Economic Growth and Tax Relief Reconciliation Act of 2001 Summary

With political deal-making as a backdrop, President Bush signed into law on June 7 the Economic Growth and Tax Relief Reconciliation Act of 2001 (the "Act"). The Act represents a pared-down version of his $1.6 trillion, 10 year tax cut plan. While the Act maintains the 10 year scope, the tax cuts were trimmed to $1.35 trillion.

From the outset, it is important to note that, due to budgetary restrictions, all of the provisions contained in the Act cease to apply (or "sunset") after December 31, 2010, which also is the year in which the federal Social Security and Medicare programs will first feel the burden of retiring baby boomers. In other words, Congress will need to act before January 1, 2011, (a likely occurrence) or current law will be reinstated. Because the Act can affect your planning in the interim, this memo briefly outlines some of the aspects of the Act that may impact estate and financial planning.

Under the Act, estate tax rates are reduced gradually, while the exemption amount is increased significantly between 2002 through 2009. In 2010, there is complete repeal of the estate tax; however, as mentioned above, the current estate tax system will be reinstated in 2011 due to the "sunset" provision of the Act. The following illustrates:

To further complicate matters, changes to the gift tax rates mirror the estate tax rates through 2009, but the increase in the gift tax exemption is limited to $1 million. Accordingly, the existing unified transfer tax system will become more complex as the estate tax exemption increases, reaching $3.5 million by 2009. Although the estate tax is repealed in 2010 (for only one year), the Act retains a modified gift tax in an effort to prevent excessive gifts of appreciated property from high income tax bracket taxpayers to low income tax bracket taxpayers. In 2010, gifts in excess of the lifetime $1 million exemption will be subject to gift tax at the top individual income tax rate at the time of the gift (under the Act, 35%).

Beginning in 2004, the Act also pegs the generation-skipping transfer (GST) tax exemption to the estate tax exemption, and repeals the GST tax in 2010. Of course, that tax also is reinstated in 2011. In 2002, the Act repeals the 5% surtax that applies to large estates (i.e., estates valued at more than $10 million). In 2004, the deduction for qualified family owned business interests also is repealed.

Although "repeal" of the death tax is not scheduled until 2010, the ability to pass property tax-free at death is greatly enhanced because the exemption amount increases over the next eight years (to $3.5 Million) for estate and GST tax purposes. As mentioned above, the gift tax exemption is capped at $1 million, so a taxpayer’s ability to make tax free lifetime transfers is more limited.

For married couples, one immediate impact of the Act on existing plans stems from the fact that many Wills and Revocable Trusts create a Family Share and a Marital Share that are funded by a formula at the death of the first spouse. Generally, the funding formula provides that the Family Share is funded with the estate tax exemption amount (currently $675,000) and all remaining assets fund the Marital Share. Because the estate tax exemption will be increasing drastically between now and 2009, under the traditional funding formula a greater proportion of the estate will fund the Family Share (rather than the Marital Share). This result may or may not be consistent with the family's wishes.

Faced with the prospect that an individual may die before repeal of the estate tax—or after repeal if the current transfer tax rules are reinstated—an individual’s future estate planning may need to use a two-pronged approach: one plan if the individual dies when the estate tax is repealed and one plan if the individual dies while an estate tax is still imposed. This determination will need to be made on a case-by-case basis because each family's goals may be different.

As a trade off for estate tax repeal in 2010, the Act modifies the "step-up in basis" rules for assets acquired from a decedent. Under current law, upon an individual’s death, his or her assets generally receive a "stepped up" basis to their date of death value. Subject to a few exceptions described below, when the estate tax is repealed in 2010, the Act will require the person acquiring property from a decedent to retain the decedent’s basis in that property (i.e., carryover basis). Under the Act, each decedent is allowed a $1.3 million exemption from this carryover basis rule. In other words, assets may continue to receive a step-up in basis of up to $1.3 million above the basis in the hands of the decedent. Also, for married couples, there is an additional $3 million step-up available for transfers to a surviving spouse. Estate planning documents may need to be revised prior to 2010 to take advantage of the limited basis step-up opportunities. Again, due to the "sunset" provision, when the current estate tax rules are reinstated in 2011, the automatic step-up in basis rules will be reinstated as well. Nonetheless, it may be prudent to ensure that all tax basis records are retained until an asset is sold.

INCOME TAXES

The centerpiece (and most expensive part) of the Act is the gradual cut in marginal income tax rates. When fully phased in by 2006, the number of marginal rates will increase from five to six. Instead of the current 15%, 28%, 31%, 36% and 39.6% rate structure, individual income taxes will be calculated using a 10%, 15%, 25%, 28%, 33% and 35% rate structure. The new 10% rate technically starts on January 1, 2002; however, a refund check is payable to taxpayers this year that effectively accelerates the benefit of this 10% income tax bracket for 2001. The refund checks will be $300 for single filers, $600 for joint filers, and $500 for heads of household.

One mainstay of family tax planning is to shift income from older (higher bracket) family members to younger (lower bracket) family members. So long as the "kiddie tax" (for minors under age 14) does not apply, the potential income tax savings are as much as 25 percentage points when the rates are fully phased in. This tax savings results from the difference between the top rate of 35% and the lowest rate of 10%.

Obviously, as the lower income tax rates are phased-in, the difference between the long term capital gains tax rate and ordinary income tax rate diminishes, so tax strategies based on this disparity become less attractive. This change may generate more interest in nonqualified deferred compensation plans for businesses and less interest in stock option strategies.

As the income tax rates drop, placing money into tax favored retirement accounts (e.g., IRAs, 401(k)s, etc.) becomes less attractive. The new rate structure should, however, encourage the use of Roth IRAs, because they are funded with after-tax earnings, but withdrawals are generally tax-free.

As the individual income tax rates drop, the choice of entity decision for businesses is impacted. With C corporations being taxed at rates between 15% and 38%, the lowering of individual tax rates continues the trend of encouraging the use of partnerships, S corporations, limited liability companies, and other pass-through entities.

As the income tax rates are lowered, the economic benefit of deductions from income is diminished. This result favors accelerating charitable giving (as well as taking other deductions) while the ordinary income tax rates are highest.

The Act increases the limit on salary reduction contributions to 401(k)-type plans from $10,500 in 2001 to $15,000 by 2006. Starting in 2002, the Act increases the limit on combined employer/employee contributions to defined contribution plans from $35,000 to $40,000 and eliminates the 25% of compensation cap. It increases the considered compensation limit from $170,000 to $200,000. The Act increases the profit sharing and stock bonus deduction limit from 15% to 25% of covered employee compensation. Finally, the Act also contains measures shortening the vesting schedules and enhancing the portability of pension assets.

Under the Act, the former $2,000 contribution limit for individual retirement accounts (both traditional and Roth IRAs) is increased to $5,000 when fully phased in. The contribution limit is $3,000 for 2002-2004, $4,000 for 2005-2007 and $5,000 for 2008 with adjustments for inflation thereafter. In addition, taxpayers who are age 50 and older are permitted to make "catch-up" contributions. Catch-up contributions can be made to either a traditional IRA or a Roth IRA so long as the taxpayer satisfies the adjusted gross income limitations, which were not liberalized. The Act also creates a "Roth 401(k)" in 2006. In other words, a plan participant can elect to make after-tax contributions to his or her 401(k) in return for tax free distributions from the 401(k) during retirement.

The Act provides for an above-the-line deduction for the payment of qualified higher education expenses. For 2002 and 2003, a single taxpayer with adjusted gross income of $65,000 or less ($130,000 or less if married filing jointly) will be eligible for a $3,000 deduction. For 2004 and 2005, the deduction will increase to $4,000 for a single taxpayer with adjusted gross income of $65,000 or less ($130,000 or less if married filing jointly). Also, in 2004 and 2005, a single taxpayer with adjusted gross income of $80,000 or less ($160,000 or less if married filing jointly) will be entitled to a $2,000 deduction. After 2005, this deduction is scheduled to sunset.

The Act expands the deductibility of student loan interest. It repeals the current requirement that the interest must be attributable to payments made during the first 60 months of the loan and it also raises the income phase-out thresholds to between $100,000 to $130,000 for joint filers.

In 2002, the Act increases the contribution limit for Education IRAs from $500 to $2,000 per year per child and relaxes the adjusted gross income limitations on contributions from joint filers. Contributions to Education IRAs are phased out for joint filers with adjusted gross income between $190,000 and $220,000, which is twice the phase out level for single filers. The Act also allows Education IRAs to be used for elementary and secondary school expenses. Furthermore, starting in 2002, contributions to Education IRAs will be allowed from corporations, tax-exempt organizations, and other entities (rather than individuals only).

Under current law, distributions from qualified tuition plans (also known as 529 plans) are taxable at the beneficiary’s (or student’s) rate. The Act provides that distributions from such programs will be excludible from gross income. This exclusion rule applies in 2002 for state sponsored programs and in 2004 for non-state sponsored programs. The Act also allows qualified tuition programs to be sponsored by eligible educational institutions (public or private), though private institutions may only sponsor prepaid tuition plans (rather than education savings accounts). Under current law, only state sponsored programs qualify.

The Act reduces the overall limitation on itemized deductions and the personal exemption phase out by 1/3 in 2006-2007, by 2/3 in 2008-2009, and completely eliminates them in 2010. Also, beginning in 2005, the Act addresses the so-called "marriage penalty" by gradually increasing the standard deduction for married couples to twice that of single taxpayers by 2009. Further, the Act expands the 15% income tax bracket for married couples who file jointly to twice that of singles by 2008. The Act gradually increases the child care tax credit from $500 to $1,000 per child by 2010 and applies the credit to the alternative minimum tax.

It is important to note that the Act provides no meaningful help for taxpayers subject to the alternative minimum tax. As a result, the number of taxpayers affected by the alternative minimum tax over the next decade is likely to increase exponentially.

This memorandum highlights just some of the changes contained in nearly 300 pages of legislation. We hope it alerts you to the potential impact this new legislation will have on your estate and financial planning. If you have any questions regarding this new legislation or the implications to your existing estate plan, please call us.