General Practice, Solo & Small Firm DivisionMagazine
VOLUME 19, NUMBER 2 MARCH 2002
ESTATE AND FINANCIAL PLANNING
The 2001 Tax Act: Uncharted Waters for Estate Planners
By Charles F. Newlin and Andrea C. Chomakos
The Economic Growth Tax Relief Reconciliation Act (Act) provides that beginning in 2002, the unified credit will be raised to increase the exemption equivalent for gift and estate taxes to $1 million per person. The generation-skipping transfer (GST) exemption in 2002 will be the same as under the law before the Act. The top marginal gift and estate tax rate will be reduced to 50 percent.
In 2003, the estate and gift tax unified credit will continue to provide a $1 million exemption equivalent. The GST exemption will be the 2001 amount of $1,060,000, adjusted for inflation. The top marginal rate will decline to 49 percent. Beginning in 2004 and continuing through 2009, the unified credit for gift tax purposes will continue to provide an exemption equivalent of $1 million. The estate tax unified credit will continue to increase, with the GST exemption being the same amount as the estate tax exemption equivalent.
As of January 1, 2004, the gift tax exemption allowed for transfers made during life will remain at $1 million, while the estate and GST tax exemptions will increase in tandem. Taxpayers will be able to transfer substantially more at death than during life without incurring a transfer tax. Although the resulting gift and estate tax exemption equivalents are no longer "unified," they are not separate credits. Lifetime taxable gifts will continue to "use up" part of the credit that would be available for estate taxes.
The effect of the increasing exemption and the decreasing maximum rates, with no adjustment to the lower rates, will "flatten" the estate tax. By 2006, both the estate tax and the GST tax will be flat taxes with a single rate.
Other transfer tax changes effective before 2010. Beginning in 2005, the state death tax credit will be repealed and the decedent's estate will be able to claim a federal estate tax deduction only for any state death tax paid. This change creates an immediate problem for those states that impose a "pick up" tax equal to the maximum credit allowable under § 2011. The more obvious problem is the loss of revenue to these states as Congress shifts part of the financial impact of the phase out to the states. If different states choose different solutions to this problem, clients will be faced with the old question of where one should be domiciled to minimize the state death tax. The less obvious problem arises from the language some states have used to impose the pick up tax. In some states, this repeal in the Act may not change the amount of state estate tax to correspond to the declining maximum federal credit allowable. Whether the change will occur depends on whether the state tax statute refers to § 2011 "as then in effect" or "as subsequently amended" or words to that effect.
Two significant changes in the GST tax provisions are (1) the automatic allocation of exemption for "indirect skips" and (2) the ability to retroactively allocate exemption for certain other transfers. An "indirect skip" is defined as a transfer made after December 31, 2000, to a GST Trust if the transfer is subject to gift tax or estate tax or is subject to the rules on the estate tax inclusion period (ETIP). A "GST Trust" is a trust that could have a generation-skipping transfer unless the trust meets one of six requirements. If the trust does not satisfy any one of those six requirements (and, therefore, is a GST Trust), the Act attempts to protect taxpayers against the pitfalls of the ETIP rules and the incorrect allocation of GST exemption. If a trust is subject to the estate tax inclusion period and there is more than a remote chance that a skip person will take under the trust, the new provision automatically allocates the taxpayer's unused GST exemption to the transfer to make the inclusion ratio on the transfer zero.
The Act allows a retroactive allocation of GST exemption to trusts in the following cases: the beneficiary is a non-skip person, is a lineal descendant of the grandparent of the transferor or the spouse or ex-spouse, is assigned to a generation younger than the transferor, and dies before the transferor.
Retention of gift tax. The Act repeals estate and GST taxes for estates of decedents who die after 2009 and (for the GST tax) for lifetime transfers made after 2009. Various recapture provisions will continue to apply to estates of decedents who die before 2010 if the estates benefited from certain estate tax provisions.
The gift tax will remain in place even after 2009. The gift tax exemption will increase to $1 million in 2002 and will remain at that level even after repeal of the estate and GST tax. The maximum gift tax rate will gradually decline, along with the maximum estate tax rate, through 2009. In 2010, the maximum gift tax rate will be 35 percent. Also beginning in 2010, any 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 for income tax purposes under the grantor trust rules. The eventual repeal of the estate tax will eliminate or reduce the desirable step-up in basis for assets held until death, which will put transfers at death on a par with transfers during life. The eventual repeal of the estate tax will end the advantage for lifetime transfers arising from the tax-exclusive method of calculating the gift tax.
Finally, in exchange for the repeal of the estate tax as of January 1, 2010, the adjustment to the basis of assets included in a decedent's gross estate to fair market value will also be repealed. The Act provides substantial relief for the problems of carryover basis, however, by allowing the executor to increase the basis of assets owned by the decedent. It is important to distinguish this provision of the Act from similar provisions in prior proposals. The Act provision on increasing basis refers to the amount by which the basis of assets may be increased and not the value of assets owned by the decedent that may receive a basis increase. The allocation of step-up in basis is to be made by the decedent's executor on an asset-by-asset approach. It appears that the Act does not permit QTIP property to receive any of the surviving spouse's step-up allocation on the death of the surviving spouse.
Habits for highly effective estate planners. Existing plans should be reviewed to determine how they will apply to the client's current situation under the Act. Estate planners must broaden the focus of their work beyond transfer tax savings. As transfer taxes are reduced and, perhaps, eventually eliminated, transfer tax issues will change and will have less importance. Income tax planning will become a more prominent aspect of the work, as will the need to consider the client's goals in disposing of wealth.
Estate planners must educate clients on the nontax aspects of dispositive provisions, particularly the benefits of trusts and the extent of a beneficiary's control over property received. They must work with the client to identify appropriate ways to build flexibility into the estate plan to deal with future developments, including tax law changes.
If legal, political, and economic factors are tending toward full estate tax repeal and use of carryover basis with a partial step-up, planners should work toward taking full advantage of any available basis step-up. Estate planners must create documents that properly provide for fiduciaries or others that may be responsible for the flexibility being built into the new estate plans and the basis allocations that may have to be made.
Charles F. Newlin is a partner in the Chicago, Illinois, office of McGuireWoods LLP. Andrea C. Chomakos is an associate in the Charlotte, North Carolina, office of McGuireWoods LLP.
This article is an abridged and edited version of one that originally appeared on page 32 of Probate and Property, September/October 2001 (15:5).