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

 

 

 

 

 

 

 

 

 

 

Part One

 

Estate Planning Under the Economic Growth and Tax Relief Reconciliation Act of 2001
 
by John R. Price*

 

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. 

 

A. Increases in the Credit Equivalents and GSTT Exemption 

 

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 transfertypically 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. 

 

 D. Review Closely Held Businesses for Qualification Under IRC  Section 6166

 

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.

 

IV.       Conclusion

 

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 trustswhich 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 techniquesparticularly 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.

 

 


Part Two

 

2001 Tax Act Changes Affecting Individuals,  Estates and Trusts

 

 by Byrle M. Abbin*

 

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.

 

C.                 Other Income Tax Provisions Affecting Individuals

 

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

 

A. GRATs and Sales to Grantor Trusts

 

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.

 

B. "Opportunity" Arrangements

 

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.

 

C.                 Charitable Lead Trust

 

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. 

 

D.                Use of Entity "Wrappers" to Discount Value

 

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.

 

III.            Other Planning Aspects

 

A. Corporate Redemptions

 

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.  .

 

C.                 How to React to Possibility of New Carryover Basis Rules

 

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.

 

D.                Some Caveats

 

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.

 

E. Applicability – Stage of Planning

 

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!!)

 

 

 

 


 

Part  Three

 

Charitable Giving Under the Economic Growth and Tax Relief Reconciliation Act of 2001

 

by Jerry J. McCoy*

 

 

I.          Overview

 

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]

 

A.                 Lower Income Tax Rates

 

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.

 

B.                 Limitation on Itemized Deductions

 

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. 

 

C.                 Estate Tax Repeal

 

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.

 

D.                Gift Tax Changes

 

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.

 

E.                 Carryover Basis

 

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.

 


A.                 Will Revisions Galore

 

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.

 

B.                 Carryover Basis As a New Factor

 

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).

 

D. Shuffling the Charitable Deck

 

            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.

 

F.                  New Planning Options

 

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.

 

F. Estate Tax Repeal Has a Long Transition Period

 

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. 

 

G. Will the Estate Tax Really Be Repealed?

 

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.

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[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.”