ongress once again has passed a complex piece of legislation that will make estate planning, as well as general tax planning, even more problematic for CPAs and their clients. A major component of the Economic Growth and Tax Relief Reconciliation Act of 2001 President Bush signed into law in June repeals the estate and generation-skipping transfer (GST) taxes as of 2010. (Unexpectedly, Congress did not repeal the gift tax.) Between 2002 and 2010, the act phases in lower rates and higher exemptions that apply to all forms of federal transfer taxes (the gift tax exemption, however, increases only once).
As if the new rules don’t make the estate planning process convoluted enough, the actual estate tax repeal is scheduled to occur only for 2010 unless Congress votes to extend it. Despite the uncertainty this creates, it is essential for estate tax practitioners not to overlook the fact that significant changes will take place for all transfer taxes as of January 1, 2002; certain transfer tax changes are even retroactive to the start of 2001.
BIG CHANGES COMING
This article focuses on the major changes to estate and gift taxes and the initial planning implications CPAs will need to discuss with their clients. (There actually are three separate transfer taxes—estate, gift and GST.) Important provisions include these:
As of January 1, 2001, expanded conservation exemption rules and modified GST tax rules apply.
As of January 1, 2002, there is a $1 million exemption for all transfer taxes, the top tax rate drops to 50% and the 5% estate tax surtax is eliminated.
The estate and GST taxes are phased out and ultimately repealed, along with an increasing exemption; the top tax rate drops from 50% to 45% by 2007.
The gift tax rate is significantly reduced as of 2010 (aligned with the top individual tax rate).
A nonincreasing $1 million gift tax exemption applies as of 2002.
The credit for state death taxes is reduced and then replaced with a deduction.
A limited step-up in basis applies beginning in 2010.
Basis reporting for large transactions is required beginning in 2010.
An expanded home-gain exclusion for the decedent’s principal residence for heirs applies beginning in 2010.
Estate-tax-installment-payment provisions will change beginning in 2002.
The exhibit below shows the maximum transfer tax rates and exemptions from 2001 (before changes) to 2011 (when the original rates are reinstated).
OTHER ESTATE TAX CHANGES
Besides the virtually immediate lowering of the estate tax rate and the higher exemption, other changes are scheduled to occur.
State death tax credit. Estates taxable at the federal level also generally incur some form of state death tax. Rules vary widely by state. Currently this tax is typically fully offset by a credit against federal estate taxes due. In fact, in lieu of more complex rules, some states levy a tax equal to the maximum federal credit. A potential problem for some clients is that, during the phase-out period, the federal credit for state death taxes is reduced and then changed to a deduction. In 2002, 2003 and 2004, the credit is 75%, 50% and 25%, respectively, of the previously allowable amount. In 2005 it becomes a deduction. Depending on the statutory language of individual states, this change could result in some estates paying more in transfer taxes than under current law. It also presents a problem for states, which may have to revise their death tax laws or miss out on what for some is an important source of revenue.
Basis rules. Estate planners will need to begin incorporating into clients’ estate plans the basis rule changes planned for 2010 and beyond. For example, CPAs should encourage clients to give away high-basis assets during the phase-out period. Currently, the cost basis of a decedent’s assets is “stepped up” to their fair market value on the date of death (or the alternate valuation date). Typically, this step-up is favorable because the heirs avoid tax on embedded capital gains and recordkeeping is simpler. If Congress actually eliminates the estate tax in 2010, a “modified carryover-basis” will apply. The stepped-up-basis increase will be limited to $1.3 million; surviving spouses get an additional $3 million. Basis increases will be indexed periodically for inflation after 2010 with increases occurring in high fixed amounts ($250,000 for a spouse; $100,000 for most others).
The law requires the executor to allocate the basis adjustment among the estate’s assets if they are valued above these amounts. This requirement could have potential liability implications for the executors of estates with multiple beneficiaries who might be unhappy with an executor’s allocation decisions. Upon repeal, executors of certain estates will be required to report basis information to the IRS and to the beneficiaries. This report will identify the property, the recipient, its tax character and the decedent’s basis. CPAs should work with clients and future executors to address these difficult issues beforehand and to obtain or establish proper basis records.
Although the Treasury Department hasn’t yet issued guidelines, if the estate tax is repealed, the modified carryover-basis is likely to work like this:
If an unmarried decedent’s only asset is stock valued at $500,000 with a $100,000 basis, the beneficiary will have a new basis of $500,000.
If an unmarried decedent’s only asset is stock valued at $5 million with a $100,000 basis, the beneficiary will have a basis of $1,400,000 ($1,300,000 step-up plus $100,000 original basis).
If a married decedent’s only asset is stock worth $5 million with a $100,000 basis, the stock will have a new basis of $4,400,000 when transferred to his or her spouse outright ($100,000 original basis plus $1,300,000 step-up plus the $3 million spousal provision).
For assets not stepped up in basis, the decedents will have a “carryover” basis (unless fair market value is lower). It’s already possible to anticipate problems between beneficiaries and the IRS. CPAs should make a concerted effort to help high- and moderate-net-worth clients determine the bases of existing assets. Fortunately, Congress provided additional relief in the act by expanding the exclusion of gain for sale of a decedent’s principal residence to apply to heirs upon repeal of the estate tax. (Previously, the exclusion did not apply due to a full-basis step-up.)
The net effect of the basis provisions is that, for larger estates, Congress is replacing a mandatory estate tax with a controllable capital gains tax (current long-term maximum rate of 20%). The ability to choose whether or not to incur the lower capital gains tax, and its timing, will present significant tax planning opportunities for CPAs and their clients.
Conservation easements. The act expands these easements, effective January 1, 2001, to include any property located in the United States. A conservation easement applies to a real property interest a taxpayer donates to a charitable organization (related to the charitable income tax deduction in IRC section 170(h)). The interest must be exclusively for “conservation purposes.”
Installment payments. The act expands the rules on installment payment of federal estate taxes by closely held businesses as of 2002 to include lending and financial businesses and makes them less restrictive as to the number of partners or shareholders. CPAs need to determine which of their clients benefit from these new liberalized rules and notify them of the changes.
GIFT TAX SURPRISE
The single biggest surprise in the transfer tax changes was that lawmakers did not repeal the gift tax, as was the case in the two previous transfer tax bills President Clinton vetoed. Among the possible reasons for their retaining the tax are concerns about revenue and potential income tax avoidance (by giving assets to low-income taxpayers). The new gift tax rules, however, will provide some immediate tax planning opportunities. Regardless of how much a taxpayer already has given away, the new $1 million exemption should allow him or her to give at least $325,000 tax-free, along with the unchanged $10,000 annual exclusion. (Note that although the $10,000 annual exclusion was to be indexed for inflation to the nearest $1,000 as part of the 1997 tax act, with the low inflation rate there has been no adjustment to date.) The actual working of the exemption depends on how the new $1 million “unified credit effective exemption amount” is incorporated in the tax calculation. Assuming it is similar to the current unified credit, the following example would apply.
Example. Mary, a high-net-worth taxpayer who has never made taxable gifts, makes a taxable gift of $675,000 in 2001. (A taxable gift is one over the $10,000 annual exclusion.) The tax on the gift—$220,550—is fully offset by the 2001 unified credit. Under the previous rules, if a taxpayer had wanted to make another taxable gift in 2002 to take full advantage of the marginally increased unified credit, he or she would have been able to make an additional taxable gift of only $25,000 ($700,000 less $675,000). Under the new credit, Mary should be able to make additional taxable gifts of up to $325,000 ($1 million less the $675,000 already given in 2001) in 2002 or later without incurring the federal gift tax.
Previously, experts routinely had advised high-net-worth individuals to make gifts aggressively. Due to the then unified nature of the estate and gift taxes, for every $1 million given away, a taxpayer potentially saved a total of $672,000 in transfer taxes (assuming the donor survived the gift by three years). Even now, an advantage to making gifts is that the value of the property is established and any appreciation is not taxed for transfer tax purposes. The major disadvantages are that the donor incurs the gift tax immediately ($550,000 per $1 million given at the top stated tax rate in 2001), he or she loses control over the asset and a carryover-basis applies.
With the post-2001 transfer tax rules, the advantages of giving are less apparent. If an individual makes taxable gifts and Congress permanently repeals the estate tax during his or her lifetime, the taxpayer will have paid an unnecessary and material tax. Conversely, if the repeal does not occur, or occurs just for tax year 2010, then high-net-worth individuals generally will incur less overall transfer taxes by making taxable lifetime gifts. In addition, the tax rates during the phase-out period will be low by historical standards.
Many observers are focusing, almost exclusively, on the fact that the estate tax repeal will be protracted, could be rescinded and applies only for 2010. While these are critical concerns, planning is still possible, even essential, beginning next year. The higher gift tax exemption, the increasing estate and GST exemptions and the lower top rate (with no surtax) all afford clients potential savings. Most high- and moderate-net-worth individuals will need to revise their wills, perhaps annually. For example, wills must be structured to maximize the phased-in higher exemption and to fully utilize the new limited step-up in basis (outright distribution or qualified terminable interest property). However, on a cautionary note, taxpayers, their CPAs and attorneys must weigh maximum use of the higher exemption amounts against a spouse’s financial needs. Incorporating all of these factors in an estate plan is critical. By strategically initiating the estate planning discussions in a yearend tax letter, with a follow-up during a tax return preparation meeting, CPAs can become an integral part of the overall planning process.
The 2001 legislation results in considerable changes that take effect as of January 1, 2002. Unlike some recent transfer tax legislation, there are meaningful changes even for large estates—in 2002 the higher exemption, the elimination of the 5% surtax and the lower 50% tax rate will result in significant savings. For example, a $20 million taxable estate will save approximately $1.3 million in federal and state taxes (assuming the law treats the unified-credit-effective-exemption amount as it treated the current unified credit). The $1 million exemption applicable in 2002 and 2003 eliminates federal tax on more than one-third of all taxable estates. Exemption increases in 2004, 2006 and 2009 will result in a further decrease in the number of taxable estates.
The increasing exemptions will give many taxpayers the impression they can avoid dealing with estate tax issues (a common problem in estate planning). CPAs can respond by emphasizing that only through proper planning can clients make maximum use of the increasing exemptions. For example, CPAs can stress the advantages of using the unified credit now to transfer assets likely to appreciate in value and the cumulative effect of annual exclusion gifts. CPAs have access to a taxpayer’s financial data on at least a yearly basis (typically, estate attorneys lack this access). In addition, CPAs usually prepare their clients’ gift tax returns. Tax practitioners can strategically use this information to make an informed and well-prepared presentation on the need to initiate the estate planning process. If a CPA begins the process, he or she is much more likely to play an integral part in it.
CPAs should work closely with a client’s attorney to make sure that client takes full advantage of all available relief. They should discuss alternative scenarios with a client before he or she meets with the attorney. Should a client hedge her estate tax exposure by making gifts? Some will want to give the tax-free $1 million outright. Should a client give now at the 55% rate, in 2007 when the 45% rate applies, in 2010 when the 35% rate applies or not at all? Should a taxpayer incorporate a complex strategy such as a grantor-retained annuity trust, a dynasty trust or a family limited partnership in his estate plan? Other potential planning devices might involve the use of family loans or term life insurance during the phase-out period. (For a summary of client planning opportunities, see the sidebar below.)
Retirement issues. Taxpayers also need to consider the income tax ramifications of retirement plans in their estate planning. Retirement plans often are a significant portion of clients’ taxable estates. Not only are they fully subject to estate taxation, but they also often have an income tax exposure when the beneficiary withdraws the funds (which the law can force a beneficiary to do at a certain time). Even if Congress fully repeals the estate tax, the potential income tax on retirement plan balances is imposing. Naming the spouse as beneficiary, using life insurance or donating retirement funds to charity are all tax planning methods CPAs can recommend under the right circumstances.
Because fewer than 60 senators voted for the tax bill on May 26, 2001 (58 for to 33 against), the Byrd rule applies. The net effect of this rule is that, unless Congress votes to permanently extend the estate tax repeal, it applies only in tax year 2010. Obviously, no one can predict when or if a permanent repeal will actually occur. Congress is known to change its mind quickly. The $1 million unified exemption was originally scheduled to be fully phased in by 2006; now both estate and gift taxes will have $1 million exemptions as of 2002.
The politics of this issue have changed. Estate planners who fail to appreciate this could end up costing their clients money. As early as 2000, the congressional repeal of all transfer taxes (ultimately vetoed) had significant Democratic support. A separate tax bill making the 2010 repeal permanent already has been introduced in Congress. It is important to note that all transfer taxes combined bring in less than 2% of federal revenue—just $29 billion in 2000. On the other hand, transfer tax changes constituted 10.22% of the expected 10-year cost of the 2001 act ($138 billion of the $1.35 trillion).
Opponents of the estate tax successfully labeled it a “death” tax. In a June 2000 Gallup poll, 60% of those polled supported the elimination of estate taxes. Some wealthy Americans, such as Warren Buffet, campaigned against repeal. It is, however, ironic that many of these individuals have acknowledged they are “planning around” the estate tax using charitable and other techniques that can be structured to bestow significant benefits on heirs for multigenerational periods (if not longer).
With proper planning, taxpayers can creatively use the bill’s early provisions to save a material amount on the cost of transferring their taxable estates to the next generation. CPAs can suggest new estate planning strategies that will enable clients to make full use of historically low rates and high exemptions. To take full advantage of these extremely favorable legislative changes CPAs will need to be especially innovative in assessing the interplay between the changes that occur immediately and those that will be phased-in over time. This interplay will, in fact, require CPAs and estate planning attorneys to develop new estate planning tactics—strategies that may change annually over the next 10 years.