The Law & You: Untangling the Tax Laws

Recent changes add new knots to the U.S. tax code.

November 1, 2001

Remember when your parents gave you your allowance and said not to spend it all in one place? Well, even if you wanted to spend all the recently enacted tax cuts in one place, you’d have a hard time figuring out how. The tax rate cuts and estate tax repeal President Bush signed in June are a complex puzzle; they become effective in different years, have various phase-in and phase-out rules, and, most surprisingly, are all repealed after 2010.

Here’s a primer to help you make sense of the new tax law.

Tax rate cuts

Under the new plan, all income tax rates are reduced in 2001, 2004, and 2006. Under the old plan, the tax rates ranged from 15 percent to 39.6 percent. But by 2006, they’ll range from 10 percent to 35 percent. How will you feel the cut? If you’re an independent contractor, your estimated quarterly tax payments might decrease, and if you’re an employee, your withholding should already have been reduced. So if your income in 2001 is about the same as it was in 2000, you’ll pay a little less income tax. As years go by, the impact of the tax cut will be greater. FICA taxes are not affected.

After calculating taxable income, most taxpayers simply go to the IRS tax tables to find their tax liability. As tax rates change, the IRS will still keep track of what rates apply in what years, so taxpayers will face no new complexity.

Estate tax repeal

A desire to “kill the death tax” generated significant political momentum for the Bush tax plan. Indeed, the estate tax is repealed, but not until 2010. Until then, the estate tax retains all the rules and regulations that were in force before Bush signed his bill.

When Bush was inaugurated, estate taxes applied to estates worth more than $675,000. The rates were very high, hitting estates of more than $3 million at 55 percent. Between now and 2009, that 55 percent rate will gradually fall to 45 percent, and the portion of an estate exempt from tax will increase to $3.5 million. In 2010, when the entire estate tax is repealed, there will be no inheritance tax; however, in 2011 we go back to taxing estates worth more than $675,000.

How should you plan your affairs between now and 2010? The most important thing is to collect records showing what you paid for the assets likely to be in your estate. Why? Because even though the estate tax is repealed in 2010, the repeal leaves behind a residue that’s arguably more challenging than current law. It’s called “carryover basis.”

A primary tax issue for anyone inheriting an asset both now and when current law is repealed in 2010 is establishing the asset’s value in the hands of the heirs. Until 2010, an asset’s value to the heirs is its fair market value at the time its owner dies. Thus, if Aunt Tillie bought land years ago for $100,000 and the land is worth $1 million when she dies, its value to the heirs under current law is $1 million, and the estate tax will be assessed based on that amount. If the heirs later sell the property for $1.2 million, they’ll also pay capital gains taxes on the $200,000 gain.

The land’s cost to Aunt Tillie and its value to the heirs are called the basis. Today, under the estate tax, Aunt Tillie’s basis is stepped up to its fair market value. In 2010 when the estate tax is repealed, her basis is carried over to the heirs. Thus, in the example above, in 2010 the land’s basis to the heirs is $100,000. They’ll pay no estate tax when they inherit the land, but if they later sell it for $1.2 million, they’ll pay capital gains taxes on $1.1 million.

Notably, new complex rules relieve families with smaller estates from the requirement of complying with these carryover basis rules.

The estate tax is repealed, but its melody lingers on for many families.

Repealing the tax bill in 2011

Strange as it may seem, the entire tax bill is repealed after Dec. 31, 2010. On Jan. 1, 2011, all tax laws revert to what they were the day before Bush signed his bill last June. The top income tax rate goes back to 39.6 percent, and the estate tax comes back to life with an exclusion of $675,000 and top rates of 55 percent; theoretically at least, it will be as if the Bush plan had never existed.

Odd as it is, the repeal enables Congress to comply with the tangled and obscure rules the Senate uses for preparing its budget. Failure to comply with those rules could have sunk the whole tax cut on a procedural vote, so tax writers had little alternative except to include repeal.

It’s expected that huge amounts of political capital will be expended on tax policy between now and 2011. World events may dictate whole new directions in government spending and could very likely generate a whole new debate about taxation. Buckle up; it will be quite a ride.

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