Carney & Sugai, LLP - New Tax Law Changes

Federal Tax Law Changes

Estate Taxes
We are currently waiting for what is perceived to be one of 2005's hot topics: the status of estate taxes. As part of the federal tax reform, the possibility of a permanent estate tax repeal remains. It is unclear if the permanent repeal will have the needed votes or if some type of larger estate tax exemption will be enacted. We will continue to monitor any proposed legislation and notify you of any changes which would impact your estate planning.

IRS Regulations
Final regulations for required distributions from retirement plans were published by the IRS on April 17, 2002. These regulations took effect for distributions beginning on January 1, 2003. While these new regulations are considered a vast improvement over the previous 2001 and 1987 proposed regulations, there still remain traps for the unwary.

Simply naming a beneficiary on the form your plan administrator places before you is no longer enough. Specific rules are now in place in order to qualify the beneficiary you have named as a "designated beneficiary" to gain the best income tax advantages under the plan. Failure to understand these complex rules can create unfortunate income tax results for your beneficiaries. In our client seminar on November 13th, we will be explaining the rules and the outcome of naming different persons, trusts and charities as your beneficiary. We hope you will join us to learn more about this very important topic.

Warning for Those With Real Property Out of State
As previously reported, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA-2001) provided a number of changes to our estate tax system, including an annual drop in the top estate tax rate, increases to the estate tax exemption amounts over the next few years, and the repeal of estate taxes in 2010 only (unless additional legislation is passed). Another change of EGTRRA-2001 included a phase-out of state death tax credits. The state death tax credit is a credit on the federal estate tax return for the amount of estate taxes paid to a state, previously resulting in a net wash to the taxpayer.

California has a "pick-up" tax, which means California receives the exact amount of the credit that was allowed for the estate. (This explains why California death taxes have not been discussed with any frequency.) Under EGTRRA-2001, the amount of this credit has been reduced 25% in this year, will be reduced another 25% in each of the next two years, and is repealed in 2005, at which time the pick-up tax (that is, the amount that had been going to California) would be zero. As any new California state death taxes would have to be approved by the voters, it seems extremely unlikely that there will be any death tax in California after 2004. Please note that this does not result in a savings to the taxpayer, but is simply a shift of the tax funds from California to the Federal Treasury.

Furthermore, for those Californians owning real property located outside the state of California, this change to the Federal Tax Code could result in more taxes being due. Some states do not impose a pick-up tax, but instead have their own state estate tax, and some have inheritance taxes which are taxed directly to the beneficiaries. Due to the way the formulas are drafted by the individual states, the amount of tax imposed by those states can be based on the full value of the estate (even those assets owned here in California) rather than just the amount of assets in that other state.

With this result, the tax can even exceed the value of the asset located in the other state! If the estate is valued at $1,000,000.00 or less, it does not appear that the state estate taxes will pose much of an issue. For larger estates, though, the potential of state estate taxes can be a problem. Some of the states where this may happen include New York, Kansas, Oregon, and Washington. If you have out-of-state property and are concerned about potential estate tax consequences, please contact our offices.

Carryover Basis

Last year, we explained The Economic Growth and Tax Relief Reconciliation Act of 2001 (The Act) and its impact on estate, gift and generation skipping transfer taxes. One area which has received little attention in the press is the effect The Act will have on income taxes. As you know, The Act is designed to reduce estate taxes by increasing the estate tax exemption and reducing the estate tax rate over the next few years. Absent additional legislation, estate taxes will be repealed in 2010, although they are scheduled to be reinstated in 2011.

Beneficiaries of an estate, under pre-Act law, receive assets inherited with a basis (i.e. the adjusted cost of an asset for capital gains computations for income taxes) stepped up to the fair market value at the date of death. However, under The Act, only a limited amount of assets will receive a basis step up. The executor will be able to increase the basis of assets transferred to beneficiaries by $1.3 million, and for assets transferred to the surviving spouse, by an additional $3 million. All other assets will pass to the beneficiaries with the decedent's basis, called the "carryover basis." Therefore, it will be critical for the executor/trustee of the estate to know the basis of the decedent in each asset passing at death. Because carryover basis may result in large capital gain taxes due when the assets are sold, and since (unless the basis can be substantiated) the IRS may deem the basis to be zero, basis will become the major issue for estates in and potentially after 2010.

Increase in Gift Tax Exclusion

One of the most overlooked areas of opportunity for estate tax planning is the area of annual gifting. The annual gift tax exclusion amount has risen to $11,000 per person. For clients needing to reduce the size of their estate for estate tax purposes, current annual gifting can provide an easy and gift-tax-free method of estate tax planning. For example, gifting can be combined with education savings plans for a child or grandchild. Using one of the new educational gifting options, including 529 plans, Education IRA's and others (as reported in a prior issue of our newsletter), you can accomplish some estate tax planning while at the same time obtaining income tax benefits. Anyone with questions on how annual gifting can benefit your estate planning, please contact our office.

Increase in Estate Tax Exemption

As reported in our last newsletter and in our July correspondence, the estate tax exemption amount for 2002 has risen to $1,000,000 per person. In addition, the top estate tax rate dropped from 55% to 50%, and the 5% surtax was eliminated. The estate tax exemption rate will remain at $1,000,000 per person in 2003; however, the top estate tax rate will drop to 49%. These changes to the estate tax system will be beneficial for all of our clients, and some may find that their estate is no longer taxable for estate tax purposes.

For married clients whose total estate is less than the one million dollar exemption amount, we would be happy to reevaluate your current estate plan with you to determine if any changes might be in order. For married clients with estates in excess of about $1,200,000, the change means that the Bypass Trust will be funded with a greater portion of the estate than may have been anticipated, leaving the surviving spouse with less complete control over the total estate. Should you have questions regarding how these and the future changes to the estate tax system may impact your existing estate plan, please contact us.

Tax Cut Proposal
We now have a President, but we still await tax code changes to benefit us in inflated California!

As of this printing, President Bush is lobbying support for his tax cut proposal. This proposal contains various tax-reducing provisions including, and particularly important for our purposes, estate tax cuts. The bill has passed the House but is facing opposition in the Senate. President Bush has indicated his willingness to compromise on some of the bill's provisions, a prospect which leaves us uncertain as to what tax changes will actually occur.

President Bush is encountering opposition to estate tax cuts from an unlikely source. Some of the super-wealthy in our country have formed a lobby designed to keep estate taxes in place. Their concerns are twofold: 1) Where would lost funds from estate tax revenues be recaptured? (presumably from the middle-class) and 2) How great a loss of charitable donations would a repeal in estate taxes cause? Charities are understandably apprehensive, for philanthropic contributions are often motivated by the threat of large estate taxes. With that threat removed, people may be less charitably inclined.

It is important to remember that any tax cut proposal, whether it be a complete repeal of estate taxes, an increase in exemption amounts or both, is scheduled to be phased in over a ten-year period, at which time a new administration could conceivably make changes to the estate tax system again. Predictably, most of the tax cuts are back-end loaded, meaning you won't see much benefit for a number of years. Whether estate taxes are repealed completely or whether the exemption amount is increased (possibly up to five million dollars per person), most of you will benefit from the changes. Until the bill is passed and completely phased in, however, estate planning efforts to reduce or eliminate estate taxes will continue to be necessary.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (The Act) has passed both Houses of Congress and was recently signed by President Bush.

The Act has tax implications for both the income tax and estate and gift tax areas. Below are some of the major points regarding the estate and gift tax aspects of the new law. This is intended as a brief overview only.

Increase of the Estate and Generation Skipping Transfer Tax Exemption Amounts
The Act repeals estate and generation skipping transfer (GST) taxes beginning January 1, 2010. Before 2010, the Act reduces tax rates and raises the exemption equivalent of the unified credit amount for estate tax purposes. Under the pre-Act law, the exemption (set at $675,000.00 per person for this year) was scheduled to increase in increments to $1,000,000.00 by the year 2006. Under the new Act, the exemption will increase much more rapidly, rising up to $3,500,000.00 per person before the tax is finally repealed in 2010. The exemption amounts for each year from 2002 through 2009 are as follows:

Year of Death	Exemption
2002, 2003	$1,000,000.00
2004, 2005	$1,500,000.00
2006, 2007, 2008	$2,000,000.00
2009	$3,500,000.00

Reduction of Maximum Estate and GST Tax Rates
The current maximum estate tax and GST tax rate is 55%, with a phaseout of the graduated rate for estates which are larger than $10,000,000.00. The Act immediately repeals the phaseout of the graduated rates for larger estates. The Act also reduces the maximum estate and GST tax rates in stages over the next six years, as follows:

Replacement of Estate Tax Credit for State Death Taxes Paid with Tax Deduction
Under the Act, the State Death Tax Credit currently available for estate taxes will slowly be phased out. Under the pre-Act law, the IRS had allowed a credit against the federal estate taxes due for a certain percentage of the taxes if that amount was paid to a state for state death taxes. In most cases, the credit resulted in the same total taxes being paid. Beginning in 2002, the credit for state death taxes paid will be reduced by 25% of the pre-Act amounts and will continue to be reduced in increments of 25% in subsequent years. In 2005, the credit for state death taxes will be replaced with an estate tax deduction for any state taxes paid. Naturally, once the federal estate tax is repealed in 2010, this deduction will have no meaning.

Gift Tax Exemption Amount and Rates
The gift tax life-time exemption amount for taxable gifts will be raised from $675,000.00 this year to $1,000,000.00 in 2002 and will remain at that level. Taxable gifts are (in general) transfers, without full and adequate consideration, in excess of $10,000.00 per year/per donee of real or personal property valued at the date of the gift. The maximum gift tax rates until 2010 will be the same as the estate tax rates set forth in the chart listed above. Then in 2010, the top gift tax rate will drop to 35%. Please note that despite the repeal of estate and GST taxes in 2010, gift taxes are not being repealed, making it better as of 2010 to transfer assets valued at over $1,000,000.00 total at death, rather than during life. This will undoubtedly make for some interesting estate planning.

Impact of Repeal after January 1, 2010, CARRYOVER BASIS
For decedents dying after January 1, 2010, all estate and GST taxes will be repealed. Gift taxes will remain in place, with a unified credit exemption amount of $1,000,000.00 and a maximum gift tax rate of 35%. However, this is unlike the pre-Act law, where beneficiaries received assets inherited with a basis (i.e. the adjusted cost of an asset for capital gains computations for income taxes), stepped up to the fair market value as of the date of death. Now, under the Act, beneficiaries will receive the assets with the basis of the decedent, called the "carryover basis." This will have very important income tax consequences for the beneficiary. As the beneficiary will receive the tax basis of the decedent, when the beneficiary sells the asset(s), potentially large capital gain taxes may be due.

To offset the impact of these additional income taxes on the capital gains, three adjustments to the carryover basis will be allowed: 1) each estate will be able to allocate $1,300,000.00 of basis to any one or more of the assets held at the decedent's death; 2) unused net operating losses and unused capital loss carry-forwards can be added to the basis; and 3) an additional $3,000,000.00 in basis may be allocated to those assets passing to the spouse. The executor will have the flexibility to select which assets will get the basis increase, subject to some limitations.

Despite the basis adjustments that will be allowed, due to high appreciation in real estate and stock, especially in this area, the beneficiaries of assets may find themselves owing a large amount of income tax on the sale of assets with accrued capital gains. While typically the income tax and capital gain rates are less than the estate tax rates, it is misleading to believe that this Act repeals all taxes relating to a person's death. Should the beneficiary of a decedent's assets wish to liquidate those assets, that beneficiary may face a rather large income tax bill on the capital gains.

One of the major difficulties surrounding deaths occurring after January 1, 2010 will be the substantiation of the basis of the asset in question. It is crucial that everyone keep good records of the basis of each asset owned. For most assets this will be documentation of the original cost. However for some assets, real property for instance, improvements can be added to the basis. Records which would illustrate the original basis, as well as records showing the costs for improvements, would need to be maintained and kept with important documents for the use of beneficiaries.

Sunset of the Act
All changes to the current law discussed above will sunset (terminate) on December 31, 2010. Thus, absent further legislation, the estate tax, though scheduled under the Act to be completely repealed on January 1, 2010, will be reinstated on January 1, 2011. Whether there will be additional legislation to keep the repeal in place will presumably depend upon the budget outlook, as well as who the President and the Congress are at that time.

We hope this summary of the portions of the Act regarding estate and gift tax laws has been of assistance to you. Should you have specific questions or concerns regarding your estate plan and how the new tax laws will impact that plan, please contact our office for an appointment.