SUPPLEMENT

 

ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT OF 2001

 

On May 25, 2001, life has changed for Estate Planners as Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTFRA) which, simply put is a very complicated change in federal tax law for income taxes, gift, estate and generation skipping (GST) taxes.  The million dollar question becomes “How does this affect Estate Planning?”

 

It is beyond the scope of this text to go into the minutiae of this voluminous act (176 pages).  If anyone is interested, the act can be obtained from the net at http://www.house.gov/rules/1836cr.pdf

 

Discussions as to estate planning techniques are rather limited at this time, as the legislation is still being studies by attorneys, accountants and financial/estate planners.  As the intricacies of the plan become more familiar to the professionals, the more ways to fit estate and financial planning to these new regulations.

 

There is an old life insurance story about the prospect who was hard to sell, and after a grueling presentation by a life insurance agent, the prospect wanted to know, “How am I going to know that what you charge me for life insurance is exactly what it should cost me?”  The exasperated agent replied, “I can tell you exactly, but I need to know two things”  your date of birth and your date of death.”

 

What does this story have to do with anything?  This act changes Estate and Generation Skipping Tax (GST) and rates, with the exempt amount presently of $675,000 increasing to $3,500,000 in 2009 and becoming unlimited in 2010 and the tax rates decrease from the present 55% to 0% in 2010.  But don’t applaud yet (the fat lady hasn’t sung) because the act itself expires on Jan. 1, 2010.  There are no guarantees that congress will renew the bill at that time. 

 

There are many who strongly believe that congress would not DARE to renew the taxes in 10 years as it would be political suicide.  There are just as many who say that if the “big spenders” are in control of congress in 10 years, reinstating just part of this act would “free up” enough money to make heroes out of the politicians, particularly if the economy is not robust.  Therefore, the approach must be that there is a likelihood that estate taxes may be reinstated right after it disappears in 2010, and the Estate (and Financial) Planner must keep this in mind at all times.

 

In any event, the mere fact that the amounts are not constant, leads to planning problems.  The plans would be different if a person were to die in 2003 as compared to 2010, particularly if the size of the estate was substantial.

 

 

First, Tables showing the changes in Estate and GSP Tax Exemptions and rates.

 

                                                      Table 1

Scheduled Changes in Estate and GST Tax

Exemptions & Rates (Gift Taxes Not Included)

                                  Year                  Rate           Exempt Amount

2001                           55%                675,000*

2002                           50%                1,000,000

2003                           49%                1,000,000

2004                           48%                1,500,000

2005                           47%                1,500,000

2006                           46%               2,000,000

2007                           45%                2,000,000

                        2008                              45%                2,000,000

                        2009                              45%                3,500,000

                        2010                              0%                  Unlimited

'Unchanged from prior law memo

 

 

 

 

Gift taxes are also affected.

 

                                                     TABLE 2

                                   Scheduled Changes in Gift Tax

Exemptions and Rates

                     Year                              Rate      Exempt Amount

2001                             55%                675,000^*

2002                             50%                1,000,000

2003                             49%                1,000,000

2004                             48%                1,000,000

2005                             47%                1,000,000

2006                             46%                1,000,000

2007                             45%                1,000,000

2008                             45%                1,000,000

2009                             45%                1,000,000

 2010+                           35%                1,000,000**

 *Unchanged from prior law

**permanent?   i

 

There are also scheduled changes in the size of the deduction allowed for state death taxes:

 

Table 3

 

Basis Step-Up Example

On Estate Left to Surviving Spouse

*Subject To Capital Gains Tax If Sold                                            

 

 

PRINCIPAL FEATURES

 

This tax act has many features that affect estate planning, a dozen (at least) of importance, and many of lesser importance.  One thing should be pointed out, while many people have (wrongly) assumed that many of estate planning features are gone, they will not have to worry about trying to avoid probate, transferring their estate after death to the chosen heirs, protection of assets after death, etc.  These can be considered as “non-tax” issues, and the tax act has no bearing on these factors and there is little change, if any, in estate planning to alleviate these concerns. 

INCREASE OF EXEMPTIONS

 

As indicated in the charts shown above, the estate tax united credit exemptions and the generation skipping tax exemptions, increase to $3.5 million in 2009.  The exempt amount (as shown in the Table above) IS THE VALUE OF THE ESTATE THAT IS FREE OF ANY ESTATE TAXES FOR THE YEAR THAT IS SHOWN.  And, as stated earlier, this tax disappears totally in 2010 (maybe, hopefully, possibly…).

 

 

 

ESTATE AND GST TAX RATES

 

The top rate for estate and GST  taxes decrease through 2007, as shown in the Table 1 above.  The percentage that is shown is the maximum tax rate (estate or GST) for the year shown, and the minimum is still 37%.  So, the amounts that hit the exempt amount will be taxed at the 37%, and amounts of estates over that amount will be taxed at the rate shown. 

 

The Generation Skipping Tax is a double tax as it is imposed in addition to the estate tax on any portion of a decedent’s estate left to a “second” or “skip” generation heir, such as a grandchild if the grandparents is alive.  (Note:  If the grandchild’s parent is not alive, the grandchild will not be considered as a second/skip generation heir).

 

REPEAL OF TAXES

 

As mentioned earlier and often, estate taxes and GST taxes are repealed as of January 1, 2010.  As Art Linkletter, well into his 80’s, recently stated, he now has reason to live for 10 more years, so that he can make sure that the money that he has worked so hard for, for so many years, can now go to the people that he wants it to go to, and not the Federal Government.  Most people with estates large enough to be concerned with estate planning, will second that with a resounding “Amen!” 

 

For the estate planner, as discussed in detail later, this is a mixed blessing.  There really is more need for an active estate planner now – no more of writing up an estate plan, and then have it gather dust on a shelf, never to be reviewed again – until death and then it is too late.  Now, thanks to the political ramifications, estate planners should stay busy by frequent review of estate plans.

 

GIFT TAX EXEMPTION AND RATES

 

The Gift Tax unified credit exemption amount for lifetime gifts will increase to $1 million in 2002, and then it will stay there until changed by subsequent law.  There is no “sunset” for gift taxes – they do not expire in 2010.  Refer to Table 2 above.

 

However, as seen in the Table 2, gift tax rates will decrease through 2010 and the rate changes re the same as the estate and GST rate changes.  However, the gift tax is not repealed in 2010 and a final rate is set at 35% in 2010.  Refer to Table 2 for the specifics.

 

STEP-UP BASIS IN ESTATES

 

Starting in 2010, the step-up in basis in estates will be limited to a maximum of $1.3 million step-up in addition to the estate’s original basis when it is passed to a non-spouse and $3 million if it is passed to a surviving spouse.  Before 2010, the estate will have an unlimited step-up in basis.  (See Table 3 for an example)  There are several rules and provisions set forth in this tax act, which are beyond the purvey of this discussion.

 

While the federal estate taxes are being phased out, the step-up in basis will be partially lost.  As an example, if the decedent’s original basis was $500,000, and the fair market value of the estate was $3.5 million at time of death, this would show an appreciation of $3 million in the estate.  Less the additional basis allowed of $1.3 million, would then show a capital gains of $1.7 million, which is subject to capital gains tax if it is sold.

 

The 2001 tax act limits the step-up in basis by shifting the taxation from estate taxes to capital gains taxes for the larger and more valuable estates.  The result of this is that this partial loss of step-up basis will create capital gains taxes which will be paid by many heirs.

 

The capital gains taxes will be created because heir will want to sell the decedent’s real estate, investments and other such taxable assets.  The estate will get the decedent’s basis in these assets, plus up to $1.3 million for non-spouses and $3 million for spouses.  The practical effect is that an estate worth only $1.5 million could very well be subject to considerable capital gains taxes when the heirs sell the assets.

 

CREDIT FOR DEATH TAXES AT THE STATE LEVEL

 

The federal credit given to estates for payment of the estate’s death taxes at the state level will be reduced by 25% in 2002;  by 50% in 2003; by 75% in 2004, and by 100% thereafter.  As to how this will affect state death taxes, is anybody’s guess, as it is almost certain that some states will change their death tax laws soon, either to increase taxation or to better integrate with the new federal law.  In some states, this will not make any difference in the total amount of estate taxes paid, but in others it will increase the amount of federal taxes paid. 

 

Some experts are predicting that states will find that since taxes are not being paid to the federal government at the same rate that they have been in the past, this will open the doors for politicians at the state level to see this as an opportunity to increase the state death taxes.  After all, people are used to paying large death taxes, so they should not scream too loudly if the money goes to the state instead of the federal government.  Anyway, this would affect only the wealthiest citizens and there are not too many of them, and besides, they will not really be aware of it as they will be dead when their estate is plundered by politicians.

 

Keep in mind that the states are not phasing out their state death taxes.  Be prepared for some states to increase death tax rates to 20% or even more.  The estate planner must keep informed of state and any other local estate taxes.

 

DEDUCTION FOR FAMILY OWNED BUSINESS

 

Presently, an estate where a family-owned business exists, has a total estate tax deduction of $1.3 million.  This will be repealed, but since the total exempt amount is raised to $1.5 million in 2001, there is little effect, one way or the other.

 

ANNUAL GIFT TAX EXCLUSION

 

The present gift tax law remains the same, i.e. one can give a tax-free gift to another person of $10,000, as can spouses.  It is indexed for inflation, so this amount will increase by $500 increments as dictated by inflation.

 

After the year 2009, gift donors will be required to provide information about the gift property, such as fair market value and the basis of the gift.  A donor who does not make such a report is subject to a penalty.

 

CAPITAL GAINS EXEMPTION

 

The $250,000 per spouse capital gains exemption on personal residences will be applied to the estate for the benefit of the heirs.  If an estate, an heir or a qualified trust sells a decedent'’ principal residence within three years of the decedent’s death, the seller will be able to use the two-out-of-five-year rule for the decedent’s use of the residence while still alive.  Where it is applicable, the seller then can claim a capital gain exclusion of $250,000, on top of any step-up in basis under the new tax act, that may have been added to the residence’s original basis.

 

 

 

 

THE EFFECT OF THE EXPIRATION PROVISION

 

As indicated earlier, what will happen if and when the act ceases to exist, is anybody’s guess.  It is doubtful that the act will simply die, as there would be chaos as the courts, the government and regulatory bodies – federal and state – and the Internal Revenue Service should try to agree on what law was in effect.  So will congress simply take the high road and simply extend it as it is?  Given the history of most laws, particularly as complicated as this act, it will demand some changes along the way.  “Fine-tuning” is what most politicians call it. 

 

Speaking of politics, any tax reform measure is absolutely motivated by politics, with only a miniscule part motivated by the best interest of the taxpayers (except, maybe, tax refunds).  Therefore, nothing that the estate planner can anticipate in the planning process can be relied upon to be completely valid in the near future.  This means that estates worth more than $1 million (per person) will need to have their plan reassessed every 2 or 3 years – at least.  Or at least until there is a modicum of stability in the system so the process of long-term planning will be legitimate. 

 

THE EFFECT OF DYING UNDER THE TAX ACT

 

For those who will probably not live past the year 2009, the process of estate taxing for the various death taxes, should remain about the same as they have been for several years.  Some amount of federal estate taxes will be paid by the estates through 2009, as well as state death taxes.  In addition, the full step-up in basis will still be around through 2009, lending a stabilizing effect to typical estate planning.

 

Now comes the “iffy” part.  It is fair to say that the earlier that the owner of an estate dies in the period between 2001 and 2009, the more likely it is that the estate will have to pay estate taxes, and the higher that rate will be.  If, for example, the client has a short life expectancies, certain techniques will need to be applied to mitigate the effects of the estate taxes.  These techniques will include, but is not limited to family and Q-TIP trusts for married couples; irrevocable life insurance trusts to provide tax-free benefits to pay these estate taxes (just like today); using gifts, either the annual exclusion or the unified gift tax credit;  annuities, which frequently reduce the size of the taxable estate; and of course, charitable giving, before the estate owner dies, and after they die.

 

As is apparent by now, it really comes down to planning an estate, with the major change in death tax planning depending upon what the tax rate is when an individual dies.  One cannot say that a younger person will live beyond 2010 when major changes in estate taxes will occur, or at a point between now and then, when the tax rates and exclusions are different. 

 

It must be remembered in estate planning, that even if the federal estate taxes expire in 2010, the step-up in basis will be partially loss, which will mean that capital gains taxes will be paid by heirs of estates as the larger estates shift from estate taxes to capital gains taxes under this 2001 act.  Then with the likelihood that states will increase rates or reduce exemptions, will just add to the conclusion that it is necessary to create very flexible plans for many people and these plans will be quite a bit more complicated that what was necessary in the past.

 

USING TRUSTS FOR ESTATE PLANNING PURPOSES

 

It is interesting to review various approaches used by financial and estate planners since the law was enacted.  It is quite evident that there has been a lot of thought gone into any recommendations as to how to approach estate planning by building on what has worked in the past, and still plan for more fluidity that was ever necessary before.  Using a family trust seems to be a “given” but with certain peculiarities to apply for different situations as they arise.

 

The trusts should be “grantor” trusts (where an individual places their own assets into the trust) and therefore any trust tax would not be applicable, or at the least, neutral.

 

The trust should be set up so that it has a bypass provision (i.e. a trust which removes the assets from a surviving spouse’s estate, thereby excluding such assets from Federal Estate Tax upon the death or the surviving spouse).  In effect, when the first spouse dies, the trustee can set up a new, irrevocable trust funded by either the decedent’s assets, or a sum of money that equals the assets.  These assets would then be exempt from estate taxes and a step-up in basis, up to whatever the maximum is in the year that the deceased spouse dies.  If this date is prior to 2010, there would be no federal estate taxes, and the step-up basis would be limited to $1.3 million.  After 2010 there would be no federal estate taxes (assuming the law remains basically the same)  and the step-up basis would also be at $1.3 million.  In either event, there would be state death taxes in some amount, probably.

 

 

The trust should probably also have a Qualified Terminable Interest Property Trust (Q-TIP) (also called a “C” Trust) provision, which would allows the trustee to set up a new irrevocable trust to hold all, or some, of the decedent’s assets and these assets would not be included in the decedent’s taxable estate, but will be in the surviving spouse’s estate.  (The “rules” for establishing such a trust are outlined in the chapter describing the Q-TIP trust earlier in the text).  Therefore, there are no estate taxes on the assets in the decedent’s estate, but are deemed to be in the surviving spouse’s estate.  It makes no difference if the first spouse dies before or after 2010, there will be no estate taxes on these assets as they are protected by being in the surviving spouse’s estate.  However, if the first spouse dies in 2010 or later, the amount in this trust will get a step-up in basis of up to $3 million because assets have been technically transferred to the surviving spouse.

 

The trustee should be given a lot of flexibility at the death of the first-to-die spouse, which will allow the trust to fund the trust – either the Q-TIP or Bypass – so as to achieve the minimum taxation from the state and federal governments.

 

It has been pointed out by high professional estate planners that before this 2001 act, the By-pass provision would have been in the trust with specific instructions as to how much and when, to place the assets into the trust.  But with the complicated law with so many variables, it is not possible to determine with any degree or accuracy, exactly what is the best planning strategy.  It could be that one could have either (or both) a capital gains tax because of a step-up in basis, and an estate tax problem.  This leave three choices:

1. Fund only the By-pass trust.
2. Fund only the Q-TIP trust.
3. Fund both the By-pass and the Q-TIP trusts.

 

Which  choice will result in the least taxes?  There is no way to know until one of the spouse’s dies.  Therefore, the estate planner must plan for several contingencies, which could be more expensive to the estate owner because of the creation of trusts, which will be more complicated and more difficult to function properly after the death of the first spouse. 

 

Capital gains tax must be considered if the basis is substantial, particularly if it also considers the personal residence, but if there is little concern about capital gains taxes, the trust could be established with only the By-pass trust provision.  (Refer to the section on the By-pass trust earlier in this text).

 

A different estate planning problem arises if the estate is quite large and the exemption of $1.3 million of $3 million step-ups in basis would not apply.  Then the vehicle of life insurance, in particular, would apply quite well.  The death benefit of the life insurance policy would provide the cash to pay the capital gains tax.

 

REVIEW EXISTING ESTATE PLAN

 

If the owner of the estate expects the estate to be worth at least $1 million by 2010 (or $2 million if married) or will be dead before that date, it would be an excellent idea to completely review the existing plans in view of the changes in the tax laws.  When the estate owner estimates the worth of the estate – now and later – everything should be considered, including any assets he/she is liable to inherit, the amounts in pension plans, and even the value of the death benefit of the life insurance policies.

 

The principal provisions that one should look for, pertain to flexibility.  The heirs or trustees must be able to take advantage of these new exceptions, the step-up in basis and the lower tax rates.  Add to that the fact that no one knows what the tax laws will be when death strikes, and the importance of a good estate planner has gained considerably because of the new tax laws. 

 

As time goes on, there will be many bright, professional estate planners, who will fine-tune the estate planning process to take advantage of not only the new tax laws, but also be prepared for changes which will inevitability occur.  In the political climate of the next few years where there is and will be more balance between the political parties in Washington, changing (“tinkering” or “improving” the tax act, depending upon which political party is doing the changing…) is almost a certainty.

 

THE ROLE OF LIFE INSURANCE WITH THE TAX ACT

 

At least for another 8 years – at least – life insurance will continue to be the most effective way of providing funds to pay estate taxes.  But now the problem is that the ownership of life insurance must be structured so that at death of the insured estate owner, the life insurance proceeds will not be subject to estate tax.  So, what is new?  This has always been the primary reason to use life insurance in estate planning.

 

The game has changed, provided the estate tax is eliminated during the lifetime of the insured.  If the estate tax is eliminated, the benefit of the life insurance policy will be to provide the insured with lifetime income-tax free access to the cash value that can be used for other purposes. 

 

Before the discussion of the specifics of using life insurance proceeds to solve this problem, there is one point that should be kept in mind.  As a practical matter, federal taxes, in particular, have climbed continually since the formation of this country.  The only way that the government can grow is by increasing taxes, as evidenced by the huge bite taken out of everyone’s income by taxes every year and which is now larger than ever in our history.  Logically, if the government has given back money to the people in tax cuts, when the economy cools (which it has already done) and there is less money in the treasury, the government will start looking for ways to increase its income.  Taxes that apparently affect only the “wealthy” and that had been taxed in the past, would again be an attractive method to gather more taxes – especially if the tax laws are to be revisited in the new future.  While this may never happen, one should never bet against it and it might be wise to keep this in mind during the estate planning procedure.

 

There are several methods proposed by planners that helps to solve the problem of accumulating funds available from life insurance if they are not needed to pay estate taxes.  One method discussed in some insurance periodicals, is a copyrighted trust that removes the insured’s policy’s cash value (income-tax free) at the death of the insured and that still allows the insured to have access to the cash value (income-tax- free) during his/her lifetime.  This particular method uses a trust that makes loans to the insured from these tax-free withdrawals (or loans from the trust’s life insurance policy’s cash value).  The trust is also structured to protect the policy and proceeds from claims of creditors of the insured. 

 

This type of trust – or any similar irrevocable insurance trust – should allow for termination of the trust if the federal estate tax law is repealed in the future. 

 

Irrevocable life insurance trusts are certainly nothing new, however with the new tax act, starting in 2010 (unless the IR+S makes an adverse ruling in the meantime) a transfer of money or property to a trust will be treated as a taxable gift  UNLESS the trust is treated as wholly owned by the donor of the trust (or donor’s spouse) under the grantor trust provisions of the IRS Code.  According to some tax specialists, this rule will stand, even if there are withdrawal powers in the “Crummey” trust (see discussion on this trust earlier in this text).  Whether this is a way that the IRS can finally do away with the Crummey trust, or not, the point remains that this area needs to be scrutinized by a good tax attorney if the Crummey trust is an important part of an existing estate plan.

 

This new provision can obviously affect transfers of cash to be used to pay insurance premiums, to an irrevocable trust – unless the trust is treated as only by the donor (or donor’s spouse) under the provision of the IRS code.  This law should be kept in mind when drafting any irrevocable insurance trusts.

 

APPLICATION OF STEP-UP IN BASIS AFTER 2010

 

The $1.3 million as a step-up in basis (for single persons) who die, using discount rate of 7%, that would equate to $660,000 in total basis in today’s dollars, that is the available step-up to members of the family heirs after the parent’s death.  Therefore, when stocks, real estate and other assets are liquidated by the family member heirs after 2009, obviously there may be considerable federal capital gains taxes, not to mention state income taxes, that are due and payable. 

 

Considering life insurance because of its unique income tax situation during the lifetime of the insured and after death, should still be an important arrow in the quiver of the estate planner, as the income-tax free distribution during lifetime and at death will continue.  Therefore cash value life insurance will be indispensable in avoiding the financial strain of federal capital gains taxes and sate income taxes, regardless.  The net gain in the value of life insurance when related to other and taxable forms of investing, will be approximately 25%, or to be more accurate, the total of the federal capital gains tax rate, plus the state income tax rate (if any).

 

It is probable that because of the income tax basis step-up at death that the charitable remainder annuity trusts and unitrusts that are funded with securities or other assets that are highly appreciated in value, will be used in order to avoid the capital gains taxes when these assets are sold.  So, as the charitable remainder trusts become more popular, the life insurance vehicle should become more popular as a means to replace wealth.

 

In particular, after the estate tax is repealed, the life insurance policy is a great vehicle to be used to replace the wealth of the family when a charitable remainder trust is used to create these income tax advantages because the family heirs will no longer benefit from the (current) estate tax law savings, which can amount to as much as 55% when the charitable trust assets pass to the designated charity at the death of the trust donor (or donor’s spouse). 

 

For example, if a donor dies now and the estate is substantial, for every dollar that the donor leaves to the family, if the estate is in the 55% estate tax bracket, elementary arithmetic shows that there is only 45 cents left for the family.  Therefore, every dollar left to a charity would cost the family only 45 cents.  The 45 cents is what is needed to be replaced by life insurance.

 

 

 

 

When (if) the federal estate tax is repealed, it will cost the family a dollar for every dollar left to charity because the family will receive no estate tax benefit as a result of the charitable gift, therefore a dollar of life insurance is needed to replace the dollar that goes to the charity. 

 

INCOME IN RESPECT TO A DECEDENT

 

The Income in Respect to a Decedent (IRD) deduction enabled the recipient(s) of IRD  items, such as benefits paid under qualified retirement plans and taxable IRAs which are subjected to both estate tax and after income tax after the owner’ death.  If the federal estate tax is eliminated, this deduction will be eliminated.  If, for instance, the estate was in the 55% bracket and if the IRD recipient was in the 45% marginal income tax bracket (both state and federal) the benefit of the IRD would be approximately 25%  (45% x 55% = 24.75% to be exact). 

 

The result of the estate tax repeal would, therefore, mean that proceeds of an IRA or other IRD benefits would be fully subject to ordinary income tax, even if the IRA assets would have been eligible for capital gain tax rate treatment if the assets would held outside the IRA – which may exceed 40%.

 

In summary, assuming that life insurance policy proceeds will always be exempt from income tax, there is no need for any IRD  deductions of the proceeds.  The recipients of IRD items, such as IRA distribution, will be subject to ordinary income tax under the new law and will therefore, lose the income tax deduction which presently is worth up to 25%.

 

SUMMARY OF BENEFITS OF LIFE INSURANCE FOR PLANNING

 

It would be hard to argue against using life insurance for estate planning today, and even if the estate tax is repealed after 10 years, it still will be a very valuable source of liquid funds.  For maximum flexibility, irrevocable trusts which are designed to remove life insurance proceeds from the taxable estate will allow the insured to take advantage of the income-tax free cash values if the policy is not needed to pay estate taxes, and will provide income-tax free proceeds for any purpose.

 

When (and if) the estate tax repeal actually happens as planned, because of the new carryover income tax basis rule, the insured (and family) will benefit from the tax advantages offered by life insurance.  In addition, as indicated earlier, they will benefit from the income tax advantages of life insurance as a result of the repeal of the income tax deduction for estate taxes paid on income in respect of a decedent (IRD).