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Post-EGTRRA Analysis and Planning The Economic Growth and Tax Relief Reconciliation Act of 2001 made extreme changes to the estate, gift and generation-skipping transfer (GST) tax laws, going so far as to repeal the estate and GST taxes by 2010. This article examines these changes and offers short- and long-term planning strategies.
Roby
B. Sawyers, Ph.D., CPA Brian
T. Whitlock, J.D., LL.M., CPA Editor's note: Messrs. Sawyers and Whitlock are members of the AICPA Tax Division's Trust, Estate and Gift Taxation Technical Resource Panel (TRP). Authors' note: The authors thank Evelyn M. Capassakis of PricewaterhouseCoopers LLP, Chair of the Trust, Estate and Gift Taxation TRP, for her helpful suggestions and comments. For more information about this article, contact Dr. Sawyers at roby_sawyers@ncsu.edu .
Executive Summary
The 107th Congress sculpted new estate and gift tax provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), including total repeal in 2010. While the EGTRRA has been heralded as the death of the estate tax, in actuality, it will arise again in 2011 if not extended.
Background A number of conservative lawmakers fought for years to repeal the Federal estate tax, but any widespread suggestion of repealing it during President Clinton's first term would likely have been met with ridicule and accusations of Congressional pandering to the wealthiest Americans.1 However, in May 1999, Sen. Jon Kyl (R-AZ) introduced S. 1128,2 calling for outright repeal of the estate tax and a carryover-basis regime with a limited basis step-up for up to $3 million of assets passing to a surviving spouse. Surprisingly, the popular press and middle-class America supported this effort and called for an end to the "death tax." Frustrated with an estate tax system that threatened to confiscate the modest savings of their elderly parents and impinge on the promised wealth of employee stock options and the roaring 1990s stock market, middle-class "baby boomers" began to view themselves as the estate and gift taxes' true victims. A modified version of S. 1128 (H.R. 83)—which would have incrementally reduced Federal transfer tax rates over 10 years, followed by full estate and gift tax repeal and a partial carryover-basis regime in the eleventh year—was passed by both the House and Senate, but vetoed by President Clinton in September 2000. A number of groups (including the AICPA) cautioned Congress of the potential problems with estate tax repeal and a carryover-basis regime (particularly a repeal with a prolonged phase-out period and little immediate relief). The AICPA prepared a study containing alternatives providing more immediate (and permanent) relief for the vast majority of taxpayers affected by the estate tax. However, it became increasingly clear that the death tax would be repealed.4 After President Bush's election, repeal of the death tax gained additional momentum. Supported by both the Republican-controlled House and the new Bush administration, the only question was whether the more evenly divided Senate would support estate tax repeal. It did; the EGTRRA was enacted on June 7, 2001. While some EGTRRA supporters have termed it the end of the death tax, in reality, repeal of the death tax is uncertain at best, taking place only after a prolonged nine-year phase out (on Jan. 1, 2010), then reappearing on Dec. 31, 2010 due to the sunset provision.5 The sunset provision also causes the EGTRRA's tax rate and effective exemption amount (previously, the applicable exclusion amount) changes to expire on Dec. 31, 2010 and to be replaced by the unified tax tables, rates, surtaxes, exclusion amount and basis step-up rules in effect in 2001.6 Effectively, the sunset provision treats EGTRRA as if it were never enacted. Finally, while the estate and generation-skipping transfer (GST) taxes are repealed by EGTRRA, the gift tax is not. In 2004, the EGTRRA effectively bifurcates the previously unified estate and gift tax system (a likely result of criticism that the income tax system would suffer from widespread erosion without a gift tax). While it is difficult to view the EGTRRA as true estate tax repeal, it does provide some short-term relief to middle-class taxpayers, by raising the gift and estate tax thresholds over the next few years. The EGTRRA also expands the possible use of conservation easements and estate tax installment payments, and eliminates some existing GST tax traps. Overall, there are benefits for taxpayers and practitioners alike, although planning may be more difficult.
EGTRRA Provisions Short-term Estate and Gift Tax Relief Under the EGTRRA, on Jan. 1, 2002, the unified credit effective exemption amount for estate, gift and GST tax purposes will increase from the current $675,000 to $1 million. At the same time, the top marginal gift and estate tax rates will decline from 55% to 50%; the 5% surtax on gifts and estates in excess of $10 million will be eliminated. As illustrated in Exhibit 1 on p. 824, the highest estate and gift tax rates will continue to decrease, until the highest rate reaches 45% in 2009.7 However, while the estate tax effective exemption and GST tax exemption will continue to rise, eventually reaching $3.5 million in 2009, the gift tax exclusion will remain at $1 million. On Jan. 1, 2004, when the estate and GST tax exemption increase to $1.5 million, the gift tax exclusion will remain at $1 million, resulting in an uncoupling of the estate and gift taxes for the first time in 28 years (since the Tax Reform Act of 1976).8 After repeal of the estate and GST tax in 2010, the maximum gift tax rate is reduced to the maximum individual income tax rate (presumably, 35%). Planning: While the scheduled increases in the estate tax effective exemption are welcome, tax professionals should pay careful attention to estate plans that rely on a formula to eliminate estate tax by increasing the assets going to a bypass trust as the effective exemption increases. In smaller taxable estates, this may result in too few assets passing to a surviving spouse.
GST Tax Retroactive to the beginning of 2001, the EGTRRA modifies the GST tax to remove a number of traps for taxpayers and tax advisers. The fundamental purpose of the GST tax is to ensure that a form of transfer tax is imposed at every generation. Without the GST tax, wealthy individuals could simply transfer assets directly to grandchildren (or even great-grandchildren), thus avoiding estate tax at the skipped generations' levels. Since 1986, each transferor has been allowed a $1 million GST exemption that can be allocated to transfers during life or at death. Beginning in 1999, the exemption has been indexed for inflation; the 2001 indexed exemption is $1.06 million. The GST tax has often been criticized as a trap for the unwary. To prevent the average taxpayer from having to deal with the complex GST tax rules and pay the tax, Congress provided an automatic allocation of the exemption to direct transfers (outright gifts). However, in connection with most transfers to trusts, taxpayers have to elect to allocate the GST exemption; serious problems can arise when taxpayers and practitioners fail to properly allocate it.9 The EGTRRA reforms the GST tax provisions and provides welcome relief.10 Specifically, it extends the automatic GST tax exemption allocation rule (that currently applies to direct skips) to GST trusts (trusts to which most people would want the GST exemption allocated). Planning: This automatic allocation will protect future contributions to many existing irrevocable life insurance trusts (ILITs). Taxpayers who do not want the automatic allocation to apply can elect out. Taxpayers may want to consider seeking retroactive relief in cases in which they have not regularly reported contributions or filed gift tax returns for previous contributions. The EGTRRA also provides statutory authority for the IRS to grant relief to taxpayers for late allocations and full discretion in granting relief for inadvertent mistakes made in prior years. Planning: In Notice 2001-50,11 the IRS confirmed that extensions to make an allocation or election may be sought under Sec. 9100. Taxpayers requesting relief should follow the procedures for requesting a letter ruling under Regs. Sec. 301.9100-3. The new law also confirms that substantial compliance provisions cover allocations evident from returns and other documents. Further, it extends the predeceased-parent exception to provide for retroactive allocation of the GST tax exemption for unnatural order of death when the transferor is still alive. It also provides a trust severance rule to cover various situations, including unexpected order of death and when there is an inclusion ratio between zero and one. Finally, it clarifies and liberalizes the valuation rules applicable to the allocation of the GST exemption. Planning: The availability of retroactive relief for GST exemption problems may inadvertently lull tax practitioners into a false sense of security and inaction. Under current law, the GST tax provisions will sunset along with all the other EGTRRA provisions. Under EGTRRA Section 521(c), the GST tax exemption remains at its current $1.06 million (and continues to be indexed for inflation) until Jan. 1, 2004, when it will increase to $1.5 million. Along with the estate tax exemption, the GST tax exemption will eventually increase to $3.5 million by 2009. Effective Jan. 1, 2002, the GST tax rate is reduced from 55% to 50% and will continue to decrease along with the highest estate and gift tax rates until eliminated in 2010 (see Exhibit 1).
State Death Tax Credit The state death tax credit was enacted in response to states' concerns that the Federal government was encroaching on their right to tax transfers at death; it has been a permanent feature of the Federal estate tax since 1926. The credit ranges from zero to 16% of the adjusted taxable estate (i.e., the Federal taxable estate less $60,000). Thirty-eight states and the District of Columbia provide that the only state tax at death is a "pick-up" tax (i.e., the state tax equals the Federal credit for state tax paid). The number of pick-up tax states was scheduled to increase to 40, with the inclusion of Connecticut and Louisiana by 2005.12 The remaining states have other forms of estate or inheritance taxes. However, if the state tax is less than the credit allowed against Federal taxes, the state tax is increased to the amount of the credit. Thus, the Federal credit for state death taxes effectively offsets most state estate taxes, minimizing interstate competition for the wealthy. EGTRRA Section 531 will restructure the Federal credit for state death taxes over the next four years. Beginning in 2002, the Federal credit is reduced 25% each year, until it is eliminated. Beginning in 2005, the credit is scheduled to change into a deduction, under EGTRRA Section 532. While the increase in the effective exemption to $1 million and the reduction of the highest marginal rate will result in a Federal revenue loss, it is lessened considerably by the reduction in the state death tax credit. Some commentators have suggested that the net effect of both increasing the effective exemption and reducing the state death tax credit is minimal during the first two years.13 If state legislatures do not act to repair the damage caused by the reduction of the Federal credit for state death taxes, the revenue loss from phasing out the Federal estate tax over the next few years will largely have been shifted by Congress from the Federal government to the states. During the Senate Finance Committee debate on the Federal state death tax credit, Sen. Phil Gramm (R-TX) correctly pointed out that nothing in the tax legislation prevents states from retaining their current estate or inheritance taxes. Rather than rely strictly on the Federal credit, the states could rely on the rate table previously used to calculate 100% of the credit and, thus, continue to collect the same amount of tax. However, the result for taxpayers would be disastrous, potentially increasing rather than decreasing total estate taxes paid in the next few years.14 The Federal state death tax credit has allowed states to "piggyback" not only the tax determination, but also tax administration. Few state agencies employ revenue agents or auditors to oversee the determination of their "pick-up" tax. State legislatures would be foolish to abandon this source of revenue or to substitute a new estate or inheritance tax that would require the creation of large administrative bureaucracies. Through 2009, state legislatures can continue to piggyback on the Federal estate tax for the determination of their pickup tax and rely on the IRS for administration. Only when the Federal estate tax system is actually repealed do the state legislatures truly need to replace their pick-up taxes. Planning: The change from a Federal credit for state death taxes to a deduction should send drafters back to the funding language contained in wills and trusts. Many documents contemplate the funding of a by-pass or credit shelter trust, using a formula that will result in no increase in either the Federal or state tax at death. Form language may need to be altered to acknowledge the state tax as a deduction rather than as a credit. Planning: If state legislatures act to establish their own systems of estate and inheritance taxes to replace the lost revenue, the multistate estate tax planning implications could be very complex and costly for taxpayers and advisers.
Carryover Basis Starting in 2010, concurrent with the repeal of the estate and GST taxes, the EGTRRA repeals the basis step-up to fair market value (FMV) for assets passing at death and replaces it with a modified carryover-basis rule. Under the new rule, a recipient's basis in property acquired from a decedent will be the lesser of the adjusted basis of the property at death or the FMV on the date of death. Each estate will be permitted to increase the basis of assets owned by the decedent and transferred at death by an additional $1.3 million.
Planning: The split-basis rules for gifts continue to apply when the donor's adjusted basis is greater than the gifted property's FMV. Thus, it generally remains advantageous to gift property with a basis in excess of FMV, rather than passing the asset to a recipient at death. (Of course, better planning may entail the original owner selling the loss property instead of gifting or bequeathing it.) In general, liabilities in excess of basis are disregarded in determining a property's adjusted basis and whether gain is recognized on the acquisition of property from a decedent. By itself, this provision seems to allow encumbering an asset shortly before death to circumvent the carryover-basis rules.15 However, the EGTRRA specifically prohibits application of the rule in the case of a transfer to a tax-exempt beneficiary (generally, a tax-exempt organization, foreign person or entity or any governmental unit, agency or instrumentality). A key component in determining whether an asset qualifies for an additional basis increase is whether the asset is deemed owned by the decedent. Property held jointly with a surviving spouse will be deemed to be owned 50% by the decedent. For property held jointly with another person, the decedent will be treated as the owner to the extent of his proportionate consideration paid for the property. Property held in a revocable trust will be deemed owned by a decedent, but not property over which the decedent had a general power of appointment. Finally, both the decedent's half and the surviving spouse's half of community property will be deemed owned by the decedent and eligible for an additional basis allocation. In addition, an estate will receive additional basis, equal to the sum of (1) the decedent's unused capital loss carryforwards, (2) the decedent's unused net operating loss carryforwards and (3) any losses allowable under Sec. 165 had the property acquired from the decedent been sold at FMV immediately before the decedent's death.
An estate will also be allowed an additional $3 million of basis increase (indexed for inflation after 2009) for assets passing to a surviving spouse (including outright property transfers and qualified terminable interest property). Special provisions prevent the additional basis step-up from being allocated to stock of a foreign personal holding company, a domestic international sales corporation (DISC) or former DISC, a foreign investment company or a passive foreign investment company. Likewise, property acquired by the decedent by gift within three years of death is not eligible for a basis step-up unless acquired from his spouse. Planning: This provision prevents a low-basis asset from being gifted to a taxpayer in anticipation of the recipient's death to obtain a basis step-up to FMV. Finally, income in respect of a decedent (IRD) assets (e.g., individual retirement accounts, Sec. 401(k) plans and other retirement plans) are not eligible for a basis increase. Planning: The additional increase in basis for assets passing to a surviving spouse should cause tax practitioners to rethink planning as to spousal transfers. In general, effective planning would dictate that the highest-basis assets be left to children (assuming that the $1.3 million additional basis could still be used). Next, the spouse should be allocated lower-basis assets that qualify for a basis increase, to use fully the $3 million available. Finally, the spouse should be allocated IRD items that can be rolled over without incurring income tax. Planning: If clients have charitable intentions, it remains beneficial to transfer to charity low-basis assets that would not be stepped up to FMV and IRD items. The executor will make allocations of basis adjustments. Executors will also be required to report a variety of information to the IRS and to beneficiaries, including the recipient's name, a description of the property, the adjusted basis of the property in the decedent's hands, the property's FMV at death, the decedent's holding period, information to determine the character of any gain on sale and the amount of any basis increase allocated to the property. Planning: While carryover basis will not go into effect until 2010 (and may never actually occur), clients should be advised to begin keeping basis records.
Miscellaneous Provisions Conservation Easements Retroactive to Jan. 1, 2001, the EGTRRA liberalizes the estate tax treatment of conservation easements, by eliminating the requirement that the land be located within a certain distance from a metropolitan area, national park, wilderness area or urban national forest. The provision effectively allows any land in the U.S. or its possessions to qualify. The EGTRRA also clarifies that the 30% test for determining the reduction in property value caused by the easement be applied when the easement is granted, rather than at the property owner's death.
Installment Payments Effective Jan. 1, 2002, the Sec. 6166 installment-payment provisions are also eased. The maximum number of shareholders or partners in a closely held business eligible for installment payments is increased from 15 to 45. EGTRRA also creates a new separate deferral category and deferral period and extends Sec. 6166 to qualifying lending and finance businesses and holding companies' nonmarketable stock (even if the underlying companies' stocks are marketable). The benefits are elective and require payment of the tax in no more than five (rather than 10) annual installments, beginning immediately (rather than after five years of payments of interest only).
QFOBI Deduction Due to the interplay between the effective exemption and the qualified family-owned business interest (QFOBI) deduction under Sec. 2057, effective Jan. 1, 2004, when the exclusion amount exceeds $1.3 million, Sec. 2057 is repealed.
Residence-sale Gain Effective in 2010, the current exclusion of gain on the sale of a principal residence will be extended to heirs; an heir who sells a decedent's principal residence within three years of death could potentially exclude up to $250,000 of capital gain. Planning: Assuming that the decedent meets the two-of-five-year rule at the time of death, this provision does not require that the heir live in the residence, only that he sell it within three years of the decedent's death.
NRAs A number of special EGTRRA provisions apply to nonresident aliens (NRAs). For example, after repeal, the additional basis increase for an NRA decedent is limited to $60,000 instead of $1.3 million. In addition, NRAs cannot increase basis by the unused losses and loss carryovers allowed under EGTRRA Section 1022(b)(2)(C). Planning: The $3 million basis increase available for assets passing to a surviving spouse is not affected by the status of the surviving spouse as a citizen or resident. Amendments to Sec. 684 extend its applicability to require that any transfer of property by a U.S. person to an NRA (in addition to foreign estates or trusts, as provided in the old law) be treated as a sale or exchange; the transferor must recognize gain to the extent the property's FMV exceeds the property's adjusted basis in the transferor's hands.
Special Valuation The EGTRRA also amends Sec. 1040 (transfer of qualified real property subject to special valuation under Sec. 2032A) to apply to the use of any appreciated carryover-basis property used to satisfy a pecuniary bequest. Gain is recognized on the transfer to the extent that the property's FMV on the exchange date exceeds its FMV at death.
Completed-gift Definition Also effective in 2010, the definition of a completed gift is changed; any transfer in trust will be treated as a taxable gift under Sec. 2503, unless the trust is treated as a grantor trust wholly owned by the donor or his spouse. Planning: Some commentators note that, without further guidance, this provision is so extreme that transfers to charitable remainder trusts would become taxable gifts. Others have suggested that it may be used to attack intentionally defective grantor trusts. However, such concerns are premature and will be clarified in technical corrections.
Planning Implications Short-term In the short-term, the EGTRRA should have little effect on common estate and gift planning techniques. ILITs remain the preferred vehicle for owning both first- and second-to-die policies, annual exclusion gifts can still be made via irrevocable grantor-type trusts, family limited partnerships still allow for the manageable fractionalization of equity interests and no clear standards or limits have been imposed on lack-of-marketability and lack-of-control discounts. Planning: In the short term, some commentators have questioned the wisdom of making any taxable gifts, calling such planning irresponsible and a malpractice risk. In addition, the EGTRRA provides some new planning opportunities and tax savings for both moderate and large estates. Tax practitioners should encourage wealthy clients to take advantage of the opportunities created as a result of the increase in the estate and gift tax effective exemption. Combined with moderate reductions in tax rates and the elimination of the 5% surtax, the increasing exemption can result in significant estate and gift tax savings. The GST changes enacted by the EGTRRA are currently in effect. Consequently, any gifts made to GST trusts since Jan. 1, 2001 will automatically be allocated GST exemption. Planning: While the automatic-allocation rule will apply to transfers to trusts to which most taxpayers would want the GST exemption allocated, nevertheless, such transfers should be examined to ensure the allocations are consistent with the taxpayer's overall goals and estate plan. Planning: Tax advisers should review previous transfers to trusts to ascertain whether the GST exemption was properly allocated and consider applying for retroactive relief if necessary.
Long-term The imposition of carryover basis will result in substantial new responsibilities (and potential penalties) for executors (even those of modest estates) and might negatively effect the choice of executors, their agreeing to serve and the fees charged. Executors will have to determine how to allocate the limited additional basis to estate assets. Executors likely would turn to CPAs, attorneys and other professionals to determine carryover basis. In some cases, a decedent's family may have to retain the services of professionals to review a lifetime's accumulation of bills, checks, insurance policies and other records to determine the acquisition dates and prices of a multitude of assets and make detailed, time-consuming computations of their bases. Long-term planning under the EGTRRA is difficult at best. The year 2010 is two presidential elections and four Congresses from now; thus, planning should not be based on the notion of complete repeal. Clients should be warned that full repeal may never take place. Some commentators are suggesting that the most likely scenario is that Congress will simply stop the scheduled changes at some point in the next few years and make that year's law permanent. However, bills have already been introduced to make repeal permanent in 2010 or earlier. In all likelihood, the changes scheduled to be phased in between now and 2003 can be relied on by planners, but beginning in 2004, the law is anyone's guess.
Conclusion Tax professionals and clients should revisit their wealth-transfer plans frequently over the next few years to ensure that the plans still meet desired tax and nontax goals. |
