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

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 marketability discount.(10) A 35% discount would reduce the gift to $312,000 ($1,000,000 X 48% X 65%).

In Examples 1, 2 and 3, if A, B and C have not made prior taxable gifts, their unified credits would be available to shield these otherwise taxable transfers from gift tax. In addition, any appreciation in the value of Z stock (in Example 1), B's personal residence (in Example 2) or the FLP (in Example 3) would generate no additional transfer tax, because the value of any gift is frozen on the date the transfer is completed.

So-called "bypass trusts" represent the preservation leg of unified credit planning. Such trusts permit taxpayers, during life and at death, to provide for their surviving spouses without the value of trust assets being included in the surviving spouse's taxable estate. Often, these trusts function in tandem with marital trusts (e.g., qualified terminable interest property trusts) that defer (but do not eliminate) estate tax. In contrast, all asset appreciation in a bypass trust escapes estate tax at the death of the surviving spouse.

Example 4: D, who is married to E, has a net worth of $1,000,000 and has made no taxable gifts during his life. D dies; his will provides for the establishment of two trusts, each for E's lifetime benefit. Under D's will, the first trust (the bypass trust) is to be funded with an amount equal to the unified credit exemption equivalent (currently, $600,000); the second trust (the marital trust) is established to hold the balance of D's estate (i.e., $400,000). The difference between the two trusts is that the assets of the bypass trust and their appreciation escape estate tax at E's death; the marital trust, if it meets certain requirements (e.g., providing a life income interest to E), will qualify for the marital deduction, but its assets (and their appreciation) will be taxable in E's estate.

The estate planning techniques in these examples turn on the successful use of the unified credit to reduce or eliminate the effect of Federal transfer taxes. In 1997, Congress decided that for many taxpayers, the size of the unified credit was inadequate. An increase was necessary to encourage saving, promote capital formation and entrepreneurial activity and help to preserve existing family-owned farms and businesses.(11)

The New Law

Unified Credit

TRA '97 Section 501(a), amending Sec. 2010(a), enacted Aug. 5, 1997, increases the unified credit over the next nine years,(12) as follows:

                   Exemption      Unified
Year               equivalent     credit

1998               $  625,000     $ 202,050
1999                  650,000       211,300
2000 and 2001         675,000       220,550
2002 and 2003         700,000       229,800
2004                  850,000       287,300
2005                  950,000       326,300
2006                1,000,000       345,800

Thus, the transfer tax relief will not be immediate, but rather, stretched over a long period of time, making it less certain that the total expected relief will actually be provided. When entirely phased-in, the increase in the unified credit represents an estate tax reduction of $153,000 on the newly exempted $400,000 ([$150,000 X 37%] + [$250,000 X 39%]). These changes will also decrease revenue to those states with an estate tax equal to the Sec. 2011 state death tax credit.

Gift Disclosure

Aside from the phase-in of the unified credit, there are a few other legislative changes that directly bear on the size of the unified credit. The first is the addition of Sec. 2001(f) by TRA '97 Section 506(a), which bars the IRS from revaluing a taxpayer's prior gift (whether or not it was taxable) for estate tax purposes if the statute of limitations (SOL) for determining the gift's value has lapsed. According to new Sec. 6501(c)(9), added by TRA '97 Section 506(b), the SOL will lapse only if (1) the gift is shown or disclosed on the return or (2) a statement describing the nature of the gift is attached to the return. A procedure under new Sec. 7477, added by TRA '97 Section 506(c)(1), allows taxpayers to obtain a judicial determination of the gifts value. Previously, if no gift tax was payable (e.g., the revalued gift only exhausted all or a portion of the unified credit), no court had jurisdiction to review the IRSs determination.

Example 5: F gives her family farm to her daughter in 1998, reporting a value of $200,000 on her Federal gift tax return. In 2005 (after the SOL has lapsed), F dies. Under pre-TRA'97 Sec. 2001, the IRS could revalue F's gift. The IRS could have increased the value of the taxable gift (say, to $1,000,000) for purposes of computing the estate tax, thereby pushing F's estate into a higher tax bracket, resulting in more estate tax. Post-TRA '97, the IPS would have to accept F's $200,000 original valuation, because the SOL has expired.

Family-Owned Businesses

Another change provides tax relief for qualified family-owned business interests. In general, under new Sec. 2033A, enacted by TRA '97 Section 502(a), a "qualified family owned business interest" is:

1. An interest as a proprietor in a trade or business carried on as a proprietorship, or

2. An interest in an entity carrying on a trade or business, if at least (i) 50% of such entity is owned (directly or indirectly) by the decedent and members of his family, (ii) 70% of such entity is so owned by members of two families or (iii) 90% of such entity is so owned by members of three families. For purposes of (ii) and (iii), at least 30% of such entity must be owned (directly or indirectly) by the decedent and members of his family.

There are two other stringent requirements. First, an executor may elect the exclusion only if the value of the qualified family-owned business interests included in the estate, along with certain interests the decedent gifted to family members, exceeds 50% of the adjusted gross estate. Second, the exclusion is available only if the decedent (or members of his family) owned and materially participated in the family-owned trade or business for at least five of the eight years preceding the decedent's death, and such interest passes to qualified heirs who agree to materially participate in the business for the 10 years following his death.

If the requirements are met, up to $1.3 million of the value of the decedent's family-owned business interest can be excluded from his estate. Use of this exclusion, however, results in a corresponding reduction of the unified credit.

Example 6. In 2006, G, a widower whose only property consists of a wholly owned car wash worth $1,500,000, dies. G bequeaths this business in equal shares to his son and daughter, who have both been active in the business for the past 10 years and who plan to continue its operation for at least another 10 years. Because the business qualifies for the family-owned business exclusion, $1,300,000 of its value can be excluded from G's estate. However, the estate must forgo the use of G's unified credit, leaving a gross estate of $200,000 that is fully taxable.

The increase in the unified credit, combined with the other Code changes, makes planning for the appropriate use of the credit all the more important.

Tax Planning Possibilities

Gifts of assets anticipated to greatly appreciate in value have always had strategic estate planning merit. The gift severs the donor's interest in the property, permitting appreciation to escape transfer tax and inure to the recipient's benefit. As the increase in the unified credit is phased in, there will be added opportunity to employ this tactic.

Example 7: Prior to the TRA '97, H could have given Y Corp. stock worth $600,000 to her son, Z. However, once the increase in the unified credit is fully phased in (in 2006), H could instead give Z $ 1,000,000 of Y stock. If H dies in 2013, seven years after the gift, when the value of the Y stock in Z's hands is $2,000,000, the tax savings inuring to H and Z, under the TRA '97 (assuming a 50% effective estate tax rate), is $400,000 ([$2,000,000 -- $1,200,000] X 50%).

There is a slight administrative drawback to the lengthy phase-in period for taxpayers who have previously exhausted their unified credits. To take full advantage of the incremental increase in the credit and commence the SOL (as was previously discussed), taxpayers must file gift tax returns or otherwise disclose the gift.

Like the gifting of highly appreciating assets, the use of valuation minimization techniques has always been an important way to transfer wealth. Under the TRA '97, there are enhanced opportunities to use these techniques, because of the increase in the unified credit and the IRSs inability to revalue a previous gift for estate tax purposes.

Bypass Trust Funding

In terms of unified credit preservation, the TRA '97 invites a number of important considerations, including adequate bypass trust funding, document review and general estate planning orientation.

To maximize the testamentary use of the unified credit, the FMV of the taxpayer's assets must equal or exceed the available unified credit shelter equivalent exemption (taking into account any prior taxable gifts); such assets must be in the taxpayer's individual name or held in a manner available to fund a bypass trust (e.g., in the name of a trustee of a revocable trust, the terms of which provide for the establishment of a bypass trust). jointly held assets and life insurance proceeds (unless payable to the estate or the subject of a disclaimer), for example, cannot be used to fund a bypass trust.

To ensure full funding of a bypass trust, estate tax planners previously recommended that taxpayers hold at least $600,000 of assets in their individual names (or in a way available to fund a bypass trust). The increase in the unified credit creates a need for a concomitant increase in the assets held individually (or in a way available to fund a bypass trust). For example, assuming sufficient net worth, in 1999, a taxpayer potentially subject to Federal transfer tax should have at least $650,000 available for bypass trust funding purposes.

Document Review

Taxpayers should review all of their estate planning instruments to ensure maximum use of the unified credit. For example, if a provision in a will funds a bypass trust using a specific dollar figure (e.g., $600,000), rather than making reference to the unified credit, new planning is in order. Taxpayers should also examine the funding formulae for their various testamentary trusts (e.g., bypass trust, marital trust and/or GST tax-exempt trust) to make sure that they are still all internally consistent after the TRA '97. Because the $1.3 million exclusion for family-owned business interests will interact with the unified credit, the effects of the exclusion election on the overall testamentary plan must be considered.

Another item is whether a bypass trust and a marital trust are still needed. Many married taxpayers whose combined net worth with their spouse is currently in the $1.2 to $2 million range may want to reconsider whether they need marital trust provisions in their wills or if the establishment of a bypass trust alone will now suffice.

Example 8: I is married to J. Their combined net worth is $1,600,000; their wills establish both a bypass trust and a marital trust on the death of the first spouse. Assuming their assets are properly titled, when the increase in the unified credit is fully phased in, I and J may decide that it is no longer necessary to have marital trusts established under their respective wills.

TRA '97 Section 501(d) provides that the Sec. 2631 (a) $1 million GST exemption is to be adjusted for inflation beginning in 1999. This exemption allows taxpayers to make any trust have a "zero inclusion ratio" and, therefore, exempt it from GST tax. A common practice of the past was to have the executor allocate $600,000 of the exemption to the bypass trust and the $400,000 balance to one of two marital trusts established under the will (the "GST Exempt Part"). The taxpayer's other marital trust (the "Non-GST Exempt Part") was commonly funded with the balance of the estate. Proper allocation of the GST exemption to the bypass and GST Exempt Part marital trusts insulated both trusts from GST tax.

Once the increase in the unified credit is fully phased in, the the amounts shielded by it and the GST exemption will be approximately equal (i.e., $1 million). In many instances, taxpayers will no longer need two GST trusts(13); instead, a bypass trust can make full use of both the unified credit and almost all of the GST exemption. Taxpayers may discover that their wills are a bit less complex absent the GST Exempt Part trust.(14)

Conclusion

Maximizing the use of the unified credit has been an estate planning mantra ever since the credit's introduction in 1976. The TRA '97 has not changed that philosophy; if anything, the increase in the credit suggests that taxpayers redouble their efforts to achieve this goal.

Therefore, they must understand the full effects brought about by the law changes; in particular, they must reevaluate each of their existing estate planning documents to determine which changes (if any) are necessary to fully maximize their use of the unified credit. This article presents a framework for taxpayers to proceed with this analysis.

(1) Tax Reform Act of 1976, Section 2001 (a)(2) and (4).

(2) Economic Recovery Tax Act of 198 1, Section 401(a).

(3) See Secs. 2501(a), 2001(a) and 2601(a).

(4) Secs. 2001(c) and 2502(a). In the case of the GST tax, the rate under Secs. 2602 and 2641(a)(1) is a flat 55%, (i.e., the current maximum estate tax rate). There is also a 5% estate tax surtax imposed by Sec. 2001(c)(2) on taxable estates between $10 million and $21.04 million.

(5) See, e.g., Harrison, "Calculating the Potential for Transfer Tax Savings in Personal Residence GRITs," 80 Journal of Taxation 232 (April 1994).

(6) See, e.g., Vorsatz, Woodson and Johnson, "GRATs Let Grantor Retain Control and Reduce Transfer Tax," 56 Taxation for Accountants 68 (Feb. 1996).

(7) See, e.g., Jones, "Family Limited Partnerships Achieve Tax and Nontax Goals," 23 Taxation for Lawyers 196 (Jan. 1995).

(8) The IRS, however, has recently issued a series of letter rulings involving FLPs and death-bed transfers in which valuation discounts have been denied. See Letter Rulings (TAM) 9735003 (5/8/97); TAM 9730004 (4/3/97); 9725002 (3/3/97);TAM 9723009 (2/24/97); and TAM 9719006 (1/14/97).

(9) The valuation calculation was performed using "Estate Planning Tools," manufactured by Brentmark Software, Inc.; [phone].

(10) See, e.g., Est. of Samuel I. Newhouse, 94 TC 193 (1990) (permitting a 35% combined discount).

(11) S. Rep. No. 105-949, 105th Cong., 1st Sess. 38 (1997).

(12) TRA '97 Section 501(a)(1)(D) extends the Sec. 2001(c)(2) 5% estate tax surtax on taxable estates greater than $10 million until the average estate tax rate is 55%.

(13) The likely small difference between the inflation-adjusted GST exemption and the fully phased-in unified credit may make some taxpayers decide to forgo establishing such a small trust, given the additional administrative complexity and costs.

(14) In the event a taxpayer's remaining unified credit and GST exemption are different (e.g., because of inter vivos allocations of GST exemption to an irrevocable life insurance trust), the executor should be able to divide the bypass or marital trust to achieve the desired results.

RELATED ARTICLE: EXECUTIVE SUMMARY

* New Sec. 2001(f) provides that the Service cannot revalue a previously disclosed gift for estate tax purposes once the SOL has expired.

* Starting in 1999, the $1, million GST exemption will be indexed for inflation.

* The first $1.3 million of a family-owned business interest will be excluded from the gross estate if strict new rules are met.