The Latest Tax Law Changes

1. The LatestTax Law Changes Everything You Need to Know July 26, 2002 Pennsylvania Bar Institute Robert R. Church, Esq. Keefer Wood Allen & Rahal, LLP Neil W. Yahn, Esq. James, Smith, Durkin and Connelly, LLP

2. The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “Act”)

3. Overview of Changes to Estate, Gift Tax and GST Tax Act §901.Sunset Provision. PBI page 123 • The “Sunset Provision” repeals the estate tax repeal and the income tax and retirement planning provisions of the Act effective December 31, 2010. However, it is important to note that the word “repeal” does not appear anywhere in the Act.

4. Repeal • Estate Tax Repeal • Estate Tax provisions inapplicable after 12/31/09. • Generation Skipping Transfer Tax Repeal • GSTT provisions inapplicable after 12/31/09. • Sunset: Repeal effective for one year due to sunset provisions. • Current law returns 1/1/11.

5. Reductions in Tax Rates Act §511- PBI Page 46. • Estate Tax • Additional Reductions beginning 1/1/02 • Top marginal rate reduced to 50% • Repeals 5% surtax • Top rate decreases 1% per year, levels at 45% in 2007—2009 • After 12/31/09, top gift tax rate is top individual income tax rate (no repeal of gift tax).

6. Exemption Equivalent Amounts Act §521 - PBI Page 48. • Estate Tax & Generation Skipping Transfer Tax Exemption Amounts • 2002 & 2003 = $1.0 million • 2004 & 2005 = $1.5 million (Estate Tax Only) • 2006, 7 & 8 = $2.0 million • 2009 = $3.5 million • Gift Tax exemption amount remains at $1 million • Gift and estate taxes no longer unified

7. Exemption Equivalent Amounts Act §521 - PBI Page 48. • Qualified Family Owned Business Deduction §2057 repealed 2004 - last year 12/31/2003.

8. Summary

9. In 2011 and thereafter, top rate will be 55%, the surtax is reinstated and the applicable exclusion amount is $1 million.

10. Credit for State Death Tax Act §§531-532 Reduction in Credit for the State Death Taxes and Credit Replaced with Deduction - PBI Page 49-52 • First: Credit Reduced for Decedents dying in: • 2002 = 75% of current amount allowed • 2003 = 50% of current amount allowed • 2004 = 25% of current amount allowed • Second: Credit Repealed for decedents dying after 2005: • Replaced with a deduction for actual state death taxes paid

11. Credit for State Death Tax Act §§531-532 Reduction in Credit for the State Death Taxes and Credit Replaced with Deduction - PBI Page 49-52 • Pick-up may take action to re-draft law: Pennsylvania Estate Tax Picks up exactly the Federal Credit • (4.5% is too low, Pennsylvania picks up difference to get you to credit amount). • Decedents in non-sponge states (such as Pennsylvania) may pay higher overall tax).

12. The Effect on Basis Act §541 Termination of Step-up in Basis at Death - PBI Page 52 • Terminates step-up in basis after12/31/2009; replaced with carry-over basis (see IRC § 1014). • Carry over basis is lesser of the adjusted basis of the decedent or the FMV as of date of death. • This provides for a step-down in basis that a beneficiary can acquire the taxable gains of the decedent, but not his or her deductible losses.

13. The Effect on Basis Act §542 Treatment of Property Acquired From a Decedent Acquired From a Decedent Dying After December 31, 2009. PBI Page 52-53 A Limited Step-up Available. . . • $3.0 million for “qualified spousal property” • $1.3 million addition (to others or spouse) Except for spousal gifts which were not gifted to the spouse (Act §542(d)), IRD assets, and stock of certain specific foreign entities.

14. The Effect on Basis Act §542 Treatment of Property Acquired From a Decedent Acquired From a Decedent Dying After December 31, 2009. PBI Page 52-53 A Limited Step-up Available. . . • Does not apply to certain gifts within 3 years of death or IRD - fossils of IRC § 2035. • Basis would be further stepped-up for any unused built-in losses or loss carryovers that were available to the decedent.

15. The Effect on Basis Act §542 (c) PBI Page 60 Exclusion of gain on sale of residence. An estate, heir or qualified trust (for individuals passing after December 31, 2009) that sells a decedent’s principal residence within three years of the decedent’s death will be permitted to use the exclusion from gain from the Sale of a Principal Residence. It may be wise then not to allocate basis to the personal residence.

16. The Effect on Basis Act §542 (c) PBI Page 60 • Exclusion of gain on sale of residence. If an heir occupies the residence as a principal residence, the decedent’s period of ownership and occupancy of the residence is tacked to the heir’s subsequent ownership and occupancy period.

17. The Effect on Basis The executor of a decedent’s estate (or trustee) has been given the arduous task to allocate the stepped-up basis among the decedent’s assets. This may result in a conflict for the fiduciary in allocating the basis among certain assets.

18. The Effect on Basis Act § 542(e). Transfers to Non-residents. • For estates of decedents dying after December 31, 2009, transfers by a U.S. decedent’s estate to a non-resident, non-U.S. citizen, will be treated as a sale or exchange of the property. • $60,000 Basis step-up. • The transfer amount will be an amount equal to the fair market value of the property on the date of transfer. • The amount of gain will be equal to the excess of the fair market value over the adjusted basis of such property in the hands of the decedent.

19. New Information Requirements Act § 542 (b). Mandatory Information PBI Page 58 • New IRC § 6018: transfers of non-cash property exceeding $1,300,000 and for property received within three years of the date of death, the executor (or trustee) of an individual dying after December 31, 2009 must report to the IRS the following:

20. New Information Requirements Act § 542 (b). Mandatory Information PBI Page 58 • name and tax identification number of the recipient of the property; • accurate description of the property;

21. New Information Requirements Act § 542 (b). Mandatory Information PBI Page 58 • adjusted basis of the property in the hands of the decedent and its fair market value at the time of decedent’s death; • decedent’s holding period for the property;

22. New Information Requirements Act § 542 (b). Mandatory Information PBI Page 58-59 • information to determine the income tax treatment of the property; • amount of basis increase allocated to the property (if any); and • any information that the IRS might prescribe.

23. New Information Requirements Act § 542. Mandatory Information Penalties PBI Page 60 • Failure to file penalty is 5% of property if intentionally disregarded.

24. New Information Requirements Act § 542. Mandatory Information Penalties PBI Page 60 • The executor or trustee must also provide the information to all recipients identified on the information report submitted to the IRS, as well as the name, address and phone number of such executor or trustee.

25. New Information Requirements Act § 542. Mandatory Information Penalties PBI Page 60 • Any executor or trustee who fails to provide such information to the IRS will be subject to a $10,000 penalty. An executor or trustee who fails to provide the required information to a beneficiary will be subject to a $500 penalty.

26. New Information Requirements Act § 542. Mandatory Information Penalties PBI Page 60 • Any lifetime gifts of property (after December 31, 2009) a donor will be required to provide to the donee the information regarding the basis and fair market value of the property that was reported on the donor Form 709. • If a donor who fails to provide the required information to a donee, the donor will be subject to a $500 penalty.

27. Conservation Easements Expansion Act § 551 Expansion of the Estate Tax Rule for Conservation Easements PBI Page 62 • Easement allows a partial exclusion from the taxable estate for property devoted to conservation with significant qualifying provisions.

28. Conservation Easements Expansion Act § 551 Expansion of the Estate Tax Rule for Conservation Easements PBI Page 62 • It is no longer a requirement to have property within a certain distance from a metropolitan area, national park, wilderness area or Urban National Forest as a qualifying provision. • Effective after 12/31/00.

29. GST Tax Modifications Act § 561 Deemed Allocation of GST Exemption to Lifetime Transfers PBI Page 63 • Effective for transfers and allocations after 12/31/2000. • The Act expands the allocation of the GST Tax Exemption Amount.

30. GST Tax Modifications Act § 561 Deemed Allocation of GST Exemption to Lifetime Transfers PBI Page 63 • IRC § 2632 Lifetime transfers to certain trusts that are not direct skips are deemed allocated GSTT exemption. Will require filing of Form 709 to elect out of automatic allocation for GST ILITs and other irrevocable trusts. • Allocation can be retroactive.

31. GST Tax Modifications Act § 562 Severing of Trusts PBI Page 65 • IRC § 2642 GSTT trusts with exclusion ratios greater than zero can be severed. • Relief for late GSTT allocations & for allocations intended to result in the lowest possible inclusion ratio.

32. GST Trust Severance Planning Act § 562 Severance Specific Severance A. Separate Application to GST Exempt and Non-Exempt Trusts. If property passes to the Settlor's descendants subject to the terms of the Descendants' Separate Trusts from both the GST Exempt and GST Non-Exempt Trusts of the Lifetime Trust, the terms of the Descendants' Separate Trusts shall be applied separately to the GST Exempt Trust and the GST Non-Exempt Trust.

33. GST Trust Severance Planning Specific Severance B. Allocation Between GST Exempt and GST Non-Exempt Separate Trusts. Property passing from the GST Exempt Trust shall be held in the GST-Exempt Separate Trust for each descendant who would otherwise receive property outright to preserve the zero-inclusion ratio, each such descendant to be the beneficiary of his or her separate trust and property passing from the GST Non-Exempt Trust shall be held in the GST Non-Exempt Separate Trust for each descendant who would otherwise receive property outright, each such descendant also to be the beneficiary of his or her separate trust.

34. GST Trust Severance Planning Standard GST Severance Clause (Wealth Transfer Planning) • The Trustee may divide any trust into two or more separate trusts and administer them as separate trusts, either before or after the trust is funded, to enable GST exemption to be allocated separately to one of the trusts, or to enable the election under Code Sec. 2652(a)(3) to be made separately over one of them, or otherwise to make possible a separate trust with a zero inclusion ratio, or because the trusts have different transferors for GST purposes, or for any other purpose.

35. Installment Payments Act § 571 Increase in Number of Allowable Partners and Shareholders in Closely Held Business. PBI Page 67 • IRC § 6166 modified to increase shareholder/partner limitation rule from15 to 45. • Effective 1/1/2002.

36. Installment Payments Act §§ 572-573 Expansion of Installment Payments PBI Page 67-68 • Adds certain lending and finance businesses to list of “active trades or businesses”. • Stock of certain non-actively traded holding companies will also be eligible. • Effective 1/1/2002.

37. What Do I Do With Existing and Future Clients?

38. Which Clients? Notify based upon age (i.e., who is likely to live until 2010)? Notify based upon previous documents, not previous net worth.

39. Letter updating clients- see exhibit.

40. Asset Protection Help your client understand the complexity. . .

41. Planning in the Interim • Consider “capping” the amount passing to a credit shelter trust once the applicable exemption amount passes a certain figure (i.e., $2 million); many clients may not want more than a certain amount passing into the credit shelter trust, with little or nothing passing to marital trust or outright to the surviving spouse, since access to the principal of the credit shelter trust may be more limited than under the terms of the marital trust.

42. Brenda and John Client Estate Summary 2001 (Total Assets: $3,000,000) Upon John’s death, his estate will be divided into two fractional shares (i) the “Family Trust” (disclaimer above $1,000,000) (ii) the “Balance of Residue” (free of trust). 2 Brenda receives balance of residue outright. Bank is the Trustee and Brenda and children are the beneficiaries (see definition of descendants). 1 Brenda: see disclaimer formula Family Trust INCOME PRINCIPAL for HMSE Brenda’s Death Upon Brenda’s death the assets are left to the children in equal shares subject however to the Descendants’ Separate Trust Child 1 and Child 2

43. Article ___ Formula Estate Tax Gift

45. Brenda and John ClientEstate Summary 2001 In 2011 and thereafter, top rate will be 55%, the surtax is reinstated and the applicable exclusion amount is $1 million.

46. Planning in the Interim • The most important concept for planning under the new tax law is “flexibility,” since it is likely that the law as it presently exists will be modified in the future, and the shape of such modification will be dependent upon the political realities that pertain at that point in time, and hence are basically unknowable now.

47. Planning in the Interim • Use of family partnerships and dynasty trusts may still have viability even if full repeal of estate tax happens, due to asset protection concerns many clients still have relative to direct ownership of assets by children and descendants that expose family assets to claims of divorcing spouses and creditors of the heirs. Dynasty trusts may also be used as a hedge against a future reinstatement of the estate tax, even if permanent repeal occurs.

48. Planning in the Interim • Consider giving an independent trustee (or “protector”) the power to terminate a trust if total repeal of the estate tax occurs and is made permanent.

49. Planning in the Interim • Disclaimer planning will clearly be important under the new law, but will be complex, given the need to avoid having any powers of appointment included in any trust “downstream” of the disclaimant where the disclaimanat will be a beneficiary of such downstream trust. • If considering full disclaimer, check on whether second spouse.

50. Planning in the Interim • Consider having a “split marital trust” whereby a portion may qualify as QTIP in order to permit an allocation of the $3 million step up in basis available to property passing to a surviving spouse and a portion as non-QTIP in order to avoid the restrictions that must be present in order for the other portion of the marital trust to qualify for QTIP treatment (e.g., mandatory income distributions to surviving spouse, rights to force conversion of property to income producing assets, etc.). • Couple the above planning with any retirement assets if necessary to assure maximized distributions for deferral of income taxes (Rev. Rul. 2000-2 and see also PLRS 200126038 and 200126036).