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How Does the Tax Cut Affect My Estate Planning?

On June 7, 2001, President Bush signed into law the "Economic Growth and Tax Relief Reconciliation Act of 2001" (the "Act") – the largest tax reduction legislation in the last twenty years. The media has widely reported that the Act eliminates the estate tax (that is, the sizeable tax imposed on the assets passed to one’s heirs after death). This is not quite true. In fact, as presently constituted, the Act gradually eliminates the estate tax between now and 2010, but unless Congress acts to make this repeal permanent before 2011, the estate tax comes back (including a top tax rate of 55%, with an exemption for $1,000,000 of assets). And, of course, there is an array of other complications that typify federal legislation of this type.

All of this has led many of our clients to ask how this change in the law affects their estate plans. In the past, these clients, concerned about the welfare of their spouses, children and other heirs, have engaged us to plan their estates to eliminate or minimize estate taxes. Is that sort of planning still necessary? Is there another kind of planning that should now be considered?

To help our clients understand what they should be doing now, and what they should be planning for in the future, we have summarized and answered some of the most frequently asked and important questions.

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Q. Am I still going to need a will?

A. Yes. Your will does more than save estate taxes. A will serves as a guide for how you want your property distributed and your personal wishes executed after your death. If you were to die without a will, or “intestate,” then the state’s intestacy laws will decide how your property is to be distributed and who will administer your estate; the end result might not only be adverse to your wishes, but also cost your survivors additional death taxes.

In addition, a will may also be important for purposes of minimizing state inheritance taxes, which have not been repealed. A will is also important to assign guardianship of minors. Otherwise, the fate of your minor children would be left to a court. A will can also act in conjunction with trusts created for the benefit of your dependants. For instance, you might create a trust for your minor child’s education. Through a will, you could appoint the trustee and determine when and for what purpose the child gets the money. Without a will, all of the property would pass to the child under the Uniform Transfers to Minors Act (in Pennsylvania and New Jersey, when the child is 21, elsewhere, at 18).

Q. I understand that I still need a will. But if the estate tax is eventually repealed, do I still need an estate plan?

A. The Act does not eliminate the need for estate planning. On the contrary, in many respects, the Act has increased the need for, and complexity of, estate planning, particularly for high net worth individuals and families. The details depend upon several factors, such as: (1) the combined value of your estate and your spouse’s estate; (2) whether you die before or after the scheduled phase-out in 2010; (3) whether Congress repeals or changes the Act prior to 2010; (4) whether Congress does nothing in 2011 and allows the estate tax to return in 2011; (5) and, perhaps most important, whether you have non-tax reasons for estate planning.

For instance, married couples with combined assets less than or near the $1,000,000 exemption might utilize disclaimer wills. Through this technique, assets will pass outright to the surviving spouse, who can at that time, if need be, opt to have a sufficient amount of property placed into an exemption trust, thereby eliminating estate taxes. If the first spouse dies after 2010 and there is no estate tax, than all of the property could pass directly, free from trust, to the surviving spouse.

For combined estates in excess of the exemption, you will need to utilize more complex estate planning techniques that address the possibility of death occurring before 2010, and the further possibility that the estate tax may be re-instituted after 2010. For instance, because the gift tax is still in effect (gifts in excess of $1,000,000 will still be subject to a 35% gift tax), valuation discounts on transfers to family limited partnerships, grantor retained annuity trusts, or qualified personal residence trusts will continue to be important planning vehicles. Various other planning techniques, involving the use of trusts, must still be utilized to minimize these and related taxes.

Q. What non-tax reasons would I have for making an estate plan?

A. In addition to the reasons for making a will, you may prefer that your assets remain in trust rather than pass outright to a beneficiary, particularly if the beneficiary is a minor, or incapacitated. Depending on how the trust instrument is written, you can restrict distributions of income and/or principal as you prefer. In addition to being free from creditors’ claims, property in a properly drafted trust is not subject to estate taxes when the beneficiary dies.

Q. I’ve heard about credit shelter trusts? Do I still need one?

A. Until the estate tax is phased out, individuals with net estates exceeding the exemption should plan their estates accordingly. Often, this means using a credit shelter trust. Basically, a credit shelter trust, if properly drafted, will shield assets from federal estate tax.

If you already have a credit shelter trust, your estate plan should be reviewed. You may no longer need to use a credit shelter trust (for instance, if your combined assets do not exceed the $1,000,000 exemption amount), or it may need to be amended to take advantage of the increased exemption amount in the Act. Estate plans that fund a specified dollar into a credit shelter trust should be reviewed and amended to maximize the increased exemptions. The usual preferred method to draft for maximizing the exemption is by a formula that funds the trust with just enough to ensure that the estate taxes are reduced to the lowest possible amount.

Q. I am not sure, but I think my estate plan uses a pre-residuary credit shelter trust. Should my plan be modified?

A. Yes, your plan should be modified. Because of the higher exemptions, your and your spouse’s estates may no longer be subject to estate tax and there would be no need to create and fund an irrevocable credit shelter trust. Alternatively, your plan may need to be modified to replace the pre-residuary credit shelter trust with a residuary credit shelter trust in order to leave more assets estate tax free to your spouse.

Q. Before the tax law change, I created a family limited partnership, charitable trust, irrevocable life insurance trust and a grantor retained annuity trust. In light of the recent changes, did I do all of this for nothing?

A. No. You may die before the phase-out, or the phase-out may never take place. In view of these uncertainties, estate planning will be needed, particularly in respect to estates with taxable assets in excess of the exemption. Family limited partnerships and grantor retained annuity trusts remain good estate planning vehicles for transferring wealth at discounted values.

Charitable trusts will still remain useful -- they provide a means to contribute low basis property without incurring capital gains taxes, receive an income stream from the trust during the trust term, while at the same time receive an income tax deduction for the value of the remainder passing to charity.

Finally, life insurance should remain in irrevocable trusts until the repeal is effective in 2011. Once the repeal is effective and made permanent, it may be advisable for you to cash in the policies, terminate the policies, sell the policies, or just replace them with new policies free of trust.

Q. Are there any new tax benefits for education under the Act?

A. Yes. The Act raises the contribution limit for educational IRAs from $500 to $2,000 per donee per year. Unlike traditional IRAs, donors cannot deduct contributions. However, distributions for qualified educational expenses are tax-free, and in addition to college and graduate school, now include expenses for elementary and secondary school education. The Act also permits corporations and other entities to contribute to education IRAs as taxable income to the employee. However, those with significant incomes cannot take advantage of an educational IRA because it is phased out at certain adjusted gross income levels. The beginning and ending adjusted gross income for the phase-out has been increased by the new law for joint filers to $190,000 and $220,000, respectively.

The Act also expands eligible qualified state tuition programs, or Section 529 plans, to include private colleges and universities (which have received prior IRS approval). Like the educational IRA, 529 distributions for qualified educational expenses are (as of January 1, 2002) now free from Federal taxes (in addition to being free from state taxes). In Pennsylvania, donors may contribute up to $170,000 per beneficiary and may change the beneficiaries within the same family (including first cousins). Pennsylvania’s Tuition Account Program also guarantees to pay for the future costs of educational expenses purchased today no matter how much the expenses may rise in the future. Qualified educational expenses include tuition, room, board, books, supplies, equipment, and fees.

In addition, married couples with adjusted gross incomes no greater than $130,000 in 2002 and 2003 can take an above-the-line deduction of no more than $3,000 (married taxpayers with adjusted gross income between $130,000 and $160,000 may deduct up to $2,000) for qualified higher education expenses paid during the year. The phase-out increases to $4,000 in 2004 and 2005. For distributions from a qualified tuition plan, taxpayers can also deduct the pro rata portion of the payment that represents a return of their contribution.

Q.How much does the Act reduce estate taxes?

A. The amount of assets exempted from the estate tax, and the new maximum rates, are as follows:

Q. The Act has a “sunset” provision. What does this mean and how does it affect me?

A. The sunset provision means the sun will set on the newly enacted changes, unless the law is made permanent by Congress between now and 2011. If the sun sets on the law, then the estate tax will return in 2011 to the previous estate tax law, with a $1,000,000 exemption and a top marginal rate of 55%. No one knows whether Congress will make the estate tax repeal permanent, or simply reinstate the estate tax prior to the phase-out in 2010. However, because the estate tax will remain in constant flux for the rest of this decade, and no one can be assured of surviving the decade, more, rather than less, complex planning, will generally be needed.

Q. May I continue to give $10,000 each year tax free to my children?

Yes. The annual gift tax exclusion from the prior law remains in effect.

Q. What about other gifts to my children?

A. Beginning in 2002, in addition to the annual exclusions of $10,000, each person will be entitled to give away $1,000,000 during his or her lifetime exempt from gift taxes. Under the prior law, there was one, unified lifetime exemption for both gifts and estates. Now, there are two separate exemptions: $1,000,000 for gifts, and $1,000,000 for estates (only the latter of which incrementally increases from 2004 to 2009 before being reinstated in 2011).

Q. Does the Act affect the basis of securities or other assets?

A. Not until the estate tax is phased out in 2010. At that time, there will no longer be a step-up in basis for inherited assets. This means that the gain on inherited assets sold by heirs is measured from the date the assets were acquired by the person who died, not from the date an heir acquires the asset, which can increase the tax bite substantially.

There are, however, certain assets that will still receive a step-up in basis:

These basis exemptions will be indexed for inflation after 2010.

Q. Does the Act give any special preferences to spouses?

A. Until the estate tax is phased out, all transfers between spouses will still be exempt from gift and estate taxes. Once the estate tax is phased out, property transferred at death to spouses will be entitled to a limited step-up in basis. It is limited because the first $3,000,000 of property transferred to a spouse will receive a date of death basis step-up. If all of the property is transferred to the spouse, then the step-up in basis for the spouse can total $4,300,000.

Q. Does the Act provide any estate tax relief for owners of the family business?

A. Unfortunately, there are no specific exemptions for the family business owner, other than what was previously in the tax code. In fact, Code Section 2057, which specifically provided relief for such owners, will be repealed for decedents dying after 2003. Owners of family businesses will require specialized planning to minimize estate taxes.

© Copyright 2001 Powell, Trachtman, Logan, Carrle & Lombardo, P.C. and Powell Trachtman Training and Consulting, LLC. All rights reserved, except that recipients hereof are permitted, for noncommercial purposes, to provide copies or excerpts, with full attribution to us, to other interested persons for their personal use. This document is distributed for general informational purposes only. It is not a substitute for personalized legal advice from a competent attorney.