The New Law in a Nutshell. The Economic Growth and Tax Relief Reconciliation Act of 2001 which was recently signed into law makes sweeping changes in the federal transfer tax system. Much of the media attention has focused on the repeal of the estate tax in the year 2010, but the new law is significantly more complex than a simple repeal. Until the total phase out in 2010, the law retains the concept of a unified credit exemption amount (currently $675,000) which passes free of tax upon the death of an individual, but it increases the amount of the exemption and it also reduces the top estate tax rate as set forth in the table. The federal gift tax, which has historically dovetailed with the federal estate tax, will not be repealed and after 2003 the estate and gift tax systems will no longer dovetail. In 2002, the gift tax exemption amount (like its estate tax exemption counterpart) increases to $1,000,000 but it remains at that level until 2011, while the estate exemption increases. The existing provisions for annual exclusion amounts ($10,000 annual gifts per donee) have not changed. The gift tax rate for total lifetime gifts in excess of $1,000,000 is the same as the estate tax rate until the estate tax is fully repealed after 2009, at which point it becomes the top individual income tax rate (projected to be 35%). The articulated purpose for keeping the gift tax is to avoid transfers of high income producing assets back and forth between high income taxpayers and low income taxpayers. The generation-skipping transfer tax exemption amount increases in the year 2004 so that it will be the same as the unified credit exemption amount for estate taxes. Prior to total repeal of the estate tax, scheduled for 2010, there are a number of technical changes in the law that can have a significant impact on planning. For example, from 2002 through 2004, the state death tax credit is phased out, and in 2005 the credit is changed to a deduction. Additionally, the family owned business estate tax deduction enacted just a few years ago is repealed effective 2004 (when the estate exemption amount increases to $1,500,000). The definition of a qualified conservation easement has been somewhat expanded to increase the number of situations where a deduction will be available and there are a number of technical changes to the generation-skipping transfer tax rules which will make allocation of exemptions and applicability of these exemptions to trusts much easier. When the full repeal of the estate tax takes effect in the year 2010, it is replaced by a carryover basis tax regime. Under prior law, when an individual died, although his or her estate was subject to estate taxes, all assets the decedent was deemed to have owned at the time of death received an increase in cost basis to the full date of death fair market value. Upon the repeal of the estate tax, this will no longer be the case and the basis of assets will be the lower of their historical cost basis carried over from the decedent or the fair market value at death. It will thus become critical for clients and their advisors to maintain adequate records to establish a cost basis that will be passed on from individual to individual. The new law allows for a limited step-up in the basis of assets acquired from a decedent up to an aggregate cap of $1,300,000. This basis adjustment amount is to be allocated by the personal representative of an estate as he or she sees fit. This will make the role of personal representative potentially much more controversial. In addition, up to $3,000,000 of additional basis adjustment can be allocated to property left to or for the benefit of a surviving spouse (with marital deduction rules similar to those we now have, which allow a marital deduction for certain trust). A tax return will need to be filed to allocate this limited basis step-up. All of the changes described above are scheduled to expire after December 31, 2010, and the prior law on estate, gift and generation-skipping transfer taxes would be reinstated. No one expects the full repeal or the full reinstatement of prior law to occur, but there is no current consensus regarding the type of corrective legislation likely to be enacted. One possibility would be a straightforward reenactment of the new rules in a more permanent form, but most professional commentators think that is highly unlikely in view of the significant revenue loss these new provisions are projected to generate. Another possibility would be to abandon the concept of full estate tax repeal, as well as carryover basis, and simply continue the existing regime with higher and identical exemption levels for estate, gift and generation skipping taxes. Until a political consensus develops on the subject of corrective transfer tax legislation, and such legislation is enacted into law, the planning process will be exceedingly difficult and challenging for both clients and professional advisors. We can only hope for some clarifying legislation within the next few years that will produce a more stable and predictable tax system that all of us can rely upon. In the interim, it will be important to analyze some of the issues highlighted below and position estate plans to be as responsive as possible to any of the projected tax regimes in a way that is consistent with your goals and objectives.

Impact of Formulas Under the New Law. Most clients with taxable estates have estate planning documents that arrange for a credit shelter trust to be funded out of the first estate in an amount equal to the unified credit amount. Typically, this trust remains available to the surviving spouse, but is not taxable in his or her estate. A separate unified credit exemption amount is then available for the second estate, and this arrangement takes maximum advantage of both exemption amounts available to a married couple. Under the new tax law, the unified credit exemption amount increases dramatically over the next several years, initially to $1,000,000 in 2002, and up to $3.5 million in 2009. Standard tax-driven formulas for funding the credit-shelter trust are designed to take maximum advantage of the exemption. That is, the maximum permissible amount of assets from the first estate will stay in the credit shelter trust, and any excess assets would be distributed outright to the surviving spouse, or to a marital deduction trust for his or her exclusive benefit. Under the new tax structure, this strategy may tie up more assets in the credit shelter trust than is really necessary to allow the couple’s assets to escape estate tax. For example, for a couple with aggregate assets of $2,000,000, once the exemptions amount to $1.5 million each (a total of $3,000,000 for the couple), far less than the full exemption amount will have to be retained in trust at the first death to result in complete avoidance of any estate tax at either death. Most documents, however, are designed to put the entire $1.5 million into the credit shelter trust on the death of the first to die, leaving only $500,000 in the hands of the surviving spouse. Client may wish to review these formula-driven arrangements and modify them to limit the size of the trust, or even consider disclaimer language that would allow the surviving spouse to choose the extent to which assets should pass into the credit shelter trust. Similarly, documents that establish generation skipping trusts often direct the full generation skipping exemption amount into that trust. Client may wish to consider whether the size of the formula-driven generation skipping trust, as the exemption increases, is consistent with their goals.

The Balancing Act Continues. One common goal for couples with taxable estates has been to arrange their asset ownership so the estate of the first to die has sufficient assets to fully fund the credit shelter trust. Thus many couples have kept at least $600,000 in the individual name of each spouse, and have been less deliberate about how the amount over $600,000 each is titled. As the unified credit exemption amount has increased over the past few years, we have recommended that the base amount that each spouse should have in his or her individual name to fully utilize the tax planning in their trusts should have increased to $675,000 and then up to $1,000,000 by 2006. The changes in the unified credit exemption amount in the new tax legislation make this balancing even more important. For example, if a couple has $3,500,000 of combined assets and last did an estate plan in 1994, they may have slightly over $600,000 in each souse’s name with the rest of their assets in joint ownership or in the name of one spouse. Even without the 2001 tax law changes it would be appropriate now to have at least $675,000 in each spouse’s name. As of January 2002, each should have least $1,000,000 of assets, and by January 2004, each should have at least $1,500,000. This will enable the credit shelter trusts in their documents to receive enough assets to generate the desired estate tax savings. This same couple should note, however, that if the assets are heavily weighted in one name only and that wealthier spouse dies first, a disproportionate amount could be directed to the credit shelter trust under traditional formula provisions. Thus the issues of asset division and balancing become more important and more subtle under the new law.

Section 529 Plans. A “Section 529 Plan” is an investment arrangement sponsored by a state intended as a tax-advantaged devise to save money for college education. Prior to this year’s tax bill, the assets in Section 529 Plans grew tax-free, but the accumulated untaxed income was taxable when the money was withdrawn to pay for college or for other purposes. Under the new tax bill, distributions from the Plan are not subject to federal income tax if the distributions are used to pay fro post-secondary school education. Consequently, Section 529 Plans are now more like Roth IRA’s. The growth in the investment is not taxed, and even the eventual distributions are not taxed, as long as the distributions are used to pay for education. There is also a benefit in using a 529 Plan in connection with financial aid eligibility. A minor’s trust or a custodial account is treated as the student’s asset for financial aid purposes. Typically, the student is expected to spend about 35% of his or her assets each year for college. However, a Section 529 Plan is treated for financial aid purposes as the parents’ asset. The parents are only expected to spend about 5.6% of their liquid asset per year for the child’s education. Contributions to a Section 529 Plan for a child or grandchild are gifts as under prior law. These gifts are eligible for the $10,000 per year annual exclusion ($20,000 if you “split-gift” with a spouse). However, you can contribute up to $50,000 ($100,000 if you “split-gift”) in a single year and have this gift treated as having been made ratably over 5 years for annual exclusion purposes. If the Donor dies during that 5 year period, the gifts are not covered by the annual exclusion for years after the Donor’s death.

Changes in Retirement Account Payouts and Beneficiary Designations. In January of 2001, the IRS issued new proposed rules relating to required minimum distributions from qualified retirement plans and individual retirement accounts (IRA’s). These new rules are a vast improvement. The most significant improvement is that the method for calculating required distributions is greatly simplified. For lifetime distributions, almost all individuals will use one “Uniform Table” for calculating lifetime required distributions, regardless of who is named as beneficiary. At the required beginning date (RBD), a participant’s required minimum distribution each year is determined by dividing the value of the plan account or IRA by the applicable distribution period, which is determined under the Uniform Table. The only exception to this new rule occurs if the designated beneficiary of the account is the participant’s spouse and the spouse is more than ten years younger than the participant. In that case, the applicable distribution period is the joint and last survivor life expectancy of the participant and the spouse, determined each distribution calendar year. For post-death required distributions, the applicable distribution period will be the life expectancy of the designated beneficiary who actually inherits the benefits when the participant dies (under the old rules it was the beneficiary who was named as of the date of death or RBD, whichever occurred first). The identity of the post-death beneficiary does not have to be determined until the end of the year following the year of death. Although this does not mean that new beneficiaries can be designated after death, it does mean that certain post-mortem planning techniques, such as disclaimers, establishment of separate accounts, and distributions, may be very helpful to achieve the most favorable payout of benefits. If the participant dies before the RBD and does not have a designated beneficiary, the IRA or plan benefits must be distributed by the end of the fifth calendar year following the calendar year of the participant’s death. If the participant dies after the RBD and does not have a designated beneficiary, the distribution period is the participant’s remaining life expectancy, determined in the year of his or her death, reduced by one for each year thereafter. Under these new rules, post-death distributions must begin by December 31 of the year following the year of the participant’s death, unless the sole designated beneficiary is the participant’s surviving spouse. In that case, distributions do not have to begin until the participant would have reached age 70½ and may be made over the spouse’s life expectancy. The new rules eliminate two elections that a participant had to make under the old rules at his or her RBD. The first is the selection of a beneficiary whose life expectancy would be used for all purposes. Under the new rules, the participant must make a choice at his or her RBD only when the participant has a spouse who is more than ten years younger than the participant. The second is the decision whether to recalculate the life expectancy of the participant and/or the participant’s spouse. Under the new rules, all participants and spouses automatically get the benefit of recalculation under the Uniform Table, without any of the drawbacks of the old rules. The new rules greatly reduce the significance of the RBD. That date is now simply the date that distributions must begin and no longer represents a date on which irrevocable elections must be made. The only other significance of the RBD is that the distribution rules are slightly different if the participant dies after the RBD rather than before. Another significant effect of the new rules is that it is now much easier to name a charity as a beneficiary of part or all of a plan account or IRA. Under the old rules, naming a charity as beneficiary meant that the participant had to withdraw his or her benefits over only his or her life expectancy. In addition, under the old rules, it was not possible to name both charitable and non-charitable beneficiaries of one account without adverse tax consequences. The new rules eliminate these concerns. The new rules are intended to be effective for calendar years beginning on or after January 1, 2002. However, plan participants and IRA owners may calculate minimum distributions for 2001 using either the new rules or the old rules. It is not clear at this time whether IRA beneficiaries may use the new rules in 2001. In addition, a plan participant who receives a distribution in 2001 calculated under the old rules, which is more than would be required under the new rules, may roll over the surplus into an IRA.

Disclaimer: Nothing in this Client Alert should be taken as legal advice for any individual case or situation. The information in these articles is intended to be general in nature and should not be relied upon for any specific set of circumstances. You should consult with an experienced attorney before applying the information in this Client Alert to your own situation.

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