What happened under the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001?
Under the Economic Growth and Tax Relief Reconciliation Act of 2001, there will be no estate tax applied to estates of decedents dying after December 31, 2009 until the year 2011 when the estate tax law reverts back to the prior law as if these provisions were never enacted at all. In the years leading up to this period of no estate tax, the applicable exclusion amount will increase as outlined in the written materials below. The applicable exclusion amount will gradually be increased, which means that decedent's will be able to shelter larger amounts of property transfers at death over the upcoming years.
Rates
Effective for estates of decedents and for gifts made after December 31, 2001 the top marginal estate and gift tax rate was reduced to from 55% to 50%. This rate is applied to amounts in excess of $2.5 million dollars. To accomplish this change, the two highest brackets in the existing rate schedule of marginal rates of 53% and 55% was replaced with the new 50% bracket. Further, the maximum marginal estate and gift tax rate is gradually reduced to 45% during years 2003 through 2009, eventually leading up to the repeal of the Estate and Generation Skipping Tax (GST) taxes in 2010. Thereafter, EGTRRA sunsets; that is, the Internal Revenue Code will be applied and administered as if the provisions and amendments in EGTRRA had not been enacted for decedents dying, for gifts made, and for generation-skipping transfers after December 31, 2010, without further legislation.
Gift Tax
Though the estate tax will not apply to estates of decedents dying after December 31, 2009 and the GST tax will not apply to GST's made after December 31, 2009, the gift tax will be retained following the repeal of the estate and GST taxes in a modified form. The retention of the gift tax is apparently deemed necessary to avoid taxpayers drastically reducing or altogether avoiding income taxes by transferring assets to relatives or other people in lower tax brackets. The retention of the gift tax after the repeal of the estate tax also appears to discourage lifetime gifts in excess of the $1,000,000 gift tax exclusion amount because holding the property until death would result in no tax being imposed. For gifts made after December 31, 2009, the gift tax will be computed using a rate schedule having a top marginal rate of 35%. This top rate of 35% will apply to total gifts of amounts over $500,000 and the remainder of the rate schedule contains marginal rates ranging from 18% to 34%. Beginning with gifts made in 2002, the applicable exclusion amount for gift tax purposes increased to $1,000,000 and is not indexed for inflation.
Applicable Federal Exclusion Amount
The application exclusion amount for estate tax purposes will gradually be increased to $3.5 million dollars by 2009, the year prior to the repeal of the estate and GST taxes. The applicable exclusion amount in effect for the years leading up to the repeal is as follows:
- For decedents dying in 2003: $1,000,000
- For decedents dying in 2004 and 2005: $1,500,000
- For decedents dying in 2006, 2007 and 2008: $2,000,000
- For decedents dying in 2009: $3,500,000
Step-up in Basis
Under the stepped-up basis rules, the income tax basis of the property acquired from a decedent at death generally is stepped-up to equal its value as of the date of the decedent's death, or the alternate valuation date of six months after the date of death. In the typical situation where property acquired from a decedent had increased in value, this basis rule allowed the recipient of the property to completely avoid income tax on any of the gain. Contrast the step-up basis rule with the carryover basis rule, where the basis of property transferred by a living donor to another person by a gift has the same basis in the hands of the recipient. The recipient keeps the donor's basis. Under EGTRRA, commencing in 2010, the stepped-up basis at death rules will be repealed and replaced with a modified carryover basis at death rule.
There is a partial replacement for the repealed basis step-up for estate property up to $1.3 million dollars or $3 million dollars in the case of property passing to a surviving spouse. Note that both the $1.3 million general basis increase and the $3 million spousal property increase can be applied to property passing to a surviving spouse. Thus, up to $4.3 million in date of death basis step-up can be allocated to properties received by a surviving spouse.
State Death Tax Credit
Under the Tax Relief Act, though the federal estate tax is phased out over a ten year period, the state death tax credit available under Code Section 2011 is reduced much more rapidly. The credit was reduced by 25% in 2002 and continues to decrease until it is repealed entirely in 2005. This reduction of the state death tax credit is shifting the burden of the cost of the repeal of the federal estate tax to the various states that currently apply a "sponge tax".
So what is the sponge tax? Since 1997, Massachusetts adopted a sponge tax, which is a revenue sharing device that allows Massachusetts, like many other states, to collect an estate tax equal to the maximum credit for state estate taxes that can be claimed on the federal estate tax return. Thus, the states that have the "sponge tax" will lose significant revenue. Many states are in the difficult position of trying to replace the lost revenue by enacting separate estate or inheritance taxes or through other revenue raising measures. Several states, including New Hampshire and Florida, derive revenues from state death taxes in excess of 2% of their total state tax revenues. Massachusetts, like New York, Rhode Island, Maine and Massachusetts General Law Chapter 65C — decoupling from the federal estate tax Vermont, has decoupled from the federal estate tax.
Chapter 364 of the Acts of 2002 amends Chapter 65C of the General Laws. See Exhibit 1 attached hereto. The new law is effective for those dying on or after January 1, 2003. For those dying on or after January 1, 2003, the Massachusetts estate tax amount will equal the credit for state death taxes that would have been allowable to a decedent's estate under section 2011 of the Internal Revenue Code in effect on December 31, 2000. In other words, the Massachusetts estate tax will be computed based on the federal law that was in effect on December 31, 2000. This new law avoids the losses Massachusetts would have incurred as a result of the scheduled reductions in the amount of the allowable credit for state death taxes paid under EGTRRA as explained above.
Accordingly, a Massachusetts estate tax will be in effect on estates as follows:
- For decedents dying in 2003 with an excess of $700,000;
- For decedents dying in 2004 with an excess of $850,000;
- For decedents dying in 2005 with an excess of $950,000; and
- For decedents dying in 2006 and thereafter with an excess of $1 million.
This means that there will be a discrepancy between the state and federal estate taxes, with many estates being subject to the Massachusetts tax which are not subject to the federal tax (at least until 2011 when the federal repeal is scheduled to expire).
Prior to the decoupling of the federal estate tax and the Massachusetts estate tax, many estate plans typically called for trust property to be allocated into two parts. The first part, which consists of the "federal applicable exclusion amount" passes into the Family Trust. The balance, if any, is distributed outright to the surviving spouse or alternatively, may be set up to pass into a Marital Trust. The Marital Trust provides the surviving spouse with all of the income and often gives the trustee discretion to distribute as much principal as the trustee determines to be necessary for the surviving spouse's maintenance and health. Upon the surviving spouse's death, the Marital Trust may be added to the Family Trust or disposed of in accordance with specific terms set forth in the trust.
The above plan eliminated both federal and state estate tax in the estate of the first spouse to die and deferred any taxability until the death of the surviving spouse. However, the majority of practitioners believe that, effective for deaths occurring in 2003, funding a family trust with $1 million may result in an unintended Massachusetts estate tax of $33,200. The Massachusetts Department of Revenue appears to have addressed this issue in Technical Information Release 02-18. The directive allows an executor to elect a marital deduction for terminable interest property for Massachusetts' estate tax purposes without requiring the executor to make the same QTIP election for federal estate tax purposes.
The following example illustrates the potential problem with some current estate plans and the solution through the use of a trust. Consider the example of a $2,000,000 estate with the husband and wife having the typical estate plan to eliminate federal and state taxes. Prior to decoupling from the federal system, when the husband dies, the $1,000,000 in his estate would flow to the Family Trust. When the surviving spouse dies, her $1,000,000 would also pass free of tax.
However, with the enactment of the new Massachusetts estate tax, if the husband dies in 2003, the funding of the family trust may result in a Massachusetts estate tax of $33,200.
One planning opportunity is the utilization of the Department of Revenue's TIR 02-18 which allows an executor to elect a marital deduction for qualified terminable interest property for Massachusetts estate tax purposes while allowing the executor to choose not to make the same election for federal estate tax purposes.
Using the directive, upon the death of the first spouse, the family trust is limited to the amount exempt for both state and federal purposes. The excess amount, up to the federal exemption, is allocated to a special Massachusetts QTIP share for the Massachusetts QTIP election referred to in the directive. The balance is distributed outright to the surviving spouse or distributed to a marital trust.
- Family Trust = Massachusetts exemption amount
- MA QTIP Trust = differential between federal and Massachusetts exemption
- Marital Trust = remainder of estate
A Different Perspective
A growing number of practitioners have questioned the accuracy of the unintended new tax ($33,200 at the death of the first spouse) because of the differential between the federal and Massachusetts estate tax exemption amount. These practitioners have further questioned the necessity of the so-called "fix" under TIR 02-18.
Here's the reasoning — the new Massachusetts estate tax serves to preserve the revenue that the state would have received had the sponge tax remained unchanged. In a $1,000,000 estate, Massachusetts would not be entitled to a tax upon the death of the first spouse. The federal exemption (prior to EGTRRA) would have been $675,000 with a corresponding marital deduction of $325,000 leaving a federal estate tax and corresponding Massachusetts estate (sponge) tax of $0. However, practitioners (and the Department of Revenue) have used the smaller "old" federal exemption of $675,000 with the smaller current federal marital deduction of $0 rather than the old marital deduction resulting in this unintended tax. In other words, it is erroneous to use a 2003 number to compute the hypothetical Massachusetts sponge tax because post-2000 federal changes are to be ignored for purposes of computing the tax. So what is a planner to do? Do we advise our client to draft the estate planning option discussed above? Do we litigate when one of our clients dies? Alternatively, should we hope for legislative action to resolve this uncertainty? Whatever we decide, we should be prepared to make further changes when the current law is modified, or solidified prior to the scheduled federal estate tax "sunset" in 2011.
"Decoupling" the Massachusetts Estate Tax from the Federal Estate Tax
Recently, the U.S. Congress made numerous changes to the Code provisions relating to estate and gift tax. For the estates of decedents dying on or after January 1, 2002, EGTRRA, inter alia, phases out the amount of the allowable credit for state death taxes by 25% a year until the credit is eliminated in 2005. Because the Massachusetts estate tax, prior to the recent statutory amendments, equaled the amount of the allowable federal credit for state death taxes, this federal change meant that the Massachusetts estate tax would be phased out and eliminated unless legislative action was taken.
The Massachusetts estate tax in G. L. c. 65C, § 2A, also known as the "sponge tax", is preserved by "decoupling" the Massachusetts estate tax from the federal estate tax. In other words, the reference point Massachusetts uses to tie itself to the Code for sponge tax purposes is a fixed date instead of a reference point that automatically incorporates any federal changes. Thus, due to the decoupling legislation, the Massachusetts sponge tax is now tied to the Code as in effect on December 31, 2000. See St. 2002, c. 186, § 28, as amended by St. 2002, c. 364, § 10.
As a result of these changes, the threshold amounts for filing Massachusetts and federal estate tax returns will be different for the estates of decedents dying on or after January 1, 2003. Massachusetts estate tax returns will be required when the gross estate plus adjusted taxable gifts, computed using the Internal Revenue Code in effect on December 31, 2000, exceeds the following amounts:
- 2003 $ 700,000
- 2004 $ 850,000
- 2005 $ 950,000
- 2006 and thereafter $ 1,000,000
Beginning in 2003, some estates will file a Massachusetts estate tax return but no federal estate tax return, and some estates will pay a Massachusetts estate tax but no federal estate tax. Future changes to the federal estate tax law will not affect the Massachusetts estate tax law, as the reference for Massachusetts is the Internal Revenue Code in effect on December 31, 2000.
The Massachusetts sponge tax computation for deaths occurring in 2002 will be computed under current federal law that has a filing threshold of $1,000,000.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
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