By Anthony F. Vitiello
Partner and ChairTaxation and Estate Planning Group
Connell Foley LLP
© 2001 Connell Foley LLP

President Bush signed into law on June 7, 2001the Economic Growth and Tax Relief Reconciliation Act of 2001. This article summarizes the major changes.

The estate tax will be reduced through 2009 by a combination of increases in the amount exempt from tax and a reduction in the maximum rates. The estate tax exemption will increase from the current amount of $675,000 per person to $3.5 million per person in 2009, with the current maximum estate tax rate of 55% dropping to 45% in 2007, as follows:

The tax code presently imposes a tax on all gifts which skip a generation (e.g. from grandparent to grandchild), whether made in trust or outright. However, the tax code presently exempts $1,060,000 per person (lifetime) from such tax ("generation-skipping transfer tax exemption"), in a similar manner to the lifetime exemption from the estate tax. Under the new law, the generation-skipping transfer tax exemption will now be equal to the estate tax exemption in effect for such year; this change is actually a much-needed simplification. The generation-skipping transfer tax rate will be equal to the highest estate and gift tax rate in effect for such year. Other more technical amendments were also incorporated. Many of these other changes may also benefit our clients.

As you have probably heard, there will be a full repeal of the estate and generation-skipping transfer taxes beginning January 1, 2010. This repeal, however, will expire on December 31, 2010 and the law in effect prior to June 7, 2001 will be revived. Congress would have to re-enact the repeal in order to make it permanent. At this time, we do not believe that Congress will do so. If the repeal is not made permanent, in 2011 the maximum estate tax exemption would be $1,000,000 and the highest normal marginal estate tax bracket would return to 55%.

The reason that the "repeal will be repealed" has to do with budgetary safeguards. In order to come within strict budgetary rules and limitations, Congress could not pass a permanent repeal of the estate tax. Thus, this "sunset provision" had to be included in the new law.

To complicate matters further, upon full repeal in 2010 (and if the repeal does become permanent), Congress has changed the rules regarding increased cost basis at death. Under present law, when an individual dies, property owned by the decedent receives a step-up in cost basis. Instead, under the new law, after full repeal, there would be a step-up in basis on the first $1,300,000 of assets. Assets passing to a surviving spouse would receive an additional step-up in basis of up to $3,000,000.

These modifications in the step-up in basis rules will cause significant increases in complexity for income tax purposes and increase the frustration of the general public with the tax code. If simplicity and fairness were intended, we do not see how such goals were accomplished with rules such as these.

Presently, if an individual exceeds his annual exclusion for gifts and utilizes his entire lifetime exemption, he would be required to pay gift taxes on any additional gifts. Under the new law, the gift tax exemption will be increased to $1,000,000 in 2002 and permanently remain at that level, even though the exemption from estate tax will continue to increase and eventually be repealed. Beginning in 2010, the top gift tax rate will be the top individual income tax rate. The gift tax will not be repealed under the new law.

One little known feature of the new law relating to estate tax repeal is the repeal of the state death tax credit. Most states (like New York and New Jersey) take a portion of what would otherwise pass to the federal government in estate taxes. This tax collected by the states never affected what a decedent’s estate actually paid in ultimate death taxes. If the state did not take it from the federal government’s share, that amount of tax would pass to the federal government anyway. This credit has been a significant revenue-raiser for many states over the years.

The new tax law gradually repeals this credit, thus depriving the states of revenue. Replacing the credit is a deduction for state death taxes paid. As a result, the states that previously relied on the federal credit in order to make budgetary projections will have to seek new sources of revenue to make up for the loss. Needless to say, this may force some states to institute their own form of independent death tax or increase other taxes to make up for the short-fall.

The centerpiece of the income tax changes is the reduction of the marginal income tax brackets. First, a portion of the 15 percent regular income tax bracket is reduced to 10 percent immediately. This reduction will be realized with the much publicized rebate checks that are due later this fall. The other regular income tax rates are also reduced as follows:

Wage withholding amounts are expected to be lowered in the near future to compensate for these changes.

The fully reduced regular income tax bracket, which will be realized in 2006, is attached to this letter as Exhibit A.

Taxpayers may claim either the basic standard deduction or itemized deductions for certain expenses incurred during the year. Many itemized deductions, such as charitable contributions, qualified residence interest, state and local income and property taxes and unreimbursed employee business expenses, are currently phased out when adjusted gross income exceeds a threshold amount (currently $132,950 for individual and joint filers).

The limitation on itemized deductions is reduced by one-third in 2006 and 2007, by two-thirds in 2008 and 2009, with a full repeal of the limitation in 2009. This will help higher-income taxpayers who ordinarily lose the benefit of their itemized deductions because of the phase-out rules.

A "marriage penalty" exists when the combined tax liability of a married couple filing a joint return is greater than the sum of the tax liabilities of each spouse computed as if they were single. The new law will gradually increase the standard deduction for married couples from $7,600 in 2005 to $9,100 in 2009. In addition, the 15% regular income tax rate bracket for married couples filing a joint return will increase to twice that of an unmarried individual filing a single return, beginning in 2005.

Please note that there has been no significant relief from the marriage penalty in the higher income tax rate brackets.

When determining taxable income, adjusted gross income is reduced by the personal exemption. A personal exemption may be taken for each of the taxpayer, his or her spouse and any dependents in the amount of $2,900 for 2001. Currently, the deduction for personal exemptions is phased-out when adjusted gross income exceeds $132,950 for single individuals, $199,450 for married individuals filing joint returns, $166,200 for heads of households and $99,725 for married individuals filing separate returns.

The phase-out of personal exemptions is reduced by one-third in 2006 and 2007, by two-thirds in 2008 and 2009, with a full repeal of the phase-out in 2009. This provides some relief for higher-income taxpayers.

The alternative minimum tax exemption amount will increase by $2,000 for single individuals and married individuals filing separate returns, with a $4,000 increase for married individuals filing jointly. However, the benefits provided by these changes are small and illusory. The increased exemptions provide no significant relief from the AMT and are not effective after December 31^st 2004; they are repealed automatically at that point.

We see a great need for AMT reform. The present law does nothing to alleviate a tax that was originally intended to prevent the ultra-wealthy from using significant deductions to wipe out their income tax liability. Today, the AMT affects middle class taxpayers and significantly increases many of their tax burdens.

EDUCATION-RELATED BENEFITS

There have been a significant number of increases in the benefits of education related tax incentives. For example, a temporary college tuition deduction and an increase in the Education IRA contribution limit from $500 to $2,000 have been added. However, these benefits are subject to income limitations.

One major change that may benefit a significant number of our clients (and their children/grandchildren) are the changes made to Qualified Tuition Programs ("529 Plans"). Under pre-existing law, taxpayers could have pre-paid higher education costs by contributing to 529 Plans, including making gifts to such plans for the benefit of children and grandchildren in an accelerated fashion (i.e. by accelerating their $10,000 per year annual exclusion for up to 5 years). Any gains distributed for higher education expenses would be taxed to the beneficiary of such funds at their (usually) lower tax rates.

Under the new law, all distributions used for qualified educational expenses would be excluded from income tax completely. These benefits commence in 2002 for state tuition programs and are also extended to new private plans beginning in 2004. Given the significant changes and increased benefits in this area, everyone should reconsider the appropriateness of making contributions to a 529 Plan, especially those plans that have greater investment flexibility.

RETIREMENT BENEFITS

The new tax law makes extensive changes to the rules relating to individual retirement accounts and qualified pension plans. The annual contribution limits for traditional and Roth IRAs are increased from $2,000 to $5,000 over the next seven years, beginning in 2002. These limits are also indexed for inflation after 2008. Please note that contributions to these IRAs have significant income eligibility requirements which may prevent you from taking advantage of them.

Beginning in 2002, employee deferrals into 401(k) and 403(b) plans are gradually increased from $10,500 to $15,000 over a five year period, and indexed for inflation after 2006.

Furthermore, maximum annual contribution limits to defined contribution plans are increased to $40,000 in 2002, with indexing continued in $1,000 increments.

In sum, the pension reforms add significant benefits for taxpayers saving for retirement.

The changes recently made will affect most taxpayers. Unfortunately, many of the changes affecting our clients and friends are significantly delayed until later part of the next nine years. Furthermore, the repeal of the estate and generation-skipping transfer taxes is not certain, given that a new Congress and President must "re-approve" the death tax repeal less than ten years from now, possibly in an environment where the projected surpluses have disappeared and political control has shifted (as it recently has in the Senate). Given this uncertainty, we strongly urge our clients to continue the estate planning process.

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