CRS Report Examines Changes to Estate and Gift Tax Law

                       CRS REPORT FOR CONGRESS

SUMMARY

[1] The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16, the Tax Relief Act) was enacted on June 7, 2001. Title V of the Act contains the provisions addressing estate, gift, and generation-skipping transfer (GST) taxes. These take effect in three distinct time phases. During the phasedown period -- calendar years 2002 through 2009 -- the Tax Relief Act reduces estate, gift, and generation-skipping transfer tax liabilities by raising the exempt amount of a taxable estate (the applicable exclusion amount) and lowering the maximum tax rate. For calendar year 2010 only, the estate tax and the GST tax Will be repealed; the step-up in basis will be replaced with a modified carryover basis for assets transferred at death; and the gift tax will remain in effect, with the maximum gift tax rate lowered to the maximum income tax rate. On December 31, 2010, all provisions in the Act are scheduled to sunset. If the new law is not reenacted beforehand, on January 1, 2011, estate and gift tax law would revert to the law in place prior to June 7, 2001.

[2] During the phasedown period, the exemption per decedent under the estate tax is scheduled to rise (from $675,000 in 2001) to $1 million in 2002 and 2003; $1.5 million in 2004; $2 million in 2006; and $3.5 million in 2009. The GST exemption ($1,060,000 in 2001) will be equal to the estate tax exemption from 2004 through 2009. For the gift tax, the lifetime gift exemption will be raised to $1 million in 2002 and remain there. Exemptions claimed for gifts will be subtracted from the exemption remaining for the estate tax. The maximum tax rate for both the estate and gift taxes is scheduled to fall (from 55%, plus a 5% surcharge over a certain range, in 2001) to 50% in 2002; 49% in 2003; 48% in 2004; 47% in 2005; 46% in 2006; and 45% in 2006-2009. The GST tax rate will be the maximum estate tax rate in effect for the year. In 2010, when the estate tax and GST taxes are repealed, the gift tax will remain in effect, but the maximum gift tax rate will be lowered to 35%. The credit for state death taxes will be reduced to 75% of its prior-law value in 2002, 50% in 2003, 25% in 2004, and repealed and replaced with a full deduction in 2005.

[3] Under the "modified carryover basis" introduced in 2010, a "basis increase" may be added to the decedent's "adjusted basis" for certain inherited property. A basis increase of up to $1.3 million per decedent may be allocated among assets transferred to any beneficiary. An additional basis increase of up to $3 million may be allocated to assets transferred to a surviving spouse. Instead of filing an estate tax return, executors of estates with more than $1.3 million in assets other than cash will be required to file a "return relating to large transfers" with the IRS, to help document the carryover basis of each asset transferred to heirs.

[4] As a consequence of the year-by-year changes in the tax law prescribed by the Tax Relief Act, the law that will apply to a particular individual's estate will vary substantially, depending upon the year of the person's death. Because the new law is scheduled to sunset at the end of 2010, knowledge of prior law remains relevant, especially for long-term estate tax planning. This report may be updated as the new law is clarified.

CONTENTS

[5] The Economic Growth and Tax Relief Reconciliation Act of 2001 was approved by Congress on May 26, 2001, and signed by President George W. Bush on June 7, 2001 (H.R. 1836, P.L. 107-16, 115 Stat. 38, henceforth referred to as the Tax Relief Act). Title V of the Tax Relief Act contains the provisions addressing estate, gift, and generation-skipping transfer (GST) taxes -- generally referred to simply as estate and gift taxes.

[6] The first section of the report emphasizes the three distinct time phases under the Act. The second section describes the major changes from prior law regarding estate and gift taxes. There are many other detailed provisions in Title V that are not addressed here. ¹ This report may be updated as the new law is clarified.

THREE PHASES OF THE ACT

[7] The effective dates for the estate and gift tax provisions in the Tax Relief Act fall into three distinct time periods:

     phasedown period, from calendar year 2002 through 2009;

       TABLE 1. YEAR-BY-YEAR CHANGES IN ESTATE AND GIFT TAX LAW:

[9] During the phasedown period for the estate tax -- calendar years 2002 through 2009 -- the Tax Relief Act reduces estate, gift, and generation-skipping transfer (GST) tax liabilities by raising the exempt amount of taxable estate (the applicable exclusion amount) and lowering the maximum marginal tax rate.

REPEAL OF ESTATE TAX AND GST TAX, 2010

[10] For calendar year 2010 only, the estate tax and the generation-skipping transfer (GST) tax are repealed. The step-up in basis is replaced with a modified carryover basis for assets transferred at death. The gift tax will remain in effect with a lifetime exemption of $1 million, but the maximum gift tax rate will be lowered to the maximum income tax rate.

SUNSET, 2011 AND AFTER

[11] Under the terms of Title IX of the Tax Relief Act, all provisions of the Act are scheduled to sunset on December 31, 2010. In particular, provisions of the Act shall not apply ". . . in the case of title V, to estates of decedents dying, gifts made, or generation skipping transfers, after December 31, 2010." As a result of this sunset provision, on January 1, 2011, estate and gift tax law is scheduled to revert to the law that was in place prior to June 7, 2001.

CHANGES RELATIVE TO PRIOR LAW

[12] This section emphasizes the major changes in estate and gift tax law made by the Taxpayer Relief Act of 2001. Because the new law is scheduled to sunset December 31, 2010, knowledge of prior law remains relevant, especially for long-term estate and gift tax planning. Furthermore, in most areas, prior law continues to apply until year-end 2001. ³

[13] The order of presentation here does not follow the sequence in the Act. To make it easier to refer to the Act, the subheadings indicate the subtitle of Title V of the Tax Relief Act that contains the provision being discussed.

EXEMPTION AMOUNT INCREASED DURING PHASEDOWN (SUBTITLE C)

[14] The amount of a decedent's ⁴ assets that may be transferred free from estate tax is commonly referred to as the "exemption amount." (Formally, in the Internal Revenue Code, the exemption is called the "applicable exclusion amount." The new law refers to it as the "unified credit effective exemption amount.")

[15] Under prior law, the exemption amount was scheduled to rise, in several steps, from $675,000 in 2001, to $700,000 in 2002 and 2003, and eventually to $1 million in 2006. Instead, the Tax Relief Act of 2001 raises the unified credit effective exemption amount (for the unified estate and gift tax) to $1 million effective in 2002. The lifetime gift exemption is to remain at $1 million, while the unified estate and gift exemption continues to rise during the phasedown period.

[16] Under prior law, the generation-skipping transfer (GST) tax exemption was set at $1 million, indexed for inflation after 1998. The indexed value of the GST exemption for 2001 is $1,060,000. Thus, the indexed value of the GST exemption is already greater than $1 million under prior law. The new law sets the GST exemption equal to the applicable exclusion amount in effect for the particular year starting in 2004.

[17] For both the estate tax and GST tax, the applicable exclusion amount or exemption is now scheduled to rise every two to three years during the phasedown period, in large steps. For the estate tax, the exemption will rise to $1 million in 2002 and 2003. For both the estate tax and GST tax, the exemption will rise to $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009. The scheduled increase in the exemption amount is shown in the first column of Table 2.

[18] The estate and gift tax are still unified from 2002 through 2009, in the sense that the exemption available at death will be reduced by the amount of lifetime gifts that claimed the gift tax exemption. Assume that a person had given cumulative gifts of $1 million or more during his lifetime and claimed the maximum permitted lifetime gift exemption of $1 million. If the person died in 2009, the exemption amount still available to his estate at the time of his death would be $2.5 million (the unified credit effective exemption for 2009 of $3.5 million minus the $1 million lifetime gift exemption). However, if the person died in 2002 or 2003, there would be no exemption remaining for his estate at his death because the unified credit effective exemption for 2002 and 2003 of $1 million would already be fully used.

[19] The exemption amount continues to apply per decedent or per person. Thus, for a couple to take full advantage of two times the exemption amount ($2 million instead of $1 million in 2002; $7 million instead of $3.5 million in 2009), they must take the necessary estate tax planning steps. This includes assigning ownership of some assets to each spouse independently, rather than jointly. ⁵

       TABLE 2. APPLICABLE EXCLUSION AMOUNT AND MAXIMUM TAX RATE

[21] FAMILY-OWNED BUSINESS DEDUCTION REPEALED. Under prior law, there is a special deduction for family-owned business interests (section 2057 of the Internal Revenue Code or IRC). Currently, that special deduction of $675,000 (maximum), in combination with the applicable exclusion amount (available to all estates), can protect up to $1.3 million in estate value from taxation. Because the exemption available to all decedents will be $1.5 million as of 2004, the family-owned business deduction would no longer offer any special advantage. The Tax Relief Act repeals that special deduction as of 2004.

MAXIMUM TAX RATES LOWERED DURING PHASEDOWN (SUBTITLE B)

[22] From 2002 through 2009, during the phasedown period, the same reductions in the maximum tax rate apply to both estate and gift tax rates. The reductions in the maximum tax rate affect taxable estate values above $2 million. The graduated rates established by prior law continue to apply to estate values up to $2 million. In 2010, when the estate tax is repealed, the gift tax will remain. At that time, the maximum gift tax rate will be lowered to 35%. This is equal to the maximum rate of the income tax in 2010, under other provisions of the Tax Relief Act.

[23] Information about the maximum tax rates in effect each year, and the level of taxable estate values above which they will apply, is summarized on the preceding page, in column 2 of TABLE 2. The two tables in the appendix at the end of this report were created by the Congressional Research Service to present the full schedule of graduated estate and gift tax rates for each year from 2002 through 2011. The column for 2011 reflects the law prior to enactment of the new law on June 7, 2001. (The new law is scheduled to sunset on December 31, 2010. Unless a new tax law is enacted beforehand, prior law will be reinstated as of January 1, 2011.) TABLE A.1 presents the schedule of federal estate tax rates. TABLE A.2 presents the schedule of gift tax rates. In both appendix tables, the changes in the maximum tax rate are highlighted in bold type.

[24] Under prior law, the maximum rate of estate and gift tax was 55% on taxable estate values over $3 million. In addition, a 5% "bubble" surtax was levied on estate values from $10 million to $17,184,000. (The surtax was intended to phase out the benefit of the graduated rates -- the rates below 55% -- for large estates,)

[25] Under the new law, the 5% surtax is repealed in 2002. Also in 2002, tax rates in excess of 50% are repealed. (These include the rates of 55% on taxable estate value over $3 million and 53% on values from $2.5 million to $3 million.) Thus, in 2002, the maximum rate will be 50% on taxable amounts over $2.5 million.

[26] In 2003, estate and gift tax rates in excess of 49% are repealed. This means that the tax rate on taxable estate values over $2.5 million will fall from 50% to 49%.

[27] The remaining four rate reductions lower the tax rate on all taxable estate values over $2.0 million. The maximum marginal tax rate will fall from 49% in 2003, by one percentage point per year, down to 45% by 2007. This means that the tax rate on estate values over $2.0 million will be 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007-2009. Under prior law, the tax rate is already 45% on taxable estate values from $1.5 million to $2.0 million. The rates in the tax brackets below $2.0 million will remain the same as under prior law.

[28] In 2011, all of these changes in estate tax law are scheduled to sunset. Under provisions of prior law, the exemption amount under the estate tax would have risen to $1 million for 2006 and years after. Tax rates would revert to their prior-law levels, with a maximum rate of 55% and the 5% surtax to phase out the benefits of the graduated rates. (See appendix TABLE A.2 for a year- by-year schedule of estate tax rates.)

ESTATE TAX REPEALED IN 2010, GIFT TAX RETAINED (SUBTITLE A)

[29] In 2010, when the estate tax and the generation-skipping transfer tax are repealed, the gift tax will remain in effect.

[30] Under prior law, the estate tax and gift tax were unified. With regard to liability for paying these taxes, it did not matter whether a person transferred assets to another person as a gift while still alive, or as a bequest after death. For each person, the applicable exclusion amount was a cumulative lifetime exemption that encompassed both taxable gifts during lifetime and the estate remaining at death. ⁸ The gift tax only became due on a current (pre-death) basis once a person had given away taxable gifts that cumulatively exceeded the applicable exclusion amount in effect for the year of the gifts. At the time of death, lifetime taxable gifts were counted as part of the estate in calculating the tentative estate tax due. In determining the net estate tax due after death, the estate was credited for gift taxes already paid. Hence the name "unified credit." The same graduated tax rate schedule applied to both estate and gift taxes.

[31] The Tax Relief Act gradually separates the estate tax from the gift tax. During the phasedown period, gift taxes receive the same reduction in the maximum tax rate as the estate tax. In 2002, the unified credit effective exemption rises to $1 million for the two taxes. However, the lifetime exemption under the gift tax will remain at $1 million thereafter, while the exemption under the estate tax is scheduled to rise in steps to $3.5 million by 2009.

[32] In 2010, when the estate tax is repealed, the gift tax remains in effect. ⁹ However, the maximum gift tax rate will be lowered from 45% to 35% -- the maximum individual income tax rate by that time, under other provisions of the Tax Relief Act. The statutory marginal tax rates will remain as under prior law on cumulative taxable gifts in the brackets up to $500,000. In 2010, the maximum marginal tax rate would be capped at 35%, applying to cumulative gift transfers above $500,000. ¹⁰

[33] The maximum value of the lifetime gift tax credit would be $330,800, the tax otherwise due on the first $1 million in taxable gifts. The total lifetime credit could be allocated in portions to separate gifts, to protect them from the gift tax.

[34] If the new tax law sunsets as scheduled on December 31, 2010, the cumulative lifetime exemption under the unified estate and gift tax would remain at $1 million, because it would have risen to $1 million for 2006 and thereafter under provisions of prior law. The maximum gift tax rate, however, would revert to its former higher level, rising from 35% in 2010 back to 55% in 2011. (See appendix TABLE A.2 for a year-by-year schedule of gift tax rates.)

[35] Several important provisions of the gift tax remain unchanged from prior law. The annual gift tax exclusion of the first $10,000 in gifts per donor, per donee, indexed for inflation, remains as under prior law. So does the gift tax exclusion for qualified transfers of payments for tuition or medical expenses on behalf of another individual. Assets transferred as gifts continue to receive a carryover basis (the transferor's adjusted basis) for the recipient for purposes of the potential income tax on capital gains when the gift is sold by the recipient, as under prior law.

[36] Retaining the gift tax is intended to help protect income tax revenues. H.R. 8, the Death Tax Elimination Act of 2001, which passed the House on April 4, 2001, would have repealed both the estate tax and the gift tax. Like the Tax Relief Act, H.R. 8 created a potential capital gains tax liability for some heirs by replacing the step-up in basis with a carryover basis for assets transferred at death. ¹¹ In discussions surrounding the passage of H.R. 8, tax practitioners pointed out a strategy to reduce the income taxes due on the capital gains when the assets are eventually sold. Absent a gift tax, wealthy people could transfer assets during their lifetime, without tax cost, to friends and relatives in lower income tax brackets, who could sell the assets subject to a lower capital gains tax rate, and possibly no tax liability at all. The original owner could then receive back the proceeds from the other person's sale of the asset, through either gift or inheritance. In an effort to discourage this potential means of evading income tax liability on capital gains, the Tax Relief Act retained the gift tax on transfers of assets in excess of $1 million during one's lifetime.

GENERATION-SKIPPING TRANSFER TAX LOWERED, THEN REPEALED

[37] Under prior law, the generation-skipping transfer (GST) tax is levied, in addition to the estate tax, on amounts transferred, either indirectly or directly, to a "skip person." A skip person is a person assigned to a generation two or more generations below the transferor (a grandchild or more distant generation). ¹² Each person transferring assets (transferor) has a cumulative exemption of $1 million (indexed) to allocate to generation-skipping transfers made either during life or at death. ¹³ The GST tax is levied at a flat rate of tax equal to the maximum estate tax rate (55% under prior law), multiplied by the "inclusion ratio." The inclusion ratio that applies to a particular transfer of property reflects the amount of the total GST tax exemption allocated to that property. ¹⁴ The GST tax is levied on the value of the taxable property at the time of the taxable event (the transfer).

[38] Under provisions of the Tax Relief Act, beginning in 2004 during the phasedown period, the exemption under the generation- skipping transfer tax will be the same as the applicable exclusion amount under the estate tax. The applicable exclusion amount is scheduled to rise to $1.5 million in 2004 and then, in steps, to $3.5 million in 2009. (See the first column of TABLE 2 earlier in the report.) As under prior law, the tax rate on generation-skipping transfers will be the highest estate and gift tax rate in effect for the year of the transfer. (Under the new law, the maximum tax rate will decline, first to 50% for 2002 and then gradually to 45% for 2007-2009. See the second column of TABLE 2 and appendix TABLE A.1.) The generation-skipping transfer tax will be repealed in 2010, at the same time as the estate tax. The repeal of the GST tax is scheduled to sunset in 2011, with prior law being reinstated, unless the new law is extended.

[39] Other changes to the GST tax are described in the subsection near the end of this report on Modifications of Generation-Skipping Transfer Tax (Subtitle G).

STEP-UP IN BASIS REPLACED WITH MODIFIED CARRYOVER BASIS FOR INHERITED ASSETS IN 2010 (SUBTITLE E)

[40] Under prior law, assets transferred at death receive a "step-up in basis." This includes assets transferred to a spouse under the unlimited marital deduction. ¹⁵ For the heir or recipient, the basis becomes the fair market value of the asset on the decedent's date of death (or the alternative valuation date, six months later, if the value is lower). For income tax purposes, when the heir sells the asset, the capital gain is calculated as the difference between the heir's selling price and the stepped-up basis of the asset as of the decedent's date of death. The step-up practice means, in effect, that the capital gain on the asset during the decedent's period of ownership is not subject to income taxation, for either the decedent or the heir. Only the capital gain (or loss) on the asset after the decedent's death is taxable to the heir when the heir sells the asset.

[41] In contrast, assets transferred by gift, during the donor's lifetime, retain a carryover basis. The carry over basis is the decedent's adjusted basis -- the decedent's acquisition cost with certain permitted adjustments, such as adding the cost of capital improvements or subtracting depreciation. The use of carryover basis for gifted assets remains unchanged under the new law. ¹⁶

[42] Under the Tax Relief Act, when the estate tax is repealed in 2010, the step-up in basis provision for inherited assets ¹⁷ will be repealed and replaced by a modified carryover basis. In 2010, assets transferred at death generally will be treated like assets transferred by gift, with certain exceptions. As with gifts, the carryover basis to the recipient of the asset will be the lesser of the decedent's adjusted basis or the fair market value of the property -- on the date of the decedent's death. Unlike with gifts, however, a limited "basis increase" to the decedent's adjusted basis will be permitted for certain inherited property.

[43] BASIS INCREASE ALLOWANCES. An "aggregate basis increase" of $1.3 million is permitted per decedent. ¹⁸ This $1.3 million limit may be increased by the amount of unused "built-in" losses associated with assets in the decedent's estate. These are losses that could have been claimed on the deceased person's income tax return, if he or she were still alive. ¹⁹ (In the case of a decedent who is a nonresident non-citizen (a nonresident alien), the aggregate basis increase is limited to $60,000 and the provision to add unused built-in losses and loss carryovers does not apply.) In addition, a $3 million basis increase is permitted for assets transferred to a surviving spouse. ²⁰ Thus, $4.3 million in basis increase could be assigned to property transferred to a surviving spouse ($1.3 million plus $3.0 million).

[44] These basis-increase amounts are counted in addition to the decedent's adjusted cost basis -- to determine the maximum total basis for all of the appreciable assets ²¹ in the estate. That is, the gross value of assets protected from possible capital gains income taxation to heirs is more than the $1.3 million and $3.0 million (spousal) basis-increase amounts. For example, if the adjusted cost basis of the assets were $1 million, then $2.3 million in assets -- $1 million plus $1.3 million -- could be transferred to any beneficiary without any potential liability for income taxes on capital gains when the assets are sold.

[45] The basis-increase limits of $1.3 million, $60,000, and $3.0 million are indexed for inflation after 2010. The permissible inflation adjustment amounts are rounded down to increments of the nearest $100,000, $5,000, and $250,000, respectively.

[46] The executor of the estate is given the responsibility for allocating portions of the basis increase or, alternatively, a strict carryover basis, to particular assets and, consequently, particular heirs. Different heirs could thus receive assets with comparable current market value, but very different basis and consequently very different capital gains tax implications upon sale of those assets. ²²

[47] The basis of any particular asset may not be increased above its fair market value at the date of the decedent's death (the former step-up basis value). Assets not assigned any basis increase at all will receive their carryover basis -- the lesser of the decedent's adjusted cost basis or the fair market value of the asset at date of death. In between are assets that receive some amount of the total basis-increase allowance, but not enough to bring their modified carryover basis up to their date-of-death fair market value.

[48] EXCLUSION FOR CAPITAL GAIN ON PRINCIPAL RESIDENCE. In addition to the basis increase allowance, the income tax exclusion of up to $250,000 of capital gain on the sale of a principal residence is extended to the estate or person inheriting the decedent's residence. There is still a requirement that the property have been used as a principal residence for 2 or more years during the 5-year period before the sale, to qualify for the exclusion. If the decedent met the residency requirement before death, the exclusion may be claimed when the residence is sold by the estate or the heir. If the decedent had not met the residency requirement, if the heir takes occupancy of the property as a principal residence, then the decedent's period of occupancy may be added to the heir's subsequent period of occupancy to satisfy the 2-year residency requirement for the exclusion.

[49] PROPERTY INELIGIBLE FOR BASIS INCREASE. The new law enumerates several categories of property that may not receive a basis increase. These include property acquired by the decedent by gift within 3 years of death and the stock of several types of foreign investment companies.

[50] In addition, the new law specifically provides that the basis-increase provisions " . . . do not apply to property which constitutes a right to receive an item of income in respect of a decedent under Section 691" One implication of this provision is that the basis increase allowance cannot be applied to assets that the decedent held in tax-deferred retirement plans such as traditional (not Roth) IRAs and 401(k) plans. As under prior law, heirs will owe income taxes on any assets they withdraw from these inherited plans. Furthermore, any withdrawals, including investment earnings from capital gains, will be taxed at the heir's ordinary income tax rate -- not the lower capital gains tax rate. ²³

[51] REPORTING REQUIREMENTS AND PENALTIES FOR FAILURE TO REPORT. The purpose of returns filed with the IRS will change. Under prior law, the emphasis is on determining the value of the taxable estate of the decedent. Under the new law, the emphasis is on establishing the carryover basis for assets transferred at death. ²⁴

[52] Under prior law, the executor of an estate with gross assets in excess of the applicable exclusion amount ($675,000 for 2001, rising to $1 million in 2006 and thereafter) is required to file an estate tax return with the Internal Revenue Service. ²⁵ The rules regarding filing an estate tax return will continue to apply during the phasedown period (to estates of decedents dying up to December 31, 2009). Also, the prior rules are scheduled to be reinstated when the new law sunsets in 2011.

[53] Under the Tax Relief Act, the language in section 6018 of the IRC referring to estate tax returns is replaced by language on "Returns Relating to Large Transfers at Death." ²⁶ For deaths occurring in 2010, the executor of the estate (or the trustee of a revocable trust) is required to report to IRS regarding all non-cash assets transferred at death -- if the gross fair market value of the property (in the aggregate) exceeds $1.3 million. ²⁷ Property which constitutes a right to receive an item of income in respect of a decedent (IRD) under Section 691 is not considered to be property acquired from a decedent for purposes of the carryover basis rules. Consequently, IRD property (including traditional IRAs and 401(k) plans) is not eligible for a step-up in basis, as previously explained, and need not be reported to the IRS on the Section 6018 return relating to large transfers.

[54] The executor also must report to the IRS on appreciated property received by the decedent within three years of death which was required to be included on a gift tax return. (Such recently- gifted property is not eligible to receive a basis increase.) The Section 6018 return is to be filed with the decedent's last income tax return, unless a later date is specified in IRS regulations.

[55] The executor must report the following information for each asset to the IRS:

     name and taxpayer identification number (TIN) of the recipient;

[57] Within 30 days of filing the return with the IRS, the executor is required to provide the same information in writing to the individuals receiving each property, along with the executor's name, address, and phone number.

[58] There are penalties on the executor for failure to provide the required information to the IRS by the required date. The penalty for each violation is $10,000 for failure to report on the transfer of noncash assets at death; $500 for failure to provide the required information to the IRS on appreciated property acquired by the decedent within three years of death; and $50 for each failure to report the information to a beneficiary.

[59] For gift transfers made during life, the donor is required by the Tax Relief Act to provide recipients of the property the information reported on the donor's gift tax return (e.g., the property's fair market value and its basis). There is a penalty of $50 for each failure to provide information to recipients.

[60] There is no penalty for a failure due to reasonable cause. However, if the failure to report is due to intentional disregard of the rules, then there is a penalty of 5% of the fair market value of the property at the date of the decedent's death or the time of the gift (for a lifetime gift).

CREDIT FOR STATE DEATH TAXES PHASED OUT, REPLACED WITH DEDUCTION (SUBTITLE D)

[61] Under prior law, a limited tax credit is permitted against the federal estate tax for death taxes (including estate, inheritance, legacy, or succession taxes) actually paid to any state or the District of Columbia, on any property included in the decedent's gross estate. The maximum amount of the credit is determined based on the size of the decedent's adjusted taxable estate ²⁸ in conjunction with a table of graduated tax rates. ²⁹

[62] The state death tax credit is nonrefundable. It may only be claimed against the federal estate tax liability remaining after subtracting the unified credit from the tentative tax on the estate. Consequently, the credit only has value to estates with a net taxable value that is larger than the applicable exclusion amount in effect for the year of death ($675,000 in 2001, corresponding to a unified tax credit of $220,550). In the aggregate, for estate tax returns filed in 1995 through 1998, claims for state death tax credits equaled approximately 20% of the federal tentative tax liability on estates before claiming the state death tax credit, with the federal government retaining the other 80%. ³⁰ /31/

[63] As a result of the dollar-for-dollar federal tax credit, there is no increase in the combined federal-state tax burden on an estate, for state death taxes levied up to the maximum federal credit. Consequently, every state has at least a "pick-up" tax that enables the state to take full advantage of the federal estate tax credit. In most states, the estate tax is the federal credit. A few states have an independent estate or inheritance tax. ³² The laws of those states provide for the state tax liability to rise to the maximum federal credit if the tax liability under the state tax formula is lower. In states with an independent tax structure, the state tax liability can exceed the federal credit for some estates.

[64] Under the new law, the state death tax credit is phased out over four years, beginning in 2002. In 2002, the credit is 75% of its former level; in 2003, 50% of its former level; in 2004, 25% of its former level; and in 2005, repealed. The credit will be replaced with a deduction in 2005. Estates in states with independent state death taxes still in existence after the repeal of the credit could deduct those taxes in full from the gross estate.

[65] In states whose tax is specifically linked to the federal credit, the state tax would disappear in 2005 when the federal credit is repealed, unless the state enacted a new estate tax law. ³³ For estates still facing state taxes in 2005-2009, the combined federal- state tax bill would be higher with the deduction than with a credit -- by the amount of state taxes not offset by the federal deduction. The deduction would reduce federal estate taxes only in proportion to the estate's marginal tax rate. (The maximum estate tax rate is 47% in 2005, 46% in 2006, and 45% in 2007-2009.) This offset is lower than the dollar-for-dollar reduction in federal taxes provided by the federal credit under prior law, but higher than the 25% credit available in 2004. ³⁴

[66] For estates not subject to the federal estate tax because they are smaller than the exemption amount, the deduction would be worthless, as would a credit. Likewise, the deduction for state taxes will be worthless to all estates when the estate tax is repealed in 2010. The credit for state death taxes would be reinstated if the provisions of the Tax Relief Act sunset as scheduled in 2011.

OTHER CHANGES

[67] CONSERVATION EASEMENTS (SUBTITLE F). Under prior law, a qualified conservation easement was geographically restricted to be in or within 25 miles of a metropolitan area, national park, or wilderness area, or in or within 10 miles of an Urban National Forest (IRC Section 2031(c)(8)(A)). Under provisions of the Tax Relief Act, a qualified conservation easement may now be claimed with respect to any land located in the United States or its possessions. The Act clarifies that the values are the values as of the date of the contribution. These amendments are effective after December 31, 2000.

[68] MODIFICATIONS OF GENERAL-SKIPPING TRANSFER TAX (SUBTITLE G). The modifications to the law on generation-skipping transfer taxes described in this subsection take effect after December 31, 2000. In general, these changes enhance the transferor's or trustee's ability to allocate the GST tax exemption in order to achieve an inclusion ratio of zero for assets transferred in indirect skips, ³⁵ so that those particular assets are not subject to the GST tax. ³⁶ The changes in the law provide for:

     deemed allocation of the GST tax exemption to lifetime transfers

[70] WAIVER ON STATUTE OF LIMITATIONS FOR TAXES ON CERTAIN FARM VALUATIONS (SUBTITLE J). Taxpayers are given one year from the date of enactment to be granted a refund or credit for overpayment of tax under IRC Section 2032A(c)(7)E which addresses renting the property to lineal descendants.

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Notes: The maximum estate tax rate scheduled to take effect each year is highlighted in bold type. The two leftmost columns identify the level of taxable estate at which the reduction in the maximum marginal rate will take effect. Although the applicable exclusion amount or exemption under the estate tax is scheduled to increase to $1 million in 2002 and to $3.5 million by 2009, the graduated rates remain relevant. The exemption takes effect through a tax credit mechanism. The graduated rates affect the calculation of both the tentative tax liability before the credit and the tax credit.

             Table A.2. Gift Tax Rate Schedule, 2002-2011

Notes: The maximum gift tax rate scheduled to be in effect each year is highlighted in bold type. From 2002 to 2009, the reduction in maximum rate for the gift tax mirrors the estate tax, shown in Table A.1. In 2010, when the estate tax is repealed, the gift tax is retained, but its maximum rate is lowered to 35%. The taxable estate brackets in the leftmost columns identify the level of gifts at which the reduction in the maximum marginal rate will take effect. Even though the cumulative lifetime exemption for taxable gifts is set at $1 million from 2002 on, the graduated rates below $1 million remain relevant. The exemption still takes effect through a tax credit mechanism. The graduated rates affect the calculation of both the tentative tax liability before the credit and the tax credit.

FOR ADDITIONAL INFORMATION

CRS REPORTS

     CRS Report RL30600. Estate and Gift Taxes: Economic Issues, by

² For purposes of estate and gift taxes, the effective dates formally apply to "estates of decedents dying, gifts made, or generation skipping transfers" after the effective date. In the law, the effective date is usually expressed as "after December 31" of a particular year (e.g., after December 31, 2001). For simplicity, this text refers to that effective date as the next calendar year, which begins the next day on January 1 (the year 2002, in this example).

³ A few provisions in the Taxpayer Relief Act are effective retroactively, beginning after December 31, 2000. These include the modifications to the treatment of generation-skipping transfers and repealing the geographic restrictions on conservation easements.

⁴ Decedent is the word used in the law to refer to a deceased or dead person. People planning ahead for their own affairs could substitute the word "person" or "individual" for "decedent." It is important to understand that the estate tax provisions apply to each person individually, not to a married couple as a unit.

⁵ The new law did not adopt the proposal (offered in some of the estate tax reform bills introduced in the 106th and 107th Congresses) that a surviving spouse be able to use any remaining exemption amount unused by the first spouse to die.

⁶ The applicable credit amount (the unified credit) is equal to the estate tax that would be due on the applicable exclusion amount (the exemption). The tax credit is subtracted from the tentative tax that would otherwise be due on the entire taxable estate. Both the exemption and its corresponding credit amount will vary according to the particular calendar year of a person's death. For further explanation, see CRS Report RS20857, How to Calculate the Estate Tax, by Nonna A. Noto.

⁷ In contrast, H.R. 8, the Death Tax Elimination Act of 2001, passed by the House on April 4, 2001, would have converted the applicable credit amount or unified credit into a "true exemption." Under that system, the exemption amount would be subtracted from the value of the taxable estate before applying the graduated tax rate schedule.

⁸ Only gifts in excess of the annual exclusion amount of $10,000 (indexed for inflation) per donor, per donee, count as potentially taxable gifts.

⁹ Beginning in 2010, a transfer to a trust will be treated as a taxable gift, unless the trust is treated as wholly owned by the donor or the donor's spouse under the grantor trust provisions of the Internal Revenue Code.

¹⁰ The graduated rates below 35% affect the calculation of the total tentative gift tax and the tax credit on the first $1 million in gifts.

¹¹ This is explained in the section below on "Step-up in Basis Replaced with Modified Carryover Basis for inherited Assets in 2010 (Subtitle E)." For further explanation of the potential capital gains tax liability, see CRS Report RL30875, Step-Up vs. Carryover Basis for Capital Gains: Implications for Estate Tax Repeal, by Nonna A. Noto.

¹² An indirect skip is where the generation one level below the decedent (e.g., the decedent's son or daughter) receives some beneficial interest in the property before the property passes to the generation two or more levels below (e.g., the decedent's grandchildren). A direct skip is where the property passes directly to the generation two or more levels below the decedent. The GST tax applies to both types of transfers. For additional explanation, see CRS Report 95-416, Federal Estate, Gift, and Generation-Skipping Taxes: A Description of Current Law, by John R. Luckey.

¹³ The GST exemption amount was indexed beginning in 1999. The inflation-indexed amount for 2001 is $1,060,000.

¹⁴ The inclusion ratio is explained in more detail in a footnote to the subsection near the end of this report on Modifications of Generation-Skipping Transfer Tax (Subtitle G).

¹⁵ Under the unlimited marital deduction, any assets left to a surviving (U.S. citizen) spouse are free from the estate tax at the time of the first spouse's death, but could be included in the surviving spouse's estate.

¹⁶ For further explanation, see CRS Report RL30875, Step-Up vs. Carryover Basis for Capital Gains: Implications for Estate Tax Repeal, by Nonna A. Noto.

¹⁷ IRC Section 1014, basis of property acquired from a decedent.

¹⁸ The basis increase provisions in the Tax Relief Act will hold most heirs harmless relative to prior law with respect to the amount of assets they may inherit free from either the estate tax or capital gains tax.

¹⁹ The built-in losses include capital loss carryovers, net operating loss carryovers, and losses not compensated by insurance. The losses need not be assigned to the particular assets from which they originated. Rather, the aggregate dollar amount of these losses can be added to the total basis increase available to be allocated.

²⁰ Qualified spousal property includes both outright transfer property and qualified terminable interest property (QTIP). QTIP is property in which the surviving spouse has a qualifying income interest for life, but which passes to others when the second spouse dies, under terms set forth by first spouse to die. The new law also establishes rules relating to the treatment of jointly held property for purposes of the basis increase.

²¹ Not all assets are appreciable and therefore candidates to receive part of the basis increase allowance. For example, bank accounts or savings bonds are not subject to a capital gain (or loss).

²² For discussion of the possible difficulties in administering a carryover basis regime, see, for example, the following three articles published in Tax Notes: Tucker, Stefan F. Thoughts on Radical Estate and Gift Tax Reform. Testimony before the Senate Finance Committee's Subcommittee on Taxation and IRS Oversight, March 15, 2001. Published in Tax Notes, vol. 91, no. 1, April 2, 2001, p. 163-70. Dodge, Joseph M. "What's Wrong with Carryover Basis H.R. 8." Tax Notes, vol. 91, no. 6, May 7, 2001, p. 961-73. Sheppard, Lee. "Debt in Contemplation of Death." Tax Notes, vol. 91, no. 11, June 4, 2001, p. 1655-60.

²³ In general, withdrawals of capital gains from tax-deferred retirement accounts, whether during one's lifetime or by heirs after one's death, are not taxed at the lower capital gains tax rate that applies to capital gains on assets held outside such accounts.

²⁴ If it can be retrieved and matched, this basis information could be used to help the IRS determine the capital gains subject to income tax, if and when the asset is eventually sold by the heir.

²⁵ Over half of estate tax returns filed during the late 1990s were not taxable because eligible deductions reduced the value of the net taxable estate below the applicable exclusion amount.

²⁶ In certain other parts of the Code, references to the term "estate tax return" will be replaced by "section 6018 return."

²⁷ 1f the estate exceeds this threshold, all of the non-cash assets must be reported, even those whose capital gains will be shielded from future income taxation by the basis-increase allowance. Different rules apply to the estates of nonresident aliens.

²⁸ For purposes of the state tax credit, the adjusted taxable estate is equal to the federal taxable estate minus $60,000.

²⁹ The rates range from 0.8% on the first taxable amounts, to 16.0% on amounts over $10,040,000. IRC Section 2011(b).

³⁰ Average nationwide percentages. Calculated by the Congressional Research Service from aggregate Internal Revenue Service data on net estate tax due before state credits, state death tax credits, and net federal estate tax after state credits, for estate tax returns filed in 1995-98. Data from: Johnson, Barry W. and Jacob M. Mikow. Federal Estate Tax Returns, 1995-97. Internal Revenue Service. Statistics of Income (SOI) Bulletin. Summer 1999. Tables 5a, 5b, and 5c, p. 118-20. Unpublished data for 1998 obtained from the authors.

³¹ This is in reverse proportion to the value of the credit at the time of its last revision, in 1926. At that time, the credit for state death taxes was increased to 80 percent of the federal tax. This was implemented through the introduction of the rate structure for the state tax credit still present in Section 2011 of the IRC. Subsequently, federal estate tax rates were changed but the state tax credit was not and the relative value of the state credit declined. U.S. Congress. Joint Committee on Taxation. Description and Analysis of Present Law and Proposals Relating to Federal Estate and Gift Taxation. 107th Congress, 1st session, JCX-14-01, March 14, 2001, p. 12.

³² As of 2001, 38 states and the District of Columbia provide that the only state death tax is a pick-up tax equal to the federal state death tax credit. Of that group, Louisiana and Connecticut have enacted laws to have a pure pick-up tax by 2004 and 2005, respectively. Ten of the remaining states have a separate inheritance tax and two a separate estate tax. Federation of Tax Administrators. Repeal of Federal Estate Tax Would Have Effect on States. FTA Bulletin B-07/01, Washington, February 22, 2001. Available on the FTA Web site [http://www.taxadmin.org/fta/rate/b-0701.html]

³³ For additional information about state taxes, see CRS Report RS20853, State Revenue from Estate, Inheritance, and Gift Taxes, by Steven Maguire.

³⁴ The increase in combined taxes (with a deduction, in contrast to a credit) would be equal to the state taxes multiplied times one minus the federal marginal estate tax rate. For the largest estates, that would be 1.00-0.45=0.55. That is, the combined federal- state tax bill would be higher by approximately 55% of the state tax bill for the largest estates. There would be some offsetting reduction if the state taxes deducted exceed the federal credit permitted under prior law.

³⁵ An indirect skip is where the generation one level below the decedent receives some beneficial interest in the property before the property passes to the generation two or more levels below. For additional explanation, see CRS Report 95-416, Federal Estate, Gift, and Generation-Skipping Taxes: A Description of Current Law, by John R. Luckey.

³⁶ An inclusion ratio of zero means that no GST tax applies. An inclusion ratio of one means that no portion of the exemption is allocated to the particular transfer and the full tax applies. An inclusion ratio between zero and one means that that particular fraction of the GST tax applies.

In algebraic terms, the inclusion ratio is equal to 1 (one) minus the "applicable fraction" which is the ratio of (a) the dollar portion of the total available exemption allocated to that transfer, to (v) the value of the property transferred; that is, 1 - (a/v). The inclusion ratio becomes zero, and no tax applies, when a sufficient amount of exemption can be allocated to fully cover the value of the property transferred. That is, when a = v, then the applicable fraction is one (a/v = 1), and the inclusion ratio is zero [1 - (a/v) = 1 - 1 = 0]. If no amount of the exemption is allocated to the particular property transfer, then a = 0, the applicable fraction is zero (0/v = 0), and the inclusion ratio is one (1 - 0 = 1 - 0 = 1), and the full tax applies. In between are cases where the allocated exemption covers part of the property's value.