Phase I of the Estate Planning process involves the implementation of Advance Directives (including Durable Powers of Attorney for Financial Matters, Durable Powers of Attorney for Health Care, and Living Wills), Wills, and Revocable Living Trusts to achieve clients’ goals through appropriate and orderly testamentary arrangements that minimize administration costs and Federal Estate and Gift Tax consequences.  Phase I of the estate planning process involves getting “the basics” in place and has two components:   (A) Implementing Advance Directives; and (B) Implementing appropriate legal arrangements to provide for the distribution of assets at death. 


A.        Advance Directives (“Lifetime Documents”)


·       Durable Power of Attorney for Financial Matters

A Durable Power of Attorney for Financial Matters specifically provides that it shall not be affected by the subsequent disability or incompetence of the principal (i.e. the client).  The power of attorney is effective upon execution and normally authorizes the attorney-in-fact to act in all areas of the principal's affairs: personal, business, legal, tax, etc., since the types of estate planning recommendations which will be made may require actions of various kinds involving different categories of the principal's assets.  The power of attorney clearly spells out the types of transactions the agent is authorized to undertake on behalf of the principal. 


·       Durable Power of Attorney for Financial Matters Letter

By this letter, which serves as a precautionary measure, the client instructs the attorney to retain custody of the Durable Power of Attorney for Financial Matters and release it or a copy of it to the attorney-in-fact only (i) upon specific direction from the client, or (ii) upon the condition that the attorney determines that the client has become disabled or incompetent and unable to provide such direction.


·       Durable Power Of Attorney for Health Care

This document enables adults to retain control over their own medical care during periods of incapacity through the prior designation of an individual to make health care decisions on their behalf.  The document only becomes effective when the person lacks capacity to make health care decisions.



·       Living Will (i.e. Terminal Care Declaration)

A person of sound mind who is 18 years of age or older may execute at any time a document commonly known as  living will, directing that no life-sustaining procedures be used to prolong his life when he is in a terminal condition or is permanently unconscious.  The document only becomes effective if the person is permanently incapable of participating in decisions about his or her care.



B.        Legal Arrangements to Provide for the Distribution of Assets at Death


            1.         Last Will and Testament

·       (See Why Should I have a Will? Handout)

·       (See “The Probate Estate Explained?” Handout)

·       Wills can provide for continuing Testamentary Trusts for families with minor children.

·       “Pourover” Wills are often used with Revocable Living Trusts



2.               Basic Revocable Living Trust Planning

            (Combined Gross Estate < $1,500,000)

·       (See “The Gross Estate Explained” Handout)

·       (See “Who Should Have a Revocable Living Trust?” Handout)

·       (See “The Duties and Responsibilities of a Successor Trustee” Handout)

·       Probate Avoidance Objectives

·       Importance of “Funding” Revocable Trusts during life

·       Important related documents: Pourover Will, Deed of Gift to Revocable Trust, Certificates of Trustee, Revocable Trust Funding Recommendations, Revocable Trust Funding Agreement

·       Other Important related documents: Quitclaim Deed(s), Stock Power(s), Assignment(s)


3.               A/B Revocable Living Trust Planning

            (Combined Gross Estate > $1,500,000)

·       Only Available for Married Couples

·       Probate Avoidance Objectives

·       Federal Estate Tax Planning Objectives






            Phase II of the Estate Planning process involves the implementation of various additional techniques and strategies for clients who, due to the size of their Gross Estate, would be subject to the Federal Estate Tax (i.e. >$1,500,000 for individuals, and >$3,000,000 for married couples), or where otherwise appropriate.  Through proper planning, one or more of the following techniques can help to alleviate the problem of “estate shrinkage” caused by Federal Estate Taxes in the absence of such planning.



A.        Lifetime Giving Program

·       (See “Advantages and Disadvantages of a Lifetime Giving Program” Handout)

·       (See “Crummey Trusts For Gifts To Children” Handout)



B.        The Family Limited Partnership (FLP)


The Family Limited Partnership Concept


            The family limited partnership concept is fairly simple.  The client contributes assets to a limited partnership in exchange for both general and limited partnership interests.  The bulk of the initial capital contribution typically would be assigned to the limited partnership interests. For example, the partnership agreement might assign 1% of the initial capital contribution to the general partnership interests and the remaining 99% to the limited partnership interests.  The client then gifts the limited partnership interests to his family members (or to trusts for their benefit) while retaining the general partnership interest.  A Family Limited Liability Company (FLLC) can be used in many of the same ways as an FLP as described in this article.


A Family Limited Partnership Reduces the Value of the Transferred Assets


            A family limited partnership is a very attractive estate planning tool because it permits the donor/parent to significantly discount the value of gifts to the donee/children that might not be discountable if made outright.  Two discounts generally are available: a lack of marketability discount and a minority discount.  A lack of marketability discount reflects the fact that the partnership agreement will restrict the sale or transfer of the partnership interests so that there is no ready market for those interests.  A minority discount reflects the inability of the limited partner to compel partnership distributions or to compel liquidation to obtain his share of the assets which the partnership owns.  It also reflects the inability of the limited partner to control partnership investments.  The combined discounts for lack of marketability and minority can be quite substantial and might range from 30% to 60%, depending upon the facts and circumstances.




A Family Limited Partnership Permits Gifts While Retaining Control

Over the Transferred Assets


            The general partners in a family limited partnership have exclusive control over, and management of, the partnership assets.  The limited partners, on the other hand, are entitled to a proportionate part of the income distributed by the partnership, if any, and to their proportionate share of the partnership assets upon termination of the partnership, but they have no right to control and manage the partnership assets.  Because the general partner has exclusive management and investment control over the partnership assets, a client may reduce his taxable estate by making gifts of the limited partnership interests while maintaining control over the underlying assets by virtue of retaining the general partnership interest.  Such control includes the power to invest and reinvest partnership assets.  More importantly, it includes the power to control the timing and amount of distributions, as a general partner is under no obligation to distribute partnership income.


            Usually, the grantor's retention of the power to control the timing and amount of distributions, even if retained in a fiduciary capacity as trustee, will result in the transferred property being included in the grantor's gross estate under Code Secs. 2036(a)(2) or  2038(a)(1).  However, the retention of this power as a general partner will not cause the transferred limited partnership interests to be included in the donor/general partner's gross estate, unless the partnership is funded with stock in a "controlled corporation."  In that event, special planning measures are necessary.


A Family Limited Partnership Protects Family Assets From Creditors


            Another advantage of the family limited partnership is that it is difficult for creditors of the limited partners to reach the underlying partnership assets.  This is significant for parents who want to transfer assets to their children but are concerned a child might be sued or that a child's former spouse might obtain such assets in the event of a divorce.  In general, a creditor's remedy against the interest of a partner (general or limited) is limited to a "charging order" against the partner's partnership interest and the creditor cannot attach the partnership interest itself.  A charging order allows the judgment creditor to receive the debtor partner's share of distributions made from the partnership, but only if and when such distributions are made.  Because the general partner controls the amount and timing of partnership distributions, the value of the charging order may be minimal.  The judgment creditor, lacking the vote to do so, cannot replace the general partner, force a liquidation of the partnership or compel distributions by the partnership.  Finally, a "poison pill" to applying for a charging order is that the judgment creditor would be treated as the owner of that portion of the partnership interest for income tax purposes and thus would incur a phantom income tax liability.


FLP Income Tax Implications


A limited partnership is a pass-through entity and partnership income and deductions are attributed directly to the partners.  Since a proportional share of the partnership's income will pass through and be taxed at the limited partners' rates, the Family Limited Partnership can shift income from the parents to the lower income tax rates of the children.  This is so even if partnership income is not distributed to the children.  However, if the child is under age 14, the income with respect to the gifted limited partnership interest will be taxed at the parent's income tax rates.  Generally, no gain will be recognized on forming a Family Limited Partnership.  However, if the property contributed to the partnership is mortgaged and the mortgage exceeds the property's basis, gain equal to the difference will be recognized.



C.        The Irrevocable Life Insurance Trust (ILIT)


Life insurance proceeds, while not subject to federal income tax, are considered part of your taxable gross estate and are subject to federal estate tax at a rate of 48%.  A solution to this problem is to create an irrevocable life insurance trust to own the policy and receive the policy proceeds on your death.  A properly drafted life insurance trust keeps the insurance proceeds from being taxed in your estate as well as in the estate of your surviving spouse.  It also protects the trust beneficiaries from their own 'excesses,' against their creditors and in the event of divorce.  Moreover, the trust also provides reliable management for the trust assets.


How the Irrevocable Life Insurance Trust Works


You create an irrevocable life insurance trust to be the original applicant, owner and beneficiary of one or more life insurance policies on your life.  You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies.  The contributions you make to the trust for premium payments generally will qualify for the annual gift tax exclusion.  The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee's discretion, may be paid or applied to or for the benefit of your spouse and descendants.  This allows indirect access to the cash surrender value of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable.  On your death, the trust continues for the benefit of your spouse during his or her lifetime.  Your spouse is given certain beneficial interests in the trust, such as entitlement to income, limited invasion rights, and eligibility to receive principal.  On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.


            Irrevocable Life Insurance Trusts can also be structured to hold Second-to-Die Policies, which insure the joint lives of both spouses and provide death benefits upon the death of the surviving spouse.  This can be quite a useful Estate Tax planning and saving technique.


The Three-Year Rule


            If you are considering setting up a life insurance trust with a policy you own currently or simply assigning away your ownership rights in such a policy, beware.  You must live for at least three years after these steps are taken or the proceeds will be taxed in your estate.  For policies in which you never held incidents of ownership, such as policies originally applied for and owned by an Irrevocable life Insurance Trust, the three-year rule doesn't apply.




D.        The Charitable Remainder Trust (CRT)


The CRT is a powerful estate planning tool that may enable you to reduce your liability for income and estate taxes and diversify your assets in a tax-advantaged manner.


How A CRT Works


A CRT is an irrevocable trust that makes annual or more frequent payment to you, typically until you die.  What remains in the trust then passes to a qualified charity of your choice.  A number of advantages may flow from the CRT.  First, you will obtain a current income tax charitable contribution deduction for the value of the charity's interest in the trust. The deduction is permitted when the trust is created even though the charity has to wait to receive anything.  Second, the CRT is a vehicle that can enhance your investment return. Because the CRT pays no income taxes, the CRT can generally sell an appreciated asset without recognizing any gain.  This enables the trustee to reinvest the full amount of the proceeds and thus generate larger payments to you for your life.


The trust will be eligible for the estate tax charitable deduction if it passes to one or more qualified charities at your death.  If you wish to replace the value of the contributed property for heirs who might otherwise have received it, you could use some of your cash savings from the charitable income tax deduction to purchase a life insurance policy on your life held in an Irrevocable Life Insurance Trust for the benefit of your heirs.  Often, through the leveraging effect of life insurance, it is possible to pass on assets of greater value than those contributed to the trust.  In this way, your heirs are not deprived of property they had expected to inherit.  CRTs are very complex arrangements, but in the right circumstances are an invaluable planning tool.



E.        The Qualified Personal Residence Trust (QPRT)


A special kind of irrevocable trust can be used to transfer your home plus one additional residence to your children at a significantly reduced gift tax cost and with no estate tax, yet allow you to continue to live in the home for as long as you wish.  This special type of trust is known as a Qualified Personal Residence Trust (QPRT).


How A QPRT Works


During your lifetime, you transfer your home to the trustee, who can be yourself.  The trustee must allow you to continue to use the home rent-free for a fixed number of years specified in the trust instrument (the 'fixed' term), which should be a term you are likely to survive.  During the fixed term, you will continue to pay mortgage expenses, real estate taxes, insurance, and expenses for maintenance and repairs, and will continue to deduct mortgage interest and real estate taxes on your individual income tax return.  If the home is sold during the fixed term, the trustee can roll over the proceeds income tax free by purchasing a replacement home within two years for you to use.  When the fixed term ends, the home is distributed to your children, or remains in further trust for them.


Even after the fixed term ends, you can continue to use the home in one of two ways. First, rather than immediately distributing the home to your children, the home can be retained in trust for your spouse's lifetime, thus assuring that the home is available indirectly to you.  Second, you can enter into a lease with your children which will allow you to live in the house for as long as you wish.


Although your transfer of the home to the trust is a taxable gift, you are allowed to subtract from the value of the home the deemed rental value for the term you have retained. Generally, no gift tax will be due as a result of your gift to the trust since the gift (after subtracting the rental value of the home for the term you have retained) would be unlikely to exceed your available $1,000,000 Applicable Exclusion Amount against the Federal Gift and Estate Tax.  If you survive the fixed term of the QPRT, the value of the home will not be included in your estate for Federal Estate Tax purposes.  A QPRT is an extremely effective way to remove a home's value from your estate at a greatly reduced gift tax cost.



F.         Business Planning


Entity Formation

·       Incorporations, Formation of Limited Liability Companies (LLCs), Limited Partnerships, and other Business Entities


Buy-Sell Agreements

Cross-Purchase Agreements   

Stock Redemption Agreements

Split Dollar Agreements


Shareholders Agreements


Business Succession Planning

·       Psychological Factors

·       Planning for Successor Managers of the Business

·       Selling the Business Before Death

·       Descendants as Managers

·       Choice of Fiduciaries

·       Wealth Transfer Tax Reduction

·       Effective use of Exceptions, Exclusions, and Exemptions

·       Deflecting Future Wealth Before it is Earned

·       Liquidity and Other Factors

·       Business Valuation






The Economic Growth and Tax Relief Reconciliation Act of 2001


            On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 providing a projected $1.35 trillion tax cut over 10 years.  Not since 1986 has tax law undergone such profound change.  The centerpiece of the 2001 Tax Act is an across-the-board cut in individual income tax rates.  The Act is a sweeping overhaul of the old federal estate tax law, increases the amount exempt from estate and gift taxes, and ultimately eliminates the estate tax.  But there is a quirk in the law. To comply with budgetary rules, the Act contains a so-called sunset provision under which the pre-2001 Act rules return after 2010, unless Congress provides otherwise at some future time. This means that the estate tax is repealed only for those who die in 2010. The changes are quite complicated and will require most estate plans to be reevaluated.  This Estate Planning Update explains how the 2001 Tax Act's gradual elimination of the estate tax affects estate planning.  A number of provisions of the Act could provide taxpayers with significant savings.




The current estate tax was created in 1916, and the first estate tax dates back to 1797.  See the History of the U.S. Estate Tax summary at the end of this update.  Under pre-2001 Act law, there is no gift or estate tax on the first $675,000 of combined transfers during life or at death for gifts made and individuals dying in 2001. These two taxes are tied together under a unified system having a top rate of 55%.


Estate Tax Exemption Increases and Rate Reductions.


The new law substantially increases the $675,000 exemption after 2001.  Effective January 1, 2002, the amount exempt from estate tax will increase to $1 million for 2002 and 2003, $1.5 million for 2004 and 2005, $2 million for 2006 through 2008, and $3.5 million in 2009.  Effective January 1, 2010, the estate tax is repealed in its entirety.  There is also a change to the unified system. The gift tax exemption amount remains at $1 million for all years after 2001, and the gift tax is not being repealed during 2010 as the estate tax is. Only the estate tax exemption amounts will rise to more than $1 million. Under the sunset provision, the exemption will go down to $1 million for both estate and gift tax purposes in 2011.  The top estate and gift tax rate drops to 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007 through 2009. In 2010, there will be no estate tax and the top gift tax rate will be 35%. The top estate and gift tax rate reverts to 55% in 2011.  The table below summarizes the amount of the estate tax exemption and the top estate tax rates under the new Act:



Estate Tax Exemption and Top Rates


Calendar Year

Amount Exempt from Estate Tax*

Highest Marginal Estate Tax Rate


$1 million



$1 million



$1.5 million



$1.5 million



$2 million



$2 million



$2 million



$3.5 million



N/A (estate tax repealed)

N/A (estate tax repealed)

* Effective January 1, 2004, the exemption for transfers subject to the generation skipping transfer tax is increased to an amount equal to the estate tax exemption.

** Unless reenacted, repeal of the estate tax ceases to apply after 2010, and pre-Act law (including any increases in the amount exempt from estate tax scheduled under pre-Act law) will be reinstated in 2011.


Change To Basis Rules


There are differences in the income tax liability of donees (recipients) of lifetime gifts and heirs of estates. A donee generally gets the donor's income tax basis (usually cost) for a lifetime gifted asset (i.e. transferred basis). As a result, if there is a gift of appreciated stock, for example, the donee will have a taxable gain if he sells at the gift's value. Property acquired from a decedent via inheritance, however, generally gets a step-up in basis equal to its value at his death. This means that, on a later sale by the heir, he won't have to pay income tax on the appreciation in the property that occurred while it was held by the decedent.


When the estate tax is repealed in 2010, the basis rules will be changed to a modified carryover or transferred basis system to be similar to the gift tax rules, but with many opportunities for heirs to get increases in basis. For example, it will be possible to increase or step-up the basis of assets received from an individual dying in 2010 by $1.3 million and by an additional $3 million for assets going to a spouse. Under the sunset provision, the old step-up in basis rules return for 2011.


Record Retention


With the scheduled change to a modified carryover basis system in 2010, it is essential that you retain all records of cost or other basis. For purchased items, this means receipts and statements showing the amount you paid for it. For items inherited before 2010, basis ordinarily is the date of death value of the item. For property acquired by gift, the donee's basis usually is the same as the donor's. For depreciable property, basis is reduced to reflect allowable depreciation. 

Gift Tax Exemption and Rates


            The gift tax has not been repealed.  Effective January 1, 2002, the amount exempt from the gift tax assessed on lifetime gifts will be $1 million.  Effective January 1, 2002, the top gift tax rate will be reduced to 50%.  This rate will gradually be reduced to 45% in 2007.  Beginning in 2010, the top gift tax rate will be equal to the top individual income tax rate.  The table below summarizes the amount of the gift tax exemption and the top gift tax rate under the Act:


Gift Tax Exemption /Top Rates


Calendar Year

Amount Exempt from Gift Tax

Highest Marginal Gift Tax Rate


$1 million



$1 million



$1 million



$1 million



$1 million



$1 million



$1 million



$1 million



$1 million



Generation Skipping Transfer (GST) Tax Changes


The new Act simplifies and reduces the GST tax, which is a special tax that is designed to prevent individuals from avoiding the estate tax by transferring assets to a generation below the next one (e.g., grandparent transferring to grandchild rather than to child).  Effective January 1, 2004, the exemption from the GST tax is increased to $1.5 million and will gradually increase to $3.5 million by 2009.  Effective January 1, 2010, the GST tax is repealed.  Unless reenacted, repeal of the GST tax ceases to apply after 2010 and pre-Act law (including any increases in the GST tax exemption scheduled under pre-Act law) will be reinstated per the sunset provision.


Other Changes


The 2001 Act contains a number of other changes, some of which are retroactive.


·       Conservation Easements.  The Act expands the availability of the exemption for conservation easements.

·       Installment Payment Relief.  The Act improves the provision that allows deferral of estate tax on a closely held business.  It even creates a retroactive refund opportunity for some estates that had farms that were valued based on actual use rather than highest and best use.

·       Family Owned Business Deduction.  Effective January 1, 2004, the estate tax deduction permitted for qualified family owner businesses (i.e., $675,000) is repealed.

·       State Death Tax Credit.  Under the Act, the federal estate tax credit for state death taxes is phased out and is eventually replaced with a deduction for decedents dying after December 31, 2004.  When full repeal of the credit occurs, it is anticipated that some states may move to implement a state inheritance tax.  This would increase a decedent’s overall tax burden.  This could lead taxpayers to consider changing domiciles to a state that does not implement a state inheritance tax.

·       Marriage Penalty Relief.  The Act phases in limited relief from the marriage penalty.

·       Education Incentives.  The Act makes qualifying distributions from Section 529 education savings plans tax exempt.

·       Pension and Retirement Provisions.  The Act increases the amount that may be contributed to IRAs and other retirement plans.

·       Individual Income Tax Provisions (Effective Rate Reductions)

·       Tax Benefits Relating to Children and Dependents.

·       Alternative Minimum Tax Relief.


Uncertain Impact On Planning


The uncertainty of whether the sunset provision will ever come into play and whether an individual will die during a period of increasing exemption amounts makes planning difficult. Also, the way the law works, when income tax costs related to the change to basis rules are factored in, some heirs will face higher total tax costs if their benefactor dies in 2010 when the estate tax is repealed than they would if he died before 2010.  One newspaper columnist wrote in response to the recent estate tax changes “Laughter is the only rational response.” (Washington Post, June 24, 2001).


What To Do Now


The Act includes provisions that will significantly affect estate planning and estate administration.  These changes provide you with an opportunity to achieve

significant tax savings for your family.  You should consider the following options in light of the new tax Act:


·       Gifting Programs.        Because total repeal of the estate tax will not occur until 2010, and may not occur at all, we recommend that you continue making your annual gifts or consider initiating an annual gifting program if feasible.

·       The Act’s Impact on Current Estate Plans.      You may need to amend your estate plan to avoid unwanted consequences resulting from the increase in the estate tax exemption amount under the Act.  In some cases, will and trust language should be altered.  In other cases, such language can be simplified.  Credit Shelter Trusts (a/k/a Family Trusts) are being rewritten with care not to unintentionally impoverish one’s spouse.  Disclaimer and other strategies can also be used.

·       Retaining Flexibility in Your Estate Plan.       Given that multiple Congressional elections and two Presidential elections will occur between now and 2010, many commentators believe that it is unlikely that complete repeal of the estate tax will in fact occur in 2010.  Even if repeal does occur, history suggests that repeal would be temporary.  Furthermore, the Act’s sunset provision all but guarantees continuing changes to the tax law.  As a result of the uncertainty in the estate tax area created by the Act, your estate plan should be designed to provide as much flexibility as possible.

·       Multigenerational Trusts.        As a result of the scheduled increases in the estate, gift, and GST tax exemptions, greater amounts may be transferred into multigenerational trusts.  If you are interested in establishing a trust to benefit your descendants, the changes made by the Act provide you with an additional incentive to do so.

·       General Recommendations.     Individuals should continue to write wills and revocable trusts and develop estate plans to ensure that their assets will pass as they desire and that special needs of particular heirs will be properly addressed. This is so even if there is a good chance of survival until a year when estate tax won't be owed because of the increasing exemption or repeal under the Act.  Even if you feel these new laws do not affect you, it may have been a while since you reviewed your overall estate plan.  It is a good idea to review your situation every year.




The inclusion of the sunset provision in the Act all but guarantees that Congress will revisit the changes made by the Act.  While many provisions of the 2001 tax Act will probably be extended through 2010, the future of some of the provisions, such as full repeal of the estate tax, is much less certain.  While the 2001 Act may well save estate tax to the benefit of your heirs, it has added many new planning complications. I invite you to contact our office with any questions or to set up an appointment so that we can properly reexamine your estate plan to help to keep your estate tax, and income tax for your heirs, to a minimum. 

History of the U.S. Estate Tax


            The estate tax repeal scheduled for 2010, if actually implemented, will be the fourth such repeal in United States history.  Following are some of the highlights in the checkered history of the estate tax.


1797    First federal estate tax imposed.  Funds were needed to bolster naval forces due to strained relations with France.


1802       Estate tax repealed.


1862       Estate tax imposed to help finance the Civil War.


1870       Estate tax repealed.


1898       Estate tax imposed to help finance the Spanish-American War.


1902       Estate tax repealed.


1916       Estate tax imposed to replace tariff revenue lost as a result of World War I.  An exemption of $50,000 was provided.


1926       Exemption increased to $100,000.


1932       With the advent of the Depression, the exemption was reduced to $50,000 and estate tax rates were increased with a top rate of 45% on transfers in excess of $10 million.


1935    Exemption reduced to $40,000.


1940       In order to help fund World War II, estate tax rates were increased with a top rate of 77% on transfers in excess of $50 million.


1976       Congress overhauls the estate and gift tax, and provides an exemption of $175,625 when fully phased in.


1987       Amount exempt from estate and gift tax increased to $600,000.


1998       Amount exempt from estate and gift tax increased to $625,000, with this amount scheduled to increase gradually to $1 million by 2006.


2001       Effective January 1, 2002, the amount exempt from estate and gift tax is increased to $1 million.  Estate tax to be repealed in full in 2010.


The Taxpayer Relief Act of 1997


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.


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


·       New Roth IRAs

·       IRA payouts for first-time homebuyers’ expenses

·       Two new education tax credits (HOPE scholarship credit, Lifetime learning


·       IRA withdrawals for education

·       Deduction for student loan interest

·       Education IRAs

·       New Child Tax Credit

·       Home Office Deduction

·       Self-employed health deduction