v Clients should update their estate plans during the transition period with a view to how and when the new laws affect their plans. v “C

v Clients should update their estate plans during the transition period with a view to how and when the new laws affect their plans. v “C

On June 7, 2001, President George W. Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "Act"). The Act suspends the estate tax in 2010. It also lowers the overall income tax by creating a new 10% income tax bracket, phasing in lower tax brackets, creating education and child care incentives, softening the "marriage penalty," and liberalizing the rules regarding qualified retirement plans and IRAs. We have briefly highlighted those aspects of the Act that we believe would be of the most interest to you, and have also set forth some estate planning considerations that might affect your planning. With these meaningful changes that phase in over the next 8-9 years, we suggest that our estate planning clients review and update their planning to ensure that the estate tax changes do not interfere with their objectives and to ensure that our clients take full advantage of the benefits offered by the relief.

Estate Tax Modifications and Repeal

Sweeping changes are on the table in the transfer tax arena, although it remains uncertain whether taxpayers will see the full benefits of these changes, many of which do not go into effect for a number of years. Specifically, as summarized in the chart below, the gift, estate and generation-skipping tax ("GST") rates begin to drop in 2002; the estate and GST exemptions increase in phases beginning in 2002 until the repeal in 2010; and the gift tax exemption increases to $1 million in 2002 but does not increase further under the Act. There is now an uncoupling of what had been a unified gift and estate tax system. Reduction and Repeal of Estate Tax Generally, beginning in 2002 and continuing through 2009, the highest federal estate tax rate will be decreased, and the federal estate tax exclusion amount will be increased. As indicated in the chart below, the highest federal estate tax rate will be reduced to 50% in 2002 and will be reduced to 45% by 2007 (it will remain at 45% in 2008 and 2009). Also, the estate exclusion amount will be increased to $1 million in 2002 and will gradually be increased to $3.5 million by 2009.

Estate, Gift and GST Rate and Exemption Changes

Calendar Year Estate Exclusion Amount and GST Exemption Lifetime Gift Tax Exemption Highest Estate and Gift Tax Rates
2002 $1 million $1 million 50%
2003 $1 million $1 million 49%
2004 $1.5 million $1 million 48%
2005 $1.5 million $1 million 47%
2006 $2 million $1 million 46%
2007 $2 million $1 million 45%
2008 $2 million $1 million 45%
2009 $3.5 million $1 million 45%
2010 N/A (taxes repealed) $1 million gift tax only – 35%

In 2010, the federal estate tax will be repealed. However, the Act does not apply to estates of decedents dying after December 31, 2010. Thus, the federal estate tax will be resurrected in 2011 unless Congress acts to make the repeal permanent. Reduction and Elimination of State Death Tax Credit The state death tax credit, which is a credit allowed against the federal estate tax for estate or inheritance taxes paid to a state on property included in a decedent's estate, will be reduced beginning in 2002 until its repeal in 2005. In 2005 the state death tax credit will be replaced with a new deduction for state death taxes actually paid to any state or to the District of Columbia. Reduction of Gift Taxes Beginning in 2002 and continuing through 2010, the highest federal gift tax rate will be reduced. As indicated in the chart, the highest federal gift tax rate will be reduced to 50% in 2002, and will gradually be reduced to 35% in 2010. Also, in 2002, the federal gift tax exemption amount will be increased to $1 million. However, unlike the estate tax exemption, the gift tax exemption will not increase after 2002. Further, unlike the federal estate tax, the federal gift tax will not be repealed in 2010. An individual will be able to make unlimited transfers to his or her U.S. citizen spouse free of gift tax. Further, an individual will still be able to make gift tax-free transfers to other individuals in the amount of the inflation-adjusted annual exclusion ($10,000 in 2001 for each individual to whom a gift is made). Except as otherwise provided in the Regulations, however, beginning in 2010, there will be no annual exclusion available for a transfer to a trust unless the trust is treated as wholly owned by the donor or the donor's spouse under the grantor trust provisions of the Internal Revenue Code. This means that unless the Regulations provide otherwise, after 2009, gifts to "Crummey trusts" may not qualify for the annual gift tax exclusion. Reduction and Repeal of Generation-Skipping Transfer Tax Generally, beginning in 2002 and continuing through 2009, the federal generation-skipping transfer tax rate will decrease. As indicated in the chart, in 2002 the federal generation-skipping transfer tax rate will be reduced to 50%, and will gradually decrease to 45% in 2007 (it will remain at 45% in 2008 and 2009). Also, beginning in 2004 and continuing through 2009, the GST exemption will increase. As indicated in the above chart, in 2004 the GST exemption will be increased to $1.5 million and will increase gradually to $3.5 million by 2009.1 In 2010, the federal generation-skipping transfer tax will be repealed (like the federal estate tax). However, the Act will not apply to gifts made, or estates of decedents dying, after December 31, 2010. Thus, the possibility exists that the federal generation-skipping transfer tax, like the federal estate tax, may also return in some form beginning in 2011. In addition to the above changes to the federal generation-skipping transfer tax, the Act provides certain relief from the federal generation-skipping transfer tax, intended to take effect after December 31, 2000. 1. The GST exemption will generally be automatically allocated to transfers made during life that are indirect skips.2 Previously, to get the benefits of a lifetime allocation to these trusts, a gift tax return had to be filed specifically allocating exemptions to these indirect skip gifts. 2. A transferor will be able to retroactively allocate GST exemption to a trust where a beneficiary (i) is a non-skip person (generally a beneficiary who is not more than one generation below the transferor), (ii) is a lineal descendant of the transferor's grandparent or a grandparent of the transferor's spouse, (iii) is a generation younger than the generation of the transferor, and (iv) dies before the transferor. This is intended to provide relief in a situation where a transferor expects a trust to only benefit non-skip persons, and thus does not allocate any GST exemption to any transfers made to the trust, and a non-skip person dies, resulting in property passing to skip person(s). Without the enactment of the new provision, if the non-skip persons who were the beneficiaries of the trust unexpectedly died before the transferor, and the terms of the trust thereafter provided benefits for skip persons, generation-skipping transfer tax could be imposed. This new provision allows the transferor to retroactively allocate GST exemption based upon the value of the property transferred to the trust as of the original date of transfer. 3. The Treasury Secretary is authorized to grant relief from late allocations of GST exemption. Under the current rules, if an allocation of GST exemption is made on a timely-filed gift tax return, then the allocation is based on the value of the property on the date of its transfer. If an allocation of the GST exemption is not made on a timely-filed gift tax return, the allocation must be made in an amount equal to the value of the property on the date of the late allocation. The new provision allows the Treasury Secretary, after considering all relevant circumstances (including evidence of intent contained in the trust instrument or instrument of transfer), to permit a late allocation of the GST exemption amount based upon the value of the property transferred to the trust at the time of the original transfer. 4. Substantial compliance with the statutory and regulatory requirements for allocating GST exemption will suffice to establish that the GST exemption was allocated to a particular transfer or a particular trust.3 All relevant circumstances will be considered in determining whether there has been substantial compliance, including evidence of intent contained in the trust instrument or instrument of transfer. If substantial compliance is demonstrated, then so much of the GST exemption will be allocated to a transfer as is necessary to produce the lowest possible federal generation-skipping transfer tax. Although this provision is intended to take effect after December 31, 2000, the Act provides that no implication is intended with respect to the availability of a rule of substantial compliance on or before December 31, 2000. Thus, one may arguably take the position that the substantial compliance provision is effective for transfers made before December 31, 2000. If that is the case, taxpayers who may have been unfairly affected by the prior allocation rule should consider requesting relief from those rules. Modified Carryover Basis Regime After 2009 To complicate matters further, beginning in 2010 after the estate, gift, and generation-skipping taxes have been fully repealed, a modified carryover basis rule will immediately go into effect. When this happens, death will become an income tax problem. The basis of assets received from a decedent will carry over from the decedent, rather than being stepped up to fair market value at the date of death or alternate valuation date (6 months from the date of death) as is now the case. The resulting "step-up" in basis eliminated the recognition of income on the appreciation of the property that occurred before the decedent's death. With limited exceptions, the Act requires that property acquired from a decedent dying after December 31, 2009 will have a tax basis equal to the lesser of (i) the decedent's adjusted basis, or (ii) the fair market value of the property at the date of the decedent's death. A few exceptions apply:

Qualified Domestic Trusts for Non-Citizen Spouses There will continue to be an estate tax imposed on (i) any distribution before 2021 from a qualified domestic trust (a special trust that qualifies for the marital deduction for a non-citizen surviving spouse) before the date of the death of the non-citizen surviving spouse and (ii) the value of the property remaining in a qualified domestic trust on the date of death of the non-citizen surviving spouse if he or she dies before 2010. In other words, if a qualified domestic trust is actually set up for non-citizen surviving spouse, and the non-citizen spouse dies after 2010, then no supplemental estate tax is due. In addition, if a non-citizen surviving spouse takes principal distributions from a qualified domestic trust after 2021, no supplemental estate tax is due. Until then, the existing supplemental estate tax system will continue to apply to principal distributions from these trusts. Other Estate Tax Relief Conservation easements. An executor may elect to exclude from the gross estate up to 40% of the value of land subject to a qualified conservation easement meeting certain requirements and subject to a dollar cap ($400,000 for individuals dying in 2001, $500,000 for those dying after 2001). Under pre-2001 Act law, one requirement is that the land must be located within 25 miles of a metropolitan area, a national park or wilderness area, or within 10 miles of an Urban National Forest. This requirement is now eliminated. 2001 Act Provisions "Sunset" in 2011 The Act's changes are not "permanent." Because of Congressional budget reconciliation rules, the Act specifically provides that none of its provisions will have any effect in tax years beginning after December 31, 2010, and it will not apply to gifts or generation-skipping transfers made, or estates of decedents dying, after December 31, 2010. At that point, the law will return to the law in effect before the 2001 Act.

Individual Income Tax Provisions

New 10% Bracket and Rebates. Effective for taxable years beginning 2001, a new 10% lowest rate bracket will apply. The 10% rate will be made available to taxpayers through a rebate mechanism. Individuals who filed 2000 tax returns will receive rebate checks between July and October. Lower Rate Brackets. While the 15% rate bracket will remain the same, the 28%, 31%, 36% and 39.6% rate brackets will gradually be reduced over five years to 25%, 28%, 33% and 35%, respectively. Personal Exemption Phase-Out and Itemized Deduction Limitation Repealed. The phase-out of the personal exemption for upper income taxpayers and the Adjusted Gross Income (AGI) limitation on itemized deductions will gradually be repealed beginning in 2006. Marriage Penalty Relief. Beginning in 2005, the Act will provide some relief for those married taxpayers who pay more tax than they would if they were single. However, the Act does not provide full relief to these married taxpayers. Alternative Minimum Tax (AMT). From 2001 through 2004, the AMT exemption amounts for married joint return filers and surviving spouses will increase by $4,000, and by $2,000 for singles and married couples filing separately. Because only limited AMT relief was enacted, some taxpayers may lose the benefits of the Act's provisions. For example, because of the Act's phase-out of itemized deduction limits, some taxpayers will be required to pay AMT as a result of these increased deductions. Pension and Individual Retirement Arrangements Increased Contribution Limits and Catch-Up Contributions to IRAs. The annual dollar contribution limit for IRAs is gradually increased from $2,000 to $5,000 in 2008. After 2008, it will be indexed for inflation. The Act includes catch-up contribution provisions allowing individuals who have attained age 50, and who have otherwise met the IRA annual dollar contribution limit, to make additional contributions of up to $500 for tax years 2002 through 2005. Beginning in 2006, this $500 amount is increased to $1,000. Increased Contribution, Deferral Limits and Benefit Limits for Qualified Plans. The limit on annual additions to defined contribution plans is increased from $35,000 to $40,000. The 25% of compensation limitation has been eliminated. The annual benefit limit, subject to age limitations, has been increased as well. The annual dollar limit on elective deferrals under 401(k) plans, 403(b) annuities, section 457 plans and salary reduction SEPs is gradually increased from $10,500 now to $15,000 in 2006 (from $6,500 to $10,000 for SIMPLE plans). After 2006, it will be indexed for inflation. The applicable dollar limit on elective deferrals under a 401(k) plan, 403(b) annuity, SEP or SIMPLE, or deferrals under a section 457 plan is increased for individuals who have attained age 50 by the end of the year. The additional amount of elective contributions that may be made is the lesser of (i) the applicable dollar amount, or (ii) the participant's compensation for the year reduced by any other elective deferrals of the participant for the year (for 457 participants, this catch-up rule does not apply during the participant's last 3 years before retirement). The applicable dollar amount is, except for a SIMPLE plan (which is one-half), as shown in the chart below.

Tax Years Applicable Dollar Limitations
2002 $1,000
2003 $2,000
2004 $3,000
2005 $4,000
2006 $5,000
2007 and thereafter Adjusted for inflation in $500 increments

Other Pension Provisions. Beginning in 2006, employees participating in a 401(k) or 403(b) plan will have the option of having some or all of their contributions subject to the same tax treatment accorded Roth IRAs (e.g., income tax-free withdrawals). The Act also includes numerous other technical changes to the rules that apply to qualified plans. Education Incentives Education IRA Rules Liberalized. Education IRA rules are substantially liberalized. Education IRAs allow for tax free growth of investments and tax-free withdrawals to pay for school expenses. Beginning in 2002, the per beneficiary contribution limit is increased from $500 to $2,000 and the definition of "Qualified Education Expenses" is expanded to include (i) kindergarten, elementary and secondary public, private or religious school tuition and expenses, including tutoring, room and board, uniforms, and extended-day program costs, and special needs for a special needs beneficiary, and (ii) the purchase of computer technology or equipment or Internet access and related services, if such technology, equipment, or services is to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in school. Additionally, the phase-out range for married taxpayers filing a joint return is increased from $190,000 to $220,000. College Savings Plan Benefits Made Significantly More Attractive. Starting in 2002, rules regarding section 529 college savings plans have been made significantly more attractive. Distributions from qualified state tuition programs to pay higher education expenses will be tax-free; currently, distributions from these plans are subject to tax at the student's rate. In addition, this exclusion would also be extended to distributions from qualified private tuition plans starting in 2004, allowing private schools and private school groups to set up similar savings plans. Transfer of credits (or other amounts) from one qualified tuition program for the benefit of a designated beneficiary to another qualified tuition program for the benefit of the same beneficiary is not considered a distribution provided that this rollover treatment does not apply to more than one transfer within any 12-month period with respect to the same beneficiary. This provides significantly greater flexibility than the current law, which does not allow this portability. The law change that now makes distributions from these college savings plans tax-free (when used for education expenses), when combined with the unusual gift and estate tax benefits of these plans, makes the 529 plans a powerful tool for education saving and tax planning. The exclusion for employer-provided educational assistance will be made permanent and reinstated for graduate education, effective for courses beginning after 2001. Student Loan Interest and Qualified Higher Education Deductions. Beginning in 2002, income phase-out ranges for the student loan interest deduction increases and both the annual dollar limitation and the limit on the number of months of interest deductibility are repealed. From 2002 to 2005, taxpayers within income limitations can deduct qualified higher education expenses. Child Care Credits Child Tax Credit Increased and Expanded. Beginning in 2001, the Child Tax Credit is gradually increased from $500 per child to $1,000 per child by 2010. For tax years 2001-2004, the Child Tax Credit will be refundable to the extent of 10% of earned income above $10,000 (cost of living indexed beginning in 2002). Beginning in 2005, the 10% rate is increased to 15%. For taxpayers with three or more qualifying children, the refundable amount allowed is the excess of the taxpayer's social security taxes for the tax year over the taxpayer's earned income credit for the year. Adoption Credit, Dependent Care Credit, Employer Provided Child Care Facilities. Beginning after 2002, the adoption credit for qualified adoption expenses will be expanded to cover children other than those with special needs. The maximum amount of the credit is increased from $5,000 to $10,000. The income phase-out range is increased from $150,000 to $190,000 of modified AGI. Beginning in 2003, $3,000 of employment-related expenses will qualify for a dependent-care credit of 35% (up from $2,400 and 30%, respectively); and $6,000 of expenses will qualify for expenses related to two or more qualifying individuals (up from $4,800). The credit percentage will phase down between AGI of $15,000 and $43,000. Beginning in 2002, a new tax credit for employers who support child care resources and referral services is available. The credit is equal to 25% of qualified expenses for employee child care and 10% of qualified expenses for child care resources and referral services, but not more than $150,000 per taxable year. ******************* 1 It is important to note, as reflected in the chart, that the GST exemption in 2002 and 2003 is $1 million. This is important because this amount represents a decrease from the current GST exemption of $1,060,000. 2 An indirect skip is generally any transfer of property (that is not a direct skip) subject to the gift tax that is made to a trust for future generations where non-skip beneficiaries (i.e., the next immediate generation) do not have the right to receive more than 25% of the trust assets before reaching age 46. 3 This provision is intended to provide relief when the transferor intended to allocate so much of GST exemption to a transfer so as to produce the lowest possible generation-skipping transfer tax, but was unable to fully comply with all of the necessary statutory and regulatory requirements to do so (due to their complexity).