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ESTATE AND TAX PLANNING
FALL 1997 REPORT

1997 TAX DEVELOPMENTS

This report highlights a number of recent tax-related developments that affect future estate planning opportunities.

Taxpayer Relief Act of 1997: Important Changes

The Taxpayer Relief Act of 1997, signed into law by President Clinton on August 5, 1997, makes a number of changes in the current U.S. estate and gift tax system. Some of these changes are briefly noted:

Increase in Unified Credit. Since 1987, a Unified Credit of $192,800 has been available for estate and gift tax purposes, effectively shielding from tax the first $600,000 of property transferred by an individual either during his or her life or at death. Inflation, of course, has eroded the value of the Unified Credit over the last ten years. The Act will minimize inflationary effects by gradually increasing the Unified Credit in stages to provide an effective exemption equivalent of $1 million by the year 2006. The increase will be phased-in as follows:

Gifts Made or Estates of Decedents Dying In

1997 (current law)
1998
1999
2000 and 2001
2002 and 2003
2004
2005
2006 (and thereafter)

Exemption Equivalent

$600,000
625,000
650,000
675,000
700,000
850,000
950,000
1,000,000

Contrary to congressional reports issued prior to the final passage of the Act, the new Unified Credit amounts will not be indexed for inflation. Consequently, this back-loaded phase-in schedule will likely do little more than track a modest inflationary trend rather than provide taxpayers with an increase in the Unified Credit in constant dollars.

Inflationary Adjustments. Under prior law, taxpayers have had available (i) the $10,000 per donee annual gift tax exclusion and (ii) the unlimited exclusion for direct transfers to pay tuition and medical expenses. The Act provides an inflationary adjustment to the annual exclusion for gifts made after 1998. The $1 million generation-skipping transfer (GST) exemption will also be indexed for inflation after 1998.

An unfortunate technicality in the annual gift tax exclusion provision limits the inflationary adjustment to increments of $1,000, which would rule out any adjustment until the cost-of-living adjustment reaches 10 percent; several years could thus pass before the annual gift tax exclusion is raised. The inflationary adjustment for GST purposes, however, should result in more immediate relief.

Capital Gains. The top capital gains tax rate has been reduced from 28% to 20% on long term gains (now limited to capital assets held more than 18 months). A number of rules under the Act affect assets sold between May 7 and July 28, 1997 and taxpayers who would otherwise be taxed in a regular bracket of less than 20%. The top capital gains tax rate will fall to 18% for assets purchased after 2000 and held for at least five years. A technical correction recently proposed by the Ways and Means Committee would clarify that all inherited property will be deemed to have been held for more than 18 months.

Sale of Principal Residence. The rollover and $125,000 exclusion provisions have been eliminated in favor of an exemption covering $250,000 ($500,000 for married taxpayers filing jointly) of capital gain on the sale of a "principal residence" which has been owned and used as such for two of the five years prior to the sale. The new exemption applies regardless of the age of the taxpayer.

Family-Owned Business Exclusion. If a qualifying family-owned business interest represents more than 50% of a decedent's adjusted gross estate, an exclusion is available in the amount of $1,300,000 less the applicable Unified Credit exemption equivalent. Thus, qualifying family business owners dying after 1997 may be able to shelter up to $1,300,000 of value from U.S. estate tax by combining the Unified Credit and the new Family-Owned Business Exclusion.

Gifts of Stock to Private Foundations. The Act has temporarily restored the tax advantage of giving stock to private foundations. For a limited time, taxpayers will receive a charitable deduction for the full fair market value of appreciated publicly traded stock contributed to a private foundation. The provision applies retroactively to gifts of "qualified stock" made between June 1, 1997 and June 30, 1998. "Qualified stock" consists of publicly traded stock for which market quotations are readily available on an established securities market. Only stock that would have generated a long-term capital gain if it had been sold by the taxpayer will receive a charitable deduction, and the deduction may still be limited by other provisions of the Internal Revenue Code (generally, the deduction cannot exceed 20% of the taxpayer's adjusted gross income).

Charitable Remainder Trusts. Two new technical requirements have been imposed. The value of the charitable remainder must equal or exceed 10 percent of the fair market value of the property transferred to the trust. The annual payment to be made to the non-charitable beneficiary must continue to meet the 5 percent minimum payout requirement, and now must not exceed 50 percent of the value of the trust assets; the latter requirement is designed to prevent abuses resulting from the use of short-term charitable trusts as a vehicle to avoid capital gains tax on appreciated property contributed to the trust and sold, with the proceeds paid almost immediately back to the grantor or other non-charitable beneficiary.

Retirement Plan Excise Tax. The 15 percent excise tax on excess distributions from IRAs and qualified plans has been repealed for years beginning after 1996. Likewise, the excess accumulations tax at death has been repealed for persons dying after 1996.

New Estate and Gift Tax Regime Benefits New York Residents

A dramatic change has recently been made in the New York State estate and gift tax law. On August 7, 1997, Governor Pataki signed into law a bill that features a phased-in reduction of the New York estate tax and a repeal of the New York gift tax.

The current regime provides a unified credit of $2,950, effectively shielding from both gift and estate tax the first $115,000 of property transferred by an individual either during lifetime or at death. Under the new law, the amount of property exempted by the New York unified credit for estate tax purposes will increase to $300,000 in the case of decedents dying on or after October 1, 1998. On February 1, 2000, the current New York State estate tax will be replaced with a "pick up" tax, namely an estate tax equal to the maximum credit allowed against the U.S. estate tax for the payment of state death taxes. In most estates subject to New York estate tax, the new "pickup tax" should result in a lower estate tax than the current estate tax.

In addition, under the new law, the amount of property exempted by the New York unified credit for gift tax purposes will increase to $300,000 in the case of gifts made on or after January 1, 1999. After January 1, 2000, the New York gift tax will be repealed.

The new law will conform New York's transfer tax system to that of the majority of other states, such as Florida, where the estate tax is tied to the U.S. state death tax credit and no gift tax is imposed on lifetime transfers. It is designed to encourage New Yorkers to remain in New York instead of moving to another jurisdiction in order to avoid higher wealth transfer taxes.

New Law Would Bar Revaluation at Death of a Donor's Lifetime Gifts

Because the U.S. estate and gift tax rates are unified, the value of all taxable gifts made during lifetime will affect the estate tax rate applicable to the assets included in a decedent's gross estate at death. In the context of an estate tax audit, courts have permitted the IRS to scrutinize and, where appropriate, to revalue gifts made by a decedent in the course of a lifetime -- even when the gift has been reported on a gift tax return and the statute of limitations has run. The specter of an estate tax review of lifetime gifts would require a careful donor to maintain value-substantiating records for many years or decades, and could be particularly troublesome in the case of a gift such as artwork valued on the basis of the opinion of an expert appraiser, who may not be available to provide supporting testimony at the donor's death.

Under a provision in the Taxpayer Relief Act of 1997, the value of a gift will now be fixed for purposes of computing the estate tax due at the donor's death if:

the subject of the gift and its value is adequately disclosed on a gift tax return or attached statement, and
the statute of limitations (usually three years) for assessing any gift tax on the transfer has expired.

The Committee Report prepared during the consideration of the bill indicates that the gift can be considered adequately disclosed even though no gift tax is payable, such as when the Unified Credit is applied to the transfer.

The new law clarifies that the statute of limitations will not run on an inadequately disclosed transfer, even if the taxpayer-donor filed a gift tax return to report other transfers during the period. Further, in the event of a valuation controversy with the IRS, the taxpayer-donor may now request that a valuation determination be made by the Tax Court.

To obtain the protection of the new law, tax-payers may be inclined to disclose transfers they would not otherwise report for purposes of the gift tax. Consider a sale of property by a taxpayer to a junior family member for adequate consideration. Disclosure of the transaction on an attachment to a gift tax return, with the "gift" being valued at "zero," should avoid any estate tax inquiry once the gift tax statute of limitations has expired. Presumably, such reporting will also be more likely to occasion a gift tax audit.

In general, the new law should promote more effective planning and reduce opportunities for the IRS to surprise a decedent's Executor with a stale valuation argument.

Sale of Remainder Interest in Property for its Actuarial Value Held to Remove Property from Decedent's Gross Estate

A decedent's gross estate will include the value of any property transferred by the decedent during lifetime, in trust or otherwise, if he or she retained a life income interest in the property. Under an important exception, this rule will not apply if the transfer was a "bona fide sale for adequate and full consideration." Some taxpayers sought to take advantage of this exception in the 1980's by selling remainder interests in property to junior family members for "consideration" equal to the actuarial value of the remainder as determined under the IRS tables. In an appropriate situation, the senior family member would continue to enjoy the lifetime use of the property while removing its value (and any future appreciation) from his or her gross estate at death.

Remainder interest sale transactions between family members invited close scrutiny, with the IRS looking for evidence that the transaction should be treated as a "gift" rather than a sale in order to tax the subject property in the senior family member's estate at death. Ultimately, Congress enacted § 2702 in 1990 to eliminate the perceived tax advantage. The IRS also vigorously attacked split-interest sales effected prior to 1990, and was successful in a number of cases such as Gradow, Pittman and D'Ambrosio. Then in late 1996 the Third Circuit Court of Appeals reversed the lower court holding in D'Ambrosio, and last Spring the U.S. Supreme Court refused to review the Third Circuit decision. Now, the Fifth Circuit has also ruled against the IRS.

In Wheeler v. U.S., a father sold to his two sons a 376-acre ranch in 1984, reserving the right to live on the ranch for the rest of his life. The IRS actuarial tables were used to determine the sale price. When the father died in 1991, the IRS claimed that the date-of-death value of the ranch should be included in his gross estate, as reduced by the consideration actually paid by the sons in connection with their purchase of the remainder interest. After reviewing the issue as analyzed in the prior cases, the Fifth Circuit in Wheeler concluded that the taxpayer's sale of the remainder interest for its actuarial value was valid for transfer tax purposes as falling within the "bona fide sale" exception.

The special valuation rule of § 2702 now provides that a transfer of a remainder interest in property to a family member will be valued as though the full fee interest in the property had been transferred. As no credit is given for the value of the retained interest (unless it meets certain criteria, as in the case of a GRAT), a senior family member could actually be subjected to an element of double-taxation on any transaction to which § 2702 applies.

The terrain after Wheeler and D'Ambrosio looks like this:

With respect to split-interest transactions prior to 1990, recent cases like Wheeler suggest that an IRS attack at a transferor's death to treat such a transaction as a transfer with a retained life estate may be unavailing and that the basic concept which involved a split interest sale for consideration based on the IRS actuarial tables may be sound after all.
Split-interest transactions after the effective date of § 2702 would normally be inadvisable. However, it should be noted that § 2702 applies to transfers to a "member of the family," a group defined as the transferor's spouse, descendants and the spouse of any descendant. Thus, there are still great opportunities, with properly structured split-interest transactions involving a nephew, a niece or other persons not falling within this statutory definition, where significant assets may be transferred at lower tax cost than through a direct gift.