Some of the changes in gift and estate taxation introduced by the Economic Recovery Tax Act of 1981 will come automatically to us if we simply wait: The top tax bracket will decline from 70% to 50% over the next four years, and the amount of property that can be passed on tax-free will move up from $175,625 to $600,000 over six years. To obtain these benefits we should stop smoking, cross streets carefully, and try to survive.
Other benefits of the new tax package require thought and action. Here are three specific things to think about now and act on immediately:
1. REVISE YOUR BEQUEST TO YOUR SPOUSE. For married persons with substantial estates, the marital deduction will be the central feature of any estate planning review. The old law allowed a deduction of up to 50% of the adjusted gross estate or $250,000, whichever was greater. The new law removes the marital deduction ceilings. Spouse A can give or leave the entire estate, tax-free, to Spouse B.
This revision is simple enough, and a bequest of your entire estate to your spouse may be adequate for a modest estate. But there are hazards that ought to be considered:
* The outright gift of A's estate to B permits B subsequently to ignore people A would have wanted to take care of, such as A's children by either the present or a previous marriage.
* The transfer of the property to B may impose excessive income taxes on B after A dies.
* The gift may expose B's assets to unnecessary estate taxation. Suppose that A dies after 1986 leaving his entire $2.8-million net estate to B. The estate taxes at A's death and at B's subsequent death would be:
Tax on A's estate
Tax on B's estate $818,600
Total taxes $818,600
A and B can substantially reduce taxation by channeling $600,000 (the amount that will be exempt from estate taxes after 1986) through a trust for their heirs that does not qualify for the marital deduction. If such a nonqualifying trust were set up by A's will, the $600,000 would legally be considered to have been bequeated to the ultimate heirs by A A's estate would still be tax exempt, but B's estate would be reduced by $600,000 to $2.2 million. Thus estate taxes would be:
Tax on A's estate
Tax on B's estate $571,200
Total taxes $571,200
Nearly $250,000 is saved. And such a plan can be phased in with the gradual rise in the estate tax exemption over the next six years. From 1981 through 1987 the exempt amounts will be:
1987 and after $600,000
Don't assume too readily that the $600,000 exemption in 1987 means your estate will be tax exempt. By 1988 inflation may have nudged many seemingly modest estates into the taxable zone.
2. STEP UP YOUR GIFT PROGRAM. Beginning January 1, 1982, the new law raises the limit on annual tax-free gifts from the present $3,000 per recipient to $10,000 per recipient. In addition, unlimited exclusions are allowed for gifts to pay medical expenses or tuition. Married couples can still "split" their gifts, so that a couple can make tax-free gifts up to $20,000 (rather than the present $6,000) per recipient per year. If you are married and make annual gifts, for example, to two children and four grandchildren, you can give them up to $120,000 (six times $20,000) in 1982 and each year after that as compared with $36,000 (six times $6,000) in 1981.
Whether you should initiate, continue, or step up a lifetime gift program to reduce your taxable estate depends, as always, on a number of personal as well as tax considerations. For many individuals, the tax incentive will expire when the exemption from estate tax reaches $600,000. But that will not occur until 1987.
January 1, 1982, is the opening day for the enlarged gift tax exclusions. And if your gifts will also shift income to persons with income tax brackets lower than yours, then the sooner the better.
3. REVOKE YOUR ORPHANS' DEDUCTION BEQUESTS. The orphans' deduction, introduced by the Tax Reform Act of 1976, is revoked by the new law. This deduction was enacted to provide for the support of minor children. The old act allowed a surviving parent's estate to deduct for each child a maximum of $5,000 times the number of years by which the child's age is less than 21. The money could be an outright bequest or go into a qualifying trust.
The abolition of this deduction by the new law means that most people who provided for orphans' deductions gifts should revoke them. Rarely do these gifts represent the benefits that one would have chosen but for the erstwhile tax benefit.
Finally, a warning on joint ownership: Under the new law, you can transfer your property into joint ownership with your spouse without fear of a gift tax. Ownership of property as "joint tenants with right of survivorship" may appeal to your for two reasons: either for its simplicity or -- depending on the laws of the state in which you live -- for possible saving of state inheritance taxes.
As far as state taxes are concerned, however, the saving of tax in A's estate will usually result in the imposition of the tax in B's, so that the advantage, if any, is of deferral rather than avoidance.Moreover, the federal estate tax law allows a graduated credit for state death taxes; to the extent that a device to reduce state taxes also reduces the federal tax credit, the state tax "saving" is illusory.
But beyond all that, joint ownership now involves a new and potentially serious tax trap. Under the old tax law, property transferred by Spouse A to the joint names of A and B remained fully part of A's gross estate. Thus, regardless of how much A originally paid for the property, if B sold the property after A's death at a price equal to the property's value for estate tax purposes, no capital gain would be recognized and no tax would be due.
Under the new law, however, only half of the property transferred by Spouse A to joint ownership of A and B will be included in A's estate for tax purposes. Thus, only that half would be valued on an appreciated basis at A's death. B's half of the jointly owned property, already transferred, would continue to be valued at original cost. Upon sale of the property by B, the gain on the 50% of the property B already owned would be calculated on the basis of the original cost, and a high capital gains tax could result. This is the special hazard of transferring into joint names property that was acquired relatively cheaply.
In summary, the changes wrought by the Economic Recovery Tax Act of 1981 are simple to state but less simple to apply. Perhaps the best advice for estate planning is: Make haste, but make haste carefully.