Estate Planning under 2001 Estate Tax Repeal Legislation

Estate Planning under 2001 Estate Tax Repeal Legislation

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The repeal of the estate tax is now law, 1 but the law itself, and the legal environment, make it uncertain that the federal estate tax, or the estate taxes of Massachusetts and other states, will cease to exist. The law itself is not effective (except for interim changes in exemptions and rates) until 2010 (leaving room for many revisions or for repeal) and ceases to be law on January 1, 2011 unless extended, or unless this "sunset rule" is abolished as Rep. Richard Armey is attempting.

Furthermore, the gift tax is not repealed. It has been suggested that this is intended to serve an income tax objective, to prevent shifting of capital gains to younger generations. But the most plausible (and cynical) explanation for this strange development is that the gift tax law stops people from transferring most of their wealth to their children during an interval in which it’s possible that the estate tax will be reenacted.

Most importantly, retention of the gift tax also gives the 50 states time to install their own estate and gift tax laws while their revenues derived from the federal estate tax law drop precipitously. This result may fit an objective entertained by many Congressmen, namely, the objective of protecting the tax revenues of their own home states. (The policy objective of shifting the burdens of certain social programs from the federal to the state governments, said to be an objective of some on the Republican side of the aisle, may also be relevant to this feature of the tax legislation.)

Massachusetts repealed its estate tax in 1997 except for a "sponge tax," under which its tax is simply an amount equal to the credit allowed against the federal estate tax. In this repeal, Massachusetts (under strong pressure from taxpayers) imitated a great many other states which have only the sponge tax. Indefinite retention of the federal gift tax should be viewed in tandem with the remarkably rapid elimination of the federal Credit for State Death Taxes, and thus of state sponge tax revenues. While full repeal of the federal estate tax is deferred for a long 10 years, the credit is reduced by a 25% cut next year, a 50% cut the year after, and a 75% cut in 2004 (with eventual total elimination).

Many prosperous states whose legislatures did not contemplate repeal of the federal estate tax when they adopted the sponge tax certainly will react now to the quick elimination of state revenue under the federal legislation. Massachusetts, for one, will have to consider quickly reverting to its pre-1997 estate tax law, and even adopting higher rates than the 1996 rates to exploit the windfall – like a $20 bill laid on the sidewalk -- created by federal repeal (with its accelerated elimination of the credit which shifts revenue to the states). As a rear guard, and while shielded by the continuing federal gift tax preventing taxpayers from frustrating new state estate taxes, Massachusetts and other states may install a gift tax, to close off lifetime gifts as an avenue of escape from the estate tax, and may attempt to reach taxpayers who have left the state to avoid the tax. 2 All this may be more onerous than the federal estate tax.

Thus, doubts that the estate tax has really been abolished are provoked by the design of the repeal legislation -- the peculiar failure to repeal the gift tax, in tandem with the peculiarly rapid elimination of the Credit for State Death Taxes. But also there is a skeptical legal and economic environment (evidenced, for example, by an article entitled, "Still Breathing," in The Economist for June, 2001), suspecting that the estate tax is far from dead.

What is likely to keep the estate tax alive? The estate tax is a long-imbedded habit of society. In England, taxes imposed upon the privilege of transferring wealth at death date from shortly after William the Conqueror (when wealth and the power to raise an army were entailed in ownership of land). Death taxes exist today in many nations. But they seem anachronistic, from an economic point of view. 3

That is a theoretical discussion. As a practical political matter, on the other hand, it seems most unlikely that the Republican supporters of the recent estate tax repeal legislation will now turn to increased income taxes as the alternative to taxes on wealth as such. They might face less politically effective resistance to reinstatement of the estate tax. And, too, on the Democratic side of the aisle, there is and has for generations been a strong populist sentiment in favor of limiting the accumulation of wealth, a sentiment which bends the tax law to serve a social objective, as if the Constitutional power to Tax were a broad power to define the Constitutional right to Property. That nicety, nevertheless, does not deter political support for the estate tax, a tax which confiscates "excessive" wealth. 4 It does so without contributing very significantly to government revenues (about 2% of the total).

Paradoxically, the sentiment in favor of the estate tax – as harsh medicine which is good for the moral health of the society -- was recently espoused by quite a few individuals of fabulous wealth (who would idealistically deny immigrants and poor Americans the right to pursue wealth avidly and even greedily, without shame or limits).

In any event, the predicament of the rich attracts little sympathy among voters.

In summary, estate tax repeal (and much of the new tax legislation) is an unfinished process. It is like a meatloaf which has been taken out of the oven after 20 minutes and served too soon, while it is still not done. It will have to go back into the oven, and the guests may stuff themselves on appetizers – a different meal altogether.

Nevertheless, in estate planning one must now deal with the tax law as it stands today. The practical approach for the foreseeable future (which now is a short period) is to continue to use the formula marital bequest, the charitable deduction, and other similar tools which we have been using.

It would not be fanciful to insert in a will or trust (a) language shifting pertinent references (e.g., in the formula marital bequest) from federal to state laws, effective if and when the estate tax focus shifts in that fashion, or (b) an alternative plan which comes into effect if and when federal and state estate taxes are both effectively repealed. There seems no urgency to that kind of amendment, however.

1 The following is a chart outlining effective dates and other aspects of the 2001 estate tax repeal statute (H.R. 1836):

Death

Year Exemption

Top

Bracket State

Credit Limit Basis

2001

$675,000

55% at $3.0 million

NA

Stepped-Up

2002

$1,000,000

50% at $2.5 million (low brackets $10MM estates)

75%

Stepped-Up

2003

$1,000,000

449% at $2.5 million (low brackets $10MM estates)

50%

Stepped-Up

2004

$1,500,000

48% at $2.5 million (low brackets $10MM estates)

25%

Stepped-Up

2005

$1,500,000

47% at $2.5 million (low brackets $10MM estates)

Deduction

Stepped-Up

2006

$2,000,000

46% at $2.5 million (low brackets $10MM estates)

Deduction

Stepped-Up

2007

$2,000,000

45% at $2.5 million (low brackets $10MM estates)

Deduction

Stepped-Up

2008

$2,000,000

45% at $2.5 million (low brackets $10MM estates)

Deduction

Stepped-Up

2009

$3,500,000

45% at $2.5 million (low brackets $10MM estates)

Deduction

Stepped-Up

2010

no estate tax except QDT distributions to 12/31/20

§1015 (Gift) Carryover

+up to $3 million, Spouse
"$1.3 million, Other

2011

Act Expires 1/1/11

2 To illustrate, in 1996, in a taxable estate of $10 million, the federal estate tax would have been about $5.3 million before a maximum credit of $1.4 million for Massachusetts estate taxes. The estate tax then paid to Massachusetts was considerably more than the $1.4 million allowed by the federal government – say $1.6 million. In 1997 Massachusetts (imitating all the other New England states and many other states) converted to a "sponge" tax. Under the highly acclaimed "sponge tax," Massachusetts accepts as its estate tax only the federal credit amount, the $1.4 million, giving up the additional $200,000.

The new federal legislation indirectly (but by a not unforeseen coincidence) cuts the $1.4 million Massachusetts tax by 25% next year, by 50% the year after, and by 75% the next year, so that in 2004 Massachusetts would get only 25% of the $1.4 million and since 1997 would have gone from the $1.6 million to $350,000 (with more reductions and eventual elimination in prospect). From the Massachusetts legislature’s point of view, this is certainly an unforeseen and unintended result of its 1997 conversion to the "sponge tax." It seems inevitable that Massachusetts will go back either to the $1.6 million or even, since the federal government has created a tax vacuum which would otherwise be a windfall to wealthy taxpayers, a much larger estate tax. The repeal of the federal estate tax has the effect of shifting this revenue opportunity (like leaving a $20 bill lying on the sidewalk) to the states. Massachusetts probably will reinstate the Massachusetts estate tax as it existed in 1996, before repeal in 1997 in favor of the "sponge tax." Other states which host wealth-generating environments will do likewise. The Massachusetts estate tax, as it was in effect at the end of 1996, includes the full panoply of marital deduction and similar details to be applied by estate planners, and will and trust provisions currently in use will continue to be used.

3 Estate and gift taxes are imposts on wealth (and wealth transfers) as such without regard to their function as capital, generating income. A tax on transfer of a medieval tract of land (supporting not only crops but also militia) fit the socio-economic reality of the middle ages. But when the image of economic reality is not a tract of land but "Wall Street," as has been true since the early 20th Century, the estate tax does not fit. Wall Street is a cauldron of earned incomes and profitable exchanges (including capital gains income and losses) for which the income tax is a better fit, and even with regard to agricultural lands and similar "capital" the income tax fits the economic reality (unproductive farms are likely to be converted to profitable uses, for example). In principle, the estate tax imposes a tax even on relatively static savings and other wealth as such including, for example, works of art; and can confiscate a huge portion of relatively modest family savings passing, for example, to orphaned children. The federal income tax not only fits the Wall Street image of economic reality, but it also fits the services peculiar to the federal government – such as national defense and economic regulation. An ad valorem tax on real estate – to illustrate the opposite – fits the fire and police services peculiar to local governments. Whether welfare and other social services are appropriate to the federal government is now the subject of renewed debate, but even those governmental services fit the income tax (to the extent they are functions of economic regulation and the pursuit of common prosperity) better than the estate tax which is a tax on savings, inheritance, good luck, thrift and other economic facts for which the federal government can take little credit. But it is certain that the federal government can take credit for national defense and economic regulation which contribute immeasurably to the eminence of Wall Street as an economic market in which there is unprecedented opportunity for prosperity.

4 This is the "fairness" argument in favor of the estate tax. This argument is a disguised version of the unsuccessful Constitutional efforts of founding father James Madison, and others, to abolish inherited wealth altogether (together with inherited titles of nobility), in the service of an economy of incentive and competition:-- "Let those who work hard and well enjoy the fruits of the New World." Other constitutional thinkers may have agreed that incentive and competition should be the backbone of prosperity, but may have believed also that any confiscation of savings at death, and any impairment of the power of the individual to leave his or her wealth to heirs, would destroy incentive, and would do so in the most productive stages of a citizen’s maturity – when he or she works for children and grandchildren. Whatever caused the failure of Madison’s initiative, the abolition of inheritance and the confiscation of "excessive" wealth are not proper questions of Tax policy, but are questions of Constitutional policy which are best debated in that open forum, and not cloaked by the mysteries of the Internal Revenue Code.

Louis Hamel
louis.hamel@haledorr.com