United States: Federal Tax Law Update

The overall limitation on itemized deductions and personal exemptions for all taxpayers is eliminated. The overall limitations are reduced by one-third in taxable years beginning in 2006 and 2007, by two-thirds in taxable years beginning in 2008 and 2009, and are eliminated after 2009.

The child tax credit is increased from $500 to $600 per qualifying child for 2001. The $600 credit will increase in phases beginning in 2005 until it reaches $1,000 in 2010. The Act makes the child credit refundable to the extent of 10% of the taxpayer's earned income in excess of $10,000 for calendar years 2001 through 2004. The percentage is increased to 15% for calendar years after 2004. The $10,000 amount is indexed for inflation beginning in 2002.

Refundable child tax credits will no longer be reduced by the amount of the alternative minimum tax. In addition, the Act allows the child tax credit to the extent of the full amount of the individual's regular income tax and alternative minimum tax. This is generally effective for years beginning after 2000, except that the child tax credit against alternative minimum tax is effective after 2001.

The adoption credit for children is extended. The maximum credit is increased to $10,000 per eligible child, including special needs children. A $10,000 credit is provided in the year a special needs adoption is finalized regardless of whether the taxpayer has qualified adoption expenses. The income phase-out range is increased to $150,000 from $75,000, and the adoption credit is permanently allowed against the alternative minimum tax.

The Act permanently extends the exclusion from income for employer-provided adoption assistance. The maximum exclusion is increased to $10,000 per eligible child. In the case of a special needs adoption, the exclusion is provided regardless of whether the taxpayer has qualified adoption expenses. The Act generally is effective for years beginning after 2001, except that the tax credit and exclusion from income for special needs adoptions are effective after 2002.

The maximum amount of eligible employment-related expenses increases from $2,400 to $3,000, if there is one qualifying individual (from $4,800 to $6,000, if there are two or more). The maximum credit is increased from 30% to 35%. These changes are effective after 2002.

Taxpayers will receive a tax credit equal to 25% of qualified expenses for employee child care and 10% of qualified expenses for child care resource and referral services. The maximum total credit that may be claimed by a taxpayer is $150,000 per taxable year. These changes are effective after 2001.

The Act increases the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. This is phased in over five years starting in 2005. The 15% tax bracket for married couples will also be double the single amount. This increase is phased in over four years beginning in 2005.

For married taxpayers who file a joint return, the beginning and ending of the earned income credit phase-out is increased by $1,000 in the case of years beginning in 2002 through 2004; by $2,000 in the case of years beginning in 2005 through 2007; and by $3,000 after 2007, which will be adjusted annually for inflation after 2008. The Act simplifies the definition of earned income by excluding nontaxable employee compensation from the definition of earned income for earned income credit purposes.

The annual limit on contributions to education IRAs is increased from $500 to $2,000 effective next year. The definition of qualified education expenses that may be paid tax-free from an education IRA is expanded to include qualified elementary and secondary school expenses. The phase-out range for married taxpayers filing a joint return is increased so that it is twice the range for single taxpayers. Corporations and other entities (including tax-exempt organizations) are permitted to make contributions to education IRAs.

For years beginning after 2001, the Act allows a taxpayer to claim a HOPE Credit or Lifetime Learning Credit for a taxable year and to exclude from gross income amounts distributed from an education IRA on behalf of the same student as long as the distribution is not used for the same educational expenses for which a credit was claimed.

The definition of "qualified tuition program" is enlarged to include certain prepaid tuition programs established and maintained by one or more eligible educational institutions (which may be private institutions) that satisfy the requirements under Section 529 of the Code. For a qualified tuition program maintained by private eligible educational institutions, persons may purchase tuition credits or certificates on behalf of a designated beneficiary. However, they would not be able to make contributions to a savings account plan. These changes apply after 2001.

The definition of qualified higher education expenses is modified to include expenses of a special needs beneficiary that are necessary in connection with his or her enrollment or attendance at an eligible education institution. Under the Act, an exclusion from gross income is provided for distributions from qualified tuition programs to the extent that the distribution is used to pay for qualified higher education expenses. A transfer of credits (or other amounts) from one qualified tuition program for the benefit of a designated beneficiary to another qualified tuition program for the benefit of the same beneficiary is no longer considered a distribution. The exclusion for distributions from an entity other than a State applies after 2003.

The Act eliminates the present law penalty on distributions not used for higher education expenses and instead applies the same additional tax that applies to education IRAs. Assets of qualified tuition plans of private institutions must be held in trust. This is effective after 2001.

The exclusion for employer-provided educational assistance is extended to graduate education, and the exclusion (as applied to both undergraduate and graduate education) is made permanent with respect to courses beginning after 2001.

The income phase-out ranges for eligibility for the student loan interest deduction are increased from $50,000 to $65,000 for single taxpayers and from $100,000 to $130,000 for married taxpayers filing joint returns. These income phase-out ranges are adjusted annually for inflation after 2002. Both the limit on voluntary payments of interest and on the number of months during which interest paid on a qualified education loan are deductible are repealed. All of this is effective after 2001.

Taxpayers are permitted an above-the-line deduction for qualified higher education expenses paid by the taxpayer during a taxable year. Qualified higher education expenses are defined in the same manner as for purposes of the HOPE Credit.

In 2002 and 2003, taxpayers with adjusted gross income that does not exceed $65,000 ($130,000 in the case of married couples filing joint returns) are entitled to a maximum deduction of $3,000. In 2004 and 2005, taxpayers with adjusted gross income that does not exceed $65,000 ($130,000 in the case of married taxpayers filing joint returns) are entitled to a maximum deduction of $4,000 and taxpayers with adjusted gross income that does not exceed $80,000 ($160,000 for married taxpayers filing joint returns) are entitled to a maximum deduction of $2,000.

Beginning in 2002, the top marginal estate, gift and generation-skipping tax rate is reduced from 55% to 50%. In addition, as of 2002, the unified credit effective exemption amount (for both estate and gift tax purposes) is increased to $1,000,000. The "unified credit effective exemption amount" is the amount which an individual may shelter from estate tax at his or her death (or from gift tax on lifetime gifts in excess of such individual's annual $10,000 gift tax exclusions). Presently, this exemption amount is $675,000. Beginning in 2002, the 5% surtax (which phases out the benefit of both the graduated rates and the unified credit for estates in excess of $10,000,000) is repealed.

In 2003, the estate and gift tax marginal rates in excess of 49% are repealed. In 2004, the estate and gift tax rates in excess of 48% are repealed, and the unified credit effective exemption amount for estate tax and generation-skipping tax purposes increases to $1,500,000. The unified credit effective exemption amount for gift tax purposes remains at $1,000,000, as increased in 2002. In addition, in 2004 the family-owned business deduction under Section 2057 of the Code is repealed.

In 2005, the estate and gift tax marginal rates in excess of 47% are repealed. In 2006, the estate and gift tax marginal rates in excess of 46% are repealed, and the unified credit effective exemption amount for both estate tax and generation-skipping tax purposes is increased to $2,000,000.

In 2007, the estate and gift tax rates in excess of 45% are repealed. In 2009, the unified credit effective exemption amount for estate and generation-skipping tax purposes is increased to $3,500,000. In 2010, the estate and generation-skipping transfer taxes are repealed in their entirety.

It should be noted, however, that under the "sunset" provisions of the Act, unless further action is taken to extend the tax relief provided prior to 2011, the provisions of the Act will become ineffective as of December 31, 2010, reverting to a $1,000,000 exemption and a 55% top marginal estate tax rate for 2011.

Thus, from 2002 through 2010, the estate GST and gift tax rates and unified credit effective exemption amount for estate tax and generation-skipping tax purposes are as shown below:

Beginning in 2010, the top gift tax rate will be the top individual income tax rate, and, except as provided in Regulations, a transfer to a trust will be treated as a taxable gift, unless the trust is treated as wholly owned by the donor or the donor's spouse under the grantor trust income tax rules. The gift tax exemption remains at $1,000,000, subject to adjustments for inflation.

Under the Act, from 2002 through 2004, the State death tax credit allowable under present law against the Federal estate tax is reduced as follows: in 2002, the State death tax credit is reduced by 25% (from present law amounts); in 2003, the State death tax credit is reduced by 50% (from present law amounts); and in 2004, the State death tax credit is reduced by 75% (from present law amounts). In 2005, the State death tax credit is repealed, after which there will be a deduction in arriving at the Federal taxable estate for death taxes (e.g., any estate, inheritance, legacy or succession taxes) actually paid to any State or the District of Columbia, in respect of property included in the gross estate of the decedent.

After repeal of the estate and generation-skipping transfer taxes, the present-law rules providing for a fair market value (i.e., stepped-up) basis for property acquired from a decedent are repealed. After 2009, a modified carryover basis regime generally takes effect, which provides that recipients of property transferred at a decedent's death will receive a basis equal to the lesser of the decedent's adjusted basis or the fair market value of the property on the date of the decedent's death.

Several exceptions apply to the new carryover basis rules. First, a surviving spouse will be allowed a stepped-up basis in up to $3,000,000 in assets received by the spouse. An additional $1,300,000 of stepped-up basis will be allowed to other heirs (whether or not a surviving spouse) on ssets passing to those individuals. The basis of an asset cannot be adjusted above its fair market value. However, not all property will be eligible for an increase in basis. Property acquired by a decedent by gift from a non-spouse within three years of his or her death will be excluded (in order to prevent "gifts" of low basis assets in anticipation of stepped-up bequests). Property which constitutes "income in respect of a decedent" is excluded, as is stock in foreign investment companies and personal holding companies. Similarly, property subject to a power of appointment is excluded.

Surviving spouses and other heirs receiving stepped-up basis assets will be required to comply with fairly complex identification and reporting procedures to keep track of the stepped-up assets. Substantial penalties will be imposed for noncompliance.

The Act also extends the income tax exclusion for $250,000 of gain on the sale of a principal residence to a decedent's estate, revocable trust and heirs. If the decedent's estate, revocable trust or an heir sells the decedent's principal residence, $250,000 of capital gain can be excluded on the sale of the residence; provided the decedent used the property as a principal residence for two or more years during the five-year period prior to sale. In addition, if an heir occupies the property as a principal residence, the decedent's period of ownership and occupancy of the property as a principal residence can be added to the heir's subsequent ownership and occupancy in determining whether the property was owned and occupied for two years as a principal residence.

The Act increases the generation-skipping tax ("GST") exemption to parallel the estate tax exemption increases, and ultimately repeals the GST beginning in 2010. In addition to these changes, the Act makes the following modifications to the GST provisions:

1. Provides for a deemed allocation of the GST exemption to lifetime transfers to certain "generation-skipping transfer trusts" that are not direct skips;
2. Allows for retroactive allocation of the GST exemption when there is an unnatural order of deaths;
3. Authorizes a "qualified severance" at any time of trusts holding property having an inclusion ratio of greater than zero. In order to be qualified, the severance must be on a fractional basis and the new trusts must provide, in the aggregate, for the same succession of interests as are provided for in the original trust;
4. Modifies certain valuation rules pertaining to timely and automatic allocations of GST exemption;
5. Authorizes the Treasury to grant relief from certain late elections and allocations of GST exemption; and
6. Allows for substantial compliance to satisfy GST allocation rules for any particular transfer.

The changes to the foregoing GST provisions (other than the phase out of the GST itself) are generally effective this year.

The maximum annual dollar contribution limit for IRA and Roth IRA contributions is increased from $2,000 to $3,000 for 2002 through 2004, $4,000 for 2005 through 2007 and $5,000 for 2008. After 2008, the limit is adjusted annually for inflation in $500 increments.

Individuals who have attained age 50 may make additional catch-up IRA contributions. The otherwise maximum contribution limit (before application of the adjusted gross income phase-out limits) for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005 and $1,000 for 2006 and thereafter.

For taxable years beginning after 2002, the Act provides that if an eligible retirement plan permits employees to make voluntary employee contributions to a separate account or annuity that is established under the plan, and meets the requirements applicable to either traditional IRAs or Roth IRAs, that such a separate account or annuity is deemed a traditional IRA or a Roth IRA, as applicable, for all purposes of the Internal Revenue Code.

The deemed IRA, and contributions to it, are subject to the exclusive benefit and fiduciary rules of ERISA to the extent otherwise applicable to the plan. However, they are not subject to the ERISA reporting and disclosure, participation, vesting, funding and enforcement requirements applicable to the eligible retirement plans. An eligible retirement plan includes a qualified plan, a Section 403(b) annuity and a governmental Section 457 plan.

Effective for years beginning after 2001 and before 2007, a temporary nonrefundable tax credit for contributions made by eligible taxpayers to a traditional IRA, Roth IRA, 401(k), 403(b), 457, SIMPLE and SARSEP plans is provided. The maximum annual contribution eligible for the credit is $2,000.

The credit rate depends on the adjusted gross income ("AGI") of the taxpayer. Only joint returns with AGI of $50,000 or less, head of household returns of $37,500 or less and single returns of $25,000 or less are eligible for the credit. The AGI limits applicable to single taxpayers apply to married taxpayers filing separate returns. The credit is limited to 50% of the $2,000 of annual contribution base. The credit percentage varies from 10% to 50% of the $2,000 base, depending upon the amount of AGI. The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution.

Present law limits the amount that can be contributed to a participant's account in a defined contribution plan to the lesser of $35,000 or 25% of compensation.

The $35,000 limit on annual additions to a defined contribution plan is increased to $40,000. This amount is indexed in $1,000 increments. The 25% of compensation limitation is increased to 100% of compensation for plan years after 2001.

The $140,000 annual benefit limit that can be funded under a defined benefit plan is increased to $160,000. This dollar limit is reduced for benefit commencement before age 62 and increased for benefit commencement after age 65. These changes are effective after 2001.

After 2001 the limit on compensation that may be taken into account under a plan is increased to $200,000 from $170,000. This amount is inflation indexed in $5,000 increments. The definition of compensation for purposes of all qualified plans and IRAs is amended to include an individual's net earnings that would be subject to self-employment taxes, but for the fact that the individual is covered by a religious exemption.

The dollar limits on annual elective deferrals under Section 401(k) plans, Section 403(b) annuities and SARSEPs is increased from $10,500 to $11,000 in 2002. In 2003 and thereafter, the limits are increased in $1,000 annual increments until the limits reach $15,000 in 2006, with inflation indexing in $500 increments thereafter.

The maximum annual elective deferrals that may be made to a SIMPLE plan is increased from $6,500 to $7,000 in 2002. In 2003 and thereafter, the SIMPLE plan deferral limit is increased in $1,000 annual increments until the limit reaches $10,000 in 2005. After 2005, the $10,000 dollar limit is indexed in $500 increments.

The dollar limit on deferrals under a Section 457 plan is enlarged to conform to the elective deferral limitations. Thus, the limit is increased from $8,500 to $11,000 in 2002, and is increased in $1,000 annual increments thereafter until the limit reaches $15,000 in 2006. The limit is inflation indexed thereafter in $500 increments. The limit can also be twice the otherwise applicable dollar limit in the three years prior to retirement. The 33 1/3% of compensation limit is increased to 100% after 2001.

In addition, amounts deferred under Section 457 state or local government plans, can now be included in the participants' incomes only when paid, while participants in other Section 457 plans continue to be subject to the "paid or otherwise made available" rules. The unique minimum distribution rules applicable to Section 457 plans are repealed, and effective 2001, Section 457 plan distributions will be subject to the minimum distribution rules generally applicable to qualified retirement plans.

Section 457 plans are not subject to the same Qualified Domestic Relations Order rules that apply to distributions of benefits from tax qualified plans when a participant goes through a dissolution of marriage. Effective as to distributions and payments next year, Section 457 QDROs are covered by the same rules which apply to other QDRO qualified plans. Thus, amounts distributed under a QDRO to a former spouse of the participant are taxable to the spouse and amounts distributed to an alternate payee, other than the spouse or the former spouse, are taxable to the participant.

The definition of compensation for purposes of the deduction limitations will include salary reduction amounts treated as compensation under Section 415. In addition, the annual limitation on the amount of deductible contributions to a profit-sharing or stock bonus plan is increased from 15% to 25% of compensation of the employees covered by the plan for the year. Elective deferrals are not to be counted as contributions subject to the deduction limit. Also, except to the extent provided in regulations, a money purchase pension plan is to be treated like a profit-sharing or stock bonus plan for purposes of the deduction rules. These changes are effective after 2001.

The Act makes a direct rollover the default option for involuntary distributions that exceed $1,000 and that are eligible rollover distributions from qualified retirement plans. The distribution must be rolled automatically to a designated IRA, unless the participant affirmatively elects to have the distribution transferred to a different IRA, to a qualified plan or to receive it directly. This provision is effective for distributions that occur after the Department of Labor has adopted final regulations implementing these changes.

The otherwise applicable dollar limit on elective deferrals under a Section 401(k) plan, Section 403(b) annuity, SEP, SIMPLE and a Section 457 plan is increased for individuals who have attained age 50 by the end of the year. The catch-up contribution provisions do not apply to after-tax employee contributions. Additional contributions may be made by an individual who has attained age 50 before the end of the plan year and with respect to whom no other elective deferrals may otherwise be made to the plan for the year because of the application of any limitation of the Code (e.g., the annual limit on elective deferrals) or of the plan.

The additional amount of elective contributions that may be made by an eligible individual participating in such a plan of elective contributions is the lesser of (i) the applicable dollar amount or (ii) the participant's compensation for the year reduced by any other elective deferrals of the participant for the year. The applicable dollar amount under a Section 401(k) plan, Section 403(b) annuity, SEP, or Section 457 plan is $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 and thereafter. The applicable dollar amount under a SIMPLE is $500 for 2002, $1,000 for 2003, $1,500 for 2004, $2,000 for 2005, and $2,500 for 2006 and thereafter. The $5,000 and $2,500 amounts are to be adjusted for inflation in $500 increments after 2006.

As discussed above, the 25% of compensation limitation on annual additions under a defined contribution plan is increased to 100%. The exclusion allowance limitation for contributions to Section 403(b) annuities is repealed. Thus, such annuities become subject to the limits applicable to tax-qualified plans. The Act also increases the 33 1/3% of compensation limitation on deferrals under Section 457 plans to 100% of compensation. These provisions are generally effective after 2001.

For plan years beginning after 2001, the Act provides faster vesting schedules for employer matching contributions. Employer matching contributions are required to vest at least as rapidly as under one of the following two alternative minimum vesting schedules. A plan satisfies the first schedule if a participant acquires a nonforfeitable right to 100% of employer matching contributions upon the completion of three years of service. A plan satisfies the second schedule if a participant has a nonforfeitable right to 20% of employer matching contributions for each year of service beginning with the participant's second year of service and ending with 100% after six years of service.

Effective for distributions after 2001, rollover distributions from qualified retirement plans, Section 403(b) annuities, and governmental Section 457 plans generally can be rolled over to any of such plans or arrangements. Similarly, distributions from an IRA generally are permitted to be rolled over into a qualified plan, Section 403(b) annuity or governmental Section 457 plan. The direct rollover and withholding rules are extended to distributions from a governmental Section 457 plan, and such plans are required to provide the written notification regarding eligible rollover distributions. The rollover notice (with respect to all plans) is required to include a description of the provisions under which distributions from the plan to which the distribution is rolled over may be subject to restrictions and tax consequences different than those applicable to distributions from the distribution plan. Qualified plans, Section 403(b) annuities and Section 457 plans would not be required to accept rollovers.

Employee after-tax contributions may be rolled over into another qualified plan or a traditional IRA. In the case of a rollover from a qualified plan to another qualified plan, the rollover must be accomplished through a direct rollover. A qualified plan is not permitted to accept rollovers of after-tax contributions unless the plan provides separate accounting for such contributions (and earnings thereon). After-tax contributions (including nondeductible contributions to an IRA) are not permitted to be rolled over from an IRA into a qualified plan, Section 403(b) annuity or Section 457 plan.

The Act provides that surviving spouses may roll over distributions to a qualified plan, Section 403(b) annuity or governmental Section 457 plan in which the surviving spouse participates.

Under present law, loans by a qualified plan to an owner-employee, usually a partner sole proprietor, or owner of an S Corporation, are not permitted because they are generally considered prohibited transactions. Effective after 2001, owner-employees may receive loans from qualified plans under the same circumstances as other participants. Loans from IRAs are not permitted.

Under existing law, amounts distributed from an IRA or qualified plan generally may be rolled over into another IRA or qualified plan on a tax free basis, if the roll-over is completed within 60 days of the date of distribution. This rule has been strictly construed.

As to distributions after 2001, the Secretary of Treasury is able to waive the sixty day requirement for rollovers where the failure to do would be against equity or good conscience, including casualty, disaster or other events beyond the reasonable control of the individual subject to the requirement.