Significant recent developments in estate planning.

This article--the first of two parts--examines recent developments in estate, gift and generation-skipping transfer tax planning. Specifically, it discusses highlights of the Economic Growth and Tax Relief Reconciliation Act of 2001 and recent regulations.

This two-part article focuses on recent developments in estate, gift and generation-skipping transfer (GST) taxes. This part analyzes current legislative and regulatory developments in areas such as the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA); inflation indexing of exemptions and exclusions; electing small business trusts (ESBTs); and retirement plan required minimum distributions (RMDs).

Legislative Developments

Estate Tax Reform

President Bush signed the EGTRRA on June 7, 2001.(1) Under EGTRRA Section 501 (a), the Federal estate tax will be eliminated over a 10-year period. A detailed analysis is beyond the scope of this article,(2) but some key provisions follow.

Under EGTRRA Section 521, the unified credit effective exemption amount will rise from $675,000 to $1 million in 2002 for both estate and gift tax purposes; the top marginal gift and estate tax rates will decline simultaneously from 55% to 50%, and the 5% surtax on gifts and estates in excess of $10 million will be eliminated. In 2004, the estate and gift taxes will uncouple. The estate tax effective exemption will increase to exempt $1.5 million; the gift tax effective exemption will remain at 2002's $1 million. The highest estate tax rate is scheduled to decrease to 49% in 2003, 48% in 2004 and continue downward until it reaches 45% in 2009. Simultaneously, the estate tax effective exemption will continue to rise, to $3.5 million in 2009. In 2010, the estate tax is scheduled to be repealed, but the gift tax will equal the highest individual income tax rate (presumably, 35%).

Starting in 2010, concurrent with estate tax repeal, EGTRRA repeals the stepped-up basis rules and replaces them with a modified carryover-basis rule. Each estate will be permitted to increase the basis of up to $1.3 million of assets transferred at death. In addition, an estate may increase the basis of up to an additional $3 million of assets transferred at death to a surviving spouse.

The Federal estate tax credit for state death taxes will be significantly restructured over the next four years, under EGTRRA Section 531. Beginning in 2002, the credit is reduced 25% each year. Beginning in 2005, the credit changes to a deduction, under EGTRRA Section 532. Became many states base their death tax on the state death tax credit, they will be forced to take action to replace the lost revenue.

A number of changes were made to the GST tax, largely the result of efforts of AICPA Tax Division members. Under EGTRRA Section 521(c), effective Jan. 1, 2001, the GST exemption is automatically allocated to lifetime indirect skips and is allocated retroactively when there is an unnatural order of death. This automatic allocation will protect many existing irrevocable life insurance trusts (ILITs) for which taxpayers have not regularly reported contributions or filed gift tax returns.

The GST exemption remains at its current $1.06 million (and continues to be indexed for inflation). Effective Jan. 1, 2002, the GST tax rate is reduced from 55% to 50%. The rate will continue to decrease along with the highest estate and gift tax rates, until elimination in 2010. In 2004, the GST exemption increases to $1.5 million.

The most interesting aspect of the EGTRRA is the sunset provision. Because the Senate was not able to approve the legislation with a greater-than-60% majority, all of the EGTRRA's tax reduction provisions expire at the end of 2010. In the absence of congressional extension, the 2001 gift, estate and GST tax laws will be reinstated in 2011.

Planning: What can tax advisers expect from Congress? The year 2011 is two presidential elections and four Congresses from now; thus, planning should not be based on the notion of complete repeal. However, the changes to be phased in between now and 2004 can probably be relied on and further changes can be expected.

Gift, Estate and GST Exclusion Indexing

The Taxpayer Relief Act of 1997 indexed a number of exclusion items, beginning in 1999. The indexing will continue even after the EGTRRA. The changes were released earlier this year and apply to calendar-year 2001.(3)

Gift Tax Annual Exclusion

For 2001, the Sec. 2503(b) gift tax annual exclusion remains at $10,000 per person per year. The adjustment is in $1,000 increments as necessary to reflect inflation. However, the relatively low inflation levels over the past three years have yet to affect this exclusion.

Noncitizen spouse: Taxpayers can transfer unlimited property to a U.S.-citizen spouse under the Sec. 2056 marital deduction. However, for a noncitizen spouse, the exclusion was historically limited to $100,000 under Sec. 2523. Effective Jan. 1,2001, the Sec. 2523 exclusion increased to $106,000.

GST Exemption

The GST exemption increased to $1.06 million for calendar-year 2001. Indexing will continue under the EGTRRA. In 2004, the phased-in increase of the GST exemption to $1.5 million will likely surpass and replace the indexed amount.

Special-use Valuation

Under Sec. 2032A, an executor may elect to value real property used in a farm or business on the basis of actual, rather than highest and best, use. The maximum allowable deduction was set at $750,000; indexing for 2001 increases it to $800,000.

Tax Deferral for Closely Held Business

The Sec. 6166 two-percent interest rate for the applicable portion of the estate tax payable in installments is increased to $1.06 million.

Receipt of large Foreign Gifts

For tax years beginning in 2001, recipients of gifts from certain foreign persons may have to report them under Sec. 6039F if the aggregate value of the gifts received in a tax year exceeds $11,273.

Regulatory Developments

Because family businesses and qualified plans form the basis for a significant portion of the estate-planning engagements undertaken by CPAs, practitioners must pay attention to apparent income tax developments, as well as to estate tax developments. Treasury published two sets of proposed and temporary income tax regulations that will significantly affect estate planning for S shareholders and qualified-plan beneficiaries.

ESBTs

Treasury issued both temporary and proposed regulations(4) to implement the ESBT provisions. ESBTs have been permitted S shareholders since the enactment of the Small Business Job Protection Act of 1996 (SBJPA).

Prior to 1996, only grantor trusts and qualified subchapter S trusts (QSSTs) were permitted trust S shareholders. QSSTs were required to have only a single income beneficiary to whom all current income was required to be distributed. Under Sec. 1361, an ESBT can have multiple beneficiaries and accumulate mast income.

Congress's stated purpose in enacting the ESBT provisions was to "facilitate family financial planning" and permit trusts that "spray" their income among family members to be S shareholders.(5) However, the ESBT provisions left several unanswered questions. First, SBJPA Section 1302 requires that all "current trust beneficiaries" be counted toward the 75-shareholder limit, without defining that phrase. Can the same trust be taxed partially as a grantor trust (under Secs. 671--678) and partially as an ESBT? This is common when trust beneficiaries have limited withdrawal rights.

Second, Sec. 1361(e)(2) provides that no ESBT interest can be acquired by purchase. Does this restriction apply to a beneficiary's acquisition; does it prohibit a trust from purchasing potential S stock?

Third, under Sec. 1361(e), an ESBT cannot simultaneously be a QSST. Can a QSST elect to convert to an ESBT? Finally, how is an ESBT election made?

The Service attempted to provide guidance to practitioners in various notices and procedures.(6) The proposed regulations address the above issues, but also raise further questions.

A current ESBT beneficiary is generally defined by Prop. Regs. Sec. 1.1361-1(m)(1)(ii) as any person who has a present, remainder or reversionary interest in the trust. Remote beneficiaries (with a less-than-five-percent probability of receiving a distribution) may be disregarded. However, the existence of a lifetime general power of appointment could jeopardize ESBT eligibility, because the number of potential beneficiaries would exceed 75 shareholders.

Second, under Prop. Regs. Sec. 1.1361-1(m)(3)(iv), the same trust may simultaneously be taxed partially as a grantor trust and partially as an ESBT. However, the proposed regulations do not identify how income should be allocated between the grantor(s) and the ESBT.

Third, the prohibition against the purchase of an interest applies only to the beneficiary's acquisition of its trust interest. The ESBT may acquire its stock by purchase, according to Prop. Regs. Sec. 1.1361-1(m)(1)(iii).

Planning: An ESBT's ability to purchase stock is important, because it permits use of a common estate planning strategy. Frequently, a family will create an ILIT with multiple beneficiaries. The ILIT may purchase S stock from the insured shareholder's estate to provide liquidity for the payment of taxes and other obligations. The regulations will allow an ILIT to qualify as an ESBT.

Under Prop. Regs. Sec. 1.1361-1(m)(2), an ESBT election must be signed by a trustee and fried with the Internal Revenue Service Center where the trust fries its income tax return.

Finally, Prop. Regs. Sec. 1.1361-1(j)(12) and (m)(7) explain how a QSST may convert to an ESBT and vice versa. However, protective ESBT elections are not allowed. Generally, the proposed regulations are effective on or after the date final regulations are published. However, the regulations on the income taxation of the grantor trust portion of an ESBT are effective for tax years ending after Dec. 28, 2000, under Prop. Regs. Sec. 1.1362-6 (b)(2)(iv) .

RMDs

Treasury also issued proposed regulations under Sec. 401 (a) (9),(7) designed to simplify the calculation of RMDs from qualified plans, IRAs, Sec. 457 deferred compensation plans and similar plans. Prop. Regs. Secs. 1.401(a)(9)1--8 will affect the calculation of RMDs during a taxpayer's life and the determination of a designated beneficiary for distributions after death.

While the proposed regulations are intended to apply to RMD calculations for 2002 and thereafter, taxpayers can rely on them for 2001. The proposed regulations change the distribution rules by (1) reducing RMDS and greatly simplifying their determination; (2) lengthening the distribution period; (3) extending the deadline for designating a beneficiary without adverse consequences, from the required beginning date to December 31 after the year of death; and (4) implementing new reporting requirements imposed on IRA trustees.

The new rules eliminate the need (1) for multiple distribution tables, (2) to recalculate life expectancies of participants and/or beneficiaries and (3) to make tax elections, by limiting the choices available to recipients and standardizing both the tables and the distribution methods. As a result, it will be easier for IRA trustees, participants and the IRS to determine RMDs each year. Additionally, the reporting requirements will finally enable the IRS to track required distributions and collect income tax and penalties, when applicable.

Conclusion

The legislative and regulatory changes of 2001 bear witness to the increased complexity that estate planners will face in the coming years under the new rules.

In the September issue, Part II of this article will examine cases and rulings, including those on grantor retained annuity trusts, family limited partnerships, gift disclosure and split-dollar life insurance.

EXECUTIVE SUMMARY

* Because many states base their death tax on the Federal state death tax credit, they will be forced to take action to replace the lost revenue.

* New income tax regulations have had an effect in the estate and gift tax area.

* Proposed regulations explain how an ESBT can convert to a QSST and vice versa.

(1) P.L. 107-16, 107th Cong., 1st Sess. (2001).

(2) A detailed analysis of these provisions will appear in a future issue of The Tax Adviser.

(3) Rev. Proc. 2001-13, IRB 2001-3, 337, Section 3.

(4) REG-251701-96 (12/29/00) and TD 8915 (12/28/00).

(5) H. Rep't No. 104-586, 104th Congress, 2d Session (1996), p. 82.

(6) Notice 97-12, 1997-1 CB 385 (ESBT election procedures); Notice 97-49, 1997-(2) CB 304 (definition of "current beneficiaries"); Rev. Proc. 98-23, 1998-1 CB 622 (procedures for a QSST to convert to an ESBT and vice versa); and Notice 2001-25, IRB 2001-13, 941 (applying estimated ESBT taxes to the deemed owners' accounts).

(7) REG-130477-00 (1/17/01), corrected by REG-130481-00 (2/21/01).

For more information about this article, please contact Mr. Whitlock at [phone] or [e-mail].

Brian T. Whitlock, J.D., LL.M., CPA
Partner-in-Charge, Wealth Transfer Services Group
Blackman Kallick Bartelstein, LLP
Chicago, IL

Jill McNamara, J.D.
Wealth Transfer Consultant
Blackman Kallick Bartelstein, LLP
Chicago, IL