The Taxpayer Relief Act of 1997
The ramifications of the Taxpayer Relief Act of 1997 (TRA 97), signed into law by the President on August 5, 1997, are extremely broad and complex. While it does provide many new planning opportunities, TRA 97 does not fundamentally change the estate planning process. Proper estate planning and business planning remain as important as ever for clients. Several of the major estate and gift tax law changes contained in TRA 97 are set forth below.
Increase in Federal Gift and Estate Tax "Applicable Exclusion Amount"
The unified credit for both estate and gift tax purposes is increased beginning next year and thereafter through the year 2006. The maximum amount which now may be protected from tax by reason of the unified credit, previously referred to as the exemption equivalent but now called the "applicable exclusion amount", increases from $675,000 this year and next year to $700,000 in 2002, and reaches $1 million in 2006. This provides an opportunity for property owners to make additional tax-free gifts beginning next year.
The applicable exclusion amount which reaches $1 million in the year 2006 is not scheduled to be increased for inflation thereafter, as set forth in the following schedule:
Practice Points: While this change will increase the amount which can be passed tax free, many are under the false impression that the unified credit increase to $1 million occurs faster than what the Act provides. While Congress did increase the unified credit, the increases take effect so slowly that assets could appreciate in value faster than the credit goes up. In other words, growth and inflation may cause clients’ estates to grow faster than the rate of unified credit increase. Thus, the net tax effect may be insignificant.
Most estate planning documents will automatically take advantage of this increase, but, unless changes are made, the effect in some cases may be to reduce the amount passing to a surviving spouse.
In addition, it will now be easier to coordinate the use of the GST tax exemption with the unified credit exemption.
Estate Tax Deduction For Qualified Family-Owned Business Interests.
Estates To Which The Family-Owned Business Deduction Applies.
An estate qualifies for the family-owned business deduction only if the decedent was a U.S. citizen or resident at the date of his death. The executor must elect to have the deduction apply, and must file an agreement signed by each person in being who has an interest (whether or not in possession) in any property designated in the agreement, consenting to the application of the recapture rules to the property. To qualify for the deduction, an estate must also meet two additional requirements: a requirement that the aggregate value of the decedent's qualified family-owned business interests that are passed to qualified heirs exceeds 50% of the decedent's adjusted gross estate, and a requirement that the decedent or a member of the decedent's family must have owned and materially participated in the trade or business for at least five of the eight years preceding the date of the decedent's death.
If an estate qualifies for the family-owned
business deduction, then, for estate tax
purposes, the value of the taxable estate
is determined by deducting from the value
of the gross estate the adjusted value of
the qualified family-owned business interests
of the decedent. The amount of the deduction
may not exceed $675,000.
Recapture Of Estate Tax Benefit Of Family-Owned Business Deduction.
The estate tax savings attributable to the family-owned business deduction may be recaptured if certain events occur within ten years after the decedent's death and before the death of the qualified heir. Recapture will be triggered if: the qualified heir ceases to meet the material participation requirements, the qualified heir disposes of any portion of his interest (other than by certain dispositions), the qualified heir loses U.S. citizenship, or the principal place of business of the trade or business ceases to be located in the U.S.
Repeal of 15% Excise/Estate Tax
The Act repeals the 15% excise tax on excess accumulation distributions and the additional estate tax on excess accumulations in qualified plans and individual retirement plans imposed by Code Sec. 4980A. This change applies to distributions received and to decedents dying after December 31, 1996.
Changes in Special Use Valuation for Real Estate
Under Code Sec. 2032A, up to $750,000 may be excluded from a decedent's gross estate by specially valuing real estate used in a farm or other closely-held businesses, in certain cases. The $750,000 amount is increased for inflation for individuals dying after 1998. In addition, the rules allowing certain cash rentals, the granting of a qualified conservation easement and the opportunity to correct failures to comply with the section are expanded.
Changes in Section 6166 Estate Tax Deferral
A decedent's estate can elect to defer the payment of estate tax attributable to certain closely-held business interests for a term of up to 14 years following the normal time that the estate tax is payable (i.e. nine months after death). Until the enactment of TRA 97, the interest charged on the first $1 million of value (including the applicable exclusion amount) was only 4% a year with interest on any additional amount due at the standard underpayment of tax rate. The interest was deductible for estate tax purposes under Code Sec. 2053(a) or income tax purposes under Code Sec. 163(h). Under the new Act, the 4% rate is reduced to 2%. In addition, the value upon which the 2% annual interest is due is increased to the tax due on the first $1 million of value above the applicable exclusion amount. The $1 million amount against which the 2% interest rate will be applied will be adjusted for inflation. The interest rate due on estate tax deferred on amounts of the estate above $1 million in value is set at 45% of the underpayment of tax rate. However, the Act denies both an estate tax deduction and income tax deduction for the interest paid.
The change to the interest payment provisions of the estate tax deferred pursuant to Code Sec. 6166 applies to decedents dying after 1997. In addition, for decedents who have died prior to that time, the executor may elect to have certain of the amendments of the section applied to payments due after the effective date of the election.
For technical reasons, taxpayers have not been able to obtain a court order establishing an estate's right to defer payment of estate tax under Code Sec. 6166 if the Internal Revenue Service denies the election or maintains that it is lost. The Act adds new Code Sec. 7479 which permits a suit in the United States Tax Court for a declaratory judgment that the election under Code Sec. 6166 should be allowed or should not be terminated.
Practice Points: It is easier to qualify for the lower interest cost on installment payments than it is to qualify for the increased exemption of $1,350,000.
By denying the interest deduction, the effect of the Act is in general to increase the ultimate (net) cost of interest on the amount of tax deferred on Code Sec. 6166.
Annual Gift Tax Exclusion to Be Indexed for Inflation
Effective for years after 1998, the $10,000 annual exclusion is increased by inflation rounded to the next lowest multiple of $1,000 (if the inflation adjusted amount is not a multiple of $1,000).
Generation-Skipping Transfer Tax Changes
The $1 million dollar GST exemption amount under Code Sec. 2631(a) is indexed by inflation for individuals who die after 1998. Although the Act does not appear to increase the GST exemption for lifetime transfers, it probably was intended to cover them as well as transfers upon death.
The generation-skipping transfer tax does not apply to transfers to children. A grandchild of a transferor can be treated as a child for certain generation-skipping transfer tax purposes if the grandchild's parent has died. Prior to the Act, this "predeceased ancestor exception" was limited to generation-skipping transfers constituting "direct skips" and applied only to descendants of the transferor or descendants of the spouse (or former spouse) of the transferor. The Act changes the rules in two ways. First, it is expanded to cover descendants of a parent of the transferor (or the transferors' spouse or former spouse). Second, the " predeceased ancestor exception" is expanded to apply to taxable terminations and taxable distributions as well as direct skips. However, the rule apparently applies only to such lineal descendant if the parent has died before the transfer is subjected to estate or gift tax (rather than generation-skipping transfer tax).
Reported Gifts May Not Be Revalued for Estate Tax Purposes But Unreported Gifts Remain Open Forever
The Act provides that gifts made after the date of enactment of the Act cannot be revalued to determine the amount of adjusted taxable gifts for estate tax purposes if the statute of limitations to assess additional gift tax with respect to the transfer (generally three years) has expired and if the value of the gift is disclosed in a manner adequate to apprise the Internal Revenue Service of the nature of the gift. However, gift tax may be assessed at any time on any gift that is not shown on a gift tax return, even if the failure to disclose the transfer is based on a good faith belief that it was not a gift.
Practice Point: This change brings certainty to lifetime gifting programs that previously could become imperiled by unexpected IRS challenges.
Exclusion of Value of Certain Conservation Easement Property
An estate may exclude up to 40% of the value of a qualifying conservation easement. Qualifying land must be within 25 miles of a metropolitan area or national park or wilderness area. The maximum available exclusion will increase from $100,000 in 1998 to $500,000 in 2002. Several other requirements must be met for the exclusion to apply. This exclusion is in addition to the other available exclusions.
Practice Point: This change may provide special planning opportunities for landowners who do not wish to develop their land.
Charitable Remainder Trusts Changes
The Act makes two important changes with respect to charitable remainder trusts. Although Code Sec. 664 provides a 5% floor for the yearly annuity and unitrust payments from such a trust, it has never before contained a ceiling. The Act now provides that the annual payments cannot be more than 50%. This change is effective for transfers in trust after June 18, 1997. In addition, the present value of the remainder interest for charity in the charitable remainder trust must be at least 10% of the net fair market value of the property as of the date the property is contributed to the trust. This change is generally effective for transfers in trust after July 28, 1997. However, the 10% minimum charitable value requirement does not apply to transfers in trust under a Will (or other testamentary instrument, such as a revocable trust) executed on or before that date if the decedent dies before 1999 without having republished the Will (or amended the other testamentary instrument) or was on July 28, 1997 under a mental disability to change the disposition of his or her property and does not regain competency before death. Code Sec. 2055(e)(3) has been liberalized to permit a charitable remainder trust to be reformed to meet the 10% minimum value rule. In addition, the section allows the trust to be declared void.
The importance of the 10% minimum value rule cannot be overstated. It means that many "standard" charitable remainder trusts cannot be created for the life of an individual who is relatively young. Where there is more than one beneficiary, it will be even more difficult to create a charitable remainder trust for their lives. For example, on August 1, 1997, a charitable remainder unitrust for the lives of a husband and wife each of whom is 50 years of age, would be disqualified if the unitrust amount (paid annually) were over 7.06% percent.
In addition to providing a special transitional rule for any trust created under an instrument executed before the date of the Revenue Reconciliation Act of 1990 where the trust requires that all the trustees be individual citizens of the United States or domestic corporations, the Act permits the Treasury Department to provide in regulations that certain arrangements having substantially the same effect as a trust can constitute qualified domestic trusts.
Transfer Within Three Years of Death Rule Changed
Courts have held that a gift from certain revocable trusts is includible in the decedent's gross estate under Code Sec. 2035 and 2038 if made within three years of the decedent's death, even though direct gifts by the grantor would not have been so includible. The Act modifies Code Sec. 2035 and Code Sec. 2038 to provide that any transfer of any portion of a trust is treated as a transfer made directly by the decedent. This should mean that a transfer from a revocable trust within three years of the grantor's death should not be included in the grantor's estate unless it is, for example, a gift of a policy of insurance which, if not transferred, would be includible under Code Sec. 2042.
Capital Gains Reduction
Under prior law, an individual’s net capital gains for assets held for more than one year were taxed at a maximum rate of 28%. The new law, effective July 28, 1997, has reduced the maximum long-term capital gains rate to 20%, but the holding period required to obtain that rate is 18 months. Property held more than 12 months but not more than 18 months, is taxed at the old capital gains rate of 28%. The 20% capital gains rate applies for most property (including stock) but a less favorable rate applies to collectibles (28% maximum rate for art, coins, etc.) For taxpayers in the 15% bracket, the capital gains rate is reduced to 10% for sales of assets held 18 months or longer. Capital gain property held after December 31, 2000 for five years will be subject to an even lower tax rate, 18%, (instead of 20%) and 8% (instead of 10%).
Practice Point: With the reduction in capital gains tax rates, taxpayers have more incentive to make gifts to remove assets from taxable estates. Removing gifted property from the taxable estate will be more attractive, in many cases, than retaining the property in the taxable estate and obtaining the step-up in income tax basis of property on death.
Universal Exclusion for Gain on Sale of Principal Residence
Effective for post May 6, 1997 sales, TRA 97 permits an individual to exclude $250,000 ($500,000 if married, filing jointly) of gain on the sale of a principal residence. The exclusion is no longer a one-time exclusion but instead is allowed for each sale of a principal residence (regardless of age of the taxpayer) provided it has been held as a principal residence for at least two of the preceding five years. This tax benefit replaces the former one-time exemption of $125,000 of gain on the sale of a principal residence by taxpayers age 55 or older and eliminates the tax-free rollover on sale of a principal residence that was available under prior law.
Practice Point: For most taxpayers the previous tax disadvantage to "buying down" is eliminated on the sale of a principal residence. The higher limit eliminates the need to reconstruct records of capital improvements when the home sales price is no more than $500,000 plus the original cost of the home.
Other Highlights of TRA 97