Ted Koester

Article Summary:

Brief summary of the gift and estate tax and the generation-skipping transfer tax as well as changes brought forth by the Economic Growth and Tax Relief Reconciliation Act of 2001.

Gift, Estate And Generation-Skipping Tax Ramifications: Parts I and II

Gratuitous transfers of property have been subject to tax by the United States government for many years. The federal government first levied a tax on decedents’ estates in 1916. It imposed the gift tax in 1932. The Generation-Skipping Transfer (“GST”) tax resulted from the Tax Reform Act of 1986. However, on June 7, 2001 President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (“the Act”). This law changes many provisions of the Internal Revenue Code (“Code”), particularly many of the Code’s sections regarding the Gift, Estate and GST taxes. To appreciate the significance of some of these changes, the Gift, Estate and GST tax laws in existence prior to the Act will be briefly summarized. Then the important changes brought about by the Act will be set forth. Finally, the effects of the Act along with the planning opportunities the Act provides will be discussed.

I. Gift, Estate and Generation-Skipping Transfer Tax Laws Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001
As stated above the federal government has subjected gratuitous transfers to three taxes. The Gift and Estate tax systems were imposed separately until they were restructured into one unified tax system in 1976. Since 1977, all gratuitous transfer made by an individual were, and continue to be until the Act is fully implemented, taxed under the same rates regardless of whether made while the individual was alive or after her death. Additionally, every U.S. citizen has been able, since 1977, to give away a limited amount of property free of Gift and Estate taxes during her lifetime and after her death. That cumulative maximum, called the applicable exclusion amount, is currently $675,000 in 2001 and was scheduled to increase to $1,000,000 by 2006.

Furthermore, every decedent is allowed a credit on her federal estate tax return for any estate, inheritance, legacy or succession taxes paid by the decedent’s estate to any State or the District of Columbia. Under current law, this State death tax credit cannot exceed a prescribed limit determined by a graduated schedule of rates. At this time most States, including Illinois, have what is called a “pick-up” tax. The death tax imposed on deceased residents of these States is equal to the maximum allowable State death tax credit computed on the decedent’s federal estate tax return.

Lastly, the income tax basis of any property transferred subject to the Estate tax is automatically “stepped-up” to the property’s fair market value on the date of the decedent’s death in the hands of the recipient. The effect of this stepped-up basis rule is less income taxes due from the recipient when she later sells the asset.

The GST tax in its current form is an additional tax imposed on lifetime gifts and post-mortem transfers, but only if the recipient is more than one generation younger than the donor, such as a grandchild. Furthermore, the tax rate applied to GSTs is the highest marginal Gift and Estate tax rate, currently 55%. Also the cumulative maximum amount of GSTs that may be made free of GST tax, called the GST tax exemption, is currently $1,060,000.

II. Changes imposed by the Economic Growth and Tax Relief Reconciliation Act of 2001
As mentioned above, the Act changes the existing Gift, Estate and GST tax laws in several ways. In particular, the Estate and GST taxes, as well as the State death tax credit, are gradually repealed; the Gift tax rates are lowered while the applicable exclusion amount is increased; and the rules for stepped-up basis are significantly modified.

A. Phase-out and Repeal of the Estate and Generation-Skipping Transfer Taxes
Repeal of the Estate and GST taxes does not completely occur until January 1, 2010. However, these taxes, and the Gift tax, are slowly reduced over the next eight years. Beginning in 2002, the top Gift, Estate and GST tax rate is lowered from 55% to 50%. Additionally, the 5% surtax which is applied to cumulative Gift and Estate transfers in excess of $10,000,000 is eliminated in 2002. Also, the applicable exclusion amount for both Gift and Estate taxes is increased to $1,000,000 next year. The GST tax exemption remains at its $1,060,000 level, adjusted annually based on inflation. In 2003, the highest Gift, Estate and GST rate is lowered to 49%. Further reductions are made in 2004. Particularly, the top rate is decreased to 48%, the applicable exclusion amount is increased to $1,500,000 for Estate tax purposes (the Gift tax applicable exclusion remains at $1,000,000), the GST tax exemption is increased to $1,500,000 (and made equal to the Estate tax applicable exclusion amount thereafter until each is repealed in 2010) and the Qualified Family-Owned Business Interests (“QFOBI”) deduction is repealed. The QFOBI deduction allowed a certain amount of family-owned business assets to be excluded from the Estate tax, in addition to the applicable exclusion amount. In 2005, Gift, Estate and GST tax rates above 47% are eliminated. The highest rate is decreased to 46% in 2006 and the Estate tax applicable exclusion amount and GST tax exemption increase to $2,000,000. The top rate is lowered to 45% in 2007 and the respective exclusion and exemption amounts are increased to $3,500,000 in 2009.

The new law also provides that one’s GST tax exemption will be automatically allocated to indirect skips and one will be able to make allocations on a retroactive basis in certain circumstances. Furthermore, it permits a trustee to sever a trust into sub-trusts for purposes of allocating GST tax exemption even after the trust had been created.

B. Retention of Gift Taxes
The Gift tax remains after 2009. As stated in the previous section the current Gift tax applicable exclusion amount is increased to $1,000,000 in 2002 and its highest marginal rate is lowered to 45% by 2009. After 2009, the top rate is equated to the top individual income tax rate. Additionally, all gifts made to a trust after 2009 will be deemed to be taxable gifts unless the trust is a grantor trust.

C. Reduction and Elimination of the State Death Tax Credit
Between 2002 and 2004 the State death tax credit is reduced until it is completely eliminated in 2005. The reductions are 25% in 2002, 50% in 2003 and 75% in 2004. In its stead will be a deduction for any State death taxes actually paid by the decedent’s estate. This means that deceased residents of States with a pick-up tax will not incur any additional death taxes after 2005 because the amount of the pick-up tax is equal to the maximum credit on the federal estate tax return. However, the States with pick-up taxes will lose this source of income.

D. New Modified Carryover Basis Rules
Once the Estate and GST taxes are repealed in 2010 the stepped-up basis rules go away also. New modified carryover basis rules take their place. Generally, these new rules will provide that the income tax basis of all property received from a decedent will be the lesser of the decedent’s adjusted basis in the property or the property’s fair market value on the date of death of the decedent. However, the Act creates two exceptions to this rule. The first we will call the general basis step-up exception. Every U.S. citizen’s estate will be able to increase, up to fair market value, the basis of $1,300,000 of its property. The second exception we will call the surviving spouse basis step-up exception. Under this exception every U.S. citizen’s estate may increase the basis, again only up to fair market value, of $3,000,000 of property passing to the decedent’s surviving spouse.

The decedent’s Executor is given the authority to determine which assets receive the increase in basis. So that the Internal Revenue Service (“IRS”) may track the basis of gifted property for income tax purposes the new law requires the Executor to file an information return setting out the specifics of the gifts. Additionally, the executor is mandated to send each property recipient a writing specifying each recipient’s adjusted basis in the property received. Penalties will be imposed on Executors who fail to comply with these filing requirements.

E. Back to the Old Rules in 2011
On January 1, 2011 the Act repeals itself. Section 901 of the Act provides that it does not apply after December 31, 2010. Essentially, the laws in effect on May 25, 2001, the day before the Act passed Congress, will go back into effect on January 1, 2011. Thus, the repeal of the Estate and GST taxes and the new carryover basis rules will only last for one year, unless additional legislation provides otherwise.

-> Continue to Part III and IV

Ted Koester is an Associate Attorney with The Law Offices of Marc J. Lane, a Professional Corporation. He was admitted to the Illinois Bar in 1998. He practices in the areas of estate planning, tax law, and business law.

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