2001 ESTATE AND GIFT TAX ALERT
By Gideon Rothschild, J.D., CPA[1]
Moses & Singer
LLP
Termination and Sunset Provisions
New
Tax Rates and Exemptions for Taxable Gifts and Estates
Reduction
of Credit for State Death Taxes
Elimination
of Stepped-Up Basis
On May 26, 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (“the Act”) into law. While it may take many months for estate planners to sift through the provisions to understand the intricacies of the law, the following is a summary of the pertinent provisions in the estate and gift tax area and some observations on the new law.
Under the Act, the estate tax and generation skipping transfer tax provided for under present law are repealed after December 31, 2009. The gift tax, however, will not be repealed.
Comment: At first blush, it appears certain that there will be an estate tax repeal for those decedents dying after December 31, 2009. However, due to budgetary restrictions contained in the Congressional Budget Act, the new law instead provides for the current exemptions and rates to be put back into effect for estates of decedents dying and gifts made after December 31, 2010. That is, the repeal is only effective for decedents dying during the calendar year 2010. If the repeal is to be effective beyond calendar year 2010, Congress must at some future time start over, readdress these issues, and enact new legislation to effectuate a more permanent repeal.
Under current law, a unified tax rate schedule and exemption equivalent applies to both taxable gifts and transfers at death. Under the Act, the tax rate table for GSTs and estates and the applicable exemption amount are modified as follows:
|
Year |
Estate and GST
tax death time transfer
exemption |
Maximum Estate and Gift Tax
Rate |
|
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 |
|
2007-2008 |
2,000,000 |
45 |
|
2009 |
3,500,000 |
45 |
|
2010 |
N/A (taxes repealed) |
Highest individual income tax rate (for gift tax only) |
|
2011 (if reinstated) |
1,000,000 |
55 |
The gift tax, however, is not repealed. The maximum tax rate is reduced in accordance with the foregoing table, but the exemption equivalent for lifetime gifts made after December 31, 2001 is increased to $1,000,000 and remains at that amount for all future years. After December 31, 2009, the maximum gift tax rate will be reduced to the highest individual income tax rate for that tax year (i.e., 35 percent under the Act). The Act further provides that, except as provided in regulations, all transfers in trust made after December 31, 2009, shall be treated as taxable gifts unless the trust is treated as wholly owned by the donor or donor’s spouse under the grantor trust rules.
Observation: The continuation of the gift tax is an attempt to preclude transfers to lower bracket income taxpayers to circumvent the new carryover basis rules. If the gift tax were also repealed, taxpayers with appreciated property would have been able to transfer such property to a lower bracket taxpayer, who would then sell the property, pay a reduced tax on the gain and then transfer the proceeds to the donor, all without any further tax consequence.
The generation skipping tax exemption for years prior to repeal is equal to the exemption amount for estate tax purposes, and the tax rate for generation skipping transfers will be the highest estate and gift tax rate in effect for such years with complete repeal after 2009.
Under the Act, the special deduction of up to $675,000 for qualified family owned business interests under IRC § 2057 is repealed for decedents dying after December 31, 2003.
The state death tax credit presently allowed for estate taxes actually paid to a state is determined under a graduated rate table with a maximum rate of 16 percent. Under the Act, the maximum credit will be reduced to 12 percent in 2002, 8 percent in 2003, and 4 percent in 2004. In 2005, the state death tax credit will be repealed and replaced with a deduction for death taxes actually paid to any state (or to the District of Columbia).
Observation: The repeal of the death tax credit will affect the majority of states that have a “sponge-tax,” i.e., a tax imposed equal to the allowable federal credit, and may lead to the adoption of state inheritance taxes again.
The present law provisions that provide for a step-up (or step-down) in basis to fair market value of property acquired from a decedent will no longer be in effect after the estate tax repeal date of December 31, 2009. Prior to that date, the current basis rules under IRC §1014 remain in effect. Special provisions in the Act outline how to treat property acquired from a decedent dying after December 31, 2009. Generally, recipients of property transferred upon death will take a basis equal to the lesser of the decedent’s adjusted basis or the fair market value of the property on the date of decedent’s death.
Certain adjustments and limitations to the carry-over basis rules will apply. A basis increase will be permitted for up to $1,300,000 in every taxable estate. This amount will be further increased by unused built-in losses and loss carryovers that were available to the decedent. For non-resident decedents who are not citizens of the United States, the step-up adjustment is limited to a $60,000 increase.
A surviving spouse will also be permitted an additional basis increase of an aggregate amount of $3,000,000 on property owned by the decedent at the time of death. Special rules apply to joint property and community property to determine the extent of the decedent’s ownership of such property. This basis increase will only apply to “qualified spousal property,” that is, property transferred outright by the decedent or qualified terminable interest property. The additional basis increase will not apply to property received by the decedent as a gift (other than from his or her spouse) within three years of his or her death. This includes gifts received by the decedent from his or her spouse during that three-year period if the spouse received the property during such three-year period for less than full and adequate consideration. The basis increase will also not apply to stocks of certain entities such as a foreign personal holding company or foreign investment companies. These additional basis amounts will all be adjusted for inflation occurring after 2009.
In addition to the foregoing basis adjustments, the beneficiary who acquires the principal residence from the decedent may benefit from the exclusion of gain on the sale of the principal residence by taking into account the ownership and use of the decedent.
The aggregate basis increase will be allocated by the executor on an asset-by-asset basis. The Act prohibits an allocation of increased basis above an asset’s fair market value.
Observation: If the estate exceeds $1,300,000, the executors will have difficult decisions to make when allocating the basis increase among assets bequeathed to different beneficiaries; there is potential for disputes regarding such allocations. Clients’ wills should provide for clear direction to the executors on making such allocations to avoid disputes.
The Act provides extensive modification of the reporting requirements for transfers at death. For lifetime transfers, donors are required to provide to the donee information relating to the fair market value and basis of property reported on the donor’s gift tax return.
For estates of decedents dying after December 31, 2009, the executor must report to the IRS such transfers of property (other than cash) in excess of $1,300,000 and appreciated property in excess of $25,000 received by the decedent within three years of death. In addition, the executor must include the decedent’s basis for each asset, its fair market value, holding period, information necessary to determine whether any gain on the sale would be treated as ordinary income, and the amount of basis increase allocated to each asset. Each beneficiary receiving such property must be furnished a statement with the foregoing information.
The Act provides substantial penalties for failure to comply with the reporting requirements.
The Act makes certain modifications to the deemed allocation rules and rules governing division of trusts. Under present law, for lifetime transfers that are not direct skips, the transferor must allocate the generation skipping transfer tax (GST) exemption to avoid the generation skipping tax. The law further provides that any unused exemption is automatically allocated on the due date of the decedent’s estate tax return: first to direct skips occurring at death and then pro rata to trusts that may have taxable terminations or distributions to skip persons. These complicated rules have resulted in numerous situations where there was a failure to make a timely allocation.
Under the Act, there will now be deemed allocations of GST exemption for certain lifetime transfers. Where a person makes an indirect skip during his or her life, any unused GST exemption will be allocated to the property transferred so as to make the inclusion ratio for that property zero. Unlike the prior law, the allocation will no longer be discretionary but will now be automatic, unless the transferor elects not to have the automatic allocation rules apply by filing a timely gift tax return. Where the indirect skip amount is greater than the unused GST exemption, the entire unused portion will be allocated to the property transferred. An indirect skip is defined as a transfer of property made to a GST trust, a newly defined term.
A GST trust is defined as a trust that could have a generation skipping transfer with respect to the transferor unless the trust instrument provides: (1) that more than 25 percent of the corpus must be distributed to non-skip persons before those persons either attain age 46 or upon occurrence of an event that will occur prior to such persons’ 46th birthday; or (2) that more than 25 percent of the trust corpus must be distributed to non-skip persons who are living on the date of death of another person who is more than 10 years older than such non-skip persons; or (3) that if one or more non-skip persons die before a date or event described in (1) and more than 25 percent of the corpus must be distributed to the estate(s) of such individual(s) or is subject to a general power of appointment exercisable by such non-skip person(s); or (4) the trust would be included in the gross estate of a non-skip person if such person died immediately after the transfer; or (5) it is a charitable lead annuity trust, charitable remainder annuity trust, or charitable unitrust. The provision for the deemed allocation rules apply to all transfers made after December 31, 2000.
Under present law, if a transferor did not allocate GST exemption to a trust that the transferor expected would not likely benefit skip persons and subsequent thereto a taxable termination or distribution occurs as a result of a child’s untimely death which results in a distribution to a grandchild, a GST tax would be due even if the transferor had unused GST exemption. Under the Act, retroactive allocations of the GST exemption are now permitted where the beneficiary (1) is a non-skip person; (2) is a lineal descendant of the transferor’s grandparent or grandparent of the transferor’s spouse; (3) is a generation younger than the generation of the transferor; and (4) dies before the transferor.
If the allocation is made on a timely filed gift tax return filed for the year of the non-skip person’s death, the value of the transfer for GST purposes will be determined as if the allocation had been made on a timely filed return for the year in which each transfer was originally made to the trust.
As noted above, many practitioners have inadvertently failed to make timely allocations of GST exemption. Under present law, if a late allocation is made, the value on the date of the allocation must be used. Under the Act, the Secretary is authorized and directed to grant extensions to make the election to allocate GST exemption using the gift tax value of the transfer after considering all relevant factors including evidence of intent contained in the trust agreement. The relief applies to requests pending on, or filed after, December 31, 2000.
Under current law, a trust can be severed into two or more trusts to create one with an inclusion ratio of zero and the other with an inclusion ratio of one only if the governing instrument allows it or the trust is severed pursuant to the trustees’ discretionary powers, provided, in either case, that the severance occurs or reformation begins before the estate tax return is due. The Act permits a trust to be severed at any time by a trustee through the use of a “qualified severance” whereby the resulting trusts will be treated as separate trusts for GST purposes. A qualified severance occurs where a single trust is divided on a fractional basis and the terms of the new trusts provide the same succession of interests as are specified in the original trust. If a trust has an inclusion ratio greater than zero but less than one, a severance will only be a qualified severance if the single trust is divided into two trusts, one of which must receive a fractional share of the total value of all trust assets equal to the applicable fraction of the single trust immediately before the severance. That trust will have an inclusion ratio of zero while the second trust will have an inclusion ratio of one. This provision applies to severances after December 31, 2000.
The availability of conservation easements is expanded under the new law. There is no longer a requirement that land subject to the easement be located within a certain distance of a metropolitan area, national park, wilderness area, or urban national forest. Under the Act, a qualified conservation may be claimed for any land that is located in the United States and its possessions. This provision will be applied retroactively to December 31, 2000.
Under present law, the estate tax can be paid in installments (of up to 15 years) if the value of the decedent’s interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate. For purposes of these rules, a closely held business includes stock in a corporation with 15 or fewer shareholders or a partnership with 15 or fewer partners. The Act expands the availability of installment payment of estate tax for the closely held business by increasing the number of shareholders or partners to 45. The provision has also been expanded to include qualified lending and finance business interests, but the tax attributable to such interest must be paid in 5 installments of principal and interest. This provision is applicable to estates of decedents dying after December 31, 2001.
What do these changes mean for the estate planner and his or her client? Unfortunately, for most individuals, these provisions can be relied on only for the interim nine-year period. Clients should be advised that there is no certainty that these tax benefits will be available after December 31, 2010. [After that date, a different administration will be in office and there is no ability to predict the political and economic forecast that far in the future.]
Accordingly, while clients may hesitate to plan in anticipation of the repeal, such a strategy may be costly. Elderly clients cannot wait for 2010 as they may not live to the purported repeal period. Clients must also continue to plan due to the uncertainty of the tax rates and repeal after 2010. Planning will need to be continued, especially in the case of high net worth clients, for the nine years leading up to the repeal to maximize the tax benefits provided by the Act.
Additionally, for the planners, there will be much to do during this period, including making changes to clients’ wills and trusts and advising them as to methods to minimize the impact of carryover basis.
Copyright © 2001 by PANEL
PUBLISHERS
A Division of Aspen
Publishers, Inc.
[1] Gideon Rothschild is a partner and co-chair of the Estate Planning and Wealth Preservation Group of the New York City law firm of Moses & Singer. He is on the Editorial Advisory Boards of BNA Tax Management, Asset Protection Journal and the Practical Accountant and has written extensively for professional publications. His email is grothchild@mosessinger.com.