In the last article we wrote for National Underwriter (Jan. 1), we commented that 2001 would be a bumpy tax ride. But few of us expected that the final tax bill would create potentially years of uncertainty.
Essentially, the new tax bill provides a number of significant benefits, but deferred or ignored action on many of the important issues. Virtually every new benefit has a lengthy phase-in period (e.g., increases in the unified credit over 8 years) or does not begin to phase in until years in the future (e.g., marriage penalty relief in 2005).
A number of the tax provisions die before 2011 if not re-enacted by a future Congress. The entire bill (including the pro-taxpayer provisions) must be re-enacted before 2011 to remain law. Effectively, nothing in the bill has any assurance of continued existence. This makes for some interesting future political conflicts.
What Did the Bill Really Do?
Among the changes are:
Income Tax Rates Reduced. The Act reduced the income tax brackets between now and 2006. This one change was the single largest revenue cut of the bill, consisting of $875 billion over the next ten years (out of a total of $1.348 trillion). In addition, the phaseout of itemized deductions and personal exemptions for high-income taxpayers is eliminated in phases from 2006-2010.
Transfer Taxes. Between 2001 and 2007, the top estate, gift and generation-skipping rates will drop to 45%. The 5% surtax on estates over $10 million is repealed in 2002. The top rate for all three taxes also drops to 50% in 2002. The amount of the unified credit for estate and generation-skipping purposes will slowly increase to $3.5 million by 2009, but the gift tax exemption will stay at $1 million after 2002 and the gift tax rate will drop to 35% in 2010.
Retirement Plans. Over various phase-in periods (most beginning in 2002), the bill substantially increases a taxpayers ability and the benefit from putting money into qualified retirement plans, IRAs and Roth IRAs. It also provides new planning opportunities for some taxpayers over age 50 who have not placed enough money in retirement plans by providing limited “catch-up” provisions.
GST Tax. The new rules significantly reduce some of the problematic tax traps in the generation-skipping rules.
Educational Benefits. The bill provides some significant new educational benefits, although the biggest educational benefit, a new deduction for higher education tuition costs, will disappear by the year 2006, unless it is re-adopted by the Congress before then.
Child Care Credit. The bill provides for the phase-in of a significantly higher child care credit (i.e., $1,000 by 2010) and provides that child care credit may be refundable to low-income taxpayers (even if taxpayer does not have an income tax liability) if the taxpayer has earned income. In effect, Social Security taxes are being refunded. This is not a door that taxpayers should want to see opened.
What Did Not Happen?
What did the tax bill not do?
Transfer Tax Repeal? First and foremost, the tax bill did not eliminate the estate tax (other than for the year 2010) and unless a taxpayer knows that death will occur in that year, relying upon the bill to avoid proper estate planning is a misplaced confidence at best.
Over the next 9 years, the amount that a taxpayer can bequeath (to a non-spouse) tax-free will slowly phase in to $3.5 million dollars. The gift tax exemption will remain $1 million after 2002. In the year 2010, the estate tax is eliminated, but unless Congress reenacts the 2001 tax bill (or some form of it), then the entire tax bill is eliminated on January 1, 2011, and the tax law as it existed on June 7, 2001 is reinstated. Thus, the estate tax exemption in 2009 is $3.5 million, the tax is eliminated in 2010 and then reinstated in 2011 with a $1 million exemption and the current laws higher tax rates. Moreover, the gift tax is never eliminated!
Marriage Penalty Relief? Despite all the preliminary political rhetoric, the bill did not substantially reduce the marriage penalty. Relief from the marriage penalty does not even begin until 2005, and much of the benefit of the bill (doubling the standard deduction and increasing the 15% tax bracket for married couples) will not substantially reduce the impact of the marriage penalty.
Family Farms & Businesses. Despite all of the political clamor about providing estate tax protection for family businesses and family farms, there is not a single provision in the bill that specifically addresses this issue and the estate tax business deduction, which was adopted as part of the 1997 Tax Act, is revoked in 2004.
Charitable Donations. There had been broad discussion of new provisions to encourage charitable donations (e.g., allowing non-itemizers to deduct charitable donations), but none of these provisions were adopted in the bill.
Smoke and Mirrors
There are also some very sneaky sections to the bill, including the following:
Estate Taxes. As discussed above, the elimination of the estate tax is a statutory illusion.
Gift Tax Exemption. Although the tax bill provides that amount that you can leave tax-free at death will increase to $3.5 million by the year 2009 and then be eliminated in 2010, the amount which can be given free of gift tax will be limited to $1 million after the year 2002. Although the estate tax is eliminated in 2010, the gift tax is never eliminated. Thus, gifts will be less tax-efficient than bequests.
Step-Up in Basis. In 2010, as a result of the estate tax elimination, the bill also eliminates the step-up in basis to fair market value that normally occurs at the time of the death of a taxpayer. Under the new rules in 2010, the step-up in basis would be replaced by a carryover basis (i.e., the decedents own basis). However, up to $1.3 million of assets passing to a non-spouse and up to $3 million of assets passing to a spouse will still be given a step-up in basis.
The taxpayer will bear the burden of proving the basis of assets that may have been in the family for decades.
During the Carter administration, a similar law was adopted but repealed a year later because it was too difficult to administer. But the loss of the step-up is probably not something that will have to be dealt with in detail for many years (and probably will never be dealt with) because the elimination of the estate tax will probably never occur.
However, just in case, taxpayers should start collecting supporting detail on the basis of their assets.
Essentially, the loss of the step-up in basis will complicate the decisions of executors, planners and family members. Executors may have to decide which beneficiary gets the income tax benefit of the step-up. Fiduciaries will be called upon to make decisions on basis allocations that may prove damaging to one or more beneficiaries, but reduces the overall taxes imposed on the estate or heirs.
Because of limits on the assets available for the limited step-up, executors will be forced to determine how the decedent obtained ownership of the asset and its basis at the time of such transfer. Records supporting an assets basis may need to be maintained forever.
The loss of the step-up will create significant future capital gains taxes on inherited assets. For example, assume an unmarried taxpayer owns a business worth $3.5 million, with a zero basis. At his death in 2010, no estate taxes will be due, but if his executor sells the business for $3.5 million (e.g., pursuant to a buy-sell agreement), a federal capital gains tax of up to $440,000 could be due (i.e., 20% tax rate times $3.5 million, less a limited step-up in basis of $1.3 million).