FEDERAL TAXATION AFFECTING ESTATE PLANNING
by James A. Harris

December, 2001

The tax legislation enacted in June 2001 makes significant changes to federal estate and gift taxes. These changes, however, are built upon laws currently in effect and thus must be examined in that context. Moreover, these changes present both opportunities and pitfalls to effective estate planning, which are further complicated by uncertainty over whether the recent changes will become permanent.

The Internal Revenue Code ("Code") currently imposes an integrated tax on the cumulative transfer of wealth during life and at death. During 2001, an individual can pass $675,000 free of federal wealth taxes; thus, a husband and wife, acting together, can dispose of $1.35 million free of federal wealth taxes. Individual gifts in excess of the individual exemption are taxed at graduated rates beginning at 37 percent and currently reaching 55 percent for taxable gifts in excess of $3 million. Taxable gifts or estates in excess of $10 million are subject to a surtax of 5 percent that phases out the benefit of the lower rates so that taxable gifts and estates in excess of $17 million are taxed at a flat rate of 55 percent.

Most gifts between spouses, whether during life or at death, are not taxable; instead, the tax is deferred until the property passes to someone other than a spouse, usually at the death of the surviving spouse. Gifts to charity, whether during life or at death, also are free of tax.

The cumulative nature of the transfer taxes is assured by a special rule that, for purposes of calculating the taxes due at death, adds back all taxable gifts made during life. Additionally, for lifetime gifts, there is an annual gift tax exclusion of $10,000 per donor per recipient before lifetime gifts begin to consume the cumulative lifetime exemption or require payment of gift taxes.

The federal estate and gift taxes apply comprehensively to all forms of wealth over which the individual taxpayer has effective personal control. Thus, taxable wealth includes not only assets that are owned directly (real estate, investments, bank accounts, etc.) but also other forms of personal wealth, including life insurance, annuities and tax-qualified retirement benefits.

The most notably expansive application of the federal wealth tax system is the manner in which interests in trust are taxed. An individual who creates a trust in which he retains either significant beneficial interest or the power to change for his own benefit, is treated, for tax purposes, as the owner of the trust property. And a person who holds a general power of appointment over property in a trust created by another is treated as the owner of the property over which the power may be exercised. A general power of appointment, in this context, is the power to appoint to oneself or for ones’ own benefit.

A common device to limit the reach of the federal wealth taxes had been the so-called "generation-skipping" trust. A person would leave wealth in a form that, while taxable at death, would remain in trust for the benefit of two and sometimes more subsequent generations of descendants before again becoming subject to estate and gift taxes. The intermediate generations were given interests in trust income and, where appropriate, independent trustees had the power to invade principal for their benefit. Structured this way, there was nothing that would be subject to federal estate tax at the deaths of the intermediate generations of life beneficiaries.

Congress first sought to address the loophole of generation-skipping trusts in 1976. Although technically correct as a policy matter, the 1976 generation-skipping tax rules proved incredibly complex and ultimately unworkable. Accordingly, Congress started over in 1986 by retroactively repealing the 1976 provisions and enacting a new generation-skipping transfer ("GST") tax.

While having the virtue of relative simplicity, the present GST tax is quite draconian in effect. Taxpayers presently are given a cumulative lifetime exemption of $1,060,000 ($1 million, indexed for inflation), which they can use or allocate as they see fit. (There are default provisions to assure taxpayers the benefit of the exemption even in the absence of an affirmative election.) Above the $1.06 million GST exemption, however, all transfers in a form that avoids federal estate and gift taxes at the next generation level (the transferors’ children) are subject to GST when they pass to the next generation at the highest applicable marginal rate for estate and gift taxes, currently 55 percent. The most significant exception to the present GST is the effective date: the GST rules simply do not apply to property that was in existing irrevocable trusts as of September 25, 1985.

There also are significant income tax issues associated with estate planning. Under current law, when an individual receives property by gift from a living donor, his basis for determining gain or loss from sale of that property is equal to the donor’s basis in the property, increased for any gift taxes the donor had to pay. This is called a "carryover" basis because any appreciation in value in the gifted property in the donor’s hands remains fully taxable to the donee when he or she sells it. But when an individual receives property by bequest or inheritance as a result of the donor’s death, his basis for determining gain or loss is adjusted to the fair market value of the property at the donor’s death. This is called a "fresh start" basis because the donee takes the property free of any income taxes that would have been due had the donor sold the property during his life. However, the "fresh start" basis is denied to certain kinds of assets that would have produced taxable ordinary income in the donor’s hands. These kinds of assets – including pension and other tax-deferred retirement benefits, including IRAs – remain fully taxable when receive by beneficiaries following a donor’s death.

Beginning next year, the maximum rates of estate, gift and GST tax are scheduled to decrease, as follows:

Additionally, the 5 percent surtax on taxable estates and gifts in excess of $10 million is repealed beginning in 2002.

Beginning next year, the exemptions from estate and GST tax (but not from gift tax) will increase substantially, as follows:

Thus, beginning in 2007, estates above the exemption amounts will be subject to a flat tax of 45 percent.

Beginning in 2002, the gift tax exemption will increase to $1.0 million, but it will stay at $1.0 million through 2009 and in fact beyond. In other words, beginning in 2004, the federal estate and gift taxes will no longer be fully integrated. Taxable gifts will still be aggregated with assets taxable at death, but the differing exemptions mean that a gift that would be tax-free at death will be taxable if made during life. Gift taxes paid during life on gifts that would have been tax-free at death are not refundable or creditable against estate taxes. This de-integration was a last-minute change in the tax legislation enacted out of concern that higher gift tax exemptions would lead wealthy taxpayers to transfer significant amounts of wealth during life to relatives whose income tax rates are much lower than those of the donors.

Finally, property acquired at death will continue to receive a fresh-start income tax basis equal to the date of death fair market value throughout the period 2002-2009. Property received by gift during life will continue to receive a carryover basis equal to the donor’s basis in the gifted property.

Under the legislation enacted in June, federal estate and GST taxes are repealed effective January 1, 2010. The gift tax remains in effect with a cumulative lifetime exemption of $1 million and a flat rate of 35 percent. The gift tax annual exclusion of $10,000 per donee, adjusted for inflation, will continue. Property received by gift will continue to have a carryover basis, equal to the donor’s basis in the property.

In 2010, property received by bequest or inheritance will no longer receive a fresh start basis equal to the date of death fair market value. Instead, this property will take a carryover basis from the donor, with certain modifications. The modifications will allow an additional $1.3 million of basis to be allocated to assets received at death, plus amounts equal to the decedent’s built in losses and unused loss carryovers. An additional $3 million of basis can be allocated to assets passing to a surviving spouse. In no case, however, can the basis exceed the fair market value of the assets on the date of death. All allocations of additional basis are made by the executor on the decedent’s final income tax return.

Absent further action by Congress, however, the repeal of estate and GST taxes and modification of gift taxes is effective only during 2010. Absent further action, the federal estate, gift and GST taxes generally will revert to their present 2001 form on January 1, 2011. This means full integration of the estate and gift taxes, a maximum rate again of 55 percent, plus a 5 percent surtax on large estates, and fresh start income tax basis for assets received at death. The only substantive change will be an exemption of $1 million instead of the present $675,000.

This sunset provision for repeal of the estate and GST taxes was a function of internal procedural rules in the Senate which preclude tax legislation having a revenue effect more than 10 years in the future absent a super-majority vote. Experts and commentators have been divided in predicting what, if anything, Congress will do about the years 2011 and beyond. Some believe that Congress must make good on its promise and make repeal permanent. Most, however, believe that the estate and GST taxes will be retained but at lower rates and with higher exemptions than at present (i.e., 2001). This view was based on projections of dwindling surpluses and impending deficits as baby boomers begin reaching normal retirement age in 2010 and projections of the revenue losses that permanent repeal would entail. The recent events, and revenue needs for the war on terrorism, make permanent repeal even less likely.

The new tax legislation leaves considerable uncertainty in how to take federal wealth taxes into account in estate planning. Until these uncertainties resolve themselves, there are a few guiding principles:

1. Planning so that husband and wife receive the full benefit of individual estate tax exemptions remains key, but care needs to be taken in defining non-spousal gifts linked to the exemptions so as not to impoverish the surviving spouse through tax-free gifts to others.
2. Lifetime gifts, other than to a spouse or charity, in excess of $1 million should be avoided.
3. No irrevocable trusts or transfers should be made before 2011 that are predicated in any way on the assumption that there will be no federal estate and GST taxes.

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