New Tax Act overhauls the transfer tax system without changing its complexity.
The Tax Division of the American Institute of Certified Public Accountants (AICPA) submitted their report, Study on Reform of the Estate and Gift Tax System, to the members of Congress and officials at the U.S. Department of Treasury and the Internal Revenue Service in March 2001. This year-long study called for immediate changes and simplification in the transfer tax system (1). In response to the public pressure, the President signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (Tax Act 2001) on June 7, 2001 (7). The law has far-reaching effects on individual, retirement and estate taxes. But an analysis of Tax Act 2001 reveals that the changes made are neither immediate, permanent, nor simplifying.
Our government has been plagued with the issue of how to tax transfers of property for almost fifty years. This most recent addition to an already long line of "reforming" acts will not be the last. Indeed, Tax Act 2001 has its own self-destruct mechanism incorporated in its sunset provisions (Sec. 901), which void out all changes after December 31, 2010. Just as Dorothy returns to Kansas as if never seeing Oz, we return, in 2011, to the pre-Tax Act 2001 system.
Tax Act 2001 overhauls the transfer tax system without changing the complexity. This paper will discuss some sections of Tax Act 2001 and their effects on transfer taxes. It will look at the new law's sections affecting: a) the phase out and final repeal of estate and generation-skipping transfer taxes; b) changes to gift taxes; c) modifications of the generation-skipping transfer tax exemption and the method of its allocation; and d) treatment of basis calculations on transfers that occur after the repeal of the estate and generation-skipping transfer taxes.
Transfer taxes include estate taxes, gift taxes, and generation-skipping transfer taxes (Exhibit 1). Estate taxes result from transfers of property occurring upon the death of an individual. Gift taxes result from transfers of property occurring during the lifetime of an individual. Generation-skipping transfer (GST) taxes arise when transfers of property are made to successive generations while by-passing, or skipping, intermediate generations. A GST can occur upon death, upon termination of a trust, or during the lifetime of an individual or trust. A direct skip, for example, might occur when a grandparent gifts property to a grandchild, skipping the parent, and, thus, skipping the first generation transfer tax that might have been levied. Congress continually attempts to block newly devised vehicles that may allow individuals to pass on property to family members without paying the appropriate taxes. At the same time, Congress wants to allow certain individuals with limited assets to escape transfer taxes completely. This interplay between Congress's conflicting objectives regarding small and large transfers requires continual review of allowable transfer tax exemptions and tax rates and requires the modification of the laws affecting them.
Phase Out and Final Repeal of Estate and GST Taxes
Tax Act 2001's phase out and final repeal of estate and GST taxes begins with the phase-in increase in the exemption equivalent of the unified credit allowed against the estate tax. Exhibit 2 shows how the exclusions under Tax Act 2001 compare with those in place prior to the changes made by the act. Generally, the estate of a decedent dying after December 31, 2001, will owe no estate tax on gross estates equal to or less than $1,000,000; after December 31, 2003, will owe no estate tax on gross estates equal to or less than $1,500,000; after December 31, 2005, will owe no estate tax on gross estates equal to or less than $2,000,000; after December 31, 2008, will owe no estate tax on gross estates equal to or less than $3,500,000. Thus, for years 2002 through 2009, increasingly larger estates can be transferred tax free. After December 31, 2009, Tax Act 2001 repeals the estate and GST taxes, thus ending the exemption equivalent of the unified credit allowed against the estate tax.
Coinciding with the phase-in increases in the estate exclusion amount, is a phase-in reduction of the maximum rate used to calculate the estate tax (see Exhibit 3). This reduction in the maximum rate also applies to gift tax calculations. And, since the GST tax rate is a flat rate based upon the maximum estate and gift tax rate in effect at the time of transfer, the phase-in reductions in the maximum rate will also reduce the GST rate. Thus, for years ending December 31, 2007 through 2009, the maximum estate, GST and gift tax rates will be 45%. After December 31, 2009, the estate and GST taxes are repealed and the gift tax rate becomes equal to the maximum individual rate. So for the estates of persons dying between January 1, 2002, and December 31, 2009, if they exceed the allowable exemption amount, estate taxes will be further reduced by the use of progressively lower maximum rates.
Tax Act 2001 progressively reduces the estate tax burden for individuals dying after December 31, 2001. It increases the amount of an estate that can be passed on tax free and decreases the maximum rate used to calculate the estate tax for those who must pay. It is possible that these changes may reduce the number of estates that will be required to file estate tax forms in the future. If so, it may also reduce administrative costs for the government as well as for the smaller estate administrator.
Changes to Gift Taxes
As discussed above, Tax Act 2001 phases in a reduction in the rate used to compute the tax liability on taxable gifts (Exhibit 3). After December 31, 2009, the gift tax rate becomes equal to the maximum individual rate. Tax Act 2001 also increases the exemption equivalent of the unified credit allowed against the gift tax. For gifts made after December 31, 2001, the lifetime gift exclusion becomes $1,000,000 (Sec. 521[b] amends Code Sec. 2505[a]). Since the gift tax is not repealed by Tax Act 2001, except for the sunset provisions, this exclusion remains in effect even after the repeal of the estate and GST taxes.
The progressive increases for exclusions shown in Exhibit 2 pertain only to estates. The gift tax exclusion is limited to $1,000,000. Thus, for example, under Tax Act 2001, in the year 2009, a transfer made by gift in excess of $1,000,000 but less than $3,500,000 will be subject to tax, while a transfer made by a decedent in excess of $1,000,000 but less than $3,500,000 will not be subject to tax. Tax Act 2001 changes the relationship between estate and gift taxes by providing each kind of transfer with a different exclusion ceiling. Under prior law, gift and estate transfers shared a common exclusion amount. The exemption was cumulatively used against each "lifetime" gift first, with the balance remaining, if any, being applied to estate transfers. Tax Act 2001's changes, presumably, will make gifting less desirable. The act encourages individuals to hold property until their death and take advantage of the higher estate tax exclusion.
After Tax Act 2001, the gift tax exclusion is still cumulative. It still applies to the aggregate of gifts made during the transferor's lifetime. The actual mechanics of the computation does not change significantly either. Generally, the computation of gift tax, under both pre-Tax Act 2001 and post-Tax Act 2001, is determined by applying a rate from one of three schedules: a) the unified rate schedule in effect for gifts made before during 2001 (Exhibit 4); b) the unified rate schedule as modified for gifts made in 2002-2009 by Tax Act 2001's phase-in rate reductions; or c) Tax Act 2001's rate schedule for gifts made after 2009 (Exhibit 4). As can be seen in Exhibit 4, the amounts in Columns A, B, and C remain the same before and after Tax Act 2001. only gifts over $500,000 are actually affected by the rate change.
In 2010, Tax Act 2001 repeals the estate and GST taxes, but the gift tax remains. The lifetime exclusion of $1,000,000 and the gift tax rate change is still in place. Of course, the sunset provisions end the changes made by Tax Act 2001 after December 31, 2010. The gift tax may stand alone, but only for one year.
Modification of the GST Tax Exemption and its Method of Allocation
Prior to Tax Act 2001, the GST tax exemption was $1,000,000. After December 31, 1998, this amount was indexed for inflation (5). Tax Act 2001 provides that the GST tax exemption will be equal to the exemption equivalent of the unified credit against estate tax for periods after December 31, 2003 until the repeal of the GST tax in 2009 (Sec. 521[c] amends Code Sec. 2631[c]). Therefore, the same exclusion rate shown in Exhibit 2 for estates of decedents dying during 2004-2009 is used for the GST tax exemption. Thus, the maximum amount of generation-skipping transfers that can be made by an individual in 2009 is $3,500,000. The increased exemption will permit the transfer of more property to family members two or more generations below that of the transferor without tax consequences. As with the gift tax exclusion, the GST tax exemption applies to the total of all such transfers made by the transferor.
Tax Act 2001 modifies the rules relating to the allocation of the GST tax exemption. Prior to the Tax Act 2001, the GST tax exemption was automatically applied to direct skips, but for most transfers in trust, an election to allocate the GST tax exemption had to be made. According to the AICPA study (p. 20), problems often arose for individuals who failed, through ignorance, to make the appropriate election (1). Tax Act 2001 retroactively provides for the automatic allocation of the GST tax exemption to indirect skips (Exhibit 1). The change applies to transfers made after December 31,2000 (Sec. 561[c] amends Code Sec. 2632 [c] and [d]). Taxpayers can elect out of the automatic allocation. Tax Act 2001 describes the method of allocation and the manner in which it will automatically be applied (Sec. 521[a]). The automatic allocation of the GST is a welcomed change. It facilitates the use of the exemption and helps to ensure that it won't be lost.
Treatment of Basis Calculations on Transfers Occurring After the Repeal of the Estate and GST Taxes
Prior to Tax Act 2001's repeal of the estate and GST taxes, property transferred by reason of death generally had a basis equal to the fair market value of that property at the date of death or on the alternate valuation date, if elected (2). Therefore, the basis of property transferred at death was stepped up for appreciation in value and stepped down for depreciation in value. Upon disposition of the transferred property, the recipient realized neither taxable gain, nor received the benefit of a tax loss, if the value of the disposed property was still equal to the basis of the property received from the decedent.
Generally, the basis of gifted property is equal to the donor's adjusted basis at the time of the gift. After a gift, the recipient stands in the shoes of the transferor. Upon disposition of gifted property, the donee, generally, realizes the same gain or loss as the transferor.
Along with the repeal of estate and GST taxes, Tax Act 2031 terminates the steppedup basis adjustment that occurred at death under prior law. For property transferred from an individual dying after December 31, 2009, basis will be determined as if transferred by gift. The basis of such property will be the lesser of the fair market value of the property at the date of death or the decedent's adjusted basis (Sec. 542 [al). This includes property that may have been previously transferred to grantor type trusts which are treated as wholly owned by the donor or donor's spouse (Sec. 511[e]).
Prior to Tax Act 2001, where property subject to liabilities, such as mortgages, was sold or transferred, the amount of the liabilities was treated as realized gain to the transferor or donor. Tax Act 2001 provides that, after December 31, 2009, liabilities in excess of basis are to be disregarded when determining whether gain is recognized on the acquisition of property from a decedent or from the decedent's estate. Thus, liabilities in excess of basis will have no effect on basis determinations with regard to estate assets, and no gain will be recognized on transfers to the decedent's estate or heirs. Presumably, when the heirs dispose of the transferred property, if the value of the property and liabilities in excess of basis are unchanged, gain will be realized.
Some relief from the termination of the stepped-up basis provisions is provided by Tax Act 2001. A basis increase for certain property acquired d from a decedent dying after December 31, 2009, is allowed under the Act. The allowable basis increase is $1,300,000. This amount can be further increased by the sum of: a) any capital loss carryover under section 1212(b) that would have been available for carryover had the decedent not died; b) the amount of any net operating loss carryover under section 172, which would have been available for carryover had the decedent not died; plus c) any loss that would have been allowable under section 165, if the property had been sold at fair market value immediately before the decedent's death (Sec. 542[a]).
In the case of a decedent who is a nonresident alien, the aggregate basis increase is limited to $60,000, with no additional increase for the carryover rules relating to the capital losses, net operating losses or date of death fair market value losses discussed. Thus, for estates of decedents who are not nonresident aliens, dying after December 31, 2009, the basis of the decedents' assets can be increased by $1,300,000 plus the carryover losses described above. The adjustment made can not increase the basis of any asset above fair market value above (Sec. 542[a]).
In addition to the $1,300,000 basis adjustment, Tax Act 2001 provides a second basis increase for property acquired by a surviving spouse. The qualified spousal property basis increase is $3,000,000 above (Sec. 542[a]). Qualified spousal property includes outright transfers and qualified terminable interest property. Generally, in order to qualify for the $3,000,000 exemption, there can be no contingencies affecting the transfer of qualified spousal property. Thus, the basis of property transferred to a surviving spouse could be increased as much as $4,300.000. This increase could be much greater with the addition of the basis adjustments available for carryover losses. The basis adjustments made under Tax Act 2001 can not be used to raise the basis of property above the fair market value.
Generally, under Tax Act 2001, property acquired from a decedent after December 31, 2009, can be stepped up in basis by $1,300,000, assuming there are no built in losses or loss carryovers, for transfers to non spousal beneficiaries. Property that is to be transferred to a spouse after December 31, 2009, can be stepped up in basis by $3,000,000 and, if not used elsewhere, $1,300,000. Assuming there are no built in losses or loss carryovers, there is a total of $4,300,000 that could be available for basis adjustments to spousal property. This amount increases even more when there are capital loss carryovers available under section 1212(b), net operating loss carryovers available under section 172, and/or any available losses allowable under section 165. After all of the allowable increases from allocations to the decedent's property have been made, property that has not been stepped up to fair market value will be transferred to beneficiaries and spouse alike at the decedent's adjusted basis.
Until December 31,2009, administrators of estates need only to gather the decedent's assets, often a difficult enough job, and have them appraised at their fair market value. Real estate, investments, paintings, collectibles, jewelry, etc., all have to be accounted for; all have to be appraised. The sum total of these values constitutes the estate of the deceased that is subject to estate tax. After December 31, 2009, the assets still have to be accounted for, still have to be appraised, but for decedents dying in 2010, administrators will also have to determine the basis for each asset It will be a Herculean task to determine the basis of assets that may have been passed down from prior estates or by gift or held for many years. This will need to be done in order to properly allocate the allowable basis increases existing under Tax Act 2001 and to inform beneficiaries of the basis of transferred assets.
As discussed throughout this article, Tax Act 2001's sunset provisions provide that all changes made by the act to the Code and ERISA run out after December 31,2010. The sunset provisions cover all of Tax Act 2001's changes -- not just the portions discussed in this paper. As far as transfer taxes are concerned, though, all phase-outs, all phase-ins, all changes, and terminations are voided in 2011. Of course, it is expected that Congress will intervene before December 31, 2010, and hopefully it won't be in the eleventh hour. But which system is going to be the one in place after the next comprehensive tax act? Will it be the present system -- the pre-Tax Act 2001/ post-sunset provisions system? Will it be the 2010 system that repeals estate and GST taxes and requires a nightmarish record-keeping burden too onerous to satisfy? Or, will it be a system similar to the one in place in 2009 with a $3,500,000 or more estate tax and GST tax exemption and a $1,000,000 or more gift tax exclusion? Until the confusion s urrounding the future of estate, GST, and gift taxes is cleared away, planning for transfer taxes will be riddled with more uncertainty then ever. Indeed, planning will have to take into account that all systems are possible. Not a simple thing to do.
EXHIBIT 1 DEFINITIONS TAX WHEN LEVIED Estate Tax Transfers upon death of decedent Gift Tax Transfers during lifetime of individual Generation Skipping 1) A transfer for the benefit of a Transfer Tax - person at least two generations Direct Skip (4) below that of the transferor. 2) A transfer of property to a trust for one or more such beneficiaries. Generation Skipping 1) A transfer for the benefit of a Transfer Tax - person at least two generations Indirect Skip (4) below that of the donor from the donor's generation skipping trust. 2) A transfer for the benefit of a person at least two generations below that of the donor upon the termination of the donor's generation skipping trust. EXHIBIT 2 COMPARISON OF PRE TAX ACT 2001 PHASE-IN INCREASES IN THE EXEMPTION EQUIVALENT OF THE UNIFIED CREDIT WITH THE PHASE-IN INCREASES UNDER TAX ACT 2001 For Estates of Decedents Pre Tax Act 2001 (8) Tax Act 2001 Dying During 2,001 675,000 No change 2,002 700,000 1,000,000 2,003 700,000 1,000,000 2,004 850,000 1,500,000 2,005 950,000 1,500,000 2,006 1,000,000 2,000,000 2,007 1,000,000 2,000,000 2,008 1,000,000 2,000,000 2,009 1,000,000 3,500,000 2,010 1,000,000 Estate & GST Taxes Repealed 2011 or thereafter ?????????? 2011 Sunset of Tax Act 2001 EXHIBIT 3 SCHEDULE OF MAXIMUM ESTATE TAX AND GIFT TAX RATES Year Maximum Rate 2,001 (3) ESTATE & GIFT No Change, 55% 2,002 ESTATE & GIFT 50% 2,003 ESTATE & GIFT 49% 2,004 ESTATE & GIFT 48% 2,005 ESTATE & GIFT 47% 2,006 ESTATE & GIFT 46% 2,007 ESTATE & GIFT 45% 2,008 ESTATE & GIFT 45% 2,009 ESTATE & GIFT 45% 2,010 ESTATE & GIFT Maximum individual rate EXHIBIT 4 TABLE COMPARING THE UNIFIED RATE SCHEDULE FOR PERIODS BEFORE DECEMBER 31, 2009 AND TAX ACT 2001 GIFT RATE SCHEDULE FOR PERIODS AFTER DECEMBER 31, 2009 (a) Column D Colume E Rate of Tax on Rate of Tax on Excess Over Excess Over Amount Column A Column B Columnn c Amount in in Column A For Taxable Taxable Tax on Colum A Gifts Made After Amount Amount Amount in Before Tax December 31, 2009 Over Not Over Colum A Act 2001 (Tax Act 2001) In Dollars In Dollars In Dollars In Percent In Percent 0 10,000 0 18 18 10,000 20,000 1,800 20 20 20,000 40,000 3,800 22 22 40,000 60,000 8,200 24 24 60,000 80,000 13,000 26 26 80,000 100,000 18,200 28 28 100,000 150,000 23,800 30 30 150,000 250,000 38,800 32 32 250,000 500,000 70,800 34 34 500,000 750,000 155,800 37 35 (b) 750,000 1,000,000 248,300 39 35 1,000,000 1,250,000 345,800 41 35 1,250,000 1,500,000 448,300 43 35 1,500,000 2,000,000 555,800 45 (C) 35 2,000,000 2,500,000 780,800 49 (c) 35 2,500,000 3,000,000 1,025,800 53 (c) 35 3,000,000 -- 1,290,800 55 (c) 35 (a)Exhibit 4 is a consolidation of the Unified Rate Schedule found ia instructions for Form 706, revised July, 1999 . (b)Rates for amounts over $500,000 in Column E reflect the reduction of the maximum individual income tax rate made by PL 107-16, Sec. 101(a)(2). (c)See Exhibit 3 for changes in maximum rates over time.
(1.) American Institute of Certified Public Accountants, Study on Reform of the Estate and Gift Tax System. AICPA; New York, 2001 (February).
(2.) Code Sec. 1014(a) (2). http://tax.cch.com/ freecoderges. Downloaded August 12,2001.
(3.) Code Sec. 2001(c). http://tax.cch.com/ freecoderegs. Downloaded August 9,2001.
(4.) Code Sec. 2612 (b) and (c) and Reg. Sec. 26.2612-1. http://tax.cch.com/freecodereos. Downloaded August 9,2001.
(5.) Code Sec. 2631(c). http://tax.cch.com/ freecoderegs. Downloaded August 12,2001.
(6.) Instructions for Form 706. July, 1999. http:// www.irs.gov/forms pubs/pubs.html. Downloaded August 9, 2001.
(7.) Public Law (PL) 107-16. 107th Congress. http://frwebgate.access.gpo.gov/cgi-bin/ useftp.cgi?IPaddress=18.104.22.168&file name=publ016.107&directory=/diskb/wais/data/107 cong public laws. Downloaded August 2,2001.
(8.) Publication 553, Highlights of Tax Changes. January, 2001. IRS Publication, Cat No. 15101G. http://www.irs.gov/forms pubs/ pubs.html. Downloaded August 9,2001.
(9.) Research Institute of America. Analysis of HR. 1836. btto://www2.checkpoint.riag.com/serlet. Downloaded August 6, 2001.
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|Publication:||Review of Business|
|Date:||Jan 1, 2002|
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