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Tax Cuts Don’t Ease Need For Estate Planning

They could have called this year’s tax legislation the Cinderella Tax Act. We go to the ball, we get a nice smooch and then we wake up to find ourselves in bed with a pumpkin.

Even by Internal Revenue Code standards, this is a bizarre fairy tale of a tax law. It phases in a variety of income, estate and gift tax breaks from now through 2009, repeals the estate tax — but not the gift tax — in 2010 and then the entire law goes away when the clock strikes midnight on Jan. 1, 2011. At that moment, we revert to the tax law as it existed on June 5, 2001.

Or not. Nobody really expects Congress and President Bush, or his successor, to allow the law to "sunset" as scheduled, if only because no politician will want to be blamed for the resulting massive tax increase. Some agreement most likely will be forged that will allow at least some of this year’s tax cuts to survive, or possibly even be enlarged. Recent history certainly supports the theory that Washington will not leave bad enough alone. Since Ronald Reagan was elected on his tax-cutting platform, we have had major tax changes in 1981, 1984, 1986, 1988, 1990, 1993, 1997 and now 2001.

On the other hand, taxes are the front line of the ceaseless partisan warfare in the Capitol. In the spring, Democrats backed off from their criticism that the Bush-proposed tax cuts were too large and demanded that the cuts be accelerated to give the economy a boost. But even before this year’s advance-refund checks got into the hands of most taxpayers, Democrats were charging that the shrinking budget surplus projections proved that they were right all along, and that the scaled-down tax cut that was passed by a coalition of Republicans and moderate Democrats was too big as well as too biased toward the wealthy.

In this environment it is conceivable, though unlikely, that partisan stalemate could keep the tax law frozen where it is, forcing us to live with this morphing legislative monster.

On the income tax front, we probably can manage this. There is relatively little that most taxpayers can do to plan their income taxes. Most of the planning opportunities that do exist have only a one- or two-year time horizon. For example, if you are self-employed and you expect a big cash payment from a client, you might decide to postpone billing from December 2001, when the maximum federal tax bracket is 39.1 percent, to January 2002, when the top bracket will fall to 38.6 percent. You would not be likely to postpone receiving that income all the way until 2006, when the maximum rate is scheduled to reach 35 percent.

The short-term nature of most income tax planning makes it easier for taxpayers to adapt to future changes in the tax laws. There will be some problem areas, especially an accelerating trend for taxpayers to be thrown into the Alternative Minimum Tax, but this will only increase the pressure on Congress to make further changes to the law.

Estate planning, and in fact all planning for inter-generational wealth transfer, is another matter. The new law does not in any way reduce the need for good planning, for tax and non-tax reasons. It just makes good planning more difficult.

Taxes change in three phases

Basically, the new law sets up three separate regimes for these wealth transfer taxes. First, from now through 2009, the estate tax and generation-skipping transfer tax are gradually liberalized. The amount that can be transferred tax-free by each individual goes from $675,000 this year to $1 million next year to $3.5 million in 2009. The amount exempt from gift taxes likewise rises to $1 million next year, but it is frozen at that level thereafter.

Second, in 2010, the estate and generation-skipping transfer taxes disappear, while the gift tax remains. However, at the same time, a major change is made to the income tax rules. In 2010, someone who sells inherited assets will compute gain or loss on the sale just as the decedent would have, using the deceased’s cost basis. This is a major change from today’s approach, in which the cost basis is usually adjusted to date-of-death values, which tends to eliminate most capital gains taxes on inherited assets.

The rules taking effect in 2010 provide two exceptions from the new carryover basis approach. The executor of each decedent is allowed to allocate up to $1.3 million in basis adjustments to step up, to fair market value, the basis of most inherited assets. Qualifying bequests to a surviving spouse can receive an additional $3 million in basis adjustments. Thus, a married couple’s estate can, if properly planned, provide for taxes to be forgiven on up to $5.6 million of gains on inherited assets.

Virtually no estate plan today provides for this kind of step-up planning, since it is a completely alien concept under prior law. Conversely, what was standard estate planning just a few months ago could have dramatic, unintended consequences under the new law. The liberalization and eventual elimination of estate taxes could cause many existing plans to effectively disinherit a surviving spouse or the decedent’s children. This problem will tend to arise most often in estate plans where the surviving spouse is not the natural parent of the children in question.

Finally, in 2011, we go back to the rules that were in effect when George W. Bush took office. The estate tax is back, the generation-skipping transfer tax is back, and the basis step-up goes away. This assumes, of course, that the law is not changed before then.

Current estate plans may require revision

Like most estate planners with wealthy clients, I am preparing for a very busy year. Most of our existing plans will have to be reviewed, and many will need to be rewritten. Clients with more than a couple of million dollars often will need to have their lawyers draft more elaborate, complex documents that can accommodate the various changes scheduled to happen in the law. Alternatively, some existing documents may be serviceable for a few more years as the changes begin to take effect. Clients who can manage for now may want simply to keep an eye on things and await further legislative developments before investing in a new estate plan.

About the only thing we know for certain is that the tax debate will go on. I am especially doubtful that the gift tax will survive for very long if the estate tax is repealed. The two taxes were integrated a quarter-century ago because they affect the same activity, namely the transfer of wealth from one generation to the next. Keeping the gift tax while repealing the estate tax will create a generation of superannuated misers who hang on to wealth for dear life to keep their families from losing a big piece of it to Washington. Who wants that?

The decision to keep the gift tax came only at the last moment, after repeal opponents asserted that removing the tax would lead to massive avoidance of state and federal income taxes as people gave away assets to relatives in lower-tax jurisdictions. Experience in places such as Canada, which has had no gift or estate taxes for about three decades, indicates that those fears are greatly overblown.

Many parents will want to be alive to see their children enjoy the family’s wealth. Owners of family businesses will want to transfer equity to their kids when the younger generation takes on the burdens of management. With more people living to their 90s and beyond, there will be a lot of pressure not to force elders to hoard their family’s wealth just to avoid taxes.

All we know is that the tax law that was passed earlier this year is not likely to stand, but, for now, it is the only law we have. We are going to have to find ways to live with it until something better, or at least something different, comes along.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s most recent book, The High Achiever’s Guide To Wealth. His contributions include Chapter 1, “Anyone Can Achieve Wealth,” and Chapter 19, “Assisting Aging Parents.” Larry was also among the authors of the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.