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 The 5% surtax on estates over $10 million is repealed in 2002.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).

State Estate Tax Credit. Currently, a federal estate tax credit is given for inheritance or estate taxes paid to a state. In most states, the state estate tax is the maximum federal credit given on the federal tax return. Effective over four years from 2002 through 2005, the federal credit will be eliminated and in 2005 the credit will be replaced with a deduction.

Essentially, the federal government is taking tax dollars from the states. Because of the loss of revenue, states may disassociate their inheritance taxes from the federal credit, resulting in an increased state and federal estate tax for many estates. Moreover, replacing a tax credit with a deduction does not begin to make taxpayers whole, and any estate tax deduction will provide a greater tax benefit to wealthier taxpayers (who are in higher tax brackets) than to less wealthy taxpayers.

What Future Estate Tax Changes May Occur?

Clearly another major estate and gift tax bill is coming and, almost certainly, it will not include a continuing elimination of the estate tax. Budgetary constraints, the politics of wealth and the need to reform Alternative Minimum Tax will not leave enough money on the table to eliminate the estate tax. Unfortunately, any change will probably not come for 3-5 years. But, we should expect:

Unified Credit. The unified credit exemption amount may become $2 million to $5 million per taxpayer–moving all but the very wealthy out of the transfer tax system.

Business Benefits. There is a possibility that some estate tax break will be given to family farms and businesses if the estate tax is not eliminated–but dont rely on it.

Tax Rate. The top tax rate for estate, gift and generation-skipping purposes will probably settle in somewhere between 35%-45%.

Estate Planning with the Bill

Given what is in the bill, what should you do in your estate planning? Among our general recommendations are:

Status Quo. Assume that the present transfer tax (albeit with a larger exemption) will remain in place. Clients should review their existing estate plans in light of the new laws and re-examine their plans about every 2 years.

Gifting. Larger estates should consider pre-funding their unified credit to move future growth out of the taxable estate. The use of annual exclusion gifts should also remain a vital part of these estate plans. View the unified credit and the annual exclusions as assets of the estate and use them as effectively as possible to avoid future estate taxes.

Discounting. At least for the next several years, all of the normal discounting techniques remain a valuable part of the estate planning process. In particular, clients having business interests and estates above $2 million to $3 million should consider plans that reduce their ownership of the business below 50% until any new bill can be examined.

Dynasty Trusts. Given the estate planning uncertainty of the next 3-5 years, parents should consider creating generation-skipping/dynasty trusts. With the amount of the GST exemption increasing with increases in the estate tax exemption, the creation of dynasty trusts will balloon. Because these trusts avoid taxation when heirs die (and also provide significant asset protection to heirs), the potential future estate tax uncertainty becomes less of an issue for heirs. More information on dynasty trusts is available on my Web site.

Disability. More than at any time in the past, taxpayers should have well-crafted documents that deal with their potential incapacity. The documents should allow for changes to occur in a taxpayers estate plan to reflect future changes in the law (e.g., adoption of real estate tax reform) and family situations (e.g., divorce of a child).

Its a bit macabre, but having a Medical Power of Attorney might become important if the estate tax law is not changed, the taxpayer is in poor health and either of the following is approaching: the end of 2009 (use the power to keep em alive) or the end of 2010 (well, you know). One commentator said that perhaps we should call this new tax bill the “Throw Momma from the Train Tax Bill of 2010.”

Life Insurance. Do not cancel life insurance because you think the tax bill eliminated the estate tax need for insurance. For no other reason, there will be at least 9 more years of estate tax and if you needed the life insurance in the first place, do not cancel it until there is some relative finality (probably 3-5 years from now) in the estate tax rules.

Life Insurance Trusts. To keep the taxable portion of an estate as low as possible, consider placing life insurance in an irrevocable life insurance trust. This moves the death benefit of the policy out of your estate, allowing greater growth in the non-insurance assets, reducing the amount of any estate tax.

Existing insurance trusts should be retained as a part of the estate plan.

Transfer Tax Costs. In most cases, pre-payment of any transfer tax should be avoided until an additional transfer tax bill is enacted.

Flexibility. Any plan should maximize the flexibility to adjust to future changes. For example, if an irrevocable trust is used, provide someone (e.g., a spouse) a special power of appointment to reconfigure the trust in the future.

Some taxpayers will be in a quandary. For example, assume a married couple with a stable combined estate of $1.7 million wants advice. From 2001-2004 they may want to maximize their estate tax savings by using standard unified credit “by-pass” trusts. However, in 2004, the unified credit is $1.5 million each. Why tie up substantial assets in such a trust, when they only need to protect $200,000 from 2004-2006? Best choice: if this is the first marriage, consider passing all of the assets to the surviving spouse and allow the surviving spouse (within 9 months of death) to disclaim the “excess” portion, if needed, to the by-pass trust, with the surviving spouse retaining benefits in the trust.

“Spray” Rights. With the reduction in income taxes, virtually all non-marital trusts should give the trustee(s) the discretion to “spray” taxable income. This allows the trust to effectively allocate taxable income to taxpayers in lower brackets–an important planning aspect with income tax rates now being reduced. In addition, business ventures that have owners with low levels of income (and therefore lower tax rates) should consider being created as S corporations, LLPs or LLCs, so the businesss taxable income is taxed at the lower rate of the owner (as opposed to C corporations in which the business entity pays its own taxes).

Step-up in Basis. Although unlikely to occur, the loss of the step-up in basis in 2010 may require planners to consider allocating specific assets to particular heirs. For example, with a spouse being entitled to $3 million in step-up, but a child only being entitled to $1.3 million, there may be income tax reasons to allocate certain assets to the surviving spouse to obtain a step-up in basis.

Wealthy taxpayers who have bequeathed less than $3 million (by 2010) to a second or third spouse may want to consider creating a Q-TIP marital trust and transferring at least $3 million to the trust for the benefit of the spouse, while the children receive the assets at the spouses death. At a 20% capital gains rate, such an approach could save up to $600,000 in federal capital gains taxes.

Buy-Sell Agreements. Most buy-sell agreements should be examined in light of the new tax bill. For example, if a cross-purchase agreement requires a purchase at a premium price, a death-triggered buy-sell could create significant taxpayer income or capital gains to the decedents estate, reducing the benefit of the insured buy-sell. Instead, non-related owners should consider using a lower value in the cross-purchase and placing the insurance on the “excess” value in an irrevocable insurance trust to move the excess value out of the estate for both income and estate tax purposes.

With a spouse receiving a $3 million step-up in basis in 2010, does it make sense to have a business interest pass to a spouse or a trust for the spouse, who receives the step-up and then requires the purchase from the spouse or trust by the remaining owner(s) of the business?

Business Deduction. Knowing that a new estate tax bill is probably coming in the next 3-5 years, and that such legislation may include some new form of an estate tax business deduction, it may make sense to retain language in wills allowing for this deduction. Thus, if the taxpayer becomes disabled before the new law is enacted, the benefits of any new deduction could be retained. The language of any such bequest could be limited to the amount permitted as a deduction at the time of the taxpayers death.

John Scroggin, J.D., LL.M, is an estate planning attorney in Roswell, Ga., and author of “The Family Incentive Trust,” published by The National Underwriter Company. He can be reached at john@scroggin.law.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, July 13, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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