Beware the Fine Print in The Tax Relief Act
by Robert M. Fells, Esq., general counsel
On June 7, President Bush signed into law the largest federal tax cut in 20 years. Officially known as "The Economic Growth and Tax Relief Reconciliation Act of 2001," the new law contains many complicated tax breaks for individuals and businesses that becomeeffective over the next 10 years.
An immediate benefit involves the reduction in the personal tax rate from 15 percent to 10 percent for the first $6,000 earned by an individual, or the first $12,000 for couples, retroactive to January 1 of this year. Taxpayers are scheduled to receive advance refund checks for up to $300 (individuals), $500 (head of household) and $600 (married filing jointly) during the fall. However, trusts and estates are not eligible for the advance refund. Most tax reductions are phased in gradually through 2010 and the so-called "repeal" of the estate tax actually does not occur until 2010, then expires at the end of that year unless Congress acts to extend it (see below).
Personal tax rates will be substantially lowered compared to the average corporate rates, a development that may cause businesses currently organized as C corporations to reorganize as sole proprietorships, partnerships and S corporations. Under the lowered rates, tax-exempt investments may seem less competitive unless they generate higher yields for investors. Some financial planners are also suggesting that the benefits of operating a business as a tax-exempt organization could be reduced due to the lowered tax rates.
The federal estate tax rate is reduced and the dollar exemption is increased beginning in 2002. Currently, estates valued over $675,000 are subject to federal tax at the 55 percent rate. Next year, the exempt amount will increase to $1 million with the top rate at 50 percent. The tax rate gradually declines to 45 percent by 2007 with a maximum exemption of $2 million, which will be increased to $3.5 million by 2009. In 2010, the estate tax is repealed but only for that year. Without Congressional action to extend the repeal after 2010, the 55 percent top rate for amounts in excess of $1 million will automatically return in 2011.
However, upon repeal of the estate tax, the basis of assets transferred from the estate to beneficiaries will increase because the value must be determined as a carry-over on the decedent's basis, not on the stepped-up market value basis as currently determined at the time of decedent's death.
Two exceptions will ease this income tax crunch provided adequate planning has been made: 1) $1.3 million of basis can be added to certain assets; and 2) $3 million of basis can be added to assets transferred to a surviving spouse. For example, tax planners are suggesting that real estate or other assets that remain in a family for generations will require generations of accurate records of basis. Without accurate basis records kept over the decades, the IRS can claim a lack of documentation and keep the asset basis low in order to tax the assets at an artificially high level.
Also, the state death tax credit allowed against the federal estate tax will be reduced by 25 percent in 2002, by 50 percent in 2003, by 75 percent in 2004, and then totally repealed and replaced by a deduction for state death taxes thereafter.
With regard to retirement plans, the new law raises the limits on an employer's deduction for contributions to certain types of defined contribution plans to 25 percent of compensation, and streamlines the pension laws to encourage small businesses to offer pension plans. The IRA contribution limits (both traditional and Roth) will increase from the current $2,000 annual limit to $5,000 by 2008. Taxpayers who are 50 and over can "catch up" with contributions to IRAs with additional amounts up to $500 in 2002-2005, and $1,000 in 2006 and thereafter.
Clearly, many of the new tax benefits will require both businesses and individuals to consult knowledgeable tax planners and preparers in order to properly use the provisions. A number of other benefits that were not included in the new tax relief law are likely to be enacted later this year. These issues include a reduction in the capital gains rate, alternative minimum tax relief, and more small business tax breaks. ICFA members will be kept informed of important legislation as events develop.