Does the TRA '97 offer true relief?

• Author: Gardner, John H.
• Position: Taxpayer Relief Act of 1997

This article examines the wealth of changes made by the Taxpayer Relief Act of 1997 in the area of estates, trusts and gifts. Some of the provisions are taxpayer favorable, offering much-needed relief, aiding compliance or adding simplicity; others (like the family-owned business exclusion) seem favorable, but very few will qualify to use it. Nevertheless, estate planners need to scrutinize the law in this area to be able to effectively serve affected clients.

The Taxpayer Relief Act of 1997 (TRA '97) was enacted on Aug. 5, 1997, after 2 1/2 years of partisan fighting, government shutdowns and political maneuvering. It included several major items affecting individuals, including a child tax credit, a lower capital gains rate, education tax incentives, savings incentives and an increase in the estate and gift tax unified credit.(1)

The 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.(2) Although the marginal estate tax rates were not reduced, the landscape has been changed through the introduction of specially targeted relief provisions, including some meant to assist owners of family businesses and farms.

The TRA '97 also introduced more complexity into an already convoluted area; family business relief, in particular, contains a series of difficult qualification rules and probably will not be available to many estates. The TRA '97 was the result of many compromises; despite congressional promises that its changes offer major relief, some of the compromises made in the estate tax arena do not bear this out.

Unified Credit

The TRA '97 provision that should have the widest impact for estate planners is the phase-in of an increase in the amount effectively exempted from transfer tax. Under pre-TRA '97 Sec. 2010(a), a unified credit of $192,800 against the estate and gift tax effectively exempted the first $600,000 of property transfers of U.S. citizens and residents during life or at death.

Under TRA '97 Section 501(a)(1), adding Sec. 2010(c), by 2006, transfers by U.S. citizens and residents aggregating $1 million will be free from estate and gift tax. The unified credit will be increased by 2006 to $345,800, resulting in an additional $153,000 of tax savings for an estate worth $1 million or more. The $1 million applicable exclusion is not adjusted for inflation after 2006, even though the House and Senate versions each provided for indexing after the phase-in was complete.(3) Nonresidents and noncitizens subject to U.S. estate tax have no relief under the TRA '97, as the Sec. 2102(c) unified credit remains at $13,000 (sufficient to exempt $60,000 of assets from estate tax)

The Sec. 6018(a)(1) requirement that an estate tax return be filed was changed by TRA '97 Section 501(a)(1)(C) to correspond with the increased applicable exclusion amount for decedents dying after 1997. Consequently, taxable estates valued at $625,000 or less in 1998 need not file an estate tax return; by 2006, taxable estates valued at $1 million or less will not need to file a return.

The table below reflects the increase in the applicable exclusion amount (only 25% of tile increase occurs during tile first six years).

For decedents dying Applicable Applicable and gifts during credit amount exclusion amount 1997 (no change) $192,800 $ 600,000 1998 202,050 625,000 1999 211,300 650,000 2000 and 2001 220,550 675,000 2001 and 2003 229,800 700,000 2004 287,300 850,000 2005 326,300 950,000 2006 and thereafter 345,800 1,000,000

The increase in the effective exemption allows taxpayers to shift even more wealth during life without incurring gift tax. For example, individuals who have not fully used the $600,000 exemption equivalent will be able to transfer a larger amount tax free. Also, individuals who have previously made $600,000 of taxable gifts will be able to make an additional $25,000 of gifts in 1998, an additional $25,000 in 1999, etc. Inter vivos transfers of appreciating assets provide an effective opportunity to fully leverage the unified credit.

Example 1: Husband H and wife W each made previous gifts totaling $600,000 ($1,200,000 in the aggregate). In 1998, to take advantage of the increase in the unified credit, they transfer marketable securities valued at $35,000 to each of their two children (each using the additional exemption available in 1998 and their Sec. 2503(b) $10,000 annual exclusion) Each $35,000 block of stock appreciates in value to $127,487 (combined appreciation of $254,974) by 2013 (average 9% return over 15 years). By making the gift in 1998, any gift tax generated by the $70,000 in gifts wild be offset by the increased unified credit, removing $254,974 from H's and W's taxable estates.

Indexing for Inflation

Other than the unified credit, most of the TRA '97's other major gift and estate tax provisions will be indexed for inflation starting in 1999, using 1997 as the base year for cost-of-living adjustment. These provisions include:

* The $1 million exemption for transfers subject to the generation-skipping transfer (GST) tax (TRA '97 Section 501 (d), amending Sec. 2631 (c)).

* The $1 million ceiling on the value of a closely held business eligible for the special 2% interest rate on deferred estate tax attributable to said business (TRA '97 Section 503(a), amending Sec. 6601(j)(1)(A).

* The exclusion of up to $750,000 of special-use real property used in a farming activity or other trade or business (TRA '97 Section 501(b), amending Sec. 2032A(a)(3)).

* The $10,000 annual gift tax exclusion ($20,000 with gift-splitting) (TRA '97 Section 501(c)(3), amending Sec. 2503(b)(2)).

Benefits of the inflation adjustments may not be as large as anticipated because of rounding effects provided under the statute; for example, the indexing of the annual exclusion is rounded to the next lowest multiple of $1,000 and indexing of the other amounts is rounded to the next, lowest multiple of $10,000. Thus, the annual exclusion will not be adjusted until cumulative inflation reaches 10%. If inflation remains at 2% or 3%, the $10,000 annual exclusion will not likely be increased until 2003.

Family Business and Farm Relief

Family-Owned Business Exclusion

After years of debate, the TRA '97 provided some estate tax relief for owners of closely held family businesses or farms.(4) Unfortunately, it is mechanically very similar to the Sec. 2032A special-use valuation rules, especially in terms of complexity.

An executor may elect to exclude from the gross estate of a U.S. citizen or resident decedent dying after 1997 certain "qualified family-owned business interests." The Sec. 2033A exclusion plus the applicable exclusion (i.e., the amount sheltered from estate tax by the unified credit) may not exceed $1.3 million. Because the $1.3 million exclusion does not increase as the applicable exclusion increases, the exclusion will actually decrease over time. For instance, a maximum of $675,000 in family-owned business interests may be excluded in 1998, but by 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 below.

For decedents dying Applicable Applicable and gifts during credit amount exclusion amount 1998 $ 625,000 $675,000 1999 650,000 650,000 2000 and 2001 675,000 625,000 2001 and 2003 700,000 600,000 2004 850,000 450,000 2005 950,000 350,000 2006 and thereafter 1,000,000 300,000

Because of the relationship between the family-owned business exclusion and the applicable exclusion amount, a reduction in the former would increase the net estate tax through 2006 for an estate that fully qualifies for it.(5) A proposed technical correction would provide that any correlating increases in the unified credit phased in through 2006 will not affect the total estate tax burden of those with family-owned business interests.(6) In other words, family-business owners dying in 2006 would have the same tax liability as if they died in 1998 (absent fluctuations in value), the first year of the qualified family-owned business exclusion.

To qualify for the exclusion, certain conditions must be met. According to SEc. 2033A(b)(1)(A), the decedent must have been a U.S. citizen or resident at death. The decedent's interest must have been in an active trade or business with its principal place of business in the U.S. Sec. 2033A(e)(2)(A) and (2) require that no more than 35% of such business's adjusted ordinary gross income can be personal holding company income; none of its stock or debt can have been publicly traded within three years prior to the decedent's death, under Sec. 2033A(a)(2)(B). According to Sec. 2033A(b)(1)(C), the qualified business interest must exceed 50% of the decedent's adjusted gross estate; this determination is made after certain adjustments to prevent manipulation of the estate's composition to meet the 50% requirement.

Generally, the 50% test is applied under Sec. 2033A(c)(2) by including in the numerator and denominator significant gifts to the decedent's spouse made within 10 years of death and other gifts made by the decedent within three years of death...