Kim Baptiste, Susan Frunzi, Howard Sharfstein and William Zabel
The "Economic Growth and Tax Relief Reconciliation Act of 2001" was signed into law by President Bush on June 7, 2001. The new law provides for the gradual reduction of marginal federal income tax rates and the repeal of the federal estate and generation-skipping taxes by 2010, as well as other changes. The most significant provisions are summarized below. It should be noted that the true cost of the tax bill is hidden by a variety of provisions that postpone most of the benefits for five years or more and cause all of the tax cuts to expire after 2010.
Estate And Generation-Skipping Tax
- Repeal - Both the estate tax and the generation-skipping tax are repealed in 2010, but only for that year. As long as the repeal remains in effect, the current step-up in basis rules at death will be replaced with carry-over basis rules, discussed below.
- Unified Credit - At present, an individual may leave up to $675,000 to any one or more persons other than a spouse free of estate tax. The same exemption applies to lifetime gifts. Thus, a married couple can effectively bequeath or give a total of $1,350,000 to their children tax free under current law.
Under the new law, the amount of the exemption gradually increases over the next ten years, but only for purposes of the estate tax. The gift tax exemption will only have one modest increase in 2002. Accordingly, starting in 2004, the amount an individual can leave at death tax free will be greater than the amount that can be given away during his lifetime. The unified credit exclusion amount, as applicable to the estate tax, will increase as follows:
|
Year |
Exclusion |
|
2002-2003 |
$1 million |
|
2004-2005 |
$1.5 million |
|
2006-2008 |
$2 million |
|
2009 |
$3.5 million |
These increased amounts are for each individual, so that a married couple can leave twice the amount indicated tax free. The same exemption applies to the generation-skipping tax, which is another layer of transfer tax imposed on transfers to grandchildren and more remote descendants.
- Reduction in Rates - The highest marginal estate tax rate of 55% is reduced to 50% in 2002 and gradually further reduced to 45% by 2007, where it will remain until 2010 when the estate tax is repealed. In addition, the five-percent surtax for estates over $10 million, which phases out the benefits of the graduated rates, is repealed in 2002.
- Carry-over basis - Under current law, when a decedent dies, the tax basis in his or her assets is "stepped-up" to the assets' fair market value at the time of death. This allows the decedent's heirs to reduce or completely avoid any capital gains tax on the sale of inherited property. Under the new law, once the estate tax is repealed in 2010, this basis step-up will be limited to the first $1.3 million of assets passing to anyone and an additional $3 million of assets passing to the decedent's surviving spouse. The basis of all assets acquired from a decedent exceeding these amounts will be equal to the lesser of the decedent's basis or the fair market value of the assets at the decedent's death.
This change effectively converts the estate tax to an income tax (which will be due on the sale of an asset). Under current law, the basis of a decedent's assets could be stepped-up or down at death, depending on whether the assets had appreciated or depreciated in value. Once the estate tax is repealed in 2010, there will be no opportunity for a step-up, only a step-down. Taxpayers will now need to keep records indefinitely in order to be able to substantiate their basis for income tax purposes. Most people think that many more taxpayers will be subject to income tax under the new carryover basis rules than pay estate tax under current law.
- State Death Tax Credit - Under current law, there is a credit against the federal estate tax for the amount a decedent's estate pays in state death taxes. In most states, including New York, the amount of the state death tax is equal to the federal credit, so that essentially the state receives a portion of the estate tax that the federal government would otherwise receive. For example, for a large estate in New York, the effective combined federal and New York estate tax is 55%. Of that total amount, the federal government receives 39% and New York receives 16%, which is the amount of the federal credit.
Under the new law, the federal credit (and the state's corresponding death tax) will be reduced beginning in 2002 and will be repealed entirely in 2005. The federal credit will be replaced with a deduction for state death taxes actually paid. Since a deduction is worth less than a credit, this change will increase the amount of federal tax. But more importantly, this repeal will eliminate the revenues most states derive from estate taxes. This may force these states to impose new estate or inheritance taxes in order to replace some or all of this lost revenue.
Gift Tax
The gift tax is not repealed. The unified credit exclusion amount for gift tax purposes will rise to $1 million in 2002 (from the current $675,000) and will remain at that amount. The gift tax rate will be the same as the gradually declining maximum estate tax rate until 2010, when the estate tax is repealed. From then on, the gift tax will be a flat tax imposed at the top marginal individual income tax rate in effect at the time of the gift (which will be 35%, unless changed by subsequent legislation).
Congress has indicated that it retained the gift tax in an effort to avoid multiple transfers between high income taxpayers and low income taxpayers. Such transfers would be aimed at reducing the high income taxpayer's income tax liability on the sale of an appreciated asset.
The generation-skipping tax exemption for lifetime transfers will remain unchanged at $1,060,000 (indexed for inflation)until 2004 when it will start to increase in stages at the same rate as the estate tax exemption.
Individual Income Tax
- Rate Reductions - The new law creates a new 10% bracket for a portion of taxable income that is currently taxed at 15%. This 10% bracket applies to the first $6,000 of taxable income for an individual and the first $12,000 for married taxpayers (filing jointly) beginning in 2001.1 Beginning as of July 1, 2001, reductions in the other marginal rates are phased in gradually. By 2006, the top 39.6% rate will be reduced to 35%, the 36% rate to 33%, the 31% rate to 28% and the 28% rate to 25%.
- The limitation on itemized deductions will be reduced beginning in 2006 and will be eliminated by 2010.
- The restrictions on deductions for personal exemptions will be phased out beginning in 2006 and will be eliminated by 2010.
Marriage Penalty Relief
Partial relief from the marriage penalty is provided (beginning in 2005) by the gradual increase of the standard deduction and the gradual expansion of the 15% income tax bracket for a married couple so that each will be equal to twice that of an individual taxpayer by 2009.
Retirement Assets
The new law increases contribution limits to IRAs gradually from $2,000 to $5,000. In addition, contribution limits to 401(k) plans are increased gradually from $10,500 currently to $15,000 in 2006. After 2006, this amount will be indexed for inflation.
Education
Prepaid Tuition Plans - Under current law, distributions from prepaid tuition plans for qualified higher education expenses are subject to federal income tax to the extent of any appreciation in the plan assets. Under the new law, all distributions from the plan used for qualified higher education expenses, without regard to any appreciation, will be tax free. In addition, private colleges and universities will be able to establish these plans beginning in 2004.
Sunset Provisions
In what is certainly the most incredible feature of the new law, all of the tax changes, including the repeal of the estate tax, will expire, or "sunset," after December 31, 2010, and current law will automatically be re-instituted unless Congress affirmatively re-enacts the changes.
Whether the legislation will be re-enacted (in the same or a revised form) will depend on many unknown factors, including the composition of Congress, who is President, and other political circumstances and budgetary considerations at that time. Of course, it is impossible to predict what will happen. It is our view that if similar legislation were to be re-enacted, the repeal of the estate tax would again be phased in gradually, to reduce the negative impact that immediate repeal would have on the budget. Since we believe that the estate tax will continue to exist in some form for an unknown period of time, we recommend that clients continue to do active estate planning, including carefully planned lifetime gifting and maintaining existing life insurance that was acquired for wealth replacement purposes. Techniques such as GRATs, qualified personal residence trusts, charitable lead trusts and installment sales to grantor trusts will continue to be of great value.
Footnotes
1
The Government will issue "rebate" checks of this new 10% bracket to taxpayers up to $300 for an individual ($500 for a household) and up to $600 for a married coupleOriginally published in SRZ Client Alert June 2001
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.