Taxation appears.
[3] See IRC § 68.
[4] The 2001 payments are deferred in full, and only 70 percent of the 2004 are deferred.
[5] Transfers in the form of a traditional power of appointment marital trust are likewise excluded from the marital stepped-up basis provision. This represents a difference in approach from some versions of the carryover basis rule included in earlier bills that were passed by Congress but vetoed by President Clinton.
[6] Note that new IRC §1040, added to the Code by §542(d)(1) of the 2001 Act, provides that an estate or trust using appreciated carryover basis property to satisfy a pecuniary bequest will be subject to tax only on post-death gains.
[7] See IRC §6019(b), added to the Code by §542(b)(2) of the 2001 Act.
[8] Note that the intermediate sanction rules of IRC § 4958 would apply to any “excess benefit transactions” between “the section 501(c)(4) organization and its disqualified persons.”
[9] With carryover basis rules in place, some estates and beneficiaries would pay more in capital gains taxes than they save from repeal of the estate tax. This could occur, for example, when property received from a decedent is subject to a debt in excess of the decedent’s basis in the property. Under present law, the step up in basis at death cures such a situation.
[10] Quotations are from Handbook on The Tax Equity and Fiscal Responsibility Act of 1982, (Prentice-Hall 1982), at page i.
[11] Note in this connection that earlier versions of the estate tax were enacted by Congress as means of financing the Civil War and the Spanish-American War. Even earlier, a death tax was proposed to help defray the costs of the War of 1812, although that war ended before Congress could enact it. As Mark Twain observed, “History may not repeat itself, but it does echo.”