he Taxpayer Relief Act of 1997 (TRA '97) included the most dramatic changes to the transfer tax system since the Economic Recovery Tax Act of 1981, when the unified credit was last increased. Though marginal estate tax rates are not reduced, the landscape is significantly altered through the introduction of several specially targeted relief provisions, including those meant to assist owners of family businesses and farms. Most high-net-worth individuals will benefit from a close review of the changes and a discussion with their estate planning advisers.

Increase in Unified Credit

The provision in TRA '97 that should have the most impact upon estate planning is the phased-in increase in the amount effectively exempted from transfer tax. Under current law, a unified credit of $202,050 against the estate and gift tax now effectively exempts the first $625,000 of property transfers during lifetime or at death. This exemption is available to U.S. citizens and residents.

By the year 2006, transfers by U.S. citizens and residents up to $1 million will be free from estate and gift taxes. In other words, the unified credit will be increased to $345,800, resulting in an additional $153,000 of tax savings for an estate worth more than $1 million. The $1 million applicable exclusion is not adjusted for inflation after 2006. Unified credit exemption equivalents could be lower for taxpayers who made gifts prior to December 31, 1976.

Nonresidents and noncitizens subject to U.S. estate tax have no relief under TRA '97, as the unified credit for estate tax purposes remains unchanged at $13,000 (sufficient to exempt $60,000 of assets from estate tax).

The requirement that an estate tax return be filed was also changed to correspond with the increased applicable exclusion amount for decedents after 1997. Consequently, beginning in 2006, taxable estates valued at less than $1 million will not need to file an estate tax return. Table 1 reflects the increase in the applicable exclusion amount. Note that only 25% of the unified credit's increase occurs during the first six years.

The increase in the effective exemption allows taxpayers to shift even more wealth during lifetime without incurring the gift tax. For example, individuals who have not fully utilized the $625,000 exemption equivalent will be able to transfer a larger amount tax-free. Also, those individuals who have previously made $600,000 of gifts will be able to make an additional $25,000 of gifts in 1998, an additional $25,000 in 1999, etc. (The additional gifts exempt from tax could be somewhat reduced for taxpayers who made substantial gifts prior to December 31, 1976.) Lifetime transfers of appreciating assets provide an effective opportunity to fully leverage the unified credit.

Example: A husband and wife each made previous gifts, after December 31, 1976, totaling $600,000 ($1,200,000 aggregate gifts). In 1998, to take advantage of the additional gifting opportunity, they transfer marketable securities valued at $35,000 to each of their two children (utilizing their $10,000 annual exclusion and the additional $25,000 lifetime exemption equivalent). Assume each $35,000 block of stock appreciates in value to $127,487 (combined appreciation of $254,974) by the year 2013 (average rate of return of nine percent over 15 years). By making the gift in 1998, with no transfer tax cost, $254,974 will have been removed from their taxable estates.

To summarize, the increase in the credit amount will permit a married couple to pass up to $2 million to their children, free of Federal estate and gift taxes, by the year 2006. The maximum tax-exempt transfer is slightly reduced for those taxpayers with substantial pre-1977 gifts. However, maximization of the use of the credits requires that estate planning documents be properly structured to ensure the exemption is fully used at the first spouse's death. Estate planning practitioners should by now have communicated these changes and arranged for face-to-face meetings with their high-net-worth clients to advise them how to take full advantage of these changes.

Modifications to New York State Estate and Gift Taxes

Under legislation enacted in 1997, the New York unified credit asset equivalent for estate tax purposes will increase, along with the threshold for filing a New York estate tax return, to $300,000 in the case of decedents dying on or after October 1, 1998.

The New York filing threshold will further increase to the level of the Federal unified credit (which is pegged at $675,000 in 2000, with scheduled increases up to the $1 million level by 2006). This increase in the New York filing threshold is applicable to decedents dying on or after February 1, 2000.

The current New York estate tax will be repealed in the case of decedents dying after February 1, 2000, and replaced with a "sop tax." A sop tax simply redirects a portion of the decedent's overall estate tax liability from the Federal to the state treasury without increasing the estate's overall transfer tax liability. This will have the effect of placing New York decedents on an equal footing with decedents of most other states.

Finally, the New York gift tax will be repealed without replacement in the case of gifts made on or after January 1, 2000.

Indexing for Inflation

Other Federal gift and estate tax provisions will be indexed for inflation starting in 1999, using 1997 as the base year for the cost-of-living adjustments. These include the following:

* The $1 million exemption allowed for transfers subject to generation-skipping transfer tax (GSTT)

* The $1 million ceiling on the value of a closely held business eligible for the special two percent interest rate on deferred estate tax attributable to the closely held business

* The exclusion of up to $750,000 as a special use valuation for qualified real property used in farming activities or other trades or businesses

* The $10,000 annual gift tax exclusion ($20,000 if gift splitting elected)

Benefits of the inflation adjustments may be slow in kicking in because of the rounding effect provided under the statute. The indexing of the annual exclusion is rounded to the next lowest multiple of $1,000, and indexing of other amounts to the next lowest multiple of $10,000. For example, the annual exclusion will not be adjusted until cumulative inflation reaches 10%. If inflation remains at two or three percent, the $10,000 annual exclusion will not likely be increased until the year 2003.

Closely Held Businesses and Family Farms

New IRC section 2033A Exclusion from Gross Estate. After years of debate, TRA '97 provides some estate tax relief for owners of closely held family businesses or farms. Such assets may be the principal source of wealth for the high-net-worth individual.

An executor may elect to exclude from the gross estate of a U.S. citizen or resident dying after 1997 certain "qualified family-owned business interests" (QFOBI). However, the family owned business exclusion plus the applicable exclusion (i.e., the amount sheltered from estate tax by the unified credit) may not exceed $1.3 million. Since the $1.3 million exclusion does not increase as the applicable exclusion increases, the amount of this QFOBI exclusion will decrease over time. For instance, $675,000 in family-owned business interests may be excluded in 1998, but in 2006, when the unified credit effectively exempts $1 million, the family-owned business exclusion provides only $300,000 of additional relief. The effect of the reduction is illustrated in Table 2.

A Technical Corrections Bill, which is designed to avoid shrinkage of the overall benefit as described above, is pending before the combined House-Senate conference committee considering the IRS reform legislation package.

For an estate to take advantage of this relief provision, certain conditions must be satisfied. The decedent must have been a U.S. citizen or resident at death. The business must also be an active trade or business having its principal place of business in the U.S. with not more than 35% of the adjusted ordinary gross income of the trade or business in personal holding company income. Corporate stock or debt should not have been publicly traded within three years prior to the decedent's death.

The interests of the decedent family must be significant from an estate perspective. This is met if the qualified business interest exceeds 50% of the decedent's adjusted gross estate. The determination is made after certain adjustments to prevent manipulation of the estate composition to meet the 50% requirement.

The 50% test generally is applied by including in the numerator and denominator significant gifts to the decedent's spouse made within 10 years prior to death and other gifts made by the decedent within three years prior to death. Annual exclusion gifts made to members of the decedent's family are not included. Gifts of QFOBI made to members of the decedent's family since 1977 are included in the computation at their original "date-of-gift values," provided those interests have continuously been held by family members since the original gift. Qualified family-owned business interests that have been the subject of intra-family sales will not be brought back unless there was a gift element. This adjustment is only for purposes of testing qualification under IRC section 2033A and in no way affects valuation.

A qualified business interest may include a sole proprietorship as well as an interest in an entity carrying on a trade or business. If the family business is an entity, the decedent and his or her family members must own at least--

* 50% percent of an entity,

* 30% of an entity in which members of two families own 70%, or

* 30% percent of an entity in which members of three families own 90%.

Besides imposing a pre-death material participation in the business requirement by the decedent or members of the decedent's family, a qualified heir must actively participate in the business. By definition, a qualified heir is a member of the decedent's family or an active employee of the business for at least 10 years before the decedent's death. If a qualified heir fails to materially participate in the business, or the qualified family-owned business interest is disposed of during a 10-year period following decedent's death, a recapture tax is imposed.

If the recapture tax applies within the first six years after a decedent's death, 100% of the value excluded from the estate is subject to tax. If the recapture tax applies more than six years after date of death, the recapture tax is reduced 20% for each year thereafter.

Example: An estate (in the 55% marginal estate tax bracket) excluded $300,000 of value as a result of the family-owned business exclusion. The decedent's daughter inherited 100% of the business. Eight years after the decedent's date of death, the daughter sold the business. A recapture tax of $99,000 is imposed at the time of sale.

Interest is also imposed on any recapture tax amount, computed from the date when the return was required to be filed and ending on the date of payment of the recapture tax.

Interest Rates on Installments. Owners of closely held businesses may qualify to pay the estate tax attributable to the value of closely held businesses included in a taxable estate over a period of up to 14 years. Under prior law, a four percent interest rate was imposed on the amount of deferred estate tax attributable to the first $1 million in taxable value of a closely held business (i.e., the first $1 million in excess of the effective exemption provided by the unified credit and any other exclusions).

TRA '97 reduces the four percent interest rate portion to two percent. To compute the two percent portion, the act provides that the $1 million amount will be added to the applicable exclusion amount, so that the amount that qualifies for the interest rate reduction will not decline as a result of the applicable exclusion increasing through 2006.

TRA '97 also reduces the rate of interest on the rest of the estate tax deferred under IRC section 6166 to 45% of the underpayment rate prescribed by the government each quarter. The underpayment interest rate (as of this writing) is eight percent. At this rate, the interest payable on the tax deferred would be computed at 3.6%.

The reduced rate did not come without a cost. The cost is that interest is no longer deductible for estate or income tax purposes. While this will relieve the compliance burden associated with recalculating interest every year and filing supplemental estate tax returns by doing complex interrelated calculations, the loss of the deductions for the interest payments is a big price to pay.

The changes made to IRC section 6166 apply to estates of decedents dying after December 31, 1997. However, an estate with an ongoing IRC section 6166 election may elect the new, lower (non-deductible) interest rates. However, the new two percent rate will apply only to the four percent portion determined under old law.

Generation-Skipping Transfer Tax Relief

Before TRA '97, if an individual transferred an interest in property to a grandchild, and, at the time of the transfer, the grandchild's parent was not alive, the transfer was not subject to the generation skipping transfer tax (GSTT). TRA '97 expands the predeceased parent exception to transfers to collateral heirs (e.g., grandnephews or grandnieces) if the transferor has no living lineal descendants at the time of transfer. TRA '97 also expands the predeceased parent exception to include certain taxable terminations and distributions from trusts. If the predeceased parent was dead at the time the transfer into a trust became subject to estate or gift tax, distributions out of the trust will be GSTT free.

Example 1. A granduncle, who has no children, wishes to gift property to his grandnephew. His nephew is deceased. Under TRA '97, transfers made to the grandnephew will be excluded from GSTT as a result of the GSTT pre-deceased parent exception. The transfer is still subject to gift and estate taxation.

Example 2. Grandparent transfers stock to a charitable lead trust that provides an annuity payable to a charity for 20 years. After 20 years, the trust remainder passes to a grandchild. Grandchild's father was dead at the time grandfather transferred the stock into the trust. Since the predeceased parent exception applies to taxable terminations and distributions, distributions to the grandchild after the trust term will be GSTT free.

Contributions

Donors making gifts after August 5, 1997, will no longer be required to file a Form 709 (gift tax return), provided the entire value of the transferred property qualifies for the gift tax charitable deduction and the donor transfers the entire property interest. This relief does not apply to individuals gifting remainder interests of property or a trust remainder interest.

Charitable Remainder Trusts

TRA '97 imposed two new restrictions that dramatically alter the economics of charitable remainder trusts (CRTs). One restriction is that the present value of the remainder interest with respect to any transfer to a CRT must equal at least 10% of the net fair market value of the property transferred as computed on the date of transfer. Congress added this provision to the legislation at the last minute.

The second requirement, effective for transfers after June 18, 1997, is that a trust will not qualify as a CRT if the required annual payout to the income beneficiary is greater than 50% of the value of the trust's assets. The minimum payout percentage remains at five percent. Due to the first restriction (10% limit rule), the second limitation will rarely be at issue.

These are drastic changes from current law. In fact, the 10% requirement seriously impairs the economic viability of charitable donations through the use of charitable remainder trusts. For example, the requirement prevents a person age 24 from establishing a single life CRT because the payout rate required to meet the 10% test would cause the rate to fall below the current minimum rate of five percent (pursuant to IRC section 664). Table 3 illustrates the dramatic impact of the 10% rule.

Observation: The new rules represent the legislative challenge to charitable remainder trusts that were deemed by the IRS to be abusive. The 50% cap on the annuity amount or unitrust payout rate applies only to transfers after June 18, 1997. The 10% present value remainder to charity minimum applies to transfers after July 28, 1997, except for transfers under a testamentary instrument executed on or before July 28, 1997, if the transferor dies before the end of 1998. Existing wills and revocable trusts that settle charitable remainder trusts should be checked to determine whether the new rules apply, especially the 10% minimum charitable benefit rule. This is another reason for advisers to high-net-worth individuals to make contact with clients and bring added value.

New Capital Gains Rates and Estate Holding Periods

After a long wait and much speculation, new individual capital gains tax rates are a reality. The maximum rate applicable to long-term realized gains is reduced to 20%; however the holding period necessary for the lower long-term rate to apply was increased to 18 months. The pre-TRA '97 28% maximum rate continues to apply to the sale or exchange of capital assets held more than one year but not more than 18 months. Gains and losses on capital assets held for 12 months or less are taxed at the same rate as the taxpayer's ordinary income. Under the 1998 IRS reform legislation, investors will qualify for the reduced 20% capital gains tax rate after 12 months rather than 18 months for sales of assets after January 1, 1998.

Special rules apply to property acquired from a decedent if it is sold within a short-term holding period after the decedent's death, even if the property was held by the decedent for only a short time. Under the special holding-period rule, property acquired or passing from a decedent is considered to have been held by an estate or other recipient for a long-term holding period if the recipient receives a stepped-up basis and the property is sold or disposed of within the short-term holding period after the decedent's death.

Property falling under this rule is considered held for the long-term holding period for all income tax purposes. It was unclear after the passage of TRA '97 as to which rates applied to inherited property. Some commentators believed the estate would have to hold the property for an additional six months to benefit from lower capital gain treatment. The tax technical corrections aspects of the 1998 tax act clarifies this point. Inherited property would be deemed to have a holding period that would allow the lower 10 and 20% rates to immediately apply. The special holding period coupled with the new capital gains rates means that capital gains will be taxed at a maximum rate of 20% even though the inherited property has been held for less than the required holding period. *

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