Planning implications of the TRA '97's increase in the unified credit.

• Author: Soled, Jay A.
• Position: Taxpayer Relief Act of 1997

Long-anticipated estate tax relief has finally arrived, with the enactment of the Taxpayer Relief Act of 1997 (TRA'97). In addition to other changes, the new law phases in over nine years an increase in the Sec. 2010(a) unified credit to $345,800. Thus, by 2006, the first $1 million of a taxpayer's assets will be shielded from Federal estate tax. This article discusses the planning opportunities arising from this favorable provision and various related TRA '97 changes.

The unified credit was introduced in 1976(1); prior to the Taxpayer Relief Act of 1997 (TRA '97), Congress had increased it only once.(2) Almost two decades later, in the TRA '97, Section 501(a), Congress has again determined to offer significant estate tax relief by raising the unified credit gradually over a nine-year period. Because the strategic use of the credit (either alone or in conjunction with other planning devices) is an important estate planning tool, the latest increase will have numerous estate planning consequences for taxpayers.

This article provides a general summary of the common estate planning techniques associated with the use of the unified credit. The salient features of the new law as it relates to the credit are discussed, followed by the implications the increase in the credit will have on estate planning. The article concludes that for taxpayers whose wealth may be subject to Federal transfer tax, this law change is of fundamental importance.

Background

All gratuitous transfers made during life and at death are potentially subject to Federal gift, estate and generation-skipping transfer (GST) taxes.(3) Transfer tax rates are progressive, starting at 18% and extending to 55%.(4) While there are a number of important exceptions to the general rule that gratuitous transfers are taxed (e,g., present interest gifts qualifying for the Sec. 2503(b) annual exclusion and certain payments under Sec. 2503(e) for medical and educational expenses), they provide only limited transfer tax relief The unified credit performs a pivotal role in shielding large gratuitous transfers and gifts of future interests from tax.

Prior to the TRA '97, the unified credit provided an exemption equivalent of $6000,000. Taxpayers could make transfers during life and at death that would generate no Federal gift or estate tax as long as the aggregate taxable transfers did not exceed $600,000.

Taxpayers often sought to capitalize on their use of unified credits, through varied means. Common transfer tax minimization techniques included (1) gifts of appreciating assets, (2) valuation leveraging and (3) unified credit preservation. Transferring assets that are anticipated to appreciate greatly in value "freezes" the value of the gifted property at the time the transfer is completed. Any asset appreciation in the hands of the gifts recipient escapes transfer tax.

Example 1: A owns stock in Z Corp. with a fair market value (FMV) of $300,000. A anticipates that the stock will double in value over the next year. A gives the stock to her child in 1997. Even if the stock appreciates in value, A will bear no additional gift tax.

Valuation leveraging involves the establishment of special forms of inter vivos trusts (e.g., qualified personal residence trusts(5) (QPRTs) and grantor retained annuity trust(6) and/or the formation of family limited partnerships (FLPs) and limited liability companies.(7) These techniques permit the taxpayer to transfer wealth at a reduced value in legislatively and judicially approved ways.(8)

Example 2: B, age 57, owns a personal residence with an FMV of $500,000. B contributes the personal residence to a QPRT when the Sec. 7520 rate for the month of contribution is 7.8%. The trust term is 10 years, with the remainder to B's children. Because of B's retained interest (i.e., the right to use the house as a personal residence until death), the FMV of B's taxable gift is only $200,965.(9)

Example 3: C owns Blackacre, undeveloped real estate with an FMV of $990,000. In January 1997, C forms X, an FLP, and contributes Blackacre; her child, D, contributes $10,000. In November 1997, C, gives a 48% interest in X to D. Rather than valuing the gift at $480,000 ($1,000,000 X 48%), many courts, under similar facts, have permitted a 30% to 40% minority and...