ESTATES, GIFTS, AND TRUSTS

Stephan R. Leimberg and Ted Kurlowicz

Prior Law: A gift tax is imposed on gratuitous lifetime transfers of property. An estate tax is imposed on transfers at death. The gift tax and the estate tax are "unified" so that a single graduated rate schedule applies to cumulative taxable transfers made by a taxpayer whether during lifetime or at death.

A unified credit of $192,800 is allowed against the estate and gift tax. This credit exempts the first $600,000 in cumulative taxable transfers from tax. Transfers in excess of that amount are subject to estate and gift tax rates that begin at 37 percent and reach 55 percent on cumulative taxable transfers over $3 million.

A 5 percent surtax is imposed on top of that tax on cumulative taxable transfers between $10 million and $21,040,000. The effect is to phase out benefits of the graduated rates and the unified credit in the estates of the wealthiest individuals.

New Law: There is an increase in the unified credit. The "applicable credit amount" (often referred to as the credit equivalent under the old rules) will be increased starting for gifts made or decedents dying on or after January 1, 1998. The phasein continues until the exemption reaches $1 million in the year 2006.

Other amendments to specific code sections were made to reflect the increased applicable credit amount to bring such sections up to date. For example, the 5 percent surtax bracket was adjusted to assure the phaseout of the increased unified credit and graduated rates to large estates. The filing requirements for an estate tax return were changed to reflect the larger applicable credit (that is, Form 706 will not have to be filed in 2006 unless the gross estate and adjusted taxable gifts total $1 million). Finally, the amount of the unified credit allowed with respect to nonresident aliens with U.S. situs property who are residents of certain treaty countries was similarly adjusted.

Although some earlier markups of the bill included an inflation-indexing feature for the applicable credit amount after 2006, the final version of the bill did not provide for indexing.

Commentary: One welcome change is in semantics only. The law now refers to the applicable credit amount rather than a tax credit. This should clear up some confusion since the tendency under the prior law was to refer to the $600,000 credit, which was actually a credit equivalent.

The value of the unified credit had been shrinking over time. At a 3 percent inflation adjustment, the credit would have been $838,000 by now if it had been increased for inflation since its last adjustment in 1988. What this change means is that wealthier clients will be able to provide more tax free to their heirs in the form of gifts or inheritances. The higher credit equivalent makes estate planning that much more important to wealthy individuals. By 2006, the failure to plan for the unified credit by a couple worth $2 million will result in $435,000 of unnecessary estate taxes. The penalty for using a "simple" will (a will without a formula provision for the optimal marital deduction/ unified credit) has gone up dramatically.

Even though the larger tax breaks under this phasein don’t happen until the end of the period, for a client who can afford to make taxable gifts and shelter the gifts with the maximum credit as it is phased in, even more estate tax savings will occur later because the post-gift appreciation on the transferred property will escape estate or gift taxes. Lifetime gifts of a business interest will not even jeopardize qualification for the new special family business exclusion discussed below since lifetime gifts are added back to the business holdings at death to determine the "50 percent liquidity" ratio.

The phasein of the increased unified credit also has a peripheral impact on planning for the $1 million GST exemption. Currently, the planning for wealthy couples involves a formula will or living trust that divides the marital trust into two components. One component, the "reverse QTIP" marital trust is funded with $400,000. This trust absorbs the difference between the unified credit trust ($600,000) and the GST exemption ($1 million) to avoid wasting any of the GST exemption. As the applicable credit amount gradually increases, the need for the reverse QTIP trust gradually will decrease. This is a welcome change and certainly reduces the complexity of marital deduction planning.

Indexing Estate, Gift, and GST Tax Provisions for Inflation

Prior Law:

Annual Exclusion for Gifts: An exclusion is allowed for up to $10,000 of present-interest gifts made by an individual ($20,000 per married couple) to each donee during a calendar year.

Special-Use Valuation: An executor may elect for estate tax purposes to value certain qualified real property used in farming or a closely held trade or business at its current-use value rather than its "highest and best use" value. The maximum reduction in value under such an election is $750,000.

Generation-Skipping Transfer (GST) Tax: An individual is allowed an exemption from the GSTT of up to $1 million for generation-skipping transfers made during life or at death.

Installment Payment of Estate Tax: An executor may elect to pay the federal estate tax attributable to an interest in a closely held business in installments over, at most, a 14-year period. The tax on the first $1 million (including the amount exempt through application of the unified credit) in value of a closely held business is eligible for a special 4 percent interest rate.

New Law: After 1998, the $10,000 annual exclusion for gifts, the $750,000 ceiling on special-use valuation, the $1 million generation-skipping transfer tax exemption, and the $1 million ceiling on the value of a closely held business eligible for the special low interest rate are indexed annually for inflation. The same basic method for computing the indexing for income tax purposes will be used in each of these four situations.

Indexing of the annual gift tax exclusion is rounded down to the next lowest multiple of $1,000. Indexing of the other amounts is rounded down to the next lowest multiple of $10,000.

Commentary: These provisions should be more valuable with an inflation adjustment. All of the planning forecasts for a client’s estate should be adjusted to reflect the benefits of the indexing. However, with inflation currently below the historical average, indexing may not result in significant changes in the near future. For example, based on the most current CPI adjustment figures and the rounding-down requirements provided by the new indexing rules, it would take 4 years of inflation adjustments to increase the annual gift tax exclusion from $10,000 to $11,000.

Estate Tax Exclusion for Qualified Family-Owned Businesses

PriorLaw: No similar provision.

New Law: A new exclusion is available for family-owned businesses that exempts the first $1.3 million of qualified "family-owned business interests" from estate taxes. This, in the opinion of the authors, becomes the most complex provision in all the estate, gift, and GST tax rules. We will break the provision into subject areas in the following discussion to attempt to organize this incredibly complex set of rules. First, the amount of the exemption is subject to limits.

Second, there are extremely detailed rules defining a "qualifying family-owned business." Congress is making the tax relief available only for a business that is family owned prior to the decedent’s death and will continue to be a family business after the decedent’s death.

Third, there are rules for qualifying estates. These rules make the relief available only if the estate meets a "liquidity ratio" test. This test was placed in the rules, presumably, to ensure that only estates that need relief will qualify.

Finally, there are recapture rules to allow the IRS to recover some or all of the tax relief provided by the new rules if the business ceases to be family owned within 10 years after the decedent’s death.

Limits on the Family-Owned Business Exclusion

In general, this provision (when used in combination with the unified credit) excludes the first $1.3 million of value in qualified family-owned business interests from a decedent’s taxable estate. In other words, the exclusion for family-owned business interests is allowed only to the extent that the exclusion for family-owned business interests, plus the amount effectively exempted by the unified credit, does not exceed $1.3 million. The effect of this is that the business exclusion becomes less valuable as the unified credit increases as the following chart indicates:

This exclusion could potentially shelter $2.6 million of a qualifying family-owned business from estate taxes if qualifying business interests will pass from each spouse’s estate in a manner not qualifying for the marital deduction. However, each estate must independently meet the qualification rules—a potentially difficult task.

Qualified Family-Owned Business Interests

A qualified family-owned business interest is any interest in a trade or business (regardless of the form in which it is held) that also meets the following requirements:

• It must have a principal place of business in the U.S., and
• Ownership of the trade or business must be held at least 50 percent by one family, 70 percent by two families, or 90 percent by three families, as long as the decedent’s family owns at least 30 percent of the trade or business.

Ownership Tests—Corporation. For purposes of applying the ownership tests in the case of a corporation, the decedent and members of the decedent’s family are required to own the requisite percentage of the total combined voting power of all classes of stock entitled to vote and the requisite percentage of the total value of all shares of all classes of stock of the corporation.

Ownership Tests—Partnership. In the case of a partnership, the decedent and members of the decedent’s family are required to own the requisite percentage of the capital interest and the requisite percentage of the profit interest in the partnership.

Ownership Tests—Tiered Entities. In the case of a trade or business that owns an interest in another trade or business (that is, "tiered entities"), special look-through rules apply. Each trade or business owned (directly or indirectly) by the decedent and members of the decedent’s family is separately tested to determine whether that trade or business meets the requirements of a qualified family-owned business interest.

Entities That Don’t Qualify. An interest in a trade or business does not qualify if

• The business’s (or a related entity’s) stock or securities were publicly traded at any time within 3 years of the decedent’s death, or
• More than 35 percent of the adjusted ordinary gross income of the business for the year of the decedent’s death was personal-holding-company income.

Reductions to the Exclusion. The exclusion is reduced if the business contains assets not in the active use of the trade or business. The exclusion is reduced to the extent that the business holds excess cash or marketable securities. Cash or marketable securities in excess of the reasonably expected day-to-day working capital needs reduce the otherwise excludible amount. Cash accumulated for capital acquisitions is not considered "working capital."

In addition, the exclusion must also be reduced by the amount of certain passive assets. Passive assets include any assets that

• produce dividends, interest, rents, royalties, annuities, and certain other types of passive income
• are an interest in a trust or partnership
• produce no income
• give rise to income from commodities transactions or foreign currency gains
• produce income equivalent to interest

Family Participation Requirement. The trade or business must meet the following requirements to qualify for the beneficial treatment:

• The decedent (or a member of the decedent’s family) must have owned and materially participated in the trade or business for at least 5 of the 8 years preceding the decedent’s date of death.
• The business must pass to a qualified heir (defined below), and each qualified heir (or a member of the qualified heir’s family) must materially participate in the trade or business for at least 5 years of any 8-year period within 10 years following the decedent’s death. "Material participation" is defined as under present-law special-use valuation rules. Physical work and participation in management decisions are the principal factors to be considered. For example, an individual generally is considered to be materially participating in the business if he or she personally manages the business, regardless of the number of hours worked, as long as any necessary functions are performed.

Members of an Individual’s Family. Members of an individual’s family are defined as

• the individual’s spouse
• the individual’s ancestors
• lineal descendants of the individual, of the individual’s spouse, or of the individual’s parents
• the spouses of any such lineal descendants

Qualified Heir. Qualified heirs include not only actual members of the decedent’s family but also any individual who has been actively employed by the trade or business for at least 10 years prior to the date of the decedent’s death.

Qualifying Estates

A decedent’s estate qualifies for the family business exclusion only if the following conditions are met:

• The decedent was a U.S. citizen or resident at the time of death.
• The aggregate value of the decedent’s qualified family-owned business interests that are passed to qualified heirs is greater than 50 percent of the decedent’s adjusted gross estate (the 50 percent liquidity test).
• If a qualified heir is not a U.S. citizen, any qualified family-owned business interest acquired by that heir must be held in a trust that meets requirements similar to those imposed on QDOTs (qualified domestic trusts), or it must meet other security requirements.

50 Percent Liquidity Ratio Test. The 50 percent liquidity test is calculated using a ratio, the numerator and denominator of which are described below.

Numerator:

Add

• the value of all qualified family-owned business interests that are includible in the decedent’s gross estate and that are passed from the decedent to a qualified heir, plus
• any lifetime transfers of qualified business interests that are made by the decedent to members of the decedent’s family (other than the decedent’s spouse), provided such interests have been continuously held by members of the decedent’s family and were not otherwise includible in the decedent’s gross estate (For this purpose, qualified business interests transferred to members of the decedent’s family during the decedent’s lifetime are valued as of the date of such transfer.)

Then subtract

• all debts of the estate, except for the following:

(1) debt on a qualified residence of the decedent

(2) debt incurred to pay the educational or medical expenses of the decedent, the decedent’s spouse or the decedent’s dependents

(3) other debts of up to $10,000

Denominator:

Add

• decedent’s gross estate, plus
• the amount of the following transfers (to the extent not already included in the decedent’s gross estate due to some estate inclusion provision for lifetime transfers):

(1) any lifetime transfers of qualified business interests that were made by the decedent to members of the decedent’s family (other than the decedent’s spouse), provided such interests have been continuously held by members of the decedent’s family, plus

(2) any other transfers from the decedent to the decedent’s spouse that were made within 10 years of the date of the decedent’s death, plus

(3) any other transfers made by the decedent within 3 years of the decedent’s death, except annual-exclusion gifts made to members of the decedent’s family

Subtract any indebtedness of the estate

Recapture Rules

The benefit of the exclusions for qualified family-owned business interests must be paid back if, within 10 years of the decedent’s death and before the qualified heir dies, one of the following "recapture events" occurs:

• the qualified heir ceases to meet the material participation requirements (that is, neither the qualified heir nor any member of his or her family has materially participated in the trade or business for at least 5 years of any 8-year period);
• the qualified heir disposes of any portion of his or her interest in the family-owned business; other than by a disposition to a member of the qualified heir’s family or through a charitable conservation contribution;
• the principal place of business of the trade or business ceases to be located in the United States; or
• the qualified heir loses U.S. citizenship—unless recapture is avoided by placing the qualified family-owned business assets into a trust meeting requirements similar to a qualified domestic trust, or through certain other IRS-approved security arrangements

A sale or disposition, in the ordinary course of business, of assets such as inventory or a piece of equipment used in the business (for example, the sale of crops or a tractor) will not trigger a recapture of tax benefits.

If one of these recapture events occurs, an additional tax is imposed on the date of that event. The portion of the reduction in estate taxes that is recaptured would be dependent upon the number of years that the qualified heir (or members of the qualified heir’s family) materially participated in the trade or business after the decedent’s death as shown by the chart below.

Each qualified heir is personally liable for his or her portion of the recapture tax. So if a brother and sister inherit a qualified family-owned business from their father, and only the sister materially participates in the business, her participation will allow both her and her brother to meet the material participation test. On the other hand, if she ceases to materially participate in the business within 10 years after her father’s death (and the brother still does not materially participate), the sister and brother would both be liable for the recapture tax; that is, each would be liable for the recapture tax attributable to his or her interest. The following chart illustrates the recapture rule.

If a recapture event occurs with respect to any qualified family-owned business interest, the amount of reduction in estate taxes attributable to that interest is determined on a proportionate basis.

Commentary: As mentioned above, however, the new $1.3 million exclusion includes the unified credit equivalent and its projected increases. Thus this new exclusion is worth more in 1998 than in later years and will exclude only $300,000 of family business value in estates where death occurs in 2006 and beyond, due to the increases in the unified credit. The effect of this change is a lower effective estate tax rate for family business owners dying in 1998 than for those who die in later years.

For example, suppose a business owner dies with a $4 million total estate and a family business worth $2 million. Assume that all the requirements for the new exclusion are met. The available family business exclusion is $675,000 if the death occurs in 1998 ($1.3 million less $625,000 unified credit equivalent). The exclusion will be only $300,000 ($1.3 million less $1 million unified credit equivalent) if death occurs in 2006. The estate taxes would be $62,500 higher in 2006 than in 1998 as a result.

Overall, this provision is fraught with complexity and risk and has been highly criticized by the ABA. The valuation of the business interest is critical to the qualification. The executor is at risk that the election will be denied due to an adverse value determination by the IRS. Interestingly, there may be good reasons for the executor to overvalue (and for the IRS to argue to reduce the value) of the business for those near the threshold. This fact could become important in cases of two estates since the election could presumably be made by both spouses. Planning for this exclusion could require the redrafting of all formula wills for family business owners since the current wills refer to the unified credit bypass trust as being funded with available "credits." This wording would have to be changed to "credits and exclusions" if the goal is to transfer as much as possible to the junior generation successors in the bypass trust.

The recapture potential is an additional problem. Each qualified heir inheriting the business is personally liable for his or her portion of the recapture tax. This liability will create the risk of family discord if some qualified heirs are not active in the business. Some form of business agreement, such as a binding buy-sell agreement, may be necessary to prevent the tax recapture that might occur if any qualified heirs would otherwise choose to sell to outsiders during the 10-year recapture period.

If IRC Sec. 2032A can be used as an example, we can expect the IRS to take a strict, literal interpretation of this provision. Expect an inordinate number of TAMs and litigation of estates that attempt to take advantage of this provision.

Installment Payments of Estate Tax Attributable to Closely Held Businesses

Prior Law: Generally the federal estate tax is due within 9 months of a decedent’s death. However, if an estate meets Code Section 6166 requirements, an executor may elect to pay the estate tax attributable to an interest in a closely held business in installments over, at most, a 14-year period. If the election is made, the estate may pay interest only for the first four installments. Then the estate must pay 10 annual installments of principal and interest.

Interest generally is imposed at the federal underpayment rate, compounded daily. A special 4 percent interest rate applies to the amount of deferred estate tax attributable to the first $1 million of business value (Note: this amount includes the unified credit and limits the special 4 percent rate to the tax attributable to the amount of value between $600,000 and $1 million).

New Law: The new law provides tax relief in three fashions beginning with deaths in 1998. First, the 4 percent rate is lowered to 2 percent. Second, the $1 million threshold for the special rate has been extended to $1 million in excess of the unified credit. For example, if the business is valued at $2 million for a death occurring in 1998, the 2 percent rate will apply to taxes attributable to the first $1 million of value for the business in excess of the $625,000 credit equivalent in 1998. (Note: in 1997, the existing special 4 percent rate would apply only to $400,000 ($1 million over the $600,000 credit equivalent) of business value.) Finally, the interest rate for deferred taxes on the business value in excess of $1 million is payable at 45 percent of the normal underpayment rate on overdue taxes.

Note that the significantly reduced interest rate comes at a significant cost—the loss of the ability to deduct the interest on the unpaid balance of the tax. Depending on the income tax bracket of the payor, this loss of an interest deduction may eliminate much of the benefit of the lower rate.

Estates already deferring estate tax under prior law may make a one-time election to use the lower interest rates. The cost of that election is that the estate must forgo the interest deduction for installments due after the date of the election.

There is a special provision that authorizes the Tax Court to provide declaratory judgments with respect to whether the taxpayer was eligible initially or was eligible at some later date for the benefits of the Sec. 6166 estate tax deferral.

Commentary: This change is a tremendous benefit to family businesses. The government is providing a 2 percent loan on overdue estate taxes. In 1998, up to $410,000 of unpaid estate taxes can be deferred at a 2 percent interest rate. Even for estates of family business owners that have significant liquidity, it makes good economic sense to pay the estate taxes in installments. However, the interest payable on the unpaid estate tax balance will no longer be deductible from income taxes as under prior law.

Sec. 6166 has been an underused provision in the past. It is an extremely complex code section, and some provisions, such as the acceleration test, are not up-to-date in the current regulations. The acceleration rules make it difficult for estates to take advantage of the maximum deferral period. Executors and heirs are concerned about leaving estates open for such an extended period. However, we need to take a closer look at this tax benefit for our clients in the future.

Used together with a properly and fully funded Sec. 303 stock purchase, this provision is probably the single biggest real benefit of the new law to business owners.

Estate Tax Recapture from Cash Leases of Special-Use Property

Prior Law: Code Sec. 2032A allows an executor to elect to value "qualified real property" used in farming or other qualifying trade or business at its "special" rather than its highest and best use value.

If, after the special-use valuation election is made, the heir who acquired the real property ceases to use it in its qualified use within 10 years (15 years for individuals dying before 1982) of the decedent’s death, an additional estate tax is imposed in order to "recapture" the benefit of the special-use valuation.

Some courts have held that cash rental of specially valued property after the death of the decedent is not a qualified use under Sec. 2032A because the heirs no longer bear the financial risk of working the property. Cash rentals therefore trigger the imposition of the additional estate tax.

A special rule applies to a decedent’s surviving spouse. This special rule provides that the surviving spouse will not be treated as failing to use the property in a qualified use solely because he or she rents the property to a member of the his or her family on a net cash basis.

New Law: The cash lease of specially valued real property by a lineal descendant of the decedent to a member of the lineal descendant’s family who continues to operate the farm or closely held business will not cause the qualified use of such property to cease for purposes of imposing the additional estate tax.

Statute of Limitation Rules for Revaluation of Lifetime Gifts Are Clarified

Prior Law: Generally any estate or gift tax based on a revaluation by the IRS of a prior gift must be assessed within 3 years after the filing of the return. No proceeding in a court for the collection of an estate or gift tax can be begun without an assessment within the 3-year period. If a return is not filed, the tax may be assessed or a suit commenced to collect the tax without assessment at any time. In addition, the limitations period is extended 6 years if an estate or gift tax return is filed and the amount of unreported items exceeds 25 percent of the amount of the reported items. For the purposes of the statute of limitations for gift taxes, the start of the clock on the time generally does not require that a particular gift be disclosed. However, a different rule applies to certain gifts that are valued under the special valuation rules of Chapter 14. The clock never starts on Chapter 14 gifts (for example, GRATs) if a gift is not disclosed on a gift tax return in a manner adequate to apprise the IRS of the nature of the item.

For estate tax purposes (to determine appropriate tax rate bracket and unified credit), many courts have allowed the IRS to redetermine the value of a gift even though the statute of limitations—for the gift tax—had expired years before. This applied to gift tax returns if no tax was due (for example, gifts entirely sheltered by the unified credit and annual exclusion).

New Law: Under the new law, a gift for which the limitations period (3 years after the filing of the return) has passed cannot be revalued by the IRS for purposes of determining the applicable estate tax bracket and available unified credit. In addition, the special rule governing gifts valued under Chapter 14 is extended to all gifts. Thus the statute of limitations will not run to protect a taxpayer on an inadequately disclosed transfer even if a gift tax return was filed for other transfers in that same year.

In order to revalue a gift that has been adequately disclosed on a gift tax return, the IRS must issue a final notice of redetermination of value (a "final notice") within the statute of limitations applicable to the gift for gift tax purposes (generally, 3 years). This rule is applicable even if the value of the gift as shown on the return does not result in any gift tax being owed (that is, the gift is sheltered by the unified credit).

Commentary: This is one of the more meaningful and significant taxpayer benefits of the new law. The old revaluation rules upheld by several courts left an estate in the tenuous position of establishing value many years after a lifetime gift when the best expert witness as to the intent of the purpose and context of the gift had died.

However, this provision will not protect the fraudulent who fail to adequately disclose enough information for the IRS to become apprised of the gift. We expect to see some litigation several years down the road to determine the meaning of "adequate disclosure." This new provision will also not protect gifts for which no return is filed due to the annual exclusion.

Throwback Rules for Domestic Trusts Are Repealed

Prior Law: Income accumulated in a trust was generally taxable to the trust rather than to its beneficiaries. Trusts are subject to their own set of tax rates. In past years, this sometimes permitted trust income to be taxed at lower rates than the rates applicable to its beneficiaries.

This artificial benefit often was compounded through the creation of multiple trusts. But over the years, Congress instituted a series of Code sections to limit the benefit that would otherwise occur from using the lower rates applicable to one or more trusts.

One of these rules designed to prevent a lowering of tax rates through the accumulation of income in a trust was called the throwback rule. Under this rule, the distribution of previously accumulated trust income to a beneficiary was subject to tax (in addition to any tax paid by the trust on that income) where the beneficiary’s average top marginal rate in the previous 5 years was higher than those of the trust.

New Law: This provision exempts from the throwback rules amounts distributed by a domestic trust after August 5, 1997 (the date of enactment). The throwback rules continue to apply with respect to the following:

• foreign trusts
• domestic trusts that were once treated as foreign trusts (except as provided in Treasury regulations)
• domestic trusts created before March 1, 1984, that would be treated as multiple trusts

Commentary: The purpose of the throwback rules was rendered pretty much obsolete by the compression of the trust income tax rates. But what will those of us who teach Subchapter J classes do with our favorite classroom examples and final exam questions that dealt with these wonderful rules?

Reduction in Estate Tax for Certain Land Subject to Qualified Conservation Easements

Prior Law: A deduction is allowed for income, estate, and gift tax purposes for a contribution of a qualified real property interest to a charity exclusively for conservation purposes. A contribution will be treated as "exclusively for conservation purposes" only if the conservation purpose is protected in perpetuity.

A qualified real property interest means the entire interest of the transferor in real property (other than certain mineral interests), a remainder interest in real property, or a perpetual restriction on the use of real property.

A "conservation purpose" is

• preservation of land for outdoor recreation by, or the education of, the general public
• preservation of natural habitat
• preservation of open space for scenic enjoyment of the general public or pursuant to a governmental conservation policy
• preservation of historically important land or certified historic structures

The same definition of qualified conservation contributions also applies for purposes of determining whether such contributions qualify as charitable deductions for income tax purposes.

No special estate tax exclusion otherwise applied for charitable conservation easements.

New Law: The Exclusion Provisions. An executor can elect to exclude from the taxable estate 40 percent of the value of any land subject to a qualified conservation easement that meets certain requirements. First, the land must be located within 25 miles of a metropolitan area or a national park or wilderness area, or within 10 miles of an Urban National Forest. Second, the land must have been owned by the decedent or a member of the decedent’s family at all times during the 3-year period ending on the date of the decedent’s death. Finally, a qualified conservation contribution of a qualified real property interest must have been granted by the decedent or a member of his or her family. Preservation of a historically important land area or a certified historic structure does not qualify as a conservation purpose.

The maximum exclusion for land subject to a qualified conservation easement is described by the following table.

The exclusion for land subject to a qualified conservation easement may be taken in addition to the maximum exclusion for qualified family-owned business interests (that is, there is no offset for the Sec. 2033A exclusion).

The exclusion amount is calculated based on the value of the property after the conservation easement has been placed on the property. The exclusion from estate taxes does not extend to the value of any development rights retained by the decedent or donor, although payment for estate taxes on retained development rights may be deferred for up to 2 years or until the disposition of the property, whichever comes first. For this purpose, retained development rights are any rights retained to use the land for any commercial purpose that is not subordinate to and directly supportive of farming purposes (for example, tree farming, ranching, viticulture, and the raising of other agricultural or horticultural commodities).

If the value of the conservation easement is less than 30 percent of (1) the value of the land without the easement reduced by (2) the value of any retained development rights, then the exclusion percentage is reduced.

The reduction in the exclusion percentage is equal to two percentage points for each point that the above ratio falls below 30 percent. Thus, for example, if the value of the easement is 25 percent of the value of the land before the easement less the value of the retained development rights, the exclusion percentage is 30 percent (that is, the 40 percent amount is reduced by twice the difference between 30 percent and 25 percent).

Under this calculation, if the value of the easement is 10 percent or less of the value of the land before the easement less the value of the retained development rights, the exclusion percentage is equal to zero.

The executor of an estate holding land subject to a qualified conservation easement must make an irrevocable election to use this provision.

The Carryover Basis Provision. To the extent that the value of such land is excluded from the taxable estate, the basis of such land acquired at death is a carryover basis (that is, the basis is not stepped up to its fair market value at death).

Conservation Easement Not a Disposition for Sec. 2032A Recapture Purposes. The granting of a qualified conservation easement is not considered a disposition triggering the recapture provisions of Sec. 2032A. In addition, the existence of a qualified conservation easement does not prevent such property from subsequently qualifying for special-use valuation treatment under Sec. 2032A.

New Income Tax Deduction Rules for Retained Mineral Interests Following a Qualified Conservation Easement. A charitable deduction (for income tax purposes or estate tax purposes) is allowed to taxpayers making a contribution of a permanent conservation easement on property where a mineral interest has been retained and surface mining is possible, but its probability is "so remote as to be negligible."

Present law provides for a charitable deduction in such a case if the mineral interests have been separated from the land prior to June 13, 1976. New law allows such a charitable deduction to be taken regardless of when the mineral interests had been separated.

Commentary: The use of a qualified charitable conservation easement, a deduction already growing in popularity, just got better. However, significant complexity was added by this provision.

GSTT Exception for Predeceased Parent Is Broadened

Prior Law: Under a so-called predeceased parent exception, a direct skip transfer to a transferor’s grandchild is not subject to the generation-skipping transfer tax (GSTT) if the child of the transferor who was the grandchild’s parent is deceased at the time of the transfer. This predeceased parent exception to the GSTT did not apply to (1) transfers to collateral heirs (for example, grandnieces or grandnephews), or (2) taxable terminations or taxable distributions.

New Law: The new law extends the predeceased parent exception to transfers after 1997 to collateral heirs other than grandchildren if the decedent has no living lineal descendants at the time of the transfer.

The new law also extends the predeceased parent exception to taxable terminations and taxable distributions if the parent of the relevant beneficiary was dead at the earliest time that the transfer (from which the beneficiary’s interest in the property was established) was subject to estate or gift tax.

Example: Suppose a GRAT was established to pay an annuity to the grantor for a term for years with a remainder interest granted to a granddaughter. The termination of the term for years would not be a taxable termination subject to GSTT if the granddaughter’s parent (who is the son or daughter of the grantor) was deceased at the time the trust was created and the transfer creating the trust was subject to gift tax.

Commentary: This provision eliminates the bias towards direct skips if the skip person’s parent is predeceased and should enhance the value of estate planning techniques (such as QPRTs, GRATs, GRUTs) and CLTs, where the grandchild-beneficiary has a predeceased parent.

Rules for Charitable Remainder Trusts (CRTs) Are Tightened

Prior Law: A charitable remainder annuity trust (CRAT) is required to pay a fixed dollar amount, annually or more frequently, of at least 5 percent of its initial value to a beneficiary other than a charity. That amount must be payable for the life of an individual or for a period of years (but no more than 20 years). At the end of that term, any amount remaining (the remainder) must pass to a qualified charity.

A charitable remainder unitrust (CRUT) generally is required to pay, annually or more frequently, a fixed percentage of the fair market value of the trust’s assets. The valuation of the annuity amount payable to the noncharitable beneficiary is redetermined at least annually and is payable for the life of an individual or a period of up to 20 years. At the end of the annuity payment period, any remainder must pass to a qualified charity.

Some donors used a short-term (2 years) high (80 percent) payout (called an accelerated charitable remainder trust) to convert appreciated assets into cash yet, through an arcane accounting provision, avoiding most of the capital gains tax that otherwise would have been payable.

New Law: A trust can no longer qualify as a CRAT if the annuity payout for any year is greater than 50 percent of the initial fair market value of the trust’s assets. The same rule limits a CRUT payout to 50 percent or less of the annual value of the principal. Any trust that fails this 50 percent rule will not qualify for the benefits of a CRT. It will be treated as a complex trust and all income will be taxed to its beneficiaries or to the trust instead of the "tier" system normally imposed.

In addition to the 50 percent test, the value of the charitable remainder with respect to any transfer to a CRAT or CRUT must be at least 10 percent of the net fair market value of such property transferred in trust on the date of the contribution to the trust. This 10 percent test is measured on each transfer to the CRT. A CRT that meets the 10 percent test on the date of transfer will not subsequently fail to meet that test if interest rates have declined in the interval between the trust’s creation and the death of a measuring life.

The new law incorporates several exceptions that provide relief for trusts that do not meet the 10 percent rule. These include:

Where a transfer is made after July 28, 1997, to a CRT that fails the 10 percent test, the trust is treated as meeting the 10 percent requirement if the trust’s governing instrument is changed by reformation, amendment, construction, or otherwise to meet such requirement by reducing the payout rate or duration (or both) of any noncharitable beneficiary’s interest to the extent necessary to satisfy such requirement so long as the reformation is commenced within the period permitted for reformations of CRTs under Sec. 2055(e)(3).

The statute of limitations applicable to a deficiency of any tax resulting from reformation of the trust extends for one year after the Treasury is notified that the trust has been reformed. This makes it easier to reform the trust to meet the 10 percent requirement.

A transfer to a trust will be treated as if the transfer never had been made where a court having jurisdiction over the trust subsequently declares the trust void (because, for example, the application of the 10 percent rule frustrates the purposes for which the trust was created) and judicial proceedings to revoke the trust are commenced within the period permitted for reformations of charitable remainders.

Where an additional contribution is made after July 28, 1997, to a CRUT created before July 29, 1997, and that CRUT would not meet the 10 percent requirement with respect to the additional contribution, the additional contribution will be treated as if it had been made to a new trust that does not meet the 10 percent requirement. In other words, the contributions that do not meet the 10 percent requirement are "segregated" and treated as if made to a separate trust. This protects the tax-favored status of the original CRUT.

The new rules do not limit or alter the validity of anti-abuse regulations proposed by the Treasury Department on April 18, 1997, or the Treasury Department’s authority to address abuses of the rules governing the taxation of CRTs or their beneficiaries.

The 10 percent requirement doesn’t apply to CRTs created by testamentary instrument (for example, a will or revocable trust) executed before July 29, 1997, if the instrument is not modified after that date and settlor dies before January 1, 1999, or could not be modified after July 28, 1997, because settlor was under a mental disability on that date (that is, July 28, 1997) and all times thereafter.

The 50 percent payout rule applies to transfers to a trust made after June 18, 1997. The 10 percent to charity rule applies to transfers to a trust made after July 28, 1997.

Commentary: The new rules add complexity and enhance the importance of actuarial valuation software for planning charitable gifts. The concern of the charitable sector is that useful and potentially beneficial donations may be avoided as a result of these provisions.

Denial of Deduction for Premiums Paid with Respect to Life Insurance Policies

Prior Law: The law prohibited the deduction of premium payments by a business or other entity on any life insurance policy covering the life of any officer, employee, or any person financially interested in a trade or business carried by the entity if the entity was directly or indirectly the policy beneficiary.

New Law: The new law prohibits the deduction of premiums for a life insurance policy, endowment, or annuity if the taxpayer is directly or indirectly a beneficiary. The general rule disallowing the deduction does not apply to (1) annuity contracts issued in connection with various types of qualified retirement plans and (2) annuity contracts held by nonnatural persons (as specified in Sec. 72(u)) and subject to tax annually on the contract income as it accrues.

Commentary: This rule expands the denial of the premium deduction to endowment and annuity contracts (other than those specified) covering all individuals, not just officers, employees, and financially interested persons. This provision was apparently added to prevent a lending organization from deducting the cost of insurance covering the lives of debtors.

Expansion of Interest Deduction Limitations on Company-Owned Life Insurance (COLI)

Prior Law: The Health Insurance Portability and Accountability Act of 1996 provided new limitations on the interest deduction for COLI. After a phase-in period, the interest incurred with respect to borrowing from life insurance policy cash values is generally denied except for coverage on so-called key persons. (Chapter 3 of Financial Planning 2000, published by The American College, provides a thorough discussion of these changes.)

New Law: New and broader restrictions are imposed on loan interest deductibility for businesses that own life insurance, annuities, and endowment contracts. The new law will deny deductions for interest expense, even for borrowing from other sources by an amount equal to the net cash values in the borrower’s life insurance policies and annuity or endowment contracts. The law excepts policies and contracts covering:

• 20 percent or more owners of the entity (including the spouse of a 20 percent owner in a joint life contract)
• officers
• directors
• employees of the entity

The law also excepts policies held by natural persons unless a trade or business is directly or indirectly a beneficiary of the policy. For partnerships or S corporations, the rules apply at the entity level.

In applying the denial of the interest deduction, a formula is used to ascertain the percentage of the total interest expense that is nondeductible. The interest that is nondeductible could be either borrowed from the life insurance policy or another source (provided the policyowner has unborrowed cash surrender value available in COLI). The new law provides that the deduction is denied for the interest expenses allocable to the unborrowed cash values. The interest expense allocable to unborrowed cash values is the ratio of total interest expense as provided by the following ratio:

The unborrowed cash values are defined as the cash surrender values of the policies and contracts held by the taxpayer (net of any surrender charges) over the amount of the existing policy loans. Again, remember that the policies and contracts covering the 20 percent owners, officers, and employees are not taken into account in this formula.

Interest that cannot be deducted will be considered basis for purposes of transfer-for-value transactions. This basis applies to all transfer-for-value situations (and will be particularly useful to viatical companies that purchase policies with borrowed money and use the expected death benefits as collateral). Although the interest on the loan used to purchase the policies can’t be deducted, that nondeductible interest later reduces gain recognized by the viatical company when the death benefit is received. The practical effect is to balance out the cost of the deduction’s disallowance.

Commentary: The primary thrust of these new limitations applies to lenders since an exception is provided for 20 percent owners, officers, directors, and employees. The 1996 changes had also carved an exception for key employee COLI. Note that the exception for spouses covered in joint life policies applies only to wives or husbands of 20 percent owners and does not apply to spouses of officers, directors, and employees. However, 20 percent or more owners can now borrow and deduct interest on COLI covering such individuals and their spouses in survivorship (second-to-die) policies. Note that the existing limitations restricting borrowing to $50,000 for key employees continues to operate.

The classic split-dollar arrangement (not one using second-to-die insurance) involving an employee, officer, or director is not subject to the rule disallowing a deduction for interest on debt allocable to life insurance cash values.

A troublesome compliance issue is presented by the unborrowed cash value ratio test. How will this be determined and reported? The law states that the IRS can require reporting from the taxpayer or the issuer as necessary to carry out the limitations. That burden is likely to fall on insurance companies.

Repeal of Excise Tax on Transfers to Foreign Entities and Recognition of Gain
on Certain Transfers to Foreign Trusts and Estates

Prior Law: A 35 percent excise tax was imposed on transfers of property by a U.S. person to a foreign trust or estate.

New Law: The excise tax is repealed.

The new law replaces the excise tax with a provision that mandates the recognition of gain upon the transfer of appreciated property by a U.S. person to a foreign estate or trust. A transfer characterized as a contribution of capital to a foreign corporation or partnership will trigger the same treatment.

A transfer to a trust in which the U.S. grantor is for income tax purposes treated as the owner of the trust will not trigger the gain on appreciation.

Estate and Gift Tax Simplification Provisions

A number of simplification provisions were added by the new law. These will be presented below without commentary.

New Law:

• Gift tax returns will no longer be required for most charitable gifts. This new law repeals prior law that had required the portion of a gift in excess of any allowable annual exclusion to be reported on a federal gift tax return. The exemption generally applies to gifts made after August 5, 1997. Gifts to charity consisting of transfers of partial interests (for example, CRTs or a remainder interest in a home) must still be reported. The only exception is for qualified transfers of easements in real property (Act Sec. 1301 amending Code Sec. 6019).
• The right of recovery for QTIP is waived only if specific intent is specified in a will or revocable trust. The surviving spouse’s executor’s right to demand a repayment of the estate tax payable by the survivor’s estate on the property in a QTIP trust is waived only to the extent that there is explicit language in the surviving spouse’s will or revocable trust of a decedent waiving that right (Act Sec. 1302 amending 2207A).
• Trusts created before November 5, 1990, will be treated as QDOTs if they meet the rules for QDOTs in effect at that time. Qualified domestic trusts (QDOTs) were enacted in 1989 and amended in 1990. Since then, significant new requirements were added by regulations. This provision permits old QDOTs to qualify if they required all trustees to be citizens of the U.S. or domestic corporations. Thus trusts created and in effect at the date specified above can avoid the onerous new requirements (Act Sec. 1303).
• Estates of individuals dying after August 5, 1997, can treat a qualified revocable trust as part of a decedent’s estate—for federal income tax purposes—if an irrevocable election is made. The treatment of the trust as part of the estate is effective from the date the decedent died until the later of (a) 6 months from the final determination of the estate tax liability (assuming an estate tax return is mandated) or (b) 2 years after the decedent’s death (assuming no estate tax return is required). This permits the executor to treat the revocable trust as part of the estate for income tax purposes and may be useful if the estate has little or no probate (Act Sec. 1305 amending Code Sec. 646).
• An executor can now elect to treat distributions paid from an estate to a beneficiary within 65 days after the close of the estate’s tax year as having been paid on the last day of the tax year. This equates estates to trusts that have the same right, and it is useful for the distribution of accounting income for a tax year that cannot be determined until after the closing of the books for the tax year. This becomes effective in taxable years beginning after August 5, 1997 (Act Sec. 1306 amending Code Sec. 663).
• The separate share rule is made available to estates. Estates with more than one beneficiary are—as are trusts—required to provide different tax treatment of distributions to different beneficiaries to properly reflect the income earned by different shares of the estate’s corpus. Effective for decedents dying after August 5, 1997 (Act Sec. 1307 amending Code Sec. 663).
• Gifts within 3 years of death from a revocable trust qualify for the annual exclusion. If an annual exclusion gift is made within 3 years of the grantor’s death by the trustee of a revocable trust, it is treated as if the grantor made that gift. This eliminates the Code Sec. 2035 problem that caused inclusion of the gift if the trust’s grantor dies within 3 years of the transfer. This makes revocable trusts more flexible (Act Sec. 1310 amending Code Sec. 2035).
• QTIP treatment for annuities is allowed in community property states. The marital deduction is allowed in a community-property situation where a nonparticipant spouse’s survivorship interest in a qualified retirement plan, IRA, or SEP is left to the surviving spouse in a qualifying manner. The nonparticipant spouse’s interest passing to the surviving spouse is deemed to qualify for QTIP treatment. This solves a problem since the nonparticipant spouse is deemed to own one-half the retirement plan value at death under Sec. 2033. There was no provision in Sec. 2056 to qualify this value for the marital deduction. To make matters worse, case law held that the nonparticipant spouse had no rights under ERISA to transfer this interest if the nonparticipant spouse died first. Thus this new provision creates a marital deduction that is necessary and fair to eliminate a potentially devastating first-death tax (Act Sec. 1311 amending Code Sec. 2056).
• There is a waiver of U.S. trustee requirements for QDOTs in some instances. The Treasury Department is given authority to waive the requirement that a QDOT (qualified domestic trust) have at least one U.S. trustee—in situations where the trust is formed in a country that does not permit U.S. trustees (Act Sec. 1314 amending Code Sec. 2056A).

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