Potential Estate and Gift Tax Changes in 2001

Presented to the Optimist Club in Augusta, Georgia, on April 19, 2001, by Frank S. Macgill.

CURRENT EVENTS.

President Bush has proposed a $1.6 trillion tax cut bill that essentially targets four areas of tax relief. They are reduction of the federal income tax rates from five brackets (15%, 28%, 31%, 36%, 39.6%) to four lower brackets (10%, 20%, 25%, 33%); marriage penalty relief (currently, taxpayers filing jointly may pay more income tax than two single filers); expansion of the child tax credit (double credit, make available to more); and repeal of the federal estate, gift and generation-skipping transfer taxes.

Other than an income tax rate reduction, the estate and gift tax has received the most publicity despite the fact that estate taxes account for only 1.5% of total federal revenues (in 1999) and historically have never accounted for more than 6.9% of total federal revenues. However, a recent study showed that the failure of 9 out of 10 failed family businesses and small farms was attributable in part to the imposition of federal estate taxes. Further, there are fundamental questions about the policy behind the federal estate tax including its effectiveness as a revenue raiser and its effectiveness to prevent vast accumulations of wealth through mandatory reallocation. In essence the taxpayer’s choices for the taxable portion of his estate are tax-funded federal initiatives or private charitable initiatives.

On Wednesday, April 4, 2001, the House of Representatives passed a $185.5 billion bill to repeal the federal estate, gift and generation-skipping transfer taxes. The vote was 274 to 154 in favor of a repeal that would be completely phased in within 10 years depending on the effective date of the legislation. Until the phase in of the repeal, the current estate tax rules would generally remain in effect subject to the gradual reduction in the federal estate and gift tax rates.

However, what the budget gives in the form of a gradual repeal of the transfer taxes, it takes away in the form of income tax basis adjustments. Traditionally, assets take new tax basis equal to their fair market value on the date of the holder’s death (commonly referred to as a “step-up” in basis). The House bill would limit the step up in basis to the first $1.3 million of property left to persons other than the decedent’s spouse, but allows a basis step up for up to $3 million in property left to a surviving spouse.

In addition, the budget specifically requires the IRS to study opportunities for income tax avoidance as a result of the repeal, meaning that obvious loopholes will be closed at the outset.

On Friday, April 6, 2001, the Senate passed a modified budget resolution by a 65 to 35 vote authorizing the Senate Finance Committee to report a ten year tax cut bill at $1.2 trillion. The Senate cut President Bush’s bill by $400 million allocating that amount plus some to education and other mandatory and discretionary spending plans.

Senator Grassley (R-Iowa) said the Senate Finance Committee will take up work on the new bill the week of April 23, 2001. The conference committee considering the bill will be composed of four Republicans and three Democrats.

HISTORY OF FEDERAL TRANSFER TAXES.

In 1916, the federal estate tax was born, soon followed by a permanent gift tax in 1932. In 1976, the estate and gift taxes were unified into a single transfer tax regime that applies the same rate structure to the cumulative history of a person’s lifetime transfers (gifts) and his/her bequests (transfers at death). In 1986, the generation-skipping transfer tax was added to the family of transfer taxes. It applies a flat 55% rate to generation-skipping transfers over $1 million.

Spurred by the compelling plight of family farmers and small business owners, Congress took a stab at eliminating the federal estate and gift tax in 2000. Despite threats of veto, Congress passed a repeal bill and sent it to the White House. As promised, President Clinton vetoed the bill.

ESTATE AND GIFT TAX REPEAL: PRESENTLY

President Bush’s budget plan and $1.6 trillion tax cut calls for a repeal of the estate and gift taxes with many elements of the prior bill that was vetoed by President Clinton. Although less than 2% of Americans pay federal estate and gift taxes, there is broad bipartisan support for some form of tax relief that includes modifications to the federal estate and gift tax regime. Whether or not we will see an outright repeal, or simply adjustments to the tax and/or an increased exclusion amount targeting small business owners, family farmers and the relatively “unwealthy,” is yet to be seen.

President Bush’s plan calls for repeal of transfer taxes within 8 years. During the 8 year phase-in, estate and gift tax rates would be reduced incrementally by reducing the top rate by 5% to 10% each year.

As mentioned above, the bill passed by the House of Representatives on April 4, 2001 provides for a very gradual 10 year phase-in of the estate and gift tax repeal, basically leaving the current rate structure in effect, with some minor reductions, until complete repeal in 2011. This bill would cost an estimated $185.5 billion, whereas President Bush’s proposal has an estimated cost in excess of $320 billion.

In addition to the reduction in estate and gift tax rates, the unified credit would also be reduced as a direct result of the decreasing rates. Under present law, the unified credit is a tax credit which is equivalent to $675,000 in assets. It is not in fact an exclusion or deduction as many people think. Thus, as the ultimate estate tax liability is reduced through a reduction in tax rates, so too would the unified credit amount be reduced. Interestingly, the unified credit equivalent (that is the amount of assets that would be sheltered by the unified estate and gift tax credit), is scheduled to increase to $1 million under present law. Both the President’s proposal and the repeal bill that passed the House leave the scheduled increases in the unified credit equivalent in place.

However, the House bill goes one step further by converting the unified credit to an exemption, meaning that taxpayers will be able to remove total assets having such value from the highest, rather than the lowest, brackets.

One of the important elements of the current estate and gift tax law is the ability of estate beneficiaries to receive assets with a stepped-up tax basis. The basis step up simply means that inherited assets take a new tax basis equal to their fair market value at death. This is important because tax basis going forward determines how much taxable gain you will have if you sell the asset later.

The new rules will likely take away this favorable basis adjustment at death. Instead the proposed law would limit the basis adjustment to the first $1.3 million of assets left to anyone other than your spouse and a $3 million of assets left to your surviving spouse. This means that proper estate planning could permit assets up to $4.3 million to receive favorable basis adjustments, but anything else would take what is called a carry-over basis. This carry-over basis means that if the decedent had a share of stock with a $10 basis that he had owned all his life, a beneficiary would inherit that share of stock with the same $10 basis, even if it was worth $400 at the date of death. In contrast, that share would take a new $400 basis if the basis step up rule is applied.

If a similar provision comes out in the final law it will open up a whole new income tax planning aspect for estate planners in order to take maximum advantage of the limited basis step up. For instance, we could see “basis step up trusts” being created to accommodate the $3 million spousal limit and the general $1.3 million limit.

CHARITABLE GIVING.

Current estate and gift tax laws generate billions in annual charitable giving. While undoubtedly most people would continue to include charitable donations as part of their lifetime and death planning, it is not unreasonable to think that the imposition of estate taxes at the 55% level might motivate people to give more at death than they otherwise would to charities because of the lower “cost” of the bequest. In the highest estate tax bracket the federal government essentially subsidizes 55% of the charitable gift. For instance, Price WaterhouseCoopers found that the repeal of the estate and gift tax would decrease annual charitable donations by $3 billion.

To help offset this almost certain effect on charitable giving, the Bush tax plan calls for an expansion of the charitable income tax deduction to allow more non-itemizing taxpayers (that is, those who simply use the standard deduction) to take tax deductions for charitable donations for their federal income taxes. The same PriceWaterhouseCoopers study says this expansion of the charitable income tax deduction to more taxpayers would increase charitable giving by up to $14.6 billion annually. In theory, this should more than cover lost charitable donations if the estate tax is repeated.

ALTERNATIVE ESTATE AND GIFT TAX REPEAL/REFORM PROPOSALS.

Congressional Democrats have put forth two estate and gift tax reform proposals. In late January, a group of Democratic Senators led by Tom Daschle proposed a bill that would increase the unified credit to $1 million in 2002 and, beginning in 2007, would further increase the unified credit to $2 million by 2010. This bill has not yet been reviewed or put to a vote before any committee or on the Senate floor.

House Democrats put forth their own estate and gift tax reform proposal in a bill sponsored by Rep. Charles Rangel of New York. This bill would increase the unified credit to $2 million in 2002 and would further increase it gradually to $2.5 million by 2010. However, this bill also contains a provision that would effectively disallow valuation discounts, otherwise currently accepted under current law and general economic principles, for interests held in entities that are not engaged in an “active trade or business”. Basically, this provision could force a decedent’s estate to pay tax on its pro rata share of the total value of the assets held by an entity (a partnership, an LLC, etc.), simply based upon the decedent’s ownership percentage interest in the entity, even when a sale of such interest would bring only 50 to 60% of such amount. This bill was defeated in the House of Representatives by a vote of 227 to 201.

Senate Republicans have presented an estate and gift tax repeal proposal of their own in the form of a bill sponsored by Sen. Kyl of Arizona. This bill would repeal the estate and gift tax immediately, but it would limit the step-up in basis to $2.8 million in assets, with such amount to be indexed for inflation in future years. This bill has not yet been considered by any committee or by the Senate as a whole.

Other Senate Republican proposals, which have received lesser consideration due to their high cost, include proposals to:

1. Repeal the estate and gift tax by 2007, while keeping the basis step-up intact;

2. Repeal the estate and gift tax immediately, while keeping the basis step-up intact; and

3. Increase the unified credit to $5 million in 2002.

WHAT THE PEOPLE SAY.

As mentioned above, the estate and gift tax impacts less than 2% of American taxpayers. Therefore, efforts by the Bush administration and Congressional Republicans to repeal such tax have been a focal point of Democratic attacks upon President Bush’s tax cut plan as being too favorable to the wealthy. This was undoubtedly a crucial factor in the Senate “compromise” of the proposed tax cut down to $1.2 trillion. As the budget debate moves to conference committee, several moderate Republican Senators are urging the conferees to keep the proposed tax cut at $1.2 trillion. If that is eventually the case, estate and gift tax repeal could be a prime candidate for compromise, as Congress obviously will be under a lot of pressure to provide primarily income tax relief this year.

Small business owners and farmers, who are the hardest hit by the estate and gift tax due to the illiquidity of their assets, have been some of the most outspoken proponents of estate tax repeal. However, repeal in the form presented in the bill that passed the House of Representatives earlier this month is not exactly what they had in mind. In the eyes of many, it will provide significant relief only after 10 years. Some small businessmen and family farmers have even voiced a preference for the Democratic proposals, which would at least increase the unified credit significantly in the very near future.

The American Institute of Certified Public Accountants (“AICPA”) has prepared a study on proposed reforms to the current estate and gift tax regime. In its report, one of the issues focused upon is the difficulty of doing away with the basis step-up (which will almost certainly accompany any estate and gift tax repeal) and implementing a carryover basis regime, whereby beneficiaries receives the decedent’s basis in the asset. The study strongly suggests that a substantial allowance for basis step-up be provided with any estate and gift tax repeal, and that the rules for determining the basis of certain types of assets held by the decedent be relaxed somewhat through the creation of “safe harbor” rules. This concern obviously arises from the common failure of business persons and their accountants to keep adequate records over long periods of time so as to accurately track basis in assets like interests in closely held business or investment entities, such as S corporations, limited liability companies, limited partnerships, etc. Under the current basis determination rules, calculating a decedent’s basis in a limited partnership interest held by him/her for 20 or more years could be a classic accountant’s nightmare.

Needless to say, large charitable institutions like universities and hospitals are very concerned about estate and gift tax repeal, as they depend heavily upon large gifts and bequests from the ultra wealthy. Many fear that, without the incentive of estate tax avoidance, many will opt to simply leave it all to their families. This thinking has also given rise to additional concerns, as voiced by none other than William Gates, Sr. (father of Mr. Microsoft), that repeal will create a new class of ultra wealthy citizens and simply worsen economic inequality in the U.S.

Representatives of state governments and their taxing authorities have also expressed concern, as repeal of the estate and gift tax would wipe out between $30 and $50 billion in state estate tax revenues. Under the estate tax laws of most states, their estate tax is simply a percentage of the federal estate tax paid, based upon the state death tax credit allowed under federal estate tax law. Therefore, if the federal estate tax goes away, so do most of the states’ estate taxes.

As many of you have read, there is still widespread support in all sectors of the American public for repeal of the estate and gift tax as an inherently unfair tax, as it is imposed upon assets that presumably are the product of earned income, which has already been taxed during the decedent’s lifetime. It is this widespread feeling that has led to somewhat bipartisan support for the repeal effort. Over 50 Democratic Representatives voted for the repeal bill that passed the House.

And last, but certainly not least, what we say is this: The old rule of “what’s done is done” simply does not apply in Congress. In short, whatever the 107th Congress does can be undone by the 108th, 109th, 110th, etc. Estate plans should be adopted to take into account the potential for estate tax repeal, but the wise planner will still use trusts and other estate planning vehicles that would not be subject to estate tax if Congress were to ever reintroduce it.

(This publication was coauthored by David A. Anderson, Esq.)