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Estate and Gift Tax Provisions of TRA '97

By Laurence Keiser

Although there was some sentiment for repeal of the estate tax, Congress did not eliminate it in the Taxpayer Relief Act of 1997 (TRA '97). It did, however, make many beneficial changes for all taxpayers with some special favors for owners of close businesses.

Applicable Credit Amount

The primary change was the increase in the unified credit equivalent (now called "applicable credit amount") from its present $600,000 to $1 million. The increase is phased in slowly until the year 2006. The applicable credit amount is also the threshold for the filing of a return.

This change does require a review of present wills. To the extent a formula type language was used (e.g., "the maximum amount that can pass free of Federal estate tax taking into account all credits"), a will need not be changed in this respect. Wills that use "$600,000" or another specific amount, however, will potentially waste part of the new exclusion. Individuals with modest estates may reconsider using the full credit amount if the surviving spouse will need more assets. Married taxpayers should also review how their assets are held to avoid wasting the credit if the first spouse to die does not have ownership of sufficient assets to use up the available exclusion.

There continues to be a five percent surcharge rate to eliminate the benefit of the "run-up-the-brackets" starting at $10 million and ending at the point the average estate tax rate is 55%. At $24.1 million, a decedent's estate is in a flat 55% bracket.

Valuation Items

Congress legislatively overturned the case of Estate of Smith v. Commission 94 T.C. 872 (1990) regarding the valuation of "adjusted taxable gifts" for purposes of computations of the estate tax. The IRS took the position in Smith that even though the three-year statute of limitations had expired for assessment of a gift tax, it could revalue prior gifts for purposes of the estate tax computation. This has the effect of boosting the estate into a higher tax bracket.

Under TRA '97, gifts made after August 5, 1997, cannot be revalued for this purpose if the applicable statute of limitations has expired and the gift is "adequately disclosed" on a gift tax return. The code was also amended so that the gift tax statute of limitations will not run if a gift is not adequately disclosed on a gift tax return.

This requirement will be particularly significant for valuation discounts. Schedule A of Form 709 now requires that a box be checked if the gift value reflects a valuation discount. The instructions require an explanation giving the factual basis for the claimed discounts and the amount of the discounts taken. Presumably, if this information is not provided, the IRS will take the position the gift is not adequately disclosed.

TRA '97 also creates a new valuation audit procedure. The IRS will have to send by certified mail a notice of a valuation determination. The donor will then have 90 days to petition the Tax Court for a declaratory judgment on the value of the gift. This procedure is similar to that presently required for the assessment of a tax in which a statutory notice of deficiency must be sent.


Congress provided for inflationary adjustments to some estate and gift limitations. The most useful will be the increase in the annual exclusion for gifts (presently $10,000). This will increase for inflation in years beginning after 1998. It will increase in multiples of $1,000, and only when it reaches a full thousand will the amount increase. (It is expected that this will take several years.) Other limits subject to an increase for inflation are the $1 million generation skipping transfer tax exclusion and the $750,000 special use valuation amount.

Installment Payment of Estate Taxes

An advantage was extended to small businesses in the form of a reduced interest rate on estate tax deferred under IRC section 6166. In summary, that section provides that if the value of a closed business is more than 35% of the decedent's adjusted gross estate, the estate tax attributable to the value of the interest may be paid in installments. Interest only is payable for the first five years. Thereafter 10% of the tax is payable every year with interest on the unpaid balance.

Prior to the new act, a special four percent interest rate applied to the tentative tax on the first one million dollars of decedent's taxable estate. This amount was $345,800 less the unified credit of $192,800 or $153,000. The interest on the excess ran at the IRC section 6621 (deficiency) rate.

Under the new law, the four percent rate is reduced to two percent on the amount now referred to as the two percent portion. The two percent portion is the lesser of the extended estate tax or the tentative tax on the sum of $1 million plus the applicable exclusion amount of the unified credit less the unified credit. Thus in 1998, the two percent portion is the tax on the difference between $1,625,000 and $625,000.

The $1 million amount will be increased for inflation for decedents dying after 1998.

Interest on the portion of the deferred estate tax that exceeds the two percent portion is imposed at 45% of the IRC section 6601(a) rate. Why 45%? It's a long story.

Interest on unpaid installments of estate tax is generally a deductible administration expense; but under IRS procedural rules, deductions could not be taken in advance. The estate had to file amended estate tax returns every time additional interest
was paid. The taxpayer could (alternatively) forego the estate tax deduction and take an income tax deduction. (Interest on estate tax deferred under IRC section 6166 is excluded from the definition of personal

The 1997 tax act eliminates the deductibility of the interest for both estate and income tax. Because the interest is now nondeductible, the interest rate is reduced to 45% of the otherwise applicable rate.

These rules apply to estates of decedents dying after December 31, 1997. Estates of decedents dying prior to 1998 may elect (prior to January 1, 1999) to use the lower rate and forego the interest deduction.

Charitable Remainder Trusts

Congress has added two significant restrictions on charitable remainder trusts. While these changes were aimed at particular abusive techniques, the restrictions apply to all trusts. The IRS had issued Notice 94-78 to restrict short-term trusts with a very high income interest. Under TRA '97, the annual annuity or unitrust payment amount cannot exceed 50% of the value of the trust. This applies to transfers after July 28, 1997.

Secondly, the charitable remainder, computed actuarially, cannot be less than 10%. This may have an adverse effect on charitable remainder unitrusts formed by relatively young people. At present IRC section 7520 valuation rates, individuals younger than their mid-40s may find themselves limited. Each transfer is treated as the creation of a separate trust. Therefore, while a trust in existence on July 28, 1997, will be grandfathered, later additions will be subject to the rules. Trusts established in wills executed before July 28, 1997, will not be affected if the decedent dies before 1999.

Congress also clarified the effect of the 1996 creation of electing small business trusts ("ESBT") on charitable remainder trusts (CRT). A CRT is not a charity [under IRC section 501(a)] and cannot qualify as an ESBT. Conveying S corporation stock to a CRT will terminate the S election.

Exclusion for Family-Owned

After several "false starts," Congress has finally enacted a limited exclusion from gross estate for the value of a decedent's closely owned business (IRC section 2033A). Because of the many limitations, it remains to be seen whether the legislation will accomplish its stated purpose "to prevent the liquidation of family-owned enterprises in order to pay estate tax." It is, however, a step in the right direction.

Up to now, there have been no exclusions for the value of closely owned businesses. There is, of course, IRC section 2032A, which permits the exclusion of up to $750,000 of value of real property used as a qualifying farm or in a closely held business. That exclusion continues along with the new exclusion. Indeed many of the definitions under the new exclusion draw from IRC section 2032A. Knowledge of IRC section 2032A will be of great help in understanding the new legislation.

Qualified Family-Owned Business Interests. Under new IRC section 2033A, an estate tax exclusion is provided for "qualified family-owned business interests." The exclusion, which is effective for estates of decedents dying after December 31, 1997, applies to an interest as a proprietor or an interest in an entity if--

* 50% of the entity is owned directly or indirectly by the decedent and members of the decedent's family or

* 70% of the entity is owned by members of two families or

* 90% of the entity is owned by members of three families. The test must be met based on voting power and value. Members of an individual's family include--

* the individual's spouse,

* the individual's ancestors,

* lineal descendants of the individual, spouse, or parents and

* the spouses of any lineal descendants of the individual, spouse, or parents. In the case of a trade or business that owns an interest in another trade or business, special look-through rules apply.

Excluded from the Exclusion. The following businesses do not qualify for the exclusion:

* A trade or business, the principal place of business of which is outside the U.S.

* An entity that was readily tradeable on an established securities market or secondary market at any time within three years of decedent's death.

* Any trade or business that has more than 35% of its adjusted ordinary gross income as personal holding company income.

* Any portion of a trade or business attributable to cash and/or marketable securities in excess of reasonable working capital.

* Any portion of a trade or business attributable to any "passive" assets that produce personal holding company income.

Passive assets for this purpose include--

* assets that produce dividends, interest, rents, royalties, and annuities;

* trust, partnership or real estate mortgage investment conduit (REMIC) interests;

* assets that produce income from commodity transactions or foreign currency gain; and

* assets that produce income from notational principal contracts or payments in lieu of dividends.

Many of these items are defined in the subpart F area (IRC section 951 et seq).

For purposes of computing the reasonably expected day-to-day working capital needs of the business, Congress intends the so-called Bardahl formula be used. Bardahl was created by the courts to mathematically compute the working capital needs of an operating cycle for the purpose of a defense against an accumulated earnings tax.

Limitation. The exclusion is limited to the lesser of 1) the adjusted value of the qualified family owned business includible in the estate or 2) the excess of $1.3 million over the applicable exclusion amount of the unified credit. The $1.3 million does not rise as the applicable exclusion amount rises. Consequently, in 1998, the limitation under 2) will be $675,000. In 2007, the limitation under 2) will be only $300,000.

The 50% Test. The sum of the includable qualified family owned business interests plus the includable gifts of family owned business interests must exceed 50% of the adjusted gross estate. The includable qualified family owned business interests must be includable in the gross estate and must pass to a qualified heir. In computing the includable gifts, those taken into account as adjusted taxable gifts are added to the amount of gifts excluded under the gift tax annual exclusion.

In computing the adjusted value of the qualified family owned business interest, the value is reduced by all indebtedness of the estate except for indebtedness on a qualified residence of the decedent determined in accordance with the requirements for deductibility of mortgage interest; indebtedness to pay education or medical expenses of the decedent, the decedent's spouse, and dependents; and other indebtedness of up to $10,000.

The adjusted taxable estate in the denominator is the decedent's gross estate reduced by any indebtedness and increased by certain other transfers: (a) lifetime transfers of qualified business interests made to members of the decedent's family (other than the spouse) plus (b) any other transfers to decedent's spouse within 10 years of date of death plus any other transfers made by the decedent within three years of death.

Example: Married D dies in 1998 owning 60% of an operating business. The 60% interest is worth $1,500,000. D bequeathed his stock to S1 and S2. In 1995, D had given 20% of the stock to S1 and another 20% of the stock to S2. Those gifts were valued at $200,000 each at the time of the transfer. D also owned a $700,000 house with a $50,000 first mortgage and a $150,000 home equity mortgage. D owes a noneducational/ medical personal loan of $50,000. Decedent's gross estate is $3,400,000. The 50% liquidity test is calculated as follows:

(A) The numerator is the 60% interest ($1,500,000) plus the prior gifts ($400,000), reduced by all the indebtedness of the estate ($250,000) except for qualified residence indebtedness ($150,000), and other indebtedness up to $10,000. The numerator is $1,500,000 plus $400,000 minus $90,000 or $1,810,000.

(B) The denominator is the gross estate ($3,400,000), reduced by indebtedness ($250,000), increased by the lifetime transfers ($400,000). The denominator is 3,550,000.

(C) The interest is 51% of the adjusted taxable estate. D's estate qualifies for the exclusion. The exclusion in 1998 is $675,000 [$1,300,000 (the maximum) minus $625,000 (the unified credit for 1998)].

Other Requirements. The decedent must have been a U.S. citizen or resident at the time of death. The interest must pass to qualified heirs, including any individual who has been actively employed by the business for at least 10 years before the decedent's death. The qualified
heir must also be a U.S. citizen or resident, or if not, the interest must be held by a domestic trust.

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 last eight years.

No one factor is determinative of material participation. The uniqueness of the particular industry must be taken into account. Physical work and participation in management decisions are the principal factors to be considered. Material participation is defined with respect to the special use exclusion of IRC section 2032A(e)(6).

The executor must elect to have the exclusion apply, and a written agreement must be signed by each person having an interest in the business consenting to the application of the recapture rule. The agreement must be filed with theSecretary.

Recapture. Once the exclusion is allowed, the interest must stay within the family. An additional estate tax (i.e., recapture) is imposed within 10 years (or the earlier death of the qualifying heir) if,

* the material participation requirements are not met.

* the interest is disposed of (other than in the family or through a qualified conservation contribution)

* the qualified heir loses U.S. citizenship, or

* the principal place of business ceases to be in the U.S.

The recapture is a percentage of the tax saved by virtue of the rule's application. For years one through six, the percentage is 100%. It then reduces 20% per year until the end of 10 years. Interest is payable at the IRC section 6621 underpayment rate from the due date of the original return to the recapture date.

Planning Aspects for
Family Owned Businesses

Gifts. There is no gift tax equivalent to the estate tax exclusion, therefore business-owners will get no exclusion for inter vivos transfers. On the other hand, inter vivos gifts may not cause the estate to fail the liquidity test since lifetime transfers of qualified business interests are included in both the numerator and denominator of the fraction.

Indeed, all prior gifts are taken into account in applying the 50% liquidity test. In essence, adding the gifts to both the numerator and the denominator saves the decedent from failing the test by giving away too much business interest, but prevents the decedent from arranging to qualify by giving away nonbusiness interests. Contrast this with the rules applicable to IRC section 303, which allows redemptions to pay estate taxes and administration expenses. In computing the value of the business interest and the value of the adjusted gross estate for purposes of IRC section 303's 35% test, prior gifts are not taken into account. You can arrange to qualify by giving away other property.

Gifts to other family members may generate multiple uses of the exclusion, but the liquidity test will have to be met by each estate.

Example. A husband owns a qualifying interest in a family owned
business with a substantial value. In
1998, he gives his spouse part of his
interest valued at $675,000 to take advantage of the exclusion. If the recipient spouse has assets in excess of $675,000, the 50% limitation will not be met
for her estate.

Valuation Discounts. Because rules regarding ownership allow the 30-70-90 tests to be applied including numbers of the decedent's family, the decedent can meet the test but also reduce his or her own interest below control.

Example. Decedent owns 51% of the stock of a closely held corporation. Unrelated individuals own the other 49%. Decedent can give away interests to other family members. If he brings himself below 50%, his interest should be subject to discounts for minority interest. At the same time, his estate will qualify for the

Laurence Keiser, LLM, CPA, is a partner in the New York City and White Plains law firm of Stern Keiser Panken & Wohl, LLP, specializing in tax planning and litigation, estate planning, and administration.

In Brief

While Estate and Gift Taxes Weren't Repealed...

The Taxpayer Relief Act of 1997 (TRA '97) made significant changes to the rules for estate and gift taxes. Among them are--

* an increase in the unified credit from $600,000 to $1,000,000 to be phased in until the year 2006.

* changes affecting valuations, including disclosures of valuation discounts.

* inflationary adjustments to some estate and gift tax limitations.

* a reduced interest rate on installment payments of estate taxes.

* the addition of two significant restrictions on charitable remainder trusts.

TRA '97 also allows an exclusion from taxable estates for qualified family owned business interests. The author explains the complicated rules and provides some tax planning for this exclusion.

Some benefits for all, especially small businesses

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