Economic Growth and Tax Relief Reconciliation Act
The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “Act”) was signed into law by President Bush on June 7, 2001. The individual income tax rate reductions have received widespread publicity and, undoubtedly, you have read about and probably already received a great deal of information regarding these changes.
The five income tax rates (or “brackets”), in effect before the Act, ranging from 15% to 39.6 % will be reduced through 2006 to six brackets ranging from 10% to 35%. However, an immediate reduction of a portion of the 15% bracket to a new 10% bracket will result in the “rebate” checks which are to be sent to most taxpayers beginning this summer. A number of other income tax changes targeted to individuals (as opposed to businesses), including married couples, are also included in the Act. Important retirement savings and education benefits are also included in the Act. Significantly, there remain important income tax issues that will require the attention of Congress. In particular, without further amendment, the alternative minimum tax will apply to an expanding group of individuals and will surprise many in the middle class who, as regular income tax rates decrease, will find themselves becoming subject to the tax. As a consequence, many will end up losing some of the benefit of the regular income tax rate reductions because they will be swept into the alternative minimum tax net. Income tax relief to businesses, including corporations, will also be on the agenda for Congress to consider.
A detailed discussion of the income and retirement savings changes made by the Act is beyond the scope of this newsletter. Should you have a question regarding these changes, please feel free to contact any of the tax or employee benefits attorneys listed at the end of this newsletter. Rather, the focus of this newsletter is on the sweeping changes made to the so-called “death tax”. As you will see from this newsletter, notwithstanding the “hype” regarding the repeal of the federal estate tax, the additional estate and gift tax complexity introduced by the Act makes timely estate planning by many individuals even more critical now than before.
The Act made significant changes in federal tax law, including gradual repeal of the estate tax, reduction of the maximum gift tax rate, and repeal of the generation-skipping transfer tax. Despite the historic nature of this legislation, the full effect of the tax relief will not be realized until 2010. Furthermore, due to a sunset provision in the Act, these changes will be reversed in 2011 unless Congress reenacts the legislation prior to that time.
The Act repeals the estate tax, but not until 2010. Between now and then, the maximum estate tax rate gradually decreases. The top rate drops from 55% to 50% (on estates over $2,500,000) in 2002. Beginning in 2003, the maximum rate decreases one percentage point per year until it reaches 45% in 2007 (i.e., 49% in 2003; 48% in 2004; 47% in 2005; 46% in 2006; and 45% in 2007). The highest estate tax rate remains 45% during 2008 and 2009, and then the estate tax is repealed for decedents dying in 2010 or later.
In 2002, the Act also eliminates the phaseout of graduated estate and gift tax rates. The phaseout increased the tax rate on estates and gifts between $10 million and $17,184,000 to 60% and was designed to eliminate the benefit of the graduated rates below 55%.
In addition to the rate reductions, the Act increases the estate tax exemption amount (which is known as the “applicable exclusion amount” and is often referred to as the “unified credit”). From 1987 until 1997, the exemption permitted assets worth up to $600,000 to pass free of estate tax. Legislation in 1997 increased the applicable exclusion amount to $625,000 in 1998; $650,000 in 1999; $675,000 in 2000 and 2001; $700,000 in 2002 and 2003; $850,000 in 2004; $950,000 in 2005; and $1,000,000 in 2006 and later years. Under current law, this exemption applies to the gift tax as well.
The Act increases the estate tax exemption (but not the gift tax exemption) to $1,000,000 in 2002 and 2003; $1,500,000 in 2004 and 2005; $2,000,000 in 2006, 2007, and 2008; and $3,500,000 in 2009. Due to the increases in the exemption, the family-owned business deduction is eliminated in 2004. As noted above, the estate tax is repealed in 2010. Nevertheless, if Congress fails to reenact this legislation, the estate tax would be reinstated in 2011 with a maximum rate of 55% and an estate tax exemption of $1,000,000 (as specified by the 1997 tax legislation described above).
The credit for state death taxes is reduced gradually until it is replaced by a deduction in 2005. For decedents dying during 2002, the maximum credit for state death taxes will be 75% of what it otherwise would be under current law. The percentage decreases to 50% in 2003 and 25% in 2004.
The reductions in the maximum gift tax rate are the same as for the estate tax from 2002 until 2009 (i.e., 50% in 2002; 49% in 2003; 48% in 2004; 47% in 2005; 46% in 2006; and 45% in 2007, 2008, and 2009). In contrast to the estate tax, however, the gift tax is not repealed in 2010. Instead, the gift tax continues at the maximum individual income tax rate, which will be 35% in 2010. In another contrast to the estate tax, although the gift tax exemption increases to $1,000,000 in 2002, it does not increase any further.
Moreover, beginning in 2010, transfers in trust will be treated as taxable gifts, unless the trust is treated as wholly owned by the donor or the donor’s spouse under the grantor trust provisions. As a result, it no longer may be possible to qualify transfers in trust for the $10,000 annual gift tax exclusion by giving beneficiaries rights of withdrawal (so-called “Crummey” rights). Similarly, transfers into Section 2503(c) minors trusts no longer may qualify for the $10,000 annual gift tax exclusion.
Generation-Skipping Transfer Tax
The Act repeals the generation-skipping transfer (“GST”) tax with respect to generation-skipping transfers in 2010 or later. Between 2002 and 2009, the highest GST tax rate will correspond to the highest estate tax rate (i.e., 50% in 2002; 49% in 2003; 48% in 2004; 47% in 2005; 46% in 2006; and 45% in 2007, 2008, and 2009). Beginning in 2004, the exemption from the GST tax (which is $1,060,000 in 2001 and is indexed annually for inflation) will be the same as the estate tax applicable exclusion amount (i.e., $1,500,000 in 2004 and 2005; $2,000,000 in 2006, 2007, and 2008; and $3,500,000 in 2009).
Step up in Basis
In what may result in a significant increase in the federal income taxes on capital gains, the Act eliminates the automatic step-up in basis at death for decedents dying in 2010 or later. As a general rule, the basis for property acquired from a decedent will be the lesser of the decedent’s adjusted basis (carryover basis) or the fair market value at the date of death. Nevertheless, the Act does permit an estate to allocate an aggregate basis increase of $1,300,000. The Act permits further increases in aggregate basis for capital loss carryovers, net operating loss carryovers, and certain losses. In addition, the Act permits an aggregate basis increase of $3,000,000 for property passing to a spouse either outright or in the form of qualified terminable interest property. Thus, if an estate passes to a surviving spouse, up to $4,300,000 of capital gain may be avoided. The aggregate basis increase for nonresident alien decedents is $60,000.
The $1,300,000, $3,000,000, and $60,000 aggregate basis increase figures will be indexed for inflation beginning in 2011 (in increments of $100,000, $250,000, and $5,000 respectively). The aggregate basis increase cannot be used to increase any property’s basis above its fair market value. Furthermore, the aggregate basis increase does not apply to property acquired by the decedent for less than adequate consideration within three years prior to death (unless the property is acquired from the decedent’s spouse, and the spouse did not acquire the property for less than adequate consideration within three years prior to the decedent’s death).
In order to provide some relief from the elimination of the step up in basis, the Act permits estates, certain transferees, and certain revocable trusts to use the exclusion of gain on the sale of a decedent’s principal residence. If an estate uses appreciated property in order to satisfy a pecuniary bequest, the estate must recognize gain on the exchange only to the extent that the fair market value on the date of the exchange exceeds the fair market value on the date of death. The gain recognized by the estate increases the basis of the recipient.
Beginning in 2010, the Act requires estates greater than $1,300,000 to file information returns in order to keep track of allocations of the basis increase. There is a similar requirement for property received as a gift by a decedent within three years prior to death.
Due to the sunset provision in the Act, the changes described above will be reversed in 2011 unless Congress reenacts the legislation prior to that time. Thus, it is possible that Congress could scale back the tax relief significantly. The sunset provision was included in the legislation in order to avoid the so-called “Byrd Rule.” Named after West Virginia Senator Robert Byrd, the rule requires 60 votes in the Senate in order to alter revenue beyond a 10 year period. Although the legislation passed the House of Representatives by a wide margin, the legislation passed the Senate with only 58 votes. As a result, the so-called repeal of the death tax may never happen. The only certainty is that you need to make sure that your estate planning takes into account the effects of the ever-changing tax laws.