The first part of this Alert describes the changes made by the Act that will apply beginning next year through 2009. The second part describes the changes that will apply beginning in 2010, assuming the law is not changed by one of multiple Congresses in the interim.
Transfer Tax Laws - 2002 Through 2009
Increased Exemptions; Decreased Tax Brackets
Commencing in 2002, the amounts that can pass free of transfer tax gradually increase and the top tax rate gradually decreases. The amounts sheltered from estate and GST taxes are the same and increase from $1 million (in 2002) to $3.5 million (in 2009). The shelter from gift tax, on the other hand, is frozen at $1 million beginning next year. The gift tax is retained notwithstanding the repeal of the estate and GST taxes in 2010, supposedly to deter taxpayers from shifting income to family members in lower income tax brackets. The table below provides a summary of the changes.
As you can see, one immediate benefit of the Act is the increase of the exemption equivalent amount (the value of transfers sheltered from tax) to $1 million in 2002, for both gift and estate tax purposes. The increase would allow each taxpayer who has not yet made gifts in excess of the current exemption equivalent amount of $675,000 to make additional tax-free gifts of $325,000. Individuals who have already paid gift tax will not be able to use the full $325,000 on a tax-free basis, but will be able to make additional gifts at a reduced gift tax cost. Although it may not be advisable to make large taxable gifts in view of the scheduled repeal of the estate and GST taxes, taxpayers should review the benefits of making additional gifts on a tax-free basis. Moreover, estate planning transactions that would permit the additional transfer of future estate appreciation, particularly those that permit transfers on a discounted basis, should be considered in view of the possibility that repeal of the estate and GST taxes may not be permanent.
Many estate planning instruments are drafted on a formula basis to take maximum advantage of the exemption from estate tax available in a particular year. Each individual should consider whether the shifting of assets under his or her estate plan as a result of the increasing exemption is appropriate. This shifting of benefits would be of particular concern, for example, in estate plans where the exemption equivalent goes to different beneficiaries than the remainder of the estate.
Reduction in State Death Tax Credit; Conversion from Credit to Deduction
Under current law, the Federal estate tax is reduced by a credit for death taxes paid to a State or the District of Columbia (the "state death tax credit"). In most States, the state death tax payable equals the state death tax credit.
The Act reduces the state death tax credit by 25% in 2002; 50% in 2003 and 75% in 2004. The effect of this change will be to shift revenue away from the States to the Federal government. But, in general, it should not increase the combined federal and state death taxes payable by a decedentís estate, unless the particular State involved enacts legislation that would recapture its lost death tax revenues. One exception is with respect to New York estates which, under the current New York estate tax law, in fact could be liable for increased taxes
In 2005, the state death tax credit is replaced by a deduction for death taxes actually paid to the State (or States) involved. When the credit converts to a deduction, States will need legislation to preserve their share of the death tax revenue. Under current law, certain States, including Florida, may not be able to enact their own estate tax, and will thus suffer a significant loss in revenue.
Installment Payment of Estate Tax Attributable to Closely-Held Business Interests
Under current law, if an estate owns a substantial interest (more than 35% of the adjusted gross estate) in a closely held business (as defined in the statute) that engages in a trade or business, the personal representative may elect to defer payment of the estate tax attributable to such business until the fifth anniversary of the initial due date for the tax, and then pay the tax in 10 annual installments. Effective for decedents dying after 2001, the Act increases from 15 to 45 the number of partners or shareholders that can have an interest in a closely held business eligible for this deferred tax payment privilege.
Expansion of Estate Tax Rule for Conservation Easements
Under current law, an estate may elect to exclude from the gross estate up to 40% of the value of land (but not in excess of $400,000 in 2001 or $500,000 in 2002 and thereafter) that is subject to a qualified conservation easement. A qualified conservation easement is a grant of a qualified interest in real property to specified types of charitable organizations, including public charities and governmental units, for enumerated conservation purposes. Under prior law, to qualify, the real property must have been owned by the decedent or members of the decedentís family during the 3-year period preceding the decedentís death and have been located within a certain number of miles from a metropolitan area, national park or urban National Forest. The Act eliminates these distance limitations. Accordingly, a decedent, a member of the decedentís family, the personal representative of a decedentís estate or the trustee of a trust that owns qualifying real property can now grant a conservation easement in land no matter where it is situated in the United States, and thereby obtain a valuable exclusion from the decedentís gross estate. This change is effective for estates of decedents dying after December 31, 2000.
Qualified Family Owned Business Interests
The Act repeals the deduction for qualified family owned businesses effective for decedentís dying after December 31, 2003.
GST Tax Revisions
GST tax generally applies when property passes from grandparent to grandchild. Each individual has a lifetime exemption from the application of the tax as set forth in the chart above. The Act contains a number of technical changes to the GST tax rules, described next, most favorable to the taxpayer. These changes apply to transfers subject to estate or gift tax made after 2000.
In order to assist taxpayers who inadvertently lose opportunities to take advantage of their GST exemption, the Act provides a new system of automatic allocation to lifetime transfers. The Act generally provides that an individualís GST exemption is automatically allocated to transfers to a trust from which there is likely to be a generation-skipping transfer in the future. The Act establishes rules that would exclude certain trusts from automatic allocation. For example, if more than 25% of the trust corpus must be distributed to one or more individuals who are not skip persons for GST purposes (for example, children) before the non-skip persons attain age 46, then no automatic allocation would take place.
The automatic allocation rules under the Act will have significance for any transfer to an irrevocable trust for descendants, particularly those to which lifetime contributions continue to be made on a regular basis, such as a life insurance trust or an annual exclusion gift trust for children or grandchildren. If automatic allocation is not desired, a gift tax return must be filed.
The Act also permits a retroactive allocation of the GST exemption in the event of an unnatural order of deaths within the transferorís family. For example, the Act would permit allocation of GST exemption to a trust upon the death of a child of the transferor prior to the transferorís death, and the allocation would take effect as if it had taken place at the time of the original transfer to the trust, and at its original value.
The Act also permits a qualified severance of a trust on a fractional basis to create two separate trusts, provided the terms of the two trusts, in the aggregate, provide for the same succession of interests. In addition, a trust that is only partially exempt for GST purposes may be divided to create a wholly exempt trust and a wholly taxable trust. Even if the governing instrument or local law does not permit severance, courts are likely to be receptive to an application for severance for GST purposes as it would permit more tax efficient administration of the trust.
The Act also liberalizes the rules governing applications for taxpayer relief when an allocation of GST exemption should have been, but is not, made, or is made, but not in full compliance with proper procedures.
The Transfer Tax Laws - 2010 and Beyond
As a corollary to the repeal of the estate tax, the Act repeals the basis step-up rules at death, and substitutes in their place a carryover basis regime. As previously mentioned, gifts during life will continue to be taxable, subject to a $1 million exemption equivalent. In addition, the estate tax will continue to apply to certain transfers made prior to 2010 for which tax deferral was obtained.
Under the Act, effective for decedents dying after 2009, property acquired from a decedent will no longer have an income tax basis equal to the propertyís estate tax value (a "stepped up" basis). Instead such property will have a basis in the hands of the recipient equal to the lesser of the decedentís cost basis in the property or the fair market value of the property at the decedentís death. Property will be deemed to be acquired from a decedent if it passes gratuitously by bequest, devise, inheritance or in any other manner by reason of the decedentís death. Information returns will be required for estates in excess of $1.3 million ($60,000 for non-resident aliens who have U.S. tangible property or leave property to U.S. persons). Accordingly, individual taxpayers should commence immediately keeping accurate records of their basis in property. As in the case of other provisions of the Act, the carryover basis regime will cease and the step up rule will be reinstated in 2011 when the estate tax is restored.
The Act permits the allocation of a limited basis increase to property owned by the decedent at death. The basis increase is initially $1.3 million, indexed for inflation. An additional basis increase is permitted for capital loss carryovers and NOLs that, but for the decedentís death, would have been carried over from the decedentís last taxable year to a later year, and for section 165 losses that would have been allowable to the decedent upon a sale immediately prior to death. Lastly, the basis of property passing to a surviving spouse outright or in a so-called QTIP Trust may be increased by an additional $3 million.
Gratuitous transfers received by a decedent within 3 years of death are not eligible for a basis increase, unless received from a spouse who did not acquire the property by gratuitous transfer within that 3-year period. The basis increase may not be allocated to property that is income in respect of a decedent, such as salary or retirement benefits. Stock of a foreign personal holding company or PFIC is also not eligible for a basis increase. The basis of a decedentís property may not be increased over its fair market value in the hands of the decedent on the date of the decedentís death.
Dealing with the allocation of the various basis increases will be a complex task not only for the draftsperson of estate planning documents, but also for the fiduciaries of a decedentís estate. Beneficiaries of the estate may not agree about the optimal allocation. It is unclear whether family member fiduciaries can participate in basis allocations without gift tax consequences.
The Act also provides for certain other modifications to the income tax law. A decedentís $250,000 exclusion from gain on the sale of a principal residence will apply to property sold by the decedentís estate, the person to whom the decedent leaves the residence or the decedentís revocable trust. Carryover basis does not apply to transfers at death to a non-resident alien, instead gain will be recognized. If appreciated, carryover basis property is used by reason of a decedentís death to satisfy a pecuniary devise or gift under a trust, gain will be recognized only to the extent the fair market value of the property received exceeds it date of death value.
Post-2009 Gift Tax
Generally, gifts will continue to be subject to gift tax. The maximum gift tax rate will be 35%.
The Act creates a new rule with respect to transfers in trust. Any transfer in trust will be treated as a taxable gift, unless the trust is treated as wholly owned by the donor or the donorís spouse for income tax purposes, in other words, as a wholly grantor trust. It is not clear under the Act what effect the termination of grantor trust status will have. One possibility is that a taxable gift occurs at the time grantor trust status terminates. Termination of grantor trust status would typically occur on the death of the grantor, but may occur sooner. In addition, it is not clear whether it will continue to be possible to make completed gifts to a wholly grantor trust. This ability would continue to be important for purposes of allowing transfers of property and its future appreciation to family members in excess of the exemption equivalent without current income or gift taxation.
Certain Estate Tax Rules Continuing after 2009
If estate tax repeal actually occurs and remains in effect past 2010, certain estate taxes nevertheless will continue to be payable. If a pre-2009 estate elected to pay the estate tax in installments, any installments due after 2009 will remain payable. Principal distributions to a non-citizen surviving spouse from a marital trust established to defer estate taxes would continue to be subject to estate tax during the life of the surviving spouse until 2022.
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The Act provides for sweeping changes to the estate, gift and GST tax laws, with collateral consequences to the income taxation of a decedentís property. The changes are neither simple nor certain to occur. Given this uncertainty, we believe all individuals need to plan for the disposition of their property to accommodate the changes in the law mandated by the Act and to manage the uncertainties. We have developed strategies to deal with these changes and uncertainties, and would be happy to assist you in reviewing your current estate plan and to discuss with you how best to take advantage of the opportunities available under the new law.
© 2001 Greenberg Traurig
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This GT ALERT is issued for general purposes only and is not intended to be construed or used as legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clientsí individual legal needs. The Firmís responsive approach to client service often cuts across legal subject matter, applying the right experience and resources to provide cost-effective solutions.