Post-EGTRRA analysis and planning (Estates, Trusts & Gifts).

• Author: Sawyers, Roby B.
• Position: Economic Growth and Tax Relief Reconciliation Act of 2001

EXECUTIVE SUMMARY

* While it is difficult to view the EGTRRA as true estate tax repeal, it does provide some short-term relief to middle-class taxpayers.

* The change from a Federal credit for state death taxes to a deduction should send drafters back to the funding language contained in wills and trusts.

* While carryover basis will not go into effect until 2010 (and may never actually occur), clients should be advised to begin keeping basis records.

The 107th Congress sculpted new estate and gift tax provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), including total repeal in 2010. While the EGTRRA has been heralded as the death of the estate tax, in actuality, it will arise again in 2011 if not extended.

Background

A number of conservative lawmakers fought for years to repeal the Federal estate tax, but any widespread suggestion of repealing it during President Clinton's first term would likely have been met with ridicule and accusations of Congressional pandering to the wealthiest Americans. (1) However, in May 1999, Sen. Jon Kyl (R-AZ) introduced S. 1128, (2) calling for outright repeal of the estate tax and a carryover-basis regime with a limited basis step-up for up to $3 million of assets passing to a surviving spouse. Surprisingly, the popular press and middle-class America supported this effort and called for an end to the "death tax" Frustrated with an estate tax system that threatened to confiscate the modest savings of their elderly parents and impinge on the promised wealth of employee stock options and the roaring 1990s stock market, middle-class "baby boomers" began to view themselves as the estate and gift taxes' true victims.

A modified version of S. 1128 (H.R. 8 (3))--which would have incrementally reduced Federal transfer tax rates over 10 years, followed by full estate and gift tax repeal and a partial carryover-basis regime in the eleventh year--was passed by both the House and Senate, but vetoed by President Clinton in September 2000. A number of groups (including the AICPA) cautioned Congress of the potential problems with estate tax repeal and a carryover-basis regime (particularly a repeal with a prolonged phase-out period and little immediate relief). The AICPA prepared a study containing alternatives providing more immediate (and permanent) relief for the vast majority of taxpayers affected by the estate tax. However, it became increasingly clear that the death tax would be repealed. (4)

After President Bush's election, repeal of the death tax gained additional momentum. Supported by both the Republican-controlled House and the new Bush administration, the only question was whether the more evenly divided Senate would support estate tax repeal. It did; the EGTRRA was enacted on June 7, 2001.

While some EGTRRA supporters have termed it the end of the death tax, in reality, repeal of the death tax is uncertain at best, taking place only after a prolonged nine-year phase out (on Jan. 1, 2010), then reappearing on Dec. 31, 2010 due to the sunset provision. (5) The sunset provision also causes the EGTRRA's tax rate and effective exemption amount (previously, the applicable exclusion amount) changes to expire on Dec. 31, 2010 and to be replaced by the unified tax tables, rates, surtaxes, exclusion amount and basis step-up rules in effect in 2001. (6) Effectively, the sunset provision treats EGTRRA as if it were never enacted.

Finally, while the estate and generation-skipping transfer (GST) taxes are repealed by EGTRRA, the gift tax is not. In 2004, the EGTRRA effectively bifurcates the previously unified estate and gift tax system (a likely result of criticism that the income tax system would suffer from widespread erosion without a gift tax).

While it is difficult to view the EGTRRA as true estate tax repeal, it does provide some short-term relief to middle-class taxpayers, by raising the gift and estate tax thresholds over the next few years. The EGTRRA also expands the possible use of conservation easements and estate tax installment payments, and eliminates some existing GST tax traps. Overall, there are benefits for taxpayers and practitioners alike, although planning may be more difficult.

EGTRRA Provisions

Short-term Estate and Gift: Tax Relief

Under the EGTRRA, on Jan. 1, 2002, the unified credit effective exemption amount for estate, gift and GST tax purposes will increase from the current $675,000 to $1 million. At the same time, the top marginal gift and estate tax rates will decline from 55% to 50%; the 5% surtax on gifts and estates in excess of $10 million will be eliminated.

As illustrated in Exhibit 1 on p. 824, the highest estate and gift tax rates will continue to decrease, until the highest rate reaches 45% in 2009. (7) However, while the estate tax effective exemption and GST tax exemption will continue to rise, eventually reaching $3.5 million in 2009, the gift tax exclusion will remain at $1 million. On Jan. 1, 2004, when the estate and GST tax exemption increase to $1.5 million, the gift tax exclusion will remain at $1 million, resulting in an uncoupling of the estate and gift taxes for the first time in 28 years (since the Tax Reform Act of 1976). (8) After repeal of the estate and GST tax in 2010, the maximum gift tax rate is reduced to the maximum individual income tax rate (presumably, 35%).

Planning: While the scheduled increases in the estate tax effective exemption are welcome, tax professionals should pay careful attention to estate plans that rely on a formula to eliminate estate tax by increasing the assets going to a bypass trust as the effective exemption increases. In smaller taxable estates, this may result in too few assets passing to a surviving spouse.

GST Tax

Retroactive to the beginning of 2001, the EGTRRA modifies the GST tax to remove a number of traps for taxpayers and tax advisers. The fundamental purpose of the GST tax is to ensure that a form of transfer tax is imposed at every generation. Without the GST tax, wealthy individuals could simply transfer assets directly to grandchildren (or even great-grandchildren), thus avoiding estate tax at the skipped generations' levels.

Since 1986, each transferor has been allowed a $1 million GST exemption that can be allocated to transfers during life or at death. Beginning in 1999, the exemption has been indexed for inflation; the 2001 indexed exemption is $1.06 million.

The GST tax has often been criticized as a trap for the unwary. To prevent the average taxpayer from having to deal with the complex GST tax rules and pay the tax, Congress provided an automatic allocation of the exemption to direct transfers...