- Contents: Estate and Gift Taxes
- Inserts: When Will the Inflation Adjustments Occur?
New Charitable Remainder Trust Qualifications
Fiduciary and Beneficiary Income Taxes
Family Farms and Businesses
Capital Gains
Taxation of Businesses
Individual Retirement Accounts
Other Provisions
Calculation of Tax Savings for an Example Family Farm
What is the Difference between an "Exemption," a "Credit," and an "Exclusion"?
The Taxpayer Relief Act of 1997 signed by the President
on August 5, 1997, provides considerable benefits to taxpayers--but also a few problems. The following article is from a newsletter sent to clients and friends of the firms, and discusses essential items not covered in the popular press. [All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.]
Estate and Gift Taxes
Increase in Exclusion. As you know, currently there is an effective $600,000 unified estate and gift tax exclusion (in addition to the unlimited spousal exclusion and charitable exclusion). The new tax law increases this amount to $1 million, phased in gradually over the next nine years. The term "unified credit" is now replaced with "applicable credit amount."
WARNING: Trusts prepared by our office typically do not specify "$600,000" when referring to this exclusion, but instead use a formula clause so that whatever the applicable credit amount is at the time one passes away, that maximum amount will apply to the trust. Therefore, most of our clients will not need to worry about making changes to their trusts to take advantage of the increased levels. However, it is a good idea to check your trust, particularly if not prepared by our office, to make sure that a formula clause is used and not a $600,000 specific dollar amount for the exclusion.
(Click here for definitions of "exemption," "credit," and "exclusion.")
No More Re-Valuations of Prior Gifts in Decedent's Estates. A serious problem with our present estate tax law, which allows the IRS to re-value prior gifts at the time the estate taxes are determined (as we have previously advised you), has now been corrected.
The new legislation provides that once the statute of limitations for assessment of gift tax has expired, the value of the gift for purposes of determining the applicable credit amount on the estate tax return is now the amount determined for gift tax purposes. Thus, no longer can the IRS challenge the value of a gift made years later when the donor passes away. This change was long overdue!
WARNING: Under the new law, for any gift of property that is required to be reported on a gift tax return and is not, a tax assessment and collection proceeding may begin at any time. However, a disclosure on the return or attached statement of the nature of the gift avoids this consequence. (See new developments.)
Additional provisions in the new law allow for a Tax Court declaratory judgment of the value of certain gifts. This is very helpful for tax planning and takes some arbitrary discretion away from the IRS. Also, certain outright gifts of property to charities now no longer require gift tax returns.
Gifts Now May Be Made Directly from Revocable Trusts. Until now we have advised you to first transfer assets from a revocable trust to the settlor's individual name, and thereafter make the gift in the settlor's individual name in order to prevent the gift from being included by the IRS in the settlor's estate later. This finally has been corrected. With the new law, a transfer from a revocable trust is deemed a transfer from the decedent settlor for estate tax purposes (for estates of decedents dying after August 5, 1997).
Inflation Adjustment to Annual Gift Tax Exclusions. For gifts made in a calendar year after 1998, the $10,000 annual gift tax exclusion will be adjusted for inflation based on calendar year 1997 (in multiples of $1,000).
(Click here for estimation of when the inflation adjustments might occur.)
Affect of Gifts on Eligibility Computations. Where gift taxes are paid within three years of death (i.e., not including annual exclusion gifts), under the new law the value of the assets subject to those gift taxes is included in the gross estate for purposes of calculating eligibility for farm special use value (§2032A ) and for eligibility to make corporate stock redemptions in order to pay estate taxes (§303).
However, for purposes of calculating eligibility to pay the estate tax attributable to a family business in installments (§6166), eligibility must be met both including and excluding the value of the gifted assets. In some instances, this may make planning for the §6166 eligibility more complicated.
WARNING: If you plan on making gifts of non-family business assets in order to make your estate eligible for §6166 installment payments, you will have to survive at least three years beyond the date of the gift to obtain the eligibility. Therefore, do not put off making the gifts.
Generation-Skipping Tax (GST). For individuals who die after 1998, the $1 million GST exemption is adjusted for inflation based on calendar year 1997 (in multiples of $10,000). (Click here for estimation of when the inflation adjustments might occur.)
Also, transfers to certain individuals, such as great-nieces and great-nephews, or grandchildren of a spouse or former spouse, whose parents are deceased, are now exempt from GST taxes under the new law.
New Charitable Remainder Trust Qualifications
For assets transferred to a charitable remainder trust after June 18, 1997, distributions from such trust must be at least 5% of the initial fair market value of trust assets and, under the new law, may not be more than 50% of that value. This illustrates Congress' reaction to certain abuses that have occurred over the last few years in the charitable remainder trust area.
Additionally, as to transfers in trust after July 28, 1997, the value of the charity's remainder interest of a charitable remainder annuity trust must be at least 10% of the initial fair market value of all property placed in trust. As to charitable remainder unitrusts, the value of the charity's remainder interest in the property contributed to the trust must be at least 10% of the net fair market value of the property as of the date the property is contributed.
Trusts which do not meet these new requirements may be either (a) declared null and void from the beginning (ab initio), and thus no deduction allowed, or (b) changed by amendment. However, the court proceeding to obtain approval to amend the trust terms must be commenced not later than the 90th day after either the filing of the estate tax return (if applicable) or an income tax return, including extensions to either.
WARNING: If you have a charitable remainder trust, the trust provisions must be amended before making any additional transfers to the trust in order to obtain a charitable deduction.
A contribution made after June 28, 1997, which would result in the trust ceasing to qualify as a charitable remainder trust will be treated as a transfer to a separate trust. Thus, the charitable deduction for the pre-existing trust would not be lost by disqualification of the trust, but no charitable deduction would be available to the new contribution, now treated as made to a separate, non-charitable trust.
Additionally, there is a short grace period for persons who die before January 1, 1999, with charitable remainder provisions in a will (or other testamentary instrument, such as a revocable living trust) executed before July 29, 1997. There are also certain exceptions for persons who lack mental capacity.
WARNING: If you have charitable remainder provisions in your will or revocable living trust, update them as soon as possible, and in no event later than December 31, 1998. (Note: allow 60 days for a court proceeding to obtain approval of the trust amendment.) Failure to timely conform the trust provisions to the new law could mean loss of the charitable deduction.
Fiduciary and Beneficiary Income Taxes
"Administrative Trust" Taxation. For estates of decedents dying after August 5, 1997, the new law provides for an election for certain revocable trusts to be taxed (for income tax purposes) as part of the decedent's entire estate (rather than a separate trust) for two years after the date of death, or until the final determination of estate tax is made (whichever is later). This new provision is consistent with the practice of many attorneys and accountants (including our office) of holding trust assets in an "administrative trust" for income tax purposes until estate administration is completed. Doing this greatly simplifies the administrative and accounting requirements.
Distributions. Under present law, irrevocable trusts are allowed to make distributions of income within 65 days after the year end and still be taxed in the prior year. The new law expands this to include distributions from estates for years beginning after August 5, 1997.
Estate Beneficiaries' Interests May Now Be Taxed Separately. Separate interests of estate beneficiaries may now be treated as separate "trusts." As the fiduciary income tax rates are high, this could mean significant tax savings in estates with more than one beneficiary.
TIP: If you are currently an executor or trustee of a decedent's estate, have your accountant analyze whether tax savings might be realized by treating each beneficiary's share as a separate trust for fiduciary income tax purposes.
Beneficiary's Income Tax Returns. New provisions require estate and trust beneficiaries to treat any reported item on their personal returns in a manner consistent with the treatment of such item on the estate or trust income tax return. However, if a beneficiary's treatment is (or may be) inconsistent, or if the estate or trust has not yet filed a return, the beneficiary may attach a statement identifying the inconsistency. These provisions apply to returns filed after August 5, 1997.
WARNING: Although the law is permissive ("may"), not attaching such a notice leaves open the possibility that the beneficiary's return may be adjusted by the IRS to comply with the estate or trust return, and interest and penalties may apply. Therefore, when in doubt, attach a statement.
Family Farms and Businesses
New Family-Owned Business Exclusion. After December 31, 1997, family-owned businesses and farms may be eligible for a new estate tax exclusion which is in addition to the increased exclusion described on the front page ("applicable credit amount"). Coordinated with the applicable credit amount, the new exclusion and the credit amount combined will be an exclusion for a total of $1.3 million for each year. An election must be made on the estate tax return, and the business or farm must exceed 50% of the adjusted gross estate. Additionally, there must be five years out of an eight-year period ending on the date of death where the business was owned by the family, and with material participation in the business by the family.
(Click here for chart showing the tax-savings dollar value over the years for an example family farm.)
If the business operates as an entity (e.g., a partnership, LLC, or corporation), at least 50% of the entity must be owned by the decedent's family. However, if at least 70% of the business is owned by two families, or if at least 90% of the business is owned by three families, then in either event only 30% of the entity must be owned by the decedent's family. Both material participation by a qualified heir and not disposing of any interest in the business to third parties is required for 10 years following the death (as it is with the special use valuation rules) or taxes saved may be recovered by the IRS.
Where the GST exemption ($1 million) is less than the combined exemption amount ($1.3 million), we may see a decedent's residual trust (also called a "bypass," "exemption equivalent," or "credit shelter" trust) being divided into a GST exempt residual trust (containing the first $1 million exempt from both GST and estate taxes) and GST non-exempt residual trust (containing the remaining $300,000 exempt from estate taxes, but not from GST taxes).
WARNING: Trust documents prepared by our office generally have such provisions, but you will need to double check your trust documents if your estate exceeds $1.2 million.
(See New Developments.)
New Exclusion for Conservation Easements. Another new estate tax exclusion for estates of decedents dying after December 31, 1997, is for land subject to a conservation easement. This is in addition to the other family farm and business exclusions. The conservation easement exclusion is limited to $100,000 for estates of decedents dying in 1998, and increases by $100,000 each year up to $500,000 in 2002 and thereafter. The exclusion will apply to interests in partnerships, corporations, or trusts if at least 30% of that entity is owned by the decedent. (See New Developments.)
§2032A Special Use. For decedents dying after 1998, the $750,000 amount of aggregate decrease in value of qualified real property under the farm valuation rules ( §2032A) is adjusted (in multiples of $10,000) for inflation based on calendar year 1997. (Click here for estimation of when the inflation adjustments might occur.) The qualified use rules now also include rental to a member of the family on a net cash basis (this provision applies with respect to leases entered into after December 31, 1976).
TIP: Older persons who no longer work the family ranch but lease it to their children now do not need to be worried that the ranch will be disqualified for special use value because they do not personally work the ranch anymore.
§6166 Deferral of Estate Tax Payments. For decedents dying after December 31, 1997, extensions under §6166 (where the business exceeds 35% of the adjusted gross estate) to pay estate taxes in installments over 15 years have new applicable tax amounts and new interest rates.
The prior rule and the new rule take different approaches to the calculations, but by way of comparison, under the former law, a 4% interest rate applies to the first $153,000 of tax, and thereafter interest is charged at the prevailing rates; whereby under the new law, a 2% interest rate applies to the first $337,200 of tax, and thereafter interest is charged at only 45% of the prevailing rates. (The prevailing rates can change quarterly; however it has remained at 9%, compounded daily, for over a year now.)
The amount of tax eligible for the 2% rate is subject to inflation based on calendar year 1997. (Click here for estimation of when the inflation adjustments might occur.)
The bad news, however, is that no deduction for either estate or income tax purposes is allowed under the new law (as it was before) for the interest paid under the §6166 election. For estate taxes in the 55% bracket, under current law the effective prevailing interest rate (after deduction on the estate tax return for the amount of interest paid) is the same 4.05% rate (9% less 55% deduction) as the new law provides. The difference between the two is that under current law a claim would have to be filed to deduct the interest paid, whereas no claim is necessary under the new law. (Similarly, the special 4% interest rate of the prior law is deductible, resulting in an effective rate of 1.8%, compared with 2% of the new law, however the new law applies the special rate to $184,200 more tax.)
For decedents dying prior to January 1, 1998, where a §6166 election has been or (before the end of 1997) is going to be made, as to any installments currently unpaid, an election may be made to apply these new provisions to the remaining installments, except that the 2% interest rate will apply only to the first $153,000 amount of tax (not $337,200) if that portion of the installments has yet to be paid.
An election as to the remaining installments means (a) reducing the interest rate where the tax rate on the estate is less than 55%, and (b) for all estates in all tax rates, avoiding having to file a claim to deduct interest paid. The election must be made before January 1, 1999, and is irrevocable.
TIP: Everyone now making installment payments will want to evaluate whether to make this election by filing it with the IRS before the end of 1998.
A new section was also added to the Internal Revenue Code to provide for Tax Court review of eligibility for the §6166 extension for payment of taxes (applies to decedents dying after August 5, 1997). Again, taking more arbitrary discretion away from the IRS.
Capital Gains
Sale of Residence. One of the biggest tax breaks in the new law is the new exclusion of $250,000 in capital gain for individuals who sell their homes ($500,000 for couples). Retroactive to sales made after May 6, 1997, it is reusable every two years.
The taxpayer must reside in the home for periods aggregating two years during the five-year period preceding the sale.
TIP: This means that once the children have left home, taxpayers can trade down to smaller homes without having to wait until age 55 (as the exemption under the former law required).
Goodbye §1034 Rollover. The bad news for persons with a low basis in a high-value home is that the new $500,000 exclusion applies to exchanges in lieu of the former Code §1034 exchange provisions which are now repealed.
Long-Term Gain Rates. Taxes on long-term capital gains (now defined as those from assets held for more than 18 months) drop from 28% to 20% under the new law. (However, they need be held only 12 months for investments sold after May 6 but before July 29, 1997.) For taxpayers in the 15% regular tax bracket ($41,200 taxable income for joint filers and $24,650 for singles), the maximum net capital gains tax rate is only 10%.
These rate cuts are effective retroactively to any sale made after May 6, 1997. For assets held more than five years, new rates commencing in 2006 will be 18% on assets purchased after December 31, 2000 (8% for those in the 15% tax bracket).
A new "mid-term" gain at the old 28% rate will apply to assets sold after July 28, 1997, which have a holding period of more than a year but less than 18 months.
TIP: Investments which yield ordinary income (such as bonds, high-dividend yield stocks, or even deferred gain from variable annuities or 401(k) plans) may no longer be as desirable when weighed against investment opportunities that yield capital gain.
Because mutual fund companies will need to conform with new reporting requirements and inform their investors of their gains and losses, look for changes in your mutual fund statements in the future.
TIP: Unless your mutual funds are already in a tax-free account, consider investing in mutual funds which tend to hold on to their stock longer than 18 months in order to obtain the new lower capital gains tax rates, rather than in fast-trading funds in which your short-term gains will be taxed at the higher income rates. Many popular index funds tend to buy and hold on to their stock long term.
Sale of Small Business Stock. A rollover feature has been added to protect gain from the sale of qualified small business stock from tax if the gain is reinvested in other qualified small business stock.
TIP: Consider this new rollover protection from gain in your evaluation of whether to operate a small business as a pass-through entity (not eligible for the rollover) or a taxable C corporation (eligible for the rollover, and thus a possible source of venture capital).
For pass-thru entities (e.g., partnerships, S corporations), the new law provides that determination of when gain and loss are properly taken into account are made at the entity level.
Taxation of Businesses
AMT. Fewer businesses will be liable for the alternative minimum tax (AMT) under the new law. Small businesses with annual gross receipts of less than $5 million (estimated to be 90% of businesses) will be exempt from paying the alternative minimum tax for tax years starting after December 31, 1997.
The new law also contains provisions that would allow businesses to conform AMT depreciation lives to the regular tax (rather than separate depreciation lives) for property placed in service after December 31, 1998.
Farmers. Retroactively for tax years beginning after 1987, cash-basis farmers who dispose of property connected with the business (e.g., crops) would be able to use the installment method to compute AMT.
Also for farmers, three-year income averaging is now permitted, and gain from sales of property (other than land) used in such business may be included.
Partnerships. The new law provides several new rules on the allocation of basis for distributed properties, substantially appreciated inventory, and pre-contribution gain.
Additionally, for tax years beginning after December 31, 1997, the taxable year of a partnership will now close with respect to a partner whose entire interest in the partnership terminates (whether by reason of death, liquidation or otherwise).
New simplified "flow-through" rules are added to the Code for "electing large partnerships." The new "electing large partnerships" are partnerships with 100 or more partners to which for any tax year elect to be treated under these new rules.
For partnership taxable years ending after August 5, 1997, there are new rules for obtaining Tax Court review of certain returns with partnership interests. If the partner/ taxpayer files an income tax return whereby the partnership interest shows no taxable income and only a net loss ("oversheltered return"), and there would be a deficiency in the return by IRS adjustment of non-partnership items were there no net partnership loss, the IRS is now required to send a notice of such adjustment by certified or registered mail. Within 90 days of the date of mailing, the taxpayer may file a petition in Tax Court for redetermination of the non-partnership adjustments. If a timely petition is not filed, the IRS notice of adjustment is deemed correct. However, there are exceptions from the timely filing, including where a claim for refund has been filed.
If such a notice of adjustment as to non-partnership items has been mailed and thereafter an adjustment to the partnership items is made by the IRS, the notice of adjustment will be treated as a notice of deficiency.
Corporations. There are now new special rules pertaining to the recognition of gain on certain distributions in connection with acquisitions, intragroup transactions, and reorganizations. Also, there are new special rules for acquisitions by foreign corporations. These rules apply to distributions and acquisitions made after June 8, 1997 (with certain exceptions, notably for written agreements already binding on June 8th).
New provisions provide that where corporations are controlled by the transferor of property into the corporation, and the transferor/shareholder receives nonqualified preferred stock in return, then upon transfer of property to the corporation gain or loss is to be recognized.
Environmental Remediation Costs. For businesses, the new law allows the immediate expensing of eligible environmental remediation costs.
Home Office. The new law revises the definition of principal place of business for the home office deduction (effective for taxable years beginning after December 31, 1998) to provide that a home office will qualify if it is used by the taxpayer to conduct administrative or management activities and there is no other fixed location where the taxpayer conducts "substantial" administrative or management activities.
Health Insurance for the Self-Employed. Commencing with the current 1997 tax year, the health insurance deduction for the self-employed increase to 40% of such costs in 1997, 45% in 1998 and 1999, and will gradually increase to 100% by 2007.
Individual Retirement Accounts
Traditional IRA's. In tax years beginning after 1997, a person will not be considered an active participant in an employee-sponsored plan merely because the individual's spouse is an active participant. Therefore, a non-working spouse will be able to make deductible contributions of up to $2,000 to an IRA even if the working spouse is covered by an employer-provided retirement plan, provided all other requirements are met.
Money withdrawn for higher education (of taxpayer, spouse, or child, after December 31, 1997), or for first-time homes (up to $10,000), or for disability will not face the 10% early-withdrawal penalty. Additionally the new Act repeals the 15% excise tax on excess distributions from retirement plans for retirees who make large withdrawals.
New "Roth" IRA for Tax-Free Growth and Distribution. Beginning after December 31, 1997, new Roth IRAs let your after-tax contributions compound tax-free forever, provided they are held at least five years and thereafter the funds are used for retirement, a first home (up to $10,000), or disability.
Traditional IRA's alleviate tax on the earnings at the time funds are contributed to the plan, but the funds are taxed upon withdrawal. The new Roth IRA contains no tax savings at the time of contribution, but it allows for tax-free compounding with no tax upon withdrawal in retirement. Additionally, contributions may be made by persons over 70½ years, unlike traditional IRA's.
Eligibility for these new accounts phases out at income levels between $95,000 to $110,000 for singles and $150,000 to $160,000 for couples. Contributions both to Roth IRAs and regular IRAs together cannot exceed $2,000 per person ($4,000 couples) per year.
Persons with an adjusted gross income of $100,000 or less who currently have regular IRAs may roll them over into Roth IRAs (for tax-free, as opposed to tax-deferred, earnings) with payment of tax on the withdrawal spread over four years.
TIP: What to do with income on stock or partnership interests gifted to donees in their teens? Anyone over age 14 who has income of at least $2,000 a year can set up a Roth IRA. Contributing after-tax funds in the early years when a child's tax rate is low, then allowing the funds to build up over a decade or so, could produce a tax-free windfall for the purchase of the child's first home.
New Education IRAs. The new law allows a parent or grandparent (or both separately) to make deductible contributions into an education IRA beginning after December 31, 1997. The new education IRA is a trust or custodial account created exclusively for paying the qualified higher education expenses of the account holders. The accounts are not taxed; and there is no tax on account distributions provided they are for qualified uses. Contributions may only be made until the beneficiary reaches age 18. Eligibility for these new accounts phases out at income levels between $95,000 to $110,000 for singles and $150,000 to $160,000 for couples.
WARNING: The owner of the account is the child, and thus when the child is ready for college he or she may have funds in the IRA which disqualify him or her for college aid eligibility.
Other Pension Plan and Profit Sharing Plan Changes. The new tax law makes numerous amendments to these plans, including a repeal of the excess distribution and excess retirement accumulation tax. The law also changes taxation of transfers of qualified employer securities to employee stock ownership plans. Many plans may need to be amended to conform with the new law.
Other Provisions
Estimated Tax Payments. The new law raises the de minimis exemption for underpayment of individual estimated tax from under $500 to under $1,000, beginning in 1998.
Tax-Exempt Organizations. The "look-through" rule for interest, annuities, royalties, and rents derived by subsidiaries of tax-exempt organizations is expanded.
WARNING: If you are involved with a charitable institution, these new rules may affect the way the charity conducts business and raises funds.
Taxpayer Protections. Certain exceptions for some penalties were expanded, certain periods for filing claims for refunds were clarified, and provisions pertaining to the award of administrative costs in taxpayer appeals was added. Additionally, on August 5, 1997, the President signed the Taxpayer Browsing Protection Act (HR 1226) which prohibits government employees from inspecting tax returns or tax return information without authorization, and permits taxpayers to claim civil damages for the unauthorized inspection or disclosure of their returns or return information.
The contents of this publication are for information purposes only and are not meant nor should be construed to be legal advice. Note, also, the date of the document. Laws are constantly changing, and are subject to differing interpretations. We, therefore, urge you to do additional research or to contact your own legal or tax counsel before acting on the information contained here.
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