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Trusts & Estates

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Taxpayer Relief Act of 1997 Passes

September 1997

On August 5, 1997, President Clinton signed The Taxpayer Relief Act of 1997 (the "Act") into law. The Act and the Congressional machinations leading to its passage have received widespread media attention; however, in our view, the significance of the Act has been largely overstated. Much of the Act is "back-loaded," with substantive provisions not becoming effective for one of more years. This, of course, leaves Congress room to reconsider portions of the Act before taxpayers take advantage of some of its more beneficial provisions. Nevertheless, we thought it appropriate to use this second edition of the Estate Panning Focus to summarize those portion of the Act that we believe will be of most interest to our clients. We hope you find this issue of the Estate Planning Focus helpful, and we welcome any questions you may have about a particular provision of the Act or how it may affect your particular circumstances.

Estate and Gift Tax-Related Provisions

The unified credit for gift and estate taxes will increase in unequal increments over a 10-year period to allow taxpayers to make taxable gifts (either during the taxpayer's lifetime or upon his or her death) of $1,000,000 (the "applicable credit amount") before any tax is imposed. This represents a $400,000 increase over a 10-year period. However, the applicable credit amount has not increased since 1986, and the Act does not contain indexing for future increases in the cost of living.

  • Beginning in 1999, certain statutory amounts will be indexed to take into account increases or decreases in the cost of living, including:

  • $10,000 annual gift tax exclusion for present interest gifts;

  • $1,000,000 exemption for generation-skipping transfer tax purposes;

  • $750,000 maximum reduction in estate valuation for special use valuation purposes;

  • $1,000,000 of value of certain closely held business interests eligible for a 2% interest rate on deferred estate tax payments.

  • The Act provides owners of small family businesses some relief from the estate tax imposed at death. Beginning in 1998, a portion of the family-owned business interests included in a decedent's estate may be excluded when determining the total value of the decedent's taxable estate. The provisions governing this exclusion are quite complex and include a number of restrictions that limit when the exclusion may be applied. For this reason, it seems to us that this much ballyhooed provision of the Act will be of limited interest to most of our clients.

  • The maximum exclusion is $1,300,000, reduced by the applicable credit amount. Thus, for all practical purposes, the exclusion starts at $675,000 in 1998 and decreases each year until it is reduced to $300,000 in 2006, when the applicable credit amount reaches $1,000,000.

  • The value of the business must exceed 50% of the total value of the decedent's estate;

The IRS can no longer revalue reported gifts for estate tax purposes after the statute of limitations has expired on the applicable gift tax return (three years after the filing date or due date of the return, whichever is later).

However, certain lifetime gifts of business interests will be taken into account for purposes of this 50% test.

  • The business must be an active trade or business, and passive assets in the business, such as cash or investment securities, will not be included when determining the value of the business interest for purposes of the 50% test.

  • The decedent and members of his or her family must own at least 50% of the business. Alternatively, if two or more families collectively own the business, then the decedent and the decedent's family must own at least 30% of the business, and the two families must collectively own at least 70% of the business or three families at least 90% of the business.

  • For five of the eight years prior to the decedent's death, the business interest must be owned by the decedent or members of decedent's family and the decedent or members of the decedent's family must have materially participated in the business.

  • The tax savings will be recaptured if the business ceases to be owned by a member of decedent's family or there ceases to be material participation in the business by a member of decedent's family. The recapture is 100% for the first six years after the decedent's death, and gradually reduces to zero between years seven and ten.

  • The IRS can no longer revalue reported gifts for estate tax purposes after the statute of limitations has expired on the applicable gift tax return (three years after the filing date or due date of the return, whichever is later). This is a welcome change in the law that will have a definite impact on estate planning for lifetime gifts of interests in property that are difficult to value or for which valuation discounts are applied.

Pension and Employee Benefit-Related Provisions

  • Beginning January 1, 1997, there will be no excess accumulation penalty for qualified plan accounts.

  • The health insurance deduction for self-employed individuals will increase in unequal increments from 40% in 1997 to 100% in 2007.

Charitable Giving-Related Provisions

  • The Act extends until June 30, 1998, the period during which contributions of appreciated publicly traded securities to certain private foundations will qualify for a charitable deduction equal to the fair market value of the securities. After June 30, 1998, these contributions will generate charitable deduction equal to the donor's tax basis in the securities, rather than the securities' fair market value.

  • The Act limits the amount a charitable remainder trust may distribute in any year to 50% of the initial value of the assets transferred to the trust. In addition, charitable remainder annuity trusts must now be structured so that the value of the remainder interest is at least 10% of the initial value of the assets transferred to the trust.

Assets acquired after December 31, 2000, and held for five years or longer will be taxed at maximum rates of 8% and 18% (instead of 10% and 20%).

  • No gift tax return need now be filed for qualifying gifts to charities. Although this is a change in the law, few taxpayers or their advisors have filed gift tax returns to document charitable donations. Nevertheless, it should be noted that certain gifts to charities (e.g., charitable remainder trusts) must still be documented through a timely filed gift tax return.

Income Tax-Related Provisions

  • The maximum capital gains tax rate is reduced to 20% for the sale or exchange of long-term capital gain assets held for a minimum of 18 months.

  • This provision will apply to sales or exchanges of assets after May 6, 1997.

  • For taxpayers in the 15% income tax bracket, the maximum capital gains tax rate is 10%.

  • Assets held between 12 and 18 months continue to be subject to a maximum 28% capital gains tax rate.

  • Sales of real estate are subject to depreciation recapture, with a maximum capital gains tax rate of 25%.

  • Assets acquired after December 31, 2000, and held for five years or longer will be taxed at maximum rates of 8% and 18% (instead of 10% and 20%).

  • The first $250,000 ($500,000 for married couples filing jointly) of capital gain on the sale of a principal residence is excluded from taxable income. However, it will no longer be possible to roll over gain from the sale of a principal residence into a new residence. Thus, capital gain in excess of $250,000 ($500,000 for married couples filing jointly) from the sale of a principal residence will be subject to capital gains regardless of whether a new residence is acquired with the sale proceeds.

  • Generally, this exclusion can be taken by a taxpayer once every two years.

  • This provision of the Act is applicable to sales or exchanges of principal residences that occur after May 6, 1997.

  • The maximum amount of tax a taxpayer can owe without being subject to a penalty for underpayment of estimated tax is increased from $500 to $1,000.

  • Beginning in 1998, a tax credit is available to taxpayers with dependent children under the age of 17. In 1998, the credit is $400 per child. Beginning in 1999, the credit will be $500 per child. This credit is phased out for taxpayers with adjusted gross income over $75,000 ($110,000 for married couples filing jointly; $55,000 for married couples filing individually).

  • Active-participant statue (participation in an employer-sponsored qualified plan) for purposes of making deductible IRA contributions is considered on an individual basis, without regard to whether the individual's spouse participates in such a plan. However, the maximum deductible IRA contribution for an individual who is not an active participant (but whose spouse is an active participant) is phased out for taxpayers with adjusted gross income from $150,000 to $160,000.

  • The income level at which phaseouts begin for purposes of making deductible contributions

The lifetime learning tax credit is a 20% credit for up to $5,000 of tuition expenses. in 2003, the credit is increased to 20% for up to $10,000 of expenses.

  • to IRAs for active participants in qualified plans is increased from $50,000 in 1998 to $80,000 in 2007 and beyond (for married taxpayers filing a joint return), and from $30,000 in 1998 to $50,000 in 2007 and beyond (for single taxpayers).

  • A new "Roth IRA" has been created, beginning in 1998. Contributions to a Roth IRA will be nondeductible, but earnings in the IRA will be tax free. Most importantly, distributions after age 59, upon the death or disability of the account holder and for certain qualified purposes, will be income tax free. Subject to certain limitations, taxable rollovers from existing IRAs into Roth IRAs will be permitted.

  • Starting in 1998, IRAs may invest in gold, silver and platinum bullion.

  • Alternative minimum tax changes:

  • Small businesses with average gross receipts of less than $5,000,000 will be exempt from the alternative minimum tax.

  • Starting in 1999, the depreciation lives used for both regular tax and alternative minimum tax will be the same.

Education-Relation Provisions

  • HOPE scholarship tax credit and lifetime learning tax credit;

  • HOPE scholarship tax credit. For the first two years of post-secondary education, there is a 100% tax credit for the first $1,000 of tuition expenses and a 50% credit for the next $1,000 of tuition expenses. Certain restrictions and limitations apply to this credit.

  • Lifetime learning tax credit. Applies to all education expenses other than expenses for which the HOPE scholarship tax credit is applied. The lifetime learning tax credit is a 20% credit for up to $5,000 of tuition expenses. In 2003, the credit is increased to 20% for up to $10,000 of expenses.

  • Both credits are phased out between $40,000 and $50,000 of adjusted gross income for single taxpayers and $60,000 and $100,000 of adjusted gross income for married taxpayers filing jointly.

  • The HOPE scholarship tax credit is effective for tuition paid after December 31, 1997, and the lifetime learning tax credit is effective for tuition paid after June 30, 1998.

  • A certain portion of interest paid on student loans will be deductible in arriving at adjusted gross income. The deduction is effective for interest payments due after December 31, 1997, and is phased out for taxpayers with adjusted gross income between $40,000 and $55,000 ($60,000 and $75,000 for married taxpayers filing jointly).

  • The deduction for employer-provided education assistance

Contributions to a Roth IRA will be nondeductible, but earnings in the IRA will be tax free.

  • for undergraduate education is extended through June 30, 2000.

  • Penalty-free withdrawals from IRAs are permitted for undergraduate and graduate education expenses, including tuition, books, and room and board. This provision is effective January 1, 1998;.

  • Education IRAs:

  • Beginning January 1, 1997, parents can establish an education IRA for each of their children up to $500 annually per child.

  • Contributions will not be tax-deductible.

  • Income accumulates tax-free and withdrawals are tax-free if used for undergraduate- or graduate-school education expenses.

  • The account must be used for education purposes by a child younger than age 30.

  • Income limits begin at $95,000 for single taxpayers and $150,000 for married taxpayers.