Does the TRA '97 offer true relief?
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.
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 (except for annual exclusion gifts made to members of his family). Gifts of qualified family-owned business interests made to family members since 1977 are included in the computation, according to Sec. 2033A(b)(3), at their original date-of-gift values, if such interests have continuously been held by family members since the original gift. This adjustment is for purposes of testing qualification under Sec. 2033A and does not affect valuation.
Apparently, the purpose of the above adjustments is to treat the decedent as having held at death qualified business interests previously given away to family members and given away to meet Sec. 2033A's requirements. Intrafamily sales of qualified family-owned business interests are not brought back unless there was a gift element.
According to Sec. 2033A(e)(1), a qualified business interest may include a sole proprietorship or an interest in an entity carrying on a trade or business.(7) If the family business is an entity,(8) the decedent and his family members must own (1) at least 50% of the entity; (2) at least 30% of an entity in which members of two families(9) own 70%; or (3) at least 30% of an entity in which members of three families own 90%.
Besides imposing a pre-death material participation requirement(10) the decedent or members of his family, a "qualified heir" must actively participate in the business after the decedent's death. Sec. 2033A(i)(1) defines a "qualified heir" under Sec. 2032A(e)(1) as a member of the decedent's family or an active employee of the business employed for at least 10 years before the decedent's death.(11) If a qualified heir fails to materially participate in the business, or the qualified family-owned business interest is disposed of during the 113-year period following the decedent's death, a recapture tax is imposed under Sec. 2033A(f).(12) If recapture applies within the first six years after a decedent's death, 100% of the value excluded from the estate is taxed; if recapture applies more than six years after the date of death, the tax is reduced 20% for each year thereafter.
Example 2: An estate in the 55% marginal estate tax bracket excluded $300,000 of value as a result of the family-owned business exclusion The decedent's daughter, D, inherited 100% of the business. Eight years after the decedent's death, D sold the business. A $99,000 recapture tax is imposed on the sale ($300,000 value x 55% marginal tax bracket x 60% (100% - 40%) recapture tax).
The family-owned business exclusion presents many challenges for estate planners whose clients own family businesses or farms. There may be an opposing interplay with discount planning and the excessively complicated qualification rules pose a major hurdle to effective relief.
Estate Tax Installment Payments
Owners of closely held businesses may qualify to pay the estate tax attributable to the value of a closely held business included in a taxable estate over up to 14 years. Under pre-TRA '97 Sec. 6601(j), a 4% interest rate was imposed on deferred estate tax attributable to the first $1 million in taxable value of a closely held business (i.e., the first $1 million in value in excess of the effective exemption provided by the unified credit and any other exclusions).
TRA '97 Section 503, amending Sec. 6601(j)(1)(A), reduces the 4% interest rate portion to 2%; to compute the 2% portion, the $1 million amount will be added to the applicable exclusion amount, so that the amount that qualifies for the interest rate reduction will not decline as a result of the increase in the applicable exclusion.
Sec. 6601(j)(1)(B), as amended, reduces the interest rate on the rest of the estate tax deferred under Sec. 6166 to 45%(13) of the underpayment rate prescribed by the government each quarter. Currently, the underpayment interest rate is 9%; thus, the interest payable on the deferred tax would be 4.05%.
The reduced rate is not without cost; the interest paid in connection with the deferred estate tax payments is no longer deductible for estate or income tax purposes, according to TRA '97 Section 503(b). While this will relieve the compliance burden associated with recalculating interest every year and filing supplemental estate tax returns by doing complex interrelated calculations, the loss of the deductions for the interest payments is a major loss.
These TRA '97 changes apply to estates of decedents dying after 1997; however, an estate with an ongoing Sec. 6166 election may elect the new, lower (nondeductible) interest rates, but the new 2% rate will apply only to the "4% portion" determined under old law. The decision to make the election is purely mathematical. The IRS was expected to issue guidance on the mechanics of the election before the end of 1997.
Predeceased Parent Exception
Under pre-TRA '97 Sec. 2612(c)(2), if an individual transferred an interest in property to a grandchild when the grandchild's parent (i.e., the transferor's lineal descendant) was not alive, the transfer was not subject to GST tax. TRA '97 Section 511, amending Sec. 2651(e), expands the predeceased parent exception to transfers after 1997 to collateral heirs (e.g., grandnephews or grandnieces) if the transferor has no living lineal descendants at the time of the transfer. The TRA 97 also expands the predeceased parent exception to include certain taxable terminations and distributions from trusts.(14) If the parent was predeceased at the time a transferors transfer into a trust became subject to estate or gift tax, distributions from the trust are not subject to GST tax.
Example 3: Granduncle, who has no children wishes to give property to his grandnephew. His nephew is deceased. Under the TRA 97 transfers made to the grandnephew will be excluded from GST tax as a result of the predeceased parent exception. The transfer is still a gift for gift tax purposes.
Example 4: Grandfather transfers stock to a charitable lead trust that provides an annuity payable to a charity for 20 years. After 20 years the trust remainder passes to Grandchild. Grandchild's father was dead when Grandfather transferred the stock into the trust. Because the predeceased parent exception now applies to certain taxable terminations the termination in favor of Grandchild after the trust term will not be subject to GST tax.
Permanent Conservation Easements
Subject to certain restrictions, for decedents dying after 1997, TRA '97 Section 508(a) allows an executor to exclude from the gross estate up to 40% of the value of land subject to a qualified conservation easement. Apparently, Congress amended Sec. 2013(c) to ease the pressure to sell land to raise funds to pay estate taxes, thus preserving environmentally significant land.
To use this provision, individuals or family members (including an executor) must grant a qualified conservation easement in certain real property to a charity. The maximum estate tax exclusion for a qualified conservation easement is $100,000 in 1998; it increases $100,000 per year until it is fully phased in at $500,000 in 2002, and is not indexed for inflation Because there is no coordination between this provision and the exclusion for qualified family-owned business interests, executors can take full advantage of both exclusions (when appropriate).
The exclusion does not extend to the value of development rights retained, but can be reduced if it is less than 50% of the value of the land without the easement minus the value of retained development rights. There is no reduction with respect to any development rights that all persons with an interest in the land agree to permanently extinguish before the due date of the estate tax return. According to TRA '97 Section 508(b), property excluded from a decedent's estate under this provision does not receive a basis step-up at death under Sec. 1014(a)(4)
Individuals may want to consider granting a qualified conservation easement in vacation or recreational property. This is an effective and relatively simple tool for generating substantial income tax and estate tax savings. For many properties, the easement will not prevent an individual from using or enjoying said property.
Fiduciary Income Tax Planning
The TRA '97 included a number of provisions affecting postmortem tax planning and tax compliance. Some of these provisions were designed to minimize the tax differences between estates and revocable trusts; others were drafted with simplification in mind.
65-Day Rule Extended
Under Sec. 663(b), as amended by TRA '97 Section 1306, an executor can elect to treat distributions paid within 65 days after the close of an estate's tax year as having been made on the last day of that tax year, effective for tax years beginning after Aug. 5, 1997. The 65-day rule was previously only available to complex trusts.(15) The election should simplify estate administration and will be of significance in minimizing the income tax liability of beneficiaries. For instance, any undistributed income of an estate (currently subject to relatively higher trust income tax rates) can now be determined with certainty within 65 days after the close of the tax year and distributed to low-bracket beneficiaries.
Election to Treat Revocable Trust as Part of Estate
In a long overdue simplification, an election is now available under new Sec. 646 to treat certain revocable trusts established by a decedent as part of his estate for income tax purposes.(16) This provision applies to any trust that the decedent has the power to revoke. (In making this determination, any powers held by the decedent's spouse or a non-adverse party under Sec. 672(e) are disregarded.) Further, under amended Sec. 2642(b)(1), the GST tax will not apply to revocable trust property subject to new Sec. 646 until two years after the decedent's death.
The election, which is irrevocable, must be filed by both the executor and the trustee no later than the due date (including extensions) for filing the estate's first income tax return and continues six months after the final determination of Federal estate tax liability (if a Federal estate tax return is required).(17) If no such return is required, the election is effective for two years after the decedent's death.
By making the election, executors will simplify trust administration and achieve some degree of consolidation in the postmortem tax compliance process; the trust's income and deductions are reported on the estate's income tax return. Income tax benefits from a trust making the election include the trust's ability to use a fiscal year and exemption from the estimated tax payment requirements for the first two years after death. Other benefits include the carryover for two years of the decedent's active participation for passive activity loss purposes, the availability of a deduction for amounts permanently set aside for charity and qualification as an S shareholder.
Executors and Estate Beneficiaries Treated As Related
In a further attempt by Congress to conform the treatment of estates and beneficiaries with the income tax treatment of trusts, trustees and beneficiaries, Secs. 267 and 1239(b)(3) have been amended by TRA '97 Section 1308; thus, an estate and its beneficiaries will now be treated as related persons.
An estate may no longer claim a loss on the sale of property to a beneficiary, nor use capital gains tax rates in computing its tax attributable to the sale of depreciable property to a beneficiary.(18) However, the executor and beneficiary will not be treated as related taxpayers in the case of a sale or exchange in satisfaction of a pecuniary bequest. This exception does not apply to revocable trusts; however, it could apply if an election is made to treat the revocable trust as part of the estate.These changes apply to tax years beginning after Aug. 5, 1997.
Example 5: An executor sells stock to an estate beneficiary at a $2,000 loss. Under post-TRA '97 Sec. 267, the loss is not deductible.
Separate Share Rule
The Sec. 663(c) separate share rule now applies to estates with more than one beneficiary, under TRA '97 Section 1307(a). (Trusts with more than one beneficiary must continue to use the separate share rule.) Under this rule, if a single trust has two or more beneficiaries with substantially separate and independent shares, the trust must treat the shares as separate trusts in determining the distributable net income (DNI) allocated to each share. The rule was originally enacted to provide different tax treatment of distributions to different beneficiaries to reflect the income earned by different shares of the trust's corpus even though a single trust income tax return is filed for all separate shares.
Example 6: Died on Dec. 28, 1997; his will provided that the estate was to be divided among three children in separate equal shares. Because the will establishes separate economic interests for each beneficiary, the separate share rule applies. In 1998, the estate has $90,000 of taxable income less deductible expenses, and is required to allocate $30,000 to each child. The executor distributes $50,000 to the youngest child, Q, to the exclusion of the other beneficiaries. Under the separate share rule, the estate is limited to a $30,000 DNI deduction and will owe tax on $60,000 of undistributed DNI. Q will receive taxable income of $30,000 and tax-free principal of $20,000. If the separate share rule did not apply, the estate would be entitled to a $50,000 DNI deduction and would owe tax on $40,000; Q would report $50,000 in income.
Repeal of Throwback Rules
As another simplification measure, TRA '97 Section 507(a)(1) repealed the complicated throwback rules of Secs. 665-667. The throwback rules taxed certain beneficiaries on distributions of prior years' accumulated income from complex trusts; they were enacted at a time when taxpayers could reduce their overall tax burden by shifting income to trusts with a lower tax rate than the beneficiaries. For a number of reasons (including the compressed trust income tax brackets(19)), the original purpose for the throwback rules no longer exists.
Even though the throwback rules applicable to accumulated income distributed by a trust are eliminated for domestic trusts making distributions in tax years beginning after Aug. 5, 1997, they continue to apply to (1) foreign trusts, (2) trusts that were foreign but became domestic and (3) certain domestic trusts created before March 1, 1984 and treated as "multiple trusts" under Sec. 643(f).
The repeal of the throwback rules is good news for trustees; not only does it eliminate complex tax computations imposed on the trust beneficiary, it eliminates burdensome recordkeeping. Because the repeal is effective for distributions made in a domestic trust's 1993 tax year, any distributions from accumulation trusts(20) that typically would have been made in 1997 should be made in 1998 (unless the instrument specifies otherwise), to eliminate the complex reporting such distributions could have on beneficiaries receiving such distributions in 1997.
TRA '97 Section 1027 requires estate and trust beneficiaries to treat on their individual returns "reported items" consistently with the treatment of such items on the Form 1041, Schedule K-1, Beneficiary's Share of Income, Deductions, Credits, Etc., filed by the estate or trust, or be subject to accuracy-related penalties. These rules apply to returns of beneficiaries and owners filed after Aug. 5, 1997. Consistency rules also apply to U.S. beneficiaries of foreign trusts. The rules put estates and trusts on the same reporting platform as partnerships and S corporations.
Closing a Partnership's Year Due to Death
Prior to the enactment of the TRA '97, a partnership's tax year closed with respect to a partner if the partner sold, exchanged or liquidated his partnership interest. The year did not dose on a partner's death, unless the death occurred on the last day of the tax year. Thus, the decedent partner's final return did not reflect partnership income or loss activity for the partnership's year that began during the tax year of death; rather, the deceased partner's successor in interest (normally, the executor) reported the full year's activity attributable to the deceased partner on the estate's income tax return.
Effective for partnership years beginning after 1997, TRA '97 Section 1246(a), amending Sec. 760(c)(2)(A), treats the partnership year as closed with respect to a partner whose entire interest in the partnership terminates by reason of death, liquidation or otherwise (except for certain bankruptcies). Therefore, a deceased partner's allocable share of partnership items up to the date of death will be taxed on his final return; any items allocated to the period after death will be treated separately.
Closing the partnership's tax year with respect to a deceased partner allows the latter's allocable share of partnership items up to the date of death to be included by a spouse on any final joint return, perhaps more fully using deductions and exemptions. The dosing may cause income bunching of more than one year's partnership income on the decedent's final return if the partnership has a fiscal year-end. If a partnership is on a fiscal year, the deceased's partner's final return may reflect his share of partnership income for a full fiscal year ending prior to death, as well as a short period ending on death. It is not clear how to calculate the deceased partner's share of short-period income. Presumably, the IRS could adopt a method similar to that used by S corporations in determining the income of a deceased shareholder.(21)
Contributions of Appreciated Stock to Private Foundations
TRA '97 Section 602(a), amending Sec. 170(e)(5)(D)(ii), retroactively reinstates an expired provision that allowed donors of qualified appreciated (i.e., publicly traded) stock to private foundations to deduct the fair market value (FMV) of the contributed stock, rather than basis. The provision is retroactively reinstated for contributions made from June 1, 1997 to June 30, 1998. However, the deduction applies only to the extent that the family's contributions of stock to private foundations do not exceed 10% of that corporation's outstanding stock.
Charitable Remainder Trusts
TRA '97 Section 1089 imposes two new restrictions that alter the economics of using charitable remainder trusts (CRTs). First, the present value of the remainder interest for any transfer to a CRT must equal at least 10% of the net FMV of the property transferred, computed on the date of transfer. (The value is computed using the applicable Sec. 7520 rate.)
Second, a trust will not qualify as a CRT if the required annual payout to the income beneficiary is greater than 50% of the FMV of the trusts assets.(22) The minimum payout percentage continues to be 5%. Due to the 10% threshold, the 50% limit will rarely be an issue. The table above illustrates the potential impact of the 10% rule.
Impact of the 10% Rule on CRUTs(*) Ages of 5% 6% 7% 8% income payout payout payout payout beneficiaries rate rate rate rate 60 and 60 Pass Pass Pass Pass 50 and 45 Pass Pass Fail Fail 35 and 34 Fail Fail Fail Fail 45 Pass Pass Pass Pass Ages of 9% 10% 11% income payout payout payout beneficiaries rate rate rate 60 and 60 Pass Fail Fail 50 and 45 Fail Fail Fail 35 and 34 Fail Fail Fail 45 Fail Fail Fail
(*) An applicable Federal rate of 7.4% is assumed.
These new rules represent the legislative response to CRTs deemed to be abusive by the IRS.(23) The 50% cap applies to transfers after June 18, 1997. The 10% threshold applies to transfers after July 28, 1997, except for transfers under a testamentary instrument executed before July 29, 1997, if the transferor dies before Jan. 1, 1999. Wills and revocable trusts that establish CRTs should be examined to determine whether the new rules would apply, especially the 10% threshold.
A favorable simplication provision, TRA '97 Section 1301(a), amending Sec. 6019(3), applies to donors making charitable contributions after Aug. 5, 1997. Said donors will no longer be required to file a Form 709, U.S. Gift Tax Return, provided that the entire value of the transferred property qualifies for the gift tax charitable deduction and the donor transfers the entire property interest. This relief does not apply to gifts of remainder interests.
New Capital Gains Rates and Holding Periods
After a long wait and much speculation, there are new individual capital gains rates. The maximum rate applicable to long-term gains is reduced to 20%, but the holding period to qualify for that rate has been increased to more than 18 months. Gains on the sale of assets held for more than 12 months but no more than 18 months are taxed at the 28% rate.(24)
Property acquired or passing from a decedent is deemed held by an estate or other recipient for a long-term holding period if the recipient received a stepped-up basis and the property is sold or disposed of within the short-term holding period after the decedent's death. Such property qualifies for the long-term holding period for all income tax purposes. It is unclear after the passage of the TRA '97 the rate applicable to the inherited property. Some commentators have stated that the estate would have to hold the property for an additional six months to benefit from the lower capital gains rate. The Tax Technical Corrections Act of 1997 clarifies this issue; if passed, inherited property would be deemed to have a holding period greater than 18 months, allowing use of the 10% and 20% rates.(25) The special holding period, coupled with the new rates, means that capital gains on inherited property will be taxed at a maximum 20% rate, even when such property has been held for no more than 18 months.
Repeal of Excess Accumulations and Excess Distributions Taxes
The recent bull market has increased the number of individuals potentially subject to the Sec. 4980A 15% estate excise tax on excess accumulations in retirement plans and the 15% excise tax on excess distributions from retirement plans. TRA '97 Section 1073(a) repealed both excise taxes for distributions and deaths occurring after 1996. Existing retirement and estate planning strategies should be reexamined in light of the repeal of these taxes.
Example 7: X, age 59 1/2, has a combined accumulation of $1,000,000 in all of his qualified retirement accounts and intends to retire at age 65. X must begin receiving distributions from the accounts following the year after reaching age 70 1/2. If the plan assets earn an average of 10% annually, withdrawals are limited to the required minimum distributions and X lives until age 79 1/2, the net benefit of the repeal of the excess accumulations tax to the heirs is approximately $138,000.
The Roth IRA
TRA '97 Section 302 introduced a new type of individual retirement account (IRA), the Roth IRA (named after its creator, Sen. William Roth (R-Del.)), that has already captured much attention. Not only will it benefit those saving for retirement; many of its features allow greater wealth accumulation than in existing traditional IRAs. Roth IRAs offer the advantage of tax-free build-up, as compared to tax-deferred build-up in traditional IRAs.
Beginning in 1998, individuals may make nondeductible contributions of up to $2,000 annually to a Roth IRA, subject to income phaseouts.(26) Under Sec. 408A(c)(4), Roth IRA contributions can be made after age 70 1/2, offering additional flexibility and wealth accumulation. Generally, spouses can make a $2,000 contribution each, as long as the couple's combined earned income is at least $4,000, according to Sec. 219(c)(1)(B)(ii).
From an estate planning perspective, Roth IRAs are advantageous. Unlike with traditional IRAs, the lifetime minimum distribution rules do not apply; consequently, earnings can accumulate for a longer period of time in a Roth IRA than in a traditional IRA or other qualified plans subject to the age 70 1/2 minimum distribution rules. Under Sec. 408A(d)(1)(A), distributions from a Roth IRA are income tax free if the IRA has been held for at least five years and the funds are withdrawn after reaching age 59 1/2, or as a result of death or disability.(27)
Although under Sec. 408A(c)(5), the minimum distribution rules do not apply to a Roth IRA during the account holder's life, at death, the account generally must be distributed within five years (or, if the account has a designated beneficiary, over the beneficiary's life). Special rules apply to spouses named as designated beneficiaries. Because the minimum distribution rules do not apply, individuals may increase their ability to pass significant wealth to their heirs by deferring distributions during life. Designated beneficiaries may receive distributions from the account over their life expectancies, allowing a continuing deferral of the undistributed account balance. More importantly, such heirs will not be required to include distributions in their income, unlike with traditional IRAs.
Individuals who own regular and nondeductible IRAs can convert their existing IRAs into Roth IRAs if income tax related to the conversion is paid and certain other conditions are met.(28) Eligible individuals at or near retirement should consider converting all or a portion of their existing IRAs to Roth IRAs, assuming they have sufficient other assets to avoid withdrawals from the Roth IRA within the five-year window. An individual and heirs may wind up with more after-tax assets by converting.
The TRA '97 contained other estate and trust provisions, including the following:
* Trustees of pre-need funeral trusts to which aggregate contributions do not exceed $7,000 can elect to have them treated as independent trusts not subject to the grantor trust rules (TRA '97 Section 1309(a), adding Sec. 685).
* For sales or exchanges after Aug. 5, 1997, repeal of Sec. 644 by TRA '97 Section 507(b)(1), which taxed precontribution gain at the donor's marginal tax rate if a trust sold an asset two years after receiving it.
* Under Sec. 2056(b)(7)(C), as amended by TRA '97 Section 1311(a), for estates of decedents dying after Aug. 5, 1997, a nonparticipant spouse's community property interest in a retirement plan qualifies for the marital deduction (as long as the nonparticipant spouse dies first).
* Under Sec. 2105(b)(4), as amended by TRA '97 Section 1304(a), short-term (i.e., Up to 183 days) original issue discount obligations of a nonresident alien (NRA) decedent are excluded from the taxable estate, provided the interest on the obligation is not effectively connected with a U.S. trade or business. While the new exclusion provides some relief to NRAs, the unified credit and applicable exemption for NRAs remain unchanged.
* Under TRA '97 Section 1302, amending Secs. 2207A(a)(2) and 2207B(a)(2), for an estate's right of recovery of qualified terminable interest property (QTIP) to be waived for decedents dying after Aug. 5, 1997, a testamentary instrument must explicitly state the testator's intention to waive the right by specifying what is waived (e.g., the QTIP the QTIP trust, Sec. 2044 or Sec. 2207A), or by describing the property to which the testator or trust settlor is relinquishing the right of recovery.
* Gifts made after Aug. 5, 1997 cannot be revalued for estate tax purposes if the gift tax statute of limitations (SOL) has expired and the gift Noms adequately reported on a gift tax return,(29) In the past, some courts have permitted the IRS to redetermine the value of a gift for which the SOL had expired to determine the appropriate tax rate bracket and unified credit for estate tax purposes. The changes made by TRA '97 Section 506(a) and (d) to Secs. 2001 (f) and 2504(c) should prevent the Service from revaluing an adequately reported gift after the SOL has expired.
(1) The TRA '97's individual tax provisions are discussed in Bukofsky and Sherr, "Diverse Planning Opportunities Available Under the TRA 97 (Part I)," p. 18 this issue.
(2) See Soled and Arnell, "Planning Implications of the TRA '97's Increase in the Unified Credit," 28 The Tax Adviser 704 (Nov. 1997).
(3) See H. Rep. No. 105-148, 405th Cong., 1st Sess. 354 (1997); S. Rep. No. 105-949, 103th Cong., 2d Sess. 1997).
(4) Sec. 2033A is an outgrowth of the "American Family-Owned Business Act" (S. 1086) v. which later became part of the "Contract With America Tax Relief Act of 1995" (H.R. 2491) vetoed by President Clinton.
(5) Increases in the unified credit provide a tax benefit at the decedent's lowest estate tax bracket, while the family-owned business exclusion provides a benefit at the decedent's highest estate tax bracket a disparity resulting in an overall estate tax increase as the unified credit increases.
(6) See Staff of the Joint Committee on Taxation, Description of Chairman's Mark of the "Tax Technical Corrections Act of 1997" (JCX-56-97 10/8/97).
(7) Special look through rules exist for business that own an interest in another entity ("tiered entities"); see Sec. 2033A(e)(3)(B).
(8) According to Sec. 2033A(e)(3) ownership of a corporation is determined by counting the total combined voting power of all classes of stock entitled to vote and the appropriate percentage of the total value of all shares, partnership interests are determined by measuring the capital interests.
(9) Sec. 2033A(i)(2) states that for purposes of determining the percentage ownership of the decedent and his family, "family member" is defined under Sec. 2032A(e)(2). An individual's family includes his spouse, parents, grandparents, children, adopted children brothers sisters nieces and nephews, and their spouses and ancestors.
(10) Under Sec. 2033A(b)(1)(D), for at least five years during the eight-year period ending on the decedent's death the decedent or family member must have owned the qualified business interest and materially participated in the operation of the business to which the interest relates Material participation is defined in sec. 2032A(c)(6)(B).
(11) According to Sec. 2033A(g) if an heir is not a U.S. citizen, property can quality for the exclusion only if held in a qualified trust.
(12) Recapture is also triggered when the business's principal place of business ceases to be located in the U.S. or the qualified heir loses U.S. citizenship. Recapture does not apply to sales or dispositions of equipment, inventory or supplies in the ordinary course of business.
(13) The net interest after giving effect to an estate tax deduction at the 55% rate.
(14) See The Taxpayer Relief Act of 1997 Statement of the Managers (8/1/97),
(15) The 65-day rule did not apply to simple trusts, because all income from such trusts is deemed to be taxable to beneficiaries regardless of whether distributions were actually made by the end of the year.
(16) TRA '97 Section 1305, adding Sec. 646 and amending Sec. 2652(b)(1), effective for decedents dying after Aug. 5, 1997.
(17) The election can be made for a revocable trust even if there is no probate estate.
(18) Gain on depreciable property is classified as ordinary income under Sec. 1 250.
(19) For 1997, the 39.6% rate applies to trust income over $8,000, under Sec. 1(e).
(20) This applies to a accumulation trusts created after Feb. 29, 1984.
(21) The IRS could adopt a per-day computation or, alternatively, an actual method.
(22) Valued at the time the trust is established in the case of a charitable remainder annuity trust (annually in the case of a charitable remainder unitrust (CRUT)).
(23) The rule is designed to eliminate a planning technique that used a short-term, high-payout CRT to eliminate most of the capital gain the sale of an appreciated asset; see Notice 94-78, 1994-2 CB 555, in which the Service indicated an intention to challenge CRUTs with high payout rates (e.g., 80%) and short terms (e.g., two years).
(24) The capital gains rates are discussed in Bukofsky and Sherr, note 1.
(25) The Tax Technical Corrections Act of 1997 (H.R. 2676), Section 5(d)(4).
(26) For joint filers, eligibility begins to phase out when adjusted gross income (AGI) reaches $150,000 and completely phases out at $160,000. For single filers, the range is between $95,000 and $110,000 of AGIl: see Sec. 408A(c)(3)(C)(ii).
(27) Subject to limitations, funds can be withdrawn and used to pay up to $10,000 of expenses related to the acquisition of a principal residence; see Sec. 408A(d)(5).
(28) Under Sec. 408A(c)(3)(B)(i), taxpayers with AGI of $100,000 or less (not married filing separately) can convert regular IRAs into a Roth IRA starting in 1998; under Sec. 408A(d)(3)(A)(iii), converted IRA amounts are taken into income (and tax is paid on the distribution) ratably over four years. The four-year tax payment option is not available for conversions after 1998. The 110% early distribution tax does not apply to the conversion, but it may apply to amounts withdrawn after conversion.
RELATED ARTICLE: EXECUTIVE SUMMARY
* The TRA '97 provision that should have the widest impact for estate planners is the phase-in of an increase in the unified credit.
* The family-owned business exclusion offers valuation discount and qualification opportunities, but the excessively complicated qualification rules pose a major hurdle to effective relief.
* The TRA '97 includes a number of provisions affecting post-mortem tax planning and tax compliance, some designed to minimize the tax differences between estates and revocable trusts, others drafted with simplification in mind.
John H. Gardner, J.D. Senior Manager Washington National Tax Office KPMG Peat Marwick LLP Washington, D.C.
Brent S. Lipschultz, CPA,J.D. Senior Manager Washington National Tax Office KPMG Peat Marwick LLP Washington, D.C.
Editor's note: Mr. Gardner chairs the AICPA Tax Division's Trust, Estate, and Gift Tax Committee.
For additional information about this article, contact Mr. Gardner at (202) 467-3870.