Tax and Estate Planning After the "Repeal" of The
Estate Tax
The
Economic Growth and Tax Relief Reconciliation Act of 2001 made many
significant changes to the Internal Revenue Code. The most notable to
many people is the scheduled repeal of the Estate tax by the year 2010.
Some think that this means that estate
tax planning is no
longer necessary. That might
be true were the repeal immediate
and
definite. In fact, the need
for continued estate tax planning is quite clear, because under the
terms of the repeal the tax is still in place until the year 2010,
and it is fully reinstated
in the year 2011 unless
Congress again votes to eliminate the tax.
The need
for estate planning will continue even if the Estate tax law is
ultimately repealed. First, while estate planning is often motivated by
the taxes that might be imposed on one’s estate, it also involves
planning to provide for the protection and disposition of assets. A
properly designed estate plan ensures that your assets will pass to the
beneficiaries you choose, and
in the manner that you want. For example, it is often desirable to leave
assets in trust to protect those assets from being reached by the
beneficiary’s creditors (which can include a spouse in the event of a
divorce), to provide for minor or disabled beneficiaries, or to provide
otherwise for an orderly disposition of your assets.
Even if the
Estate tax is ultimately repealed in the year 2010 and is further
repealed for future years, between now and 2010 the tax is only being
phased out. Thus, there is always the possibility that death could occur
before the tax is fully phased out.
Prior Law
The estate
tax law prior to The Economic Growth and Tax Relief Reconciliation Act
of 2001 provided for a tax on estate and gift transfers in excess of an
“exclusion amount” (often erroneously called an "exemption") of $675,000
for 2001. That exclusion amount had been scheduled to increase gradually
to $1,000,000 by the year 2006. In addition, there is a Generation
Skipping Transfer Tax (the "GST Tax"). The purpose of the GST Tax is to
partially plug the loophole that allows assets to pass from one
generation to the next without the imposition of the Estate tax. The GST
tax rate is a flat tax imposed at the maximum Estate tax rate (55% for
2001) when assets pass to a person more than one generation below the
original transferor. A parent might leave $1,000,000 in property in
trust for his children. Assuming the maximum $1,000,000 estate tax
exclusion amount, that amount passes without any estate taxes to his
children. If the trust provides that the property is to be retained in
trust for the children’s entire lifetimes, when those children
subsequently die, the assets in the trust will not be subject to any
estate taxes when they now pass to the next generation, i.e., to the
original transferor’s grandchildren. It is at this time, however, that
the GST tax may be imposed, because the government does not like the
fact that the children received the use and enjoyment of the property
for their lifetimes and can now pass that property on to their own
children (the grandchildren) without further transfer taxation. Thus,
when those assets do pass to the grandchildren, the GST tax will apply.
There is, however, an exemption of $1,120,000 that can be applied
against this GST tax. Thus, in the above example, the original
$1,000,000, plus whatever it appreciates to, could escape both
the Estate tax and the GST tax at the children’s death.
Repeal of Estate and GST Taxes
Congress
has repealed the foregoing taxes with respect to the estates of persons
dying after December 31, 2009. While the Estate and GST taxes
will be repealed, the Gift Tax will be retained, more or less in
its current form. The reason for the retention of the Gift Tax is to
prevent persons from easily avoiding income taxes by transferring assets
to relatives in lower income tax brackets.
Does Phase-out Require Changes in your Plan?
In most
cases, the dispositive scheme of your estate plan probably does not need
immediate modification. In some cases, however, estate plans are
designed with a formula that provides that the amount that is exempt
from Estate taxes (the "old" $675,000 exclusion amount previously
applicable in 2001) would pass to the children with only the
excess over that exempt passing to the surviving spouse. With the
substitution of a $1,000,000 exclusion amount in 2002 and higher amounts
in later years ($1,500,000 in 2004 and 2005, $2,000,000 in 2006, etc.),
that type of formula might leave
everything to the children in a moderate sized estate, leaving
nothing for the surviving spouse. While this type of formula is not
typical, it is sometimes used, particularly in the case of second
marriages. Each spouse may have children from a prior marriage and each
wishes to leave part of their estates to their children and part to the
spouse. If the repeal actually goes through in 2010 and remains
permanent, even a very large estate will leave everything to the
children if such a formula is used. Thus, in some cases, immediate
changes are in order.
Reduction of Estate and Gift Tax Rates
The present
rate schedule used in computing the Estate and Gift Taxes contains rates
ranging from 37% (after the exclusion amount) to a top rate of 55% (for
amounts exceeding $3 million). In addition, a 5% surtax is imposed on
cumulative taxable transfers between $10 million and $17,184,000, which
has the effect of phasing out the benefit of the graduated rates
(effectively making the effective top marginal rate close to 60% for
certain large estates).
Effective
for estates of decedents dying, and gifts made, after December 31, 2001,
the top marginal Estate and Gift Tax rate is reduced to 50%, applicable
to amounts in excess of $2.5 million. In addition, the 5% surtax is
repealed for estates of decedents dying, and gifts made, after
December 31, 2001.
Between
2002 and the year 2007, the maximum marginal Estate and Gift Tax rates
gradually decrease to 45% in the following amounts: 49% for persons
dying or making gifts in 2003, 48% in 2004, 47% in 2005, 46% in 2006,
and 45% in 2007. The same reductions apply to the rate used to determine
the GST Tax for those same years.
As earlier
noted, the Gift Tax will be retained following the repeal of the Estate
and GST taxes in 2010. For gifts made after December 31, 2009, the Gift
Tax will be computed using a rate schedule having a top effective
marginal rate of 35%, which will apply to amounts over $500,000.
Increase in Exclusion Amount
Under
current law, the estate of every decedent is allowed a credit equal to
the "applicable credit amount" in determining the amount of Estate tax
due. In application, this credit works to exempt from the Estate tax an
amount equal to the applicable exclusion amount then in effect. The
applicable exclusion amount for estates of decedents dying, and gifts
made, during 2001 is $675,000 and had been scheduled to gradually
increase to $1 million by the year 2006. This same amount applies to the
Gift Tax so that the Estate and Gift Tax provisions work in tandem to
effectively shield from transfer taxes a cumulative amount of transfers
(whether made during life or at death) equal to the applicable exclusion
amount.
Under the
new law, the applicable exclusion amount for estate (but not gift) tax
purposes will be gradually increased to $3.5 million by 2009, the year
prior to the total repeal of the Estate and GST taxes. The applicable
exclusion amount in effect for the years leading up to repeal is as
follows:
-
$1
million for decedents dying in 2002 and 2003;
-
$1.5 million in 2004 and 2005;
- $2
million in 2006, 2007, and 2008; and
-
$3.5 million in 2009.
Beginning with gifts made in 2002, the applicable exclusion amount for
Gift Tax purposes will be increased to $1 million. Unlike the gradual
increase in the Estate tax applicable exclusion amount in the years
leading up to repeal, the Gift Tax applicable exclusion amount will
remain at $1 million and is not indexed for inflation.
In light of
this pending repeal, the reduction of the Estate and Gift Tax rates, and
the increase in the Estate, gift and generation-skipping transfer tax
exemptions, planning strategies may be slightly different and may be
more focused on one’s age and/or health. For example, the focus for an
older client who might be more unlikely to survive until 2010 (i.e.,
until the planned repeal of the Estate tax) would be the reduction in
the value of his estate for Estate tax purposes. That would include the
use of various techniques under current estate planning practice to
transfer property at little or no Gift Tax cost. On the other hand, a
younger client in good health may choose to postpone transfers. Of
course, postponing transfers assumes that the client will survive until
2010 and that the estate tax is actually repealed.
Phase Out of State Death Tax Credit
Prior to
this new law, decedents’ estates were entitled to a federal credit for
state death taxes paid. As most states (Massachusetts and Florida among
them) had eliminated their own separate Estate taxes, this credit
essentially "split" part of the Estate tax between the federal
government and the state. This credit is more commonly referred to as
the "sponge" tax, which allows the state to share part of the Estate
taxes collected without adding to the estate tax burden.
Under the
new law, the state death tax credit will be reduced by 25% beginning in
2002 and will continue to decrease by an additional 25% each year
thereafter until it is repealed entirely in 2005.
With the
reduction in the state death tax credit, the states that use the sponge
tax approach will lose a substantial amount of revenue. As a result,
many states might try to replace that lost revenue by enacting a
separate estate or inheritance tax. In fact, Massachusetts (among
others) has passed legislation to offset this loss of revenue. (See
The "New" Massachusetts
Estate Tax.)
In 2005 the
credit for state death taxes will be replaced by a deduction. By
changing the state death tax credit to a deduction, the benefits to
taxpayers have effectively been reduced. A tax credit differs from a
deduction in that the credit is subtracted from the tax itself,
resulting in a dollar-for-dollar reduction in the tax liability. A
deduction is only worth as much as the marginal bracket of the estate.
Thus, for an estate that is paying a tax at the 45% rate, a deduction
of one dollar reduces the tax by 45 cents, whereas a credit
of one dollar reduces the federal tax by one dollar. Because most states
have eliminated their separate estate and/or inheritance tax, this
deduction will not have much of an impact on most estates until
those states re-enact their own separate estate or inheritance tax to
replace the loss of revenue.
Stepped-Up Basis Repealed
The "cost
basis" of an asset is essentially what one has paid for the asset. It is
used to determine the profit or “gain” that is taxed when the asset is
sold. The cost basis of property acquired from a decedent at death
generally is stepped up (or stepped down) to equal the value of the
asset on the date of the decedent’s death. In the typical situation
where property acquired from a decedent had increased in value during
the decedent’s life, this step-up in basis allows the recipient of the
property to sell the asset and completely avoid the income tax on all
the gain that occurred prior to the decedent’s death.
The
stepped-up basis at death is very different from the "carryover basis"
rule applicable to lifetime gifts of assets. Under the carryover basis
rule, the donor’s cost basis in assets transferred by gift becomes the
cost basis in the hands of the recipient.
In further
contrast, the recipient of property from a decedent not only receives a
stepped-up basis equal to its date-of-death value, but the recipient is
also generally deemed to have met the one-year capital gains holding
period whenever it is sold; Thus, any gain occurring after death
is deemed to be long term gain (taxed at a maximum of 20%), regardless
of how long the decedent owned the property before death.
Beginning
in 2010, as the estate tax is repealed, the stepped-up basis at death
rules will also be repealed. Those rules will be replaced with rules for
a modified carryover basis at death. These rules will likely cause more
complexity and confusion than might otherwise have initially been
thought. The new complexity, as well as the new penalty provisions, will
undoubtedly add greater risk for estate fiduciaries who make property
distributions and then become required to file information returns with
the IRS and others. These factors may prompt professional fiduciaries to
raise their fees generally for some estate services, or to charge
additional fees on a case-by-case basis where a decedent’s lack of
record keeping will require the fiduciary to spend an inordinate amount
of time and effort to establish the bases of assets. But regardless of
whether a professional fiduciary, or one of the decedent’s
beneficiaries, is named as executor and/or trustee, the key to an
efficient estate administration from a tax perspective will be to ensure
the adequacy of the decedent’s lifetime record keeping with respect to
his or her assets. Assets with uncertain bases will potentially be a
large problem for both estate fiduciaries and beneficiaries in the
future.
Carryover Basis for Property Acquired from a Decedent
Effective
for property acquired from a decedent dying after December 31, 2009, the
income tax basis of property acquired from a decedent will generally be
carried over from the decedent. More specifically, the recipient of the
property will receive a basis equal to the adjusted basis of the
property in the hands of the decedent or the fair market value of the
property on the date of the decedent’s death, whichever is the lesser.
As a
partial replacement for the repealed basis step-up, executors will be
able to increase the basis of estate property by up to
$1,300,000, or up to $3,000,000 in the case of property passing to the
surviving spouse, if any. In the case of the estates of nonresidents who
are not U.S. citizens, they are allowed an aggregate step-up of only
$60,000. Nonresidents who are not U.S. citizens are not allowed the
$3,000,000 spousal property basis increase.
Many
properties transferred at death to heirs and beneficiaries will have
appreciated in value during the decedent’s lifetime. (Real estate,
stocks, collectibles, and family businesses are typical examples.)
Because under the new carryover basis rules the recipient will take on
the tax basis of the decedent (as modified by adjustments noted below),
the recipient’s basis for such appreciated property will be a lesser
amount than under the old rules. Where this is true, the recipient will
incur a larger gain on the sale of the property than would have been the
case under the former stepped-up basis rules.
Unlike some
prior law changes affecting cost basis rules, there is no "fresh-start
rule" applicable to the carryover basis rules enacted by the new law.
Accordingly, no matter how long a living investor has owned a property,
if the investor survives until 2010 and still owns the property, his or
her executor will be called upon to determine the tax basis of any
non-cash property that will pass to the investor’s heirs or
beneficiaries at death. Although this may not be too difficult with
respect to readily marketable securities, it could be a daunting task
for other types of property, and may lead to uncertainty in establishing
basis. This could invite the IRS to make its own determination of basis
(normally not a "good thing" for taxpayers, when it happens). To avoid
these potential problems, investors and their advisors should carefully
begin investigating the tax basis of all assets of significant value.
The process should be much easier while the investor is alive and able
to help establish the facts surrounding property acquisitions and other
facts leading to basis adjustments.
Under the
existing stepped-up basis rules, an owner’s poor record keeping and/or
general ignorance of an asset’s basis can be "cured" at death, because
an asset’s basis is stepped-up to its date-of-death value. Because this
cure will not be available for assets acquired from a decedent after
December 31, 2009, an individual currently holding a property of
uncertain basis may do well to consider a sale or transfer of the
property during lifetime. While doing so will not necessarily avoid a
dispute with the IRS, the individual’s ability to provide facts in
furtherance of the claimed basis might lead to a better settlement with
the IRS than an executor could later obtain. In any case, a lifetime
resolution of a potential basis problem would remove unneeded
uncertainty for the heirs at a later date.
To be
weighed against this "dispose-of-the-problem-assets now" strategy,
should be a realistic estimation of the asset owner’s expected
longevity. If, because of advanced age or ill health, survival until
December 31, 2009 is unlikely and holding on to the asset still makes
sense from an investment point of view, a lifetime disposition of the
asset may needlessly squander the possibility for obtaining a stepped-up
basis under existing rules. If this were the case, the lifetime
disposition would probably not be wise.
Investors,
in order to give their beneficiaries a stepped-up basis in currently
under-performing, yet appreciated securities, sometimes have been known
to hang on to such securities long after the time has come to sell them.
With a stepped-up basis at death no longer a consideration for assets
that will be retained by an investor after December 31, 2009, investors
may feel freer to unleash their “dog” stocks.
The new law
grants to the executor of a decedent’s estate the authority to increase
(subject to the stated maximums of $1.3 million and $3 million) the
basis of assets passing from the decedent. Once made, an executor is not
able to change the allocation of increased basis except pursuant to
strict rules provided by the IRS. For this reason, it is important
either to have a very capable person named as executor or to have the
executor seek competent tax advice when the time comes.
In order
for the $3 million spousal property basis increase (instead of only
$1.3 million) to be available, the property transferred to the surviving
spouse must be "qualified spousal property." To be classified as
qualified spousal property, the transferred property must be either
"outright transfer property," or "qualified terminable interest
property" (QTIP property).
As a
general rule, outright transfer property means any interest in property
acquired from a decedent by the decedent’s surviving spouse
directly—without any restrictions on the spouse’s right to use and
dispose of the property.
The
definition of qualified terminable interest property (QTIP) for purposes
of the spousal basis increase rules closely tracks the statutory
language of the QTIP provisions relating to the allowance of the estate
tax marital deduction available under the law prior to the new law.
Essentially, this requirement is met if the assets pass to the spouse in
a typical "Marital Share" trust designed to qualify for the so-called
"marital deduction." If you have a trust that contains a "Marital Share"
created by Fedele and Murray, P.C., you can be fairly certain that the
assets passing to that portion of your estate plan are "qualified
spousal property."
The
$1,300,000, $3,000,000, and $60,000 basis increase amounts are subject
to adjustments for inflation occurring after 2010 pursuant to the
general cost-of-living adjustment provisions of the Code.
Reporting and Penalty Provisions
As noted
above, assets acquired from a decedent receive a basis that is stepped
up to its date-of-death value, and the recipient is generally deemed to
have automatically met the one-year capital gain holding period for such
assets. Under this stepped-up basis at death system, ascertaining basis
and holding period can be a straight-forward process even without
adequate records of the decedent, at least where marketable or readily
appraisable assets are involved. Where, however, a recipient of property
acquired from a decedent will take over the decedent’s basis and holding
period in the property, the recipient will need detailed information
from the decedent’s executor in order to determine the correct carryover
basis and holding period.
With the
eventual replacement of the stepped-up basis at death rules with the
carryover basis rules the government has a vital interest in ensuring
that individuals who receive property from a decedent after 2009 will
have the information necessary to correctly calculate their tax
liability on a later sale or exchange of the property. In order to do
this, the recipient will have to know the property’s basis, and the
applicable holding period (to determine if capital gain or ordinary
income tax rates apply). To this end, the law now includes penalty
provisions designed to encourage compliance with the reporting
requirements related to the enactment of the carryover basis at death
rules, which will be effective for estates of decedents dying after
December 31, 2009. These penalties apply both to failures to provide
information required for property received from a decedent, and property
received from a living donor who was required to file a Gift Tax return
relating to the transfer.
Unless
excused by a showing of reasonable cause, the executor or other person
who fails to file a required return by the applicable due date
(including extensions) will be liable for a penalty of $10,000.
Additionally, a failure to file written statements to property
recipients will subject the executor or other person required to file to
a penalty of $500 for each such failure.
Unless
excused by a showing of reasonable cause, a failure to furnish a written
statement to beneficiaries by the person having the responsibility to do
so is subject to a $50 penalty for each such failure.
If any
person’s failure to furnish a return or written information is due to
intentional disregard of the carryover basis reporting requirements, a
five-percent penalty will be assessed. For property acquired from a
decedent at death, this penalty will be applied against the fair market
value of the property on the date of death. For property acquired by
gift, the penalty will be applied against the fair market value of the
property on the date of the gift.
With all
these penalty provisions, it is easy to see why laws such as the estate
tax "repeal" are often referred to as "Lawyers and Accountants’ Relief
Acts."
Income Tax Exclusion for Sale of Principal Residence
Under
current law, each taxpayer may exclude from income up to $250,000 of
gain realized on the sale of a principal residence ($500,000 for a
married couple). The exclusion may be applied each time the taxpayer
sells a principal residence, provided the taxpayer owned the property as
a principal residence for at least two of the five years before the sale
and has not used the exclusion for another sale within the last two
years.
Under the
new law (because of the new carryover basis rules) the exclusion of gain
on sale of principal residence will be extended to estates, heirs, and
qualified revocable trusts. However, this change will not be effective
until 2010—when the carryover basis rules go into effect. The decedent’s
ownership and use of the property will be taken into account for
purposes of calculating the exclusion. Thus, the decedent must have
owned and occupied the property as his or her principal residence for a
total of two years during the five-year period prior to the sale for the
estate to exclude the gain.