The Economic Growth and Tax Relief Reconciliation Act of 2001, signed into law by President Bush on June 7, 2001, is the most significant tax legislation in over a decade. The Act provides many changes to the federal income tax system. The Act also substantially alters the federal estate, gift and generation-skipping tax system over the next several years with an outright repeal of the estate and generation-skipping taxes in 2010.

Long-range planning will take on a new dimension, especially in view of the fact that the Act's changes are not "permanent." Because of Congressional budget reconciliation rules, all of the Act's provisions sunset. The Act specifically provides that it won't have any effect in tax years beginning after December 31, 2010, and won't apply to gifts made, or estates of decedents dying after December 31, 2010. Thus, by the end of this decade, Congress will need to extend the provisions of the Act to prevent their expiration.

However, other less “taxpayer friendly” Congressional action is just as likely. Several high profile tax commentators and Congressional staff members have stated publicly that they fully expect many of the Act’s provisions will be modified, delayed or repealed by a future Congress before full implementation. For example, several of these commentators and staffers have stated their belief that for economic and/or political reasons, Congress will not allow the federal estate and generation- skipping taxes to be repealed for one year in 2010. Unfortunately, the prospect for change adds yet another layer of complexity and uncertainty to income and estate tax planning.

The Act, which involves a $1.35 trillion tax cut, represents the government’s largest tax relief measure in more than 20 years. It offers refunds and a host of favorable changes for individual taxpayers, but little relief for business taxpayers.

The following is a brief overview of some of the more significant changes made by the Act. We will first discuss some of the changes made to the estate and gift tax followed by a discussion of changes made to the individual income tax.

Estate, Gift and Generation-Skipping Transfer Taxes

One of the most important changes in the Act is the gradual elimination of the federal estate tax that, since 1917, has been imposed on some estates. The estate and generation-skipping transfer (GST) taxes are repealed in 2010. However, since the entire Act expires after December 31, 2010, these taxes will once again apply to decedents dying and generation-skipping transfers in 2011 and thereafter.

In order to achieve the elimination of the estate tax, the estate tax exemption equivalent (commonly referred to as the "unified credit") and top tax rate are adjusted from 2002 to 2010. During this time the estate tax exemption equivalent increases from $1 million in 2002-2003 to $3.5 million in 2009. At the same time the top tax rate will decrease from 50% in 2002 to 45% in 2009. The 5% surtax that applied to estates over $10 million is repealed in 2002 as well. However, if the provisions of the Act are not extended, in 2011 the exemption equivalent will again be $1 million and the top tax rate will be 55%.

ESTATE TAX EXEMPTION AND TOP TAX RATE

Although the estate tax is repealed in 2010, the gift tax is not repealed. Under the Act, the gift tax exemption amount is fixed at $1 million and, beginning in 2010, the top gift tax rate will equal the top individual income tax rate (35% under the Act). Until 2010, the gift tax rate will decrease on the same schedule as the estate tax rate. Above is a chart setting forth the exemption amount and the top tax rate.

Beginning in 2004, the GST exemption for any given year will be increased to equal the estate tax exemption equivalent.

Since the GST tax rate is tied to the highest estate tax rate, the GST tax rate will also decrease as the estate tax rate decreases.

To illustrate the effect of the tax changes, we have prepared this chart:

EFFECT OF TAX CHANGES

Beginning in 2010, property inherited from a decedent will no longer receive a full "step-up" in basis. Under current law, heirs who receive property from a decedent are generally not required to carry over the decedent's income tax basis for that property for income tax purposes. Rather, their basis for the property is equal to the fair market value at the date of the decedent's death. Thus any appreciation that occurs after the decedent acquired the property until his or her death is not subject to the capital gains tax.

When the estate tax is repealed, heirs will be required to "carryover" the basis of the decedent in inherited property. There will be a limited basis "step up" of $1.3 million for the property of a decedent, regardless of who inherits it. In addition, an additional basis step up of up to $3 million will apply for property passing to a surviving spouse.

Example: John dies in 2010, leaving stock in Widgets, Inc. to his son Sam. At his death, the stock has a fair market value of $2 million with a cost basis to John of $300,000. John's executor can increase the basis in the stock in Widgets, Inc. to $1.6 million ($300,000 carryover basis + $1.3 million general basis increase).

Example: John dies in 2010, leaving stock in Widgets, Inc to his wife Jane. At his death, the stock has a fair market value of $7.5 million with a cost basis to John of $2.2 million. John’s executor can increase the basis in the stock in Widgets, Inc. to $6.5 million ($2.2 carryover basis + $1.3 general basis increase + $3 million spousal property basis increase).

Many people do not keep accurate records on the basis of property on the assumption that the basis, if the property is held until death, will be “corrected” at death. The new law will effectively put an end to this practice.

Currently, when computing the federal estate tax owed by an estate, a credit is allowed against the federal estate tax for the estate or inheritance tax paid to one or more states. The amount of the credit is computed using tables established by Congress. Many states, including Kansas, base the amount of the state death tax on the allowed federal credit. Under the Act, from 2002 to 2005, the current credit will be phased-out, and a credit will only be allowed for amounts actually paid to the state. If states such as Kansas, who base the state death tax on the federal credit, do not take any action to change the state law then an estate will not receive a credit against the federal estate tax. Furthermore, the states will lose revenue. However, if states move to enact new estate and inheritance taxes, then part of the benefit of the rate reduction and exemption increases will be taken away.

Individual Income Taxes

Another significant part of the Act is the reduction in individual income tax rates. This reduction is accomplished in part by establishing a new 10% rate for taxable income up to $6,000 for singles and $12,000 for married couples filing jointly. The new rate is effective retroactively to the beginning of 2001. The new rates result in an annual savings of up to $300 for singles and $600 for married couples. The tax savings for 2001 will be rebated to taxpayers in the form of checks to be received during the summer and fall of 2001.

In addition to the new 10% bracket, all brackets, excluding the 15% bracket will be decreased 1% effective July 1, 2001.

The Act also decreases the so-called “invisible” taxes that are paid by higher income individuals. The first is the repeal of the phase-out of itemized deductions. The second is the repeal of the phase-out of personal exemptions.

In 2001, the allowed itemized deductions are reduced, subject to certain limitations, by 3% of their adjusted gross income (AGI) above a threshold of $128,950 for married couples filing jointly and one-half that amount for singles. The Act reduces the phase-out to 2% of the AGI above the threshold in 2006 and 1% of AGI above the threshold in 2008. In 2009 the phase-out is repealed completely.

INDIVIDUAL RATE REDUCTIONS

Taxpayers with income above a second threshold also lose some benefit of the personal exemption. The thresholds for 2000 were AGI of $193,400 for married couples filing jointly and $128,950 for singles. The Act reduces the phase-out by one-third in 2006, an additional one-third in 2008 and repeals the phase-out in 2009.

Phase-out of Exemptions and Itemized Deductions

Alternative minimum tax is another area that many people believe needs to be corrected or eliminated. The Act does not reduce the alternative minimum tax but does increase the allowed exemption by $4,000 for married couples filing jointly and $3,000 for singles. This increase is only effective for 2001 through 2004.

The Act makes several modifications with respect to children. The first is an expansion of the child tax credit. The current child tax credit is $500 for each child under the age of 17, claimed as a dependent. The credit begins to phase-out, however, as the parents’ modified AGI exceeds $110,000 (joint) or $75,000 (single). Under the Act, the $500 amount would be increased to $600 this year and would ultimately be doubled to $1,000 by 2010. The Act also makes the credit refundable to the extent of 10% of the taxpayer’s earned income in excess of $10,000 beginning this year. The 10% increases to 15% in 2005. Beginning in 2002, the child tax credit will be available to offset alternative minimum tax.

In an attempt to promote placement of children in homes through adoption, the Act makes several changes to the current law. First, the adoption credit becomes permanent. Second, it doubles the maximum credit to $10,000 per eligible child. Third, it also doubles the beginning point of income phase-out range to $150,000 of modified AGI. Fourth, the Act permits the use of the adoption credit against the alternative minimum tax.

The third change with respect to children is the increase in the expenses for dependent care from $2,400 to $3,000 for a single child and from $4,800 to $6,000 if two or more children qualify.

A major issue for many people is the so-called “marriage penalty” whereby working couples filing a joint return pay more income tax than they would have had they filed as single individuals. This is addressed in the Act in two ways. First, married couples filing jointly can claim a standard deduction twice that of singles. This provision is phased in beginning in 2005. The full effect of this provision will not occur until 2009.

The second provision addressing the marriage penalty doubles the 15% tax bracket for married couples filing joint returns. This provision is also phased in beginning in 2005, with the full effect not occurring until 2008.

Tax incentives with respect to education also received a boost under the Act. Those areas benefitting are education individual retirement accounts, qualified tuition plans (Section 529 plans) and student loan interest deduction.

Under current law, contributions to education individual retirement accounts are limited to $500 per year per child. Only individuals can make contributions. Under the Act, beginning after 2001, the annual contribution is increased to $2,000. In addition, corporations and other entities, including tax-exempt organizations, will be able to make contributions.

Qualified tuition plans allow taxpayers to make contributions to a state-sponsored investment program on behalf of a beneficiary. The earnings are not taxed until the funds are withdrawn to pay for qualified education expenses at a post-secondary school. The Act makes two major changes. First, beginning in 2002 private institutions will also be allowed to establish such plans. Second, "qualified education expenses" will include elementary and secondary school expenses.

Finally, with respect to education, the Act expands the deductibility of interest on student loans. This will make student loans more attractive to some taxpayers as a method of financing education.

IRA CONTRIBUTIONS

Retirement Planning

In order to encourage individuals to save for retirement, the maximum annual contribution to traditional individual retirement accounts (IRAs) and to Roth IRAs will be increased over the next seven years until it reaches $5,000 in 2008 with inflation adjustments thereafter. Individuals who are age 50 or older will be allowed to make additional "catch-up contributions" to an IRA. Above is a chart illustrating the changes.

The Act also increases the dollar limits on defined contribution plans and elective deferrals to 401(k) plans. With respect to defined contribution plans, the Act increases the maximum annual addition from $35,000 to $40,000. In addition, the allowed deferral to a 401(k) plan will increase to $15,000 by 2006.

Conclusion

What should a taxpayer do in light of the many changes? First, realize that many of the changes won't take effect for several years. Second, take advantage of the increased limitations for contributions to IRA's and qualified plans. Third, review your estate plan carefully. Most people will conclude it is advisable to continue their gifting plans or engage in other estate planning procedures. In addition, many wills and trusts include formula clauses which govern how much a spouse (or marital trust) receives, and how much passes to other beneficiaries (or into a "bypass" trust). Those amounts will automatically change as the exemptions increase, which may or may not be in accordance with your desires. It is impossible to predict with certainty what future law changes may be, so it is important for each person to review his or her situation carefully. Our firm is available to assist you, but the process will need to initiated by requesting our assistance.