Brady,
Morton,PLLC
4141 Parklake Avenue
Raleigh, NC 27612
Phone: 919-782-3500
Fax: 919-573-1430
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MEMORANDUM TO OUR CLIENTS AND FRIENDS ABOUT THE ECONOMIC GROWTH AND TAX
RECONCILIATION ACT OF 2001
By Brady Morton, PLLC
In June of 2001 Congress enacted and President Bush signed into law
the Economic Growth and Tax Reconciliation Act of 2001. This Act changes
the rules that govern estate and gift taxation and will have an impact on
how we draft estate plans for our clients in the years to come. However,
despite the headlines and sound bites about the repeal of the “death tax”
the estate and gift tax will remain a major factor in how people structure
and plan for their families' futures for many years to come.
This Memorandum is intended to provide a basic outline of the
changes in the tax code that will go into effect over the next ten years,
it is not intended to be a form of legal advice and you should always seek
the opinion of a qualified tax professional who has reviewed the facts and
circumstances of your individual case.
Wealth Transfer Tax
Reform
Estate and Generation-Skipping Tax
The 2001 Act increases the amount exempt from estate tax from
$675,000 in 2001 to $1,000,000 effective January 1, 2002. The exemption
amounts are then slowly increased over the next eight years until January
1, 2010 when the estate tax, as it is known today, is repealed.
Additionally, the 5% surtax on estates between $10,000,000 and 21,000,000
and the rates in excess of 50% will be repealed as of January 1, 2002. The
highest rate of tax will be slowly reduced over the years 2002 to 2009.
The table below outlines the new exemption amounts and highest estate and
gift tax rates over the next nine years.
Calendar
Year |
Exemption Amount |
Highest
Marginal
Rate |
|
2002 |
$1.0 Million |
50% |
|
2003 |
$1.0 Million |
49% |
|
2004 |
$1.5 Million |
48% |
|
2005 |
$1.5 Million |
47% |
|
2006 |
$2.0 Million |
46% |
|
2007 |
$2.0 Million |
45% |
|
2008 |
$2.0 Million |
45% |
|
2009 |
$3.5 Million |
45% |
|
2010 |
Estate Tax Repealed |
0% |
Capital Gains Tax and
Carryover Basis
Under current law a person incurs a tax on capital gains earned upon
the sale of a capital asset. The amount of gain that a person realizes is
determined by subtracting their adjusted cost basis in the property from
the proceeds received from the sale of the property. Under current law, a
person who receives an asset as the result of a transfer upon death
receives a step-up in basis so that their cost basis in the property
received is generally equal to the fair market value of the property at
the time of the decedent's death. On the other hand, if a person receives
an asset as a lifetime gift, his or her basis in the property is the same
as the transferor's cost-basis. This is referred to as carry-over basis.
The 2001 Act imposes a carry-over basis on heirs who receive
property from a decedent after January 1, 2010. This means that heirs will
inherit a decedent's property with a cost basis equal to the lesser of the
decedent's adjusted cost basis or the fair market value of the property on
the date of the decedent's death.
However, a decedent's executor will be permitted to increase the
adjusted cost basis in a decedent's property to the lesser of $1.3 Million
or the actual value of the property. Also, the cost basis of certain
property transferred to a surviving spouse may be increased up to $3.0
Million. Certain property like retirement plan assets would not qualify
for this cost basis adjustment.
Gift Tax
The gift tax on transfers made during lifetime is not repealed by
the 2001 Act. Instead the gift tax rates are set to decrease with the
reduction in the highest marginal estate tax rates. Beginning in 2010 the
highest marginal gift tax rate will be equal to the highest income tax
rate (probably 35%).
The amount exempt from gift taxes is also set to increase with the
estate tax exemption, however, it is capped at $1.0 Million. This means
that after 2002 a donor will be able to exempt up to $1.0 Million from
gift taxes. Please be aware that the exemption does not increase after
2002 like the estate tax exemption. Additionally, the current annual
exclusion amount from gift tax equal to $10,000 (indexed) will continue to
remain in effect after 2002. However, as previously stated, if a person
receives an asset as a lifetime gift, his or her basis in the property is
the same as the transferor's cost-basis.
Sunset Provision
It is very important to note that the repeal of the estate tax may
never become a reality. The 2001 Act has a built in sunset provision which
was required to comply with the Congressional Budget Act of 1974. This
means that all provisions of the 2001 Act sunset for years beginning after
December 31, 2010, right after the Congressional elections of November
2010. Continued repeal of the estate tax will require Congress to re-enact
the legislation to keep the repeal alive. Additionally, many changes can
occur over the next ten years with shifts of power to new Presidents and
legislative players so we will continue to monitor the horizon for future
changes in the law.
Income Tax Reform
Income Tax Rates
The 2001 Act creates a new 10% income tax bracket for the first
$6,000 of income for single persons (no children), the first $10,000 for
single parents and the first $12,000 for married persons filing jointly.
This new income tax bracket is retroactively applied to January 1, 2001,
which will result in income tax refunds for many Americans. All other
income tax rates are reduced over the next six years in accordance with
the table set out below.
|
Calendar Year |
28% Rate
Reduced to: |
31% Rate
Reduced to: |
36% Rate
Reduced to: |
39.6% Rate
Reduced to: |
|
2001-2003 |
27% |
30% |
35% |
38.6% |
|
2004-2005 |
26% |
29% |
34% |
37.6% |
|
2006 - future |
25% |
28% |
33% |
35% |
Repeal of the Phase-Out
of Itemized Deductions
Prior to the 2001 Act itemized deductions were phased-out for
married taxpayers with income greater than $139,950 and $66,475 for single
taxpayers. Under the 2001 Act, the phase-out of itemized deductions is
reduced by one-third beginning in 2006, by two-thirds beginning in 2008
and completely eliminated in 2010.
Repeal of the Phase-Out
of the Personal Exemption
Prior to the 2001 Act the personal exemption was phased-out for
married taxpayers with income greater than $199,450 and $132,950 for
single taxpayers. Under the 2001 Act, the phase-out of personal exemptions
is reduced by one- third beginning in 2006, by two-thirds beginning in
2008 and completely eliminated in 2010.
Education Savings
The 2001 Act allows taxpayers to deduct certain higher education
expenses. As of January 1, 2002, taxpayers whose taxable income does not
exceed $130,000 will be permitted to deduct up to $3,000 per year for
qualified higher education expenses. As of January 1, 2004 this deduction
will increase to $4,000.
The 2001 Act also attempts to breathe some new life into the
Education IRA, a vehicle that has not proven to be as useful as was hoped
when enacted. As of January 1, 2002 taxpayers will be permitted to
contribute up to $2,000 to an Education IRA per calendar year.
Recently many taxpayers have discovered the benefits of saving for
education through the use of qualified tuition programs such as prepaid
tuition programs and college savings plans (also known as Section 529
Plans). The 2001 Act liberalizes these qualified tuition programs in many
ways making them even more attractive to families saving for educational
expenses.
In general there are two forms of qualified tuition programs each of
which is state sponsored. The prepaid tuition plan generally allows the
taxpayer to purchase credits or certificates for a designated beneficiary
(e.g. the taxpayer's child) who is then entitled to a waiver or payment of
qualified higher education expenses. The Section 529 Plan generally allows
the taxpayer to contribute an account set up to meet the qualified higher
expenses of a designated beneficiary. Under both plans beneficiary changes
are only allowed between members of the same family. Neither the
contributor nor the beneficiary is taxed currently on the earnings on
contributions to the programs. However, before the 2001 Act, the
beneficiary was taxed on the earnings when distributions or educational
benefits were provided to him or her and the amounts refunded to the
contributor are taxed to the contributor to the extent of earnings and
there was a penalty imposed on such refunds.
Under the 2001 Act, for tax years beginning after January 1, 2001,
the definition of qualified tuition program will include certain prepaid
tuition programs established and maintained by eligible educational
institutions, including private institutions. This means that taxpayers
will be able to buy education credits or certificates from such private
plans, but will not be able contribute to savings account plans set up to
pay for educational expenses like under the Section 529 plans.
The 2001 Act also allows distributions made after December 31, 2001
from qualified state tuition programs to be excluded from gross income to
the extent such assets are used to pay for qualified higher education
expenses. The Act allows distributions from qualified tuition programs
maintained by other entities (other than states) to be excluded from gross
income after December 31, 2003.
Planning Under the
2001 Act
From an estate planning perspective the 2001 Act has made some
significant changes that will impact how we plan for the future. A
significant number of people will no longer be subject to the tax simply
because of the increase in the exemption. However, with repeal not
occurring until 2010 most people are going to be faced with the same
estate and gift tax issues with a slightly lower net tax liability. After
2010 there will be new issues as far as capital gains tax and the
carry-over basis provisions that will become effective.
In short, the need for a comprehensive plan, developed by an
attorney who specializes in the area of estate planning, will remain well
into the future and taxpayers should not be lulled into a false sense of
security by the headlines and sound bites in the media touting a repeal of
the death tax.
What to Do Now
Informed estate administration and appropriate executor elections taking
advantage of the adjustment to basis provisions will be critical. It is
now appropriate to review and possibly revise plans that currently fund
the credit shelter trusts to the maximum available exemption amount. That
funding formula may no longer be appropriate if the combined family assets
do not exceed the higher exemption amounts. The termination of certain
trusts that were designed to avoid tax at the second death of the husband
and wife and the elimination of the administrative burden and expense
associated with those trusts may also be appropriate. The review of
insurance policies that were purchased to pay estate tax is also
recommended.
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