The 1997 Tax Act: Estate and Gift Taxes

Chapter 4
Estate, Gift and Generation-Skipping
Tax Provisions
A Tax News & Views Special Report:
Promises Kept: The 1997 Tax Law

Guide to
Promises Kept

Tax Cuts for Individuals

Principal Tax Increases

Other Key Provisions

Table of Contents

s part of their Contract with America, Republicans promised to increase the estate tax exclusion to $750,000 from $600,000. The Act goes well beyond this promise in reducing estate, gift, and generation-skipping transfer taxes. Some of the major highlights include:

Increasing the estate and gift tax unified credit to exempt $1 million from tax.
Indexing certain estate and gift tax provisions.
An additional estate tax exclusion for qualified family-owned businesses.
Adding new limitations on charitable remainder trusts.
Providing taxpayers with administrative and compliance relief.

Major Provisions

Increase in estate and gift tax unified credit: A unified credit of $192,800 against the estate and gift tax now effectively exempts the first $600,000 of property transfers during life or at death. The Act gradually increases this effective exemption until it reaches $1 million in 2006. The increases are listed in the table below.

Effective date: The provision is effective for decedents dying and gifts made after Dec. 31, 1997.

Estate and Gift Tax Credit Phase-In
Year	Limit
1998 1999 2000 2001 2002 2003 2004 2005 2006	$ 625,000 $ 650,000 $ 675,000 $ 675,000 $ 700,000 $ 700,000 $ 850,000 $ 950,000 $ 1,000,000

Planning Point: The $192,800 unified credit in effect will be increased to $345,800 so as to exclude the first $1 million of an estate from taxation. The result is a tax savings of $153,000 for an estate in excess of $1 million. Under current law, the benefits of the graduated rate schedule and the current unified credit are recaptured by a 5% surcharge on estates between $10,000,000 and $21,040,000. This recapture range is broadened to provide a recapture of the new increased unified credit amount. Thus, very large estates (over $24,100,000) will not enjoy any tax reduction as a result of the exemption increase.

The increase in the effective exemption will allow taxpayers to transfer, during life or death, more property without the imposition of an estate or gift tax. Lifetime transfers deliver deeper tax savings because the posttransfer appreciation in the value of the gifts shifts to the recipient of the gift, instead of the donor's estate.

For example, assume a wealthy individual has a portfolio of stocks worth $1 million that could be transferred to the next generation either now or at death. Assume that at death the stocks will be worth $3 million. A transfer today will have no tax cost, but the children will be liable for capital gains taxes on the appreciation when they sell since their parent bought the stock. If they sold it when their parent died, that would create a tax of up to $600,000, depending on the parent's basis in the stock. If the stock remains in the estate, the estate tax on the $2 million of appreciation would be $1.1 million. Thus, by accelerating the transfer, the family saves at least $500,000 in taxes.

Indexing of certain other estate and gift tax provisions: The Act provides for annual indexing for inflation, starting with 1999 inflation, of the following amounts:

The $10,000 annual exclusion for gifts.
The $750,000 ceiling on special use valuation.
The $1 million generation-skipping transfer tax exemption.
The $1 million ceiling on the value of a closely held business eligible for the special low interest rate.

Effective date: The provision is effective for decedents dying and gifts made after Dec. 31, 1997.

Planning Point: Indexing the annual exclusion will allow donors to give more property to designated individuals without transfer tax costs and without using part of their unified credit. A number of years ago, rumors abounded that perceived abuses of the annual exclusion by high-wealth individuals making planned annual gifts to numerous children and grandchildren and their spouses would cause Congress to limit the annual exclusion. The Act demonstrates that this Congress is comfortable with the annual exclusion.

Estate tax exclusion for qualified family-owned businesses: The Act allows an exclusion of value attributable to a qualified family-owned business interest if the interest is left to qualified heirs. The excludable amount is the difference between $1.3 million and the amount exempted under the unified credit for the year. The decedent must be a U.S. citizen or resident at the time of death. To qualify, a "family-owned business interest" must comprise more than half of the estate and must have its principal place of business in the United States. A business is family owned if one family owns at least half of the business, two families own at least 70% of the business, or three families own at least 90%. An individual's family includes the individual's (1) spouse, (2) parents and grandparents, and (3) children, stepchildren, brothers, sisters, nieces, and nephews, and their spouses, and ancestors.

Qualified heirs include any individual who has been actively employed by the trade or business for at least 10 years prior to the date of the decedent's death, and members of the decedent's family. If a qualified heir is not a citizen of the United States, then different rules apply. To the extent that a decedent held qualified family-owned business interests in more than one trade or business, the executor must aggregate all such interests. If certain triggering events occur, then taxpayers may lose the benefit of this relief provision and additional tax is imposed on the date of such event.

An estate able to take advantage of the full $1.3 million exclusion would save in 1998 $277,000 of taxes that would have been due under prior law.

Effective date: The provision is effective with respect to estates of decedents dying after Dec. 31, 1997.

Reduction in estate tax for certain land subject to permanent conservation easement: The Act provides an exclusion from the estate tax for 40% of the value of land subject to a qualified conservation easement granted to a qualified charity that restricts development rights to preserve habitat, open space, or recreational uses. The 40% exclusion is based on the value of the property after the grant of the easement. The maximum exclusion will be $100,000 in 1998 and will increase $100,000 each year until 2002, when it reaches $500,000.

Effective date: The estate tax exclusion applies to decedents dying after Dec. 31, 1997.

Installment payments of estate tax attributable to closely held businesses: The Act modifies interest due on these payments:

Interest rate. The interest rate imposed on the amount of deferred estate tax attributable to the taxable value of the closely held business in excess of $1 million is reduced to an amount equal to 45% of the rate applicable to underpayments of tax. The interest rate on the first $1 million of value will be 2%. The interest paid on estate taxes will no longer be deductible for estate tax or income tax purposes.
Example. In 1998 (when the unified credit is $625,000), if the business qualifies for the $1 million deferral of tax payments for qualified family-owned business interests but not the $1.3 million exclusion, and the executor so elects, the amount of estate tax attributable to the value of the closely held business between $1,625,000 and $625,000 would be eligible for the 2% interest rate.

Effective date: The provision is effective for decedents dying after Dec. 31, 1997.

Charitable remainder trusts: In order for a trust to qualify as a charitable remainder annuity or unitrust, the value of the charity's remainder interest in any transfer to the trust must be at least 10% of the value of the property on the day it is contributed. This provision is effective for transfers after July 28, 1997, and will significantly reduce the tax benefits for such transfers. Special transition rules are provided for certain transfers under wills in place on July 28, 1997.

Additionally, the Act sets a maximum payout percentage of 50%, effective for transfers after June 18, 1997.

Trust and estate conformity: The Act makes several changes designed to achieve greater conformity in the taxation of trusts and estates. These rules generally apply to taxable years beginning after the date of enactment.

Separate share rules available to estates. The Act extends mandatory application of the separate share rule to estates. Separate shares in an estate exist if the governing instrument of the estate creates separate economic interests in one beneficiary (or class) that are not affected by economic interests accruing to another beneficiary (or class).
Related persons for disallowance of losses. An estate and beneficiaries of the estate are treated as related persons (except in the case of a sale or exchange in satisfaction of a pecuniary bequest).
Distributions during first 65 days of taxable year of estate. An executor may elect to treat distributions made within the first 65 days of the tax year of the estate as having been made during the previous tax year.

Administrative Provisions

The Act attempts to improve the administration of the estate and gift tax through a number of changes. These changes repeal complex rules, remove opportunities to plan taxes through the use of administrative rules, allow correction of defective elections or similar problems, and limit the re-opening of issues from past years. These changes generally are effective upon enactment unless otherwise noted.

Trust throwback rules for domestic trusts: For years beginning after enactment, the throwback rules for amounts distributed by a domestic trust are repealed, except for certain trusts created before March 1, 1984.

Precontribution gain by domestic trust: Precontribution gain on property sold after the date of enactment by a domestic trust will no longer be taxed at the contributor's marginal tax rate.

Revaluation of gifts: A gift for which the limitations period has passed cannot be revalued for purposes of determining the estate tax bracket and available unified credit; however, the statute of limitations will not run on an inadequately disclosed transfer regardless of whether a gift tax return was filed for other transfers in that same year.

Elimination of gift tax filing requirements for gifts to charities: Donors need not file a gift tax return as long as the entire value of the transferred property qualifies for the gift tax charitable deduction.

Certain revocable trusts treated as part of estate: The Act provides that an irrevocable election can be made to treat a qualified revocable trust as part of the decedent's estate for federal income tax purposes.

Opportunity to correct certain failures: An executor who makes the special use valuation election and substantially complies with the regulations may supply missing required information or signatures within a reasonable period of time (not exceeding 90 days) after notification by the Internal Revenue Service.

Waiver of certain rights of recovery: To waive recovery of the estate tax attributable to the inclusion of Qualified Terminable Interest Property (QTIP) from the person receiving the property, a surviving spouse's will or revocable trust must specifically so indicate (e.g., by a specific reference to a QTIP, the QTIP trust, or certain Internal Revenue Code sections). Also, the right of contribution for property over which the decedent retained rights to enjoyment or income may be waived by a specific indication in the decedent's will or revocable trust.

Family Transactions: The Act adopts a number of rules that reflect a more practical view of the definition of a family and the way in which family members interact.

Specially valued property recapture: A cash lease of specially valued real property by a lineal descendant to a member of the lineal descendant's family, who continues to operate the farm or closely held business, will not trigger recapture.

Generation-skipping transfers to individuals with deceased parents: The "predeceased parent exception" is extended to transfers to collateral heirs if the donor/transferor has no living lineal descendants at the time of the transfer.

Other simplifications

1990 Act transition rules: Certain qualified domestic trusts created before the enactment of the Omnibus Budget Reconciliation Act of 1990 will be treated as satisfying that Act's withholding requirement if the governing instruments require that all trustees be U.S. citizens or domestic corporations.

Short-term obligations held by nonresident aliens: If income from a debt instrument would be eligible for exemption as short-term Original Issue Discount (OID) if received by the decedent on the date of death, that instrument will be treated as property located outside of the United States.

Pre-need funeral trusts: The trustee of a qualified funeral trust could elect to have the income of the trust taxed to the trust but the trust would not be permitted a personal exemption deduction.

Community property rights and retirement benefits: The Act clarifies that the transfer at death of a survivorship interest in an annuity to a surviving spouse will be a deductible marital transfer under the QTIP rules regardless of whether the decedent's annuity interest arose out of his or her employment or arose under community property laws by reason of the employment of his or her spouse.

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Tax News & Views is produced by the Financial Counseling Specialists and the Legislative & Regulatory Services Group at Deloitte & Touche LLP.