Some Interesting Aberrations in the 2001 Tax Bill

Laws and Estates: Some Interesting Aberrations in the 2001 Tax Bill

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By Jeff Scroggin

While much has been made of the 2001 Tax Bill's sunset provisions, there are still some aspects of the law yet to be explored.

Much has been made of the odd set of starting and ending dates that are sprinkled throughout the 2001 tax bill. And the provision's sunset date of Dec. 31, 2010, has been the subject of near constant rumination in this magazine and throughout the financial press. However, there are a few areas of the bill that have escaped scrutiny--that is, until now.

Flat Tax. Beginning in 2006, the estate tax becomes a flat tax of 46 percent, dropping to 45 percent in 2007. This is because the larger estate tax unified credit and estate tax rate reductions will result in a beginning effective estate tax bracket of 46 percent on estates above $2 million (the unified credit in 2006). This happens to be the new top estate tax bracket. For gift-tax purposes, the bottom rate will be 41 percent (for gifts above the gift tax unified credit of $1 million) and a top rate of 46 percent (dropping to 45 percent in 2007).

This change has a couple of interesting implications. First, the benefit of prepaying estate or gift taxes is reduced. With rates dropping within the next five years, the prepayment of a transfer tax could result in a larger overall tax burden. Second, in 2006 the benefit of equalizing estates of a married couple to use the lower marginal transfer tax brackets of both the husband and wife is eliminated. Certainly, planners want to make sure each estate has enough assets to fully fund the individual unified credits, but the taxable portion of an estate does not receive any benefit from the lower marginal rates. The rate is a flat 45 percent or 46 percent. Third, it would be relatively easy to compute the transfer tax costs of any transfer by using a straight 46 percent rate in 2006 (45 percent in 2007).

State Inheritance Taxes. The 2001 bill essentially stole inheritance taxes from the state governments by converting the present federal tax credit (a dollar-for-dollar tax benefit) for state inheritance taxes to a tax deduction (a benefit only at the effective federal estate tax bracket of the estate). It is estimated this change could cost states up to $70 million over the next 10 years. Thirty-eight states tie their state inheritance tax to the maximum federal credit and will now have to revise their state inheritance taxes to avoid losing this revenue.

Without question, the states affected by this change will need to adopt new state inheritance taxes, but there is no assurance that they will adopt the large federal tax exemptions and credits, which essentially eliminate the estate tax on the majority of decedents. Therefore, many estates that are not subject to a federal tax may have to pay a significant new state inheritance tax.

Valuation Adjustments Upward. The estate tax unified credit will be $1 million in 2002-2003, $1.5 million in 2004-2005 and $2 million in 2006. Most of the estates will be below these exemption amounts.

Valuation strategies for nontaxable estates may shift to increase the fair market value of an estate's assets. If the estate's value is less than the available unified credit, obtaining a higher valuation (but below the taxable point) may allow heirs a higher step-up in basis (i.e., that occurs at the time of death). This reduces the taxes paid by the heirs on the sale of inherited assets. We may actually find that those brilliant valuation arguments of the IRS were simply misunderstood and now should be used, but only for taxpayers who are not subject to an estate tax. This will also create an interesting problem for the IRS. Previously, its attention was focused on whether taxpayers had purposely undervalued assets. Now, it will have to concentrate also on whether taxpayers are purposely overvaluing assets to obtain a higher basis.

Business Deduction. When adopted in 1997, the estate tax business deduction (then a credit) was designed to provide some reduction in estate taxes on family farms and businesses. The provision was so complicated that it was virtually unusable. Because of its complexity, the death of the business deduction in 2004 is more than appropriate.

Many estates not subject to a federal tax may have to pay a significant new state inheritance tax.

However, planners may be making a mistake if they do not put provisions in their estate planning documents to provide for the maximum available business deduction (or any deduction, exemption or credit available to business owners in the future). Certainly, in 2002 and 2003, the $300,000 business deduction (potentially $600,000 for a married couple) can provide a significant estate tax benefit. There is little possibility that the estate tax will actually be eliminated and there is hope that any subsequent change may provide a new and workable estate tax benefit for family farms and businesses. To the extent that a family business is intended to be passed to heirs, planners should maintain language in the documents to take advantage of both the current rules for family businesses and farms and any rules that may be adopted before 2010.

Generation Skipping. The 2001 bill substantially simplifies the rules governing generation skipping. The gift tax unified credit will remain at $1 million after 2001, while the generation-skipping exemption will match the estate tax exemption of $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009.

These differences may offer an interesting new perspective beginning in 2004. Clients who wish to maximize their generation-skipping exemption may be advised to create lifetime generation-skipping trusts using all of their available GST exemption (e.g., $2.0 million in 2006). The gift tax unified credit will protect the first $1 million from current transfer taxation and a lifetime marital trust can protect the remaining portion of the generation- skipping exemption from current taxation. Essentially, the trust is similar to a Reverse Q-TIP.

Given the fact that it is unlikely Congress will maintain the elimination of the estate tax after 2010, the above aberrations may only last for the next four to five years--until the next set of major changes. It is definitely going to be an interesting couple of years for planners.

John J. Scroggin, J.D., LL.M., is a nationally recognized speaker and author. You can contact him at Penny@scrogginlaw.com.

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