Economic Growth and Tax Relief Reconciliation Act of 2001 Estate, Gift and Generation-Skipping Transfer Tax Provisions

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1 T O O U R F R I E N D S A N D C L I E N T S April 10, 2008 Economic Growth and Tax Relief Reconciliation Act of 2001 Estate, Gift and Generation-Skipping Transfer Tax Provisions On June 7, 2001, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Tax Act ), which made significant changes to the Federal estate, gift and generation-skipping transfer taxes. Generally, the 2001 Tax Act provides for progressively increasing reductions in estate taxes for persons who die in the years 2002 through The much-heralded repeal of the Federal estate tax in the 2001 Tax Act, however, will benefit only the estates of persons who die in the year Consequently, we believe that there will be further legislation in this area, as described below. First, we will discuss the provisions that affect estate, gift and generationskipping transfer taxes before estate tax repeal, which generally take effect January 1, 2002 and are adjusted periodically through Second, we will discuss the estate tax repeal and other changes that are effective only in Third, we offer some comments on future developments in this area. Finally, we offer suggestions for what you should do now. Pre-Estate Tax Repeal Provisions (Years ) Estate Tax: Starting January 1, 2002, the Federal estate tax will be reduced by (i) increasing the amount of property you can leave free of Federal estate tax (the Applicable Exclusion Amount ), and (ii) decreasing the maximum marginal Federal estate tax rate, as shown in the table on the following page: A Partnership Including Professional Corporations New York One New York Plaza New York, NY Washington, DC 1001 Pennsylvania Avenue, NW Washington, DC Los Angeles 250 South Grand Avenue Los Angeles, CA London 99 City Road London EC1Y 1AX United Kingdom Paris 7, rue Royale Paris France

2 Year Applicable exclusion amount Maximum marginal federal estate tax rate 2001 $ 675,000 55% 2002 $1,000,000 50% 2003 $1,000,000 49% 2004 $1,500,000 48% 2005 $1,500,000 47% 2006 $2,000,000 46% 2007 $2,000,000 45% 2008 $2,000,000 45% 2009 $3,500,000 45% The amount required to fund credit shelter bequests (which are used to leave as much as possible free of Federal estate tax) will automatically increase as the Applicable Exclusion Amount increases, beginning January 1, This may produce unanticipated and possibly undesired results in some cases. Gift Tax: Effective January 1, 2002, the amount of property you can transfer during your lifetime free of Federal gift tax will be increased to $1 million (the Lifetime Gift Exemption ). Unlike the Applicable Exclusion Amount for estate tax outlined above, the Lifetime Gift Exemption will not increase above $1 million. The maximum Federal gift tax rate will, however, decrease in step with the reduction in the maximum Federal estate tax rate outlined above. Generation-Skipping Transfer Tax: The 2001 Tax Act makes a number of changes in the generationskipping transfer tax ( GST tax ), which affects transfers to your grandchildren and younger generations, as well as transfers to unrelated persons who are substantially younger than you. The Fried, Frank, Harris, Shriver & Jacobson 2 April 10, 2008

3 principal change is to make each person s GST exemption (i.e., the amount that you can transfer free of GST tax) equal to the Applicable Exclusion Amount shown in the table above, thus making the estate tax and the GST tax parallel. The 2001 Tax Act also contains a number of technical changes in the administration of the GST tax. In particular, if you created trusts this year for your children that will last until the children are more than 45 years old, and you do not want to apply GST exemption to these trusts, you must file a gift tax return and elect to opt out of the automatic allocation of GST exemption under the 2001 Tax Act. The 2001 Tax Act also allows trusts that are only partially exempt from GST tax to be severed into two trusts, one wholly exempt and one wholly non-exempt. Repeal of the Estate Tax (Year 2010): Under the 2001 Tax Act, there will be no estate tax or GST tax in the year In addition, the existing rule that adjusts the income tax basis of most types of property inherited from a decedent to its stepped up (or stepped down ) fair market value at the date of death will be replaced by a carryover basis rule. With limited exceptions, an heir s basis in property inherited from a decedent who dies in 2010 will be the same as the decedent s basis. (A similar provision was enacted in 1976 and was repealed retroactively as being too difficult to administer.) The gift tax will not be repealed in 2010, but the maximum marginal gift tax rate will be reduced to 35%. Finally, in the year 2010, subject to a limited exception for grantor trusts (which should include insurance trusts), any contribution of property made to a trust will not qualify for the annual exclusion from Federal gift tax. In other words, so-called Crummey powers will no longer allow you to make non-taxable $10,000 gifts to non-grantor trusts. Fried, Frank, Harris, Shriver & Jacobson 3 April 10, 2008

4 Comments Under the 2001 Tax Act, a number of provisions, including repeal of the estate tax and GST tax, take effect January 1, Under the sunset provision of the 2001 Tax Act, however, all provisions of the Act are repealed as of January 1, In theory, on January 1, 2011, the estate, gift and GST tax provisions will revert to those now in effect (including a maximum marginal Federal tax rate of 55% and lower Applicable Exclusion Amount, Lifetime Gift Exemption and GST exemption). We predict with confidence that the 2001 Tax Act will not be the last word on the subject of Federal estate, gift and GST taxes. We think it is extremely likely that Congress will extend at least some of the provisions of the 2001 Tax Act past 2010, including some increases in the Applicable Exclusion Amount and GST exemption and some decreases in the maximum marginal transfer tax rates. On the other hand, we think that some of the provisions of the 2001 Tax Act including the repeal of the estate tax for estates larger than $3.5 million and the adoption of a modified carryover basis rule may never take effect in their present form. First, Congress may decide that the overall cost of the 2001 Tax Act is simply too high as the full economic impact of the various tax cuts it contains becomes known. Second, many of the estates that would pay no estate tax and receive a step-up in basis under the rules in effect in 2002 through 2009 could ultimately pay more taxes (in the form of capital gains taxes because of the carryover basis rules) under the rules in effect for Thus, there may be significant pressure to keep the liberalized rules of in effect instead of adopting estate tax repeal coupled with carryover basis under the 2010 rules. Finally, the 2001 Tax Act affects state estate taxes in many states, including New York. The ultimate impact in each state depends on possible action by the state legislatures over the next decade. Fried, Frank, Harris, Shriver & Jacobson 4 April 10, 2008

5 What Should You Do Now? In due course, you should review your Wills, Trusts and estate plan and consider whether they need to be updated in light of the 2001 Tax Act. You should consider whether you want to take advantage of the increase in the Lifetime Gift Exemption to $1 million ($2 million in the case of a married couple) to make additional non-taxable gifts early next year. You should consider re-allocating assets between spouses so that each spouse has separately owned assets at least equal to the Applicable Exclusion Amount as it increases. You should continue any program of making nontaxable annual exclusion gifts and nontaxable payments of medical expenses and tuition. You should not discontinue any existing life insurance programs, but should periodically review your life insurance planning with your advisers. You should keep records that establish the income tax basis of your assets, such as receipts or bills of sale for significant purchases. You should consult your income tax adviser about the expected impact of the 2001 Tax Act on your personal income tax liability. In particular, the provisions of the 2001 Tax Act may subject many more taxpayers to the Alternative Minimum Tax after Fried, Frank, Harris, Shriver & Jacobson 5 April 10, 2008

6 This memorandum summarizes the highlights of the 2001 Tax Act concerning estate, gift and generation-skipping taxes but it does not purport to be an exhaustive summary of the 2001 Tax Act. If you have any questions concerning the 2001 Tax Act and how it affects your personal planning, please contact: New York Ann B. Lesk Barry S. Berger Fried, Frank, Harris, Shriver & Jacobson 6 April 10, 2008