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Published: 2008-03-26

The Taxpayer Relief Act of 1997: An Overview of Selected Provisions

The Taxpayer Relief Act of 1997, which was signed by President Clinton on August 5, 1997 (the "Act"), provides tax benefits that affect a broad range of taxpayers. The following is a brief description of the important provisions of the Act that will affect you and your families.

Reductions in Capital Gains Rates for Individuals
The Act's reduction of capital gains tax rates has received much attention. Up to 12 different rules may now apply to the taxation of capital gains.

Transition Rules
For property held over 12 months and sold before May 7, 1997, the 28% maximum rate applicable under prior law still applies.

  • For property held over 12 months and sold after May 6, 1997, and before July 29, 1997, a new 20% maximum rate applies (10% for taxpayers in the 15% bracket).

  • For property held between 12 months and 18 months and sold after July 28, 1997, a 28% maximum rate applies, as under prior law.

New Rules
For property held over 18 months and sold after July 28, 1997, the 20% maximum rate applies (10% for those in the 15% bracket).

  • A 25% maximum rate will apply to gains on the disposition of real estate assets otherwise eligible for the 20% rate to the extent of depreciation claimed thereon.

  • An 18% maximum rate will apply to property acquired in 2001 or later and held for more than five years.

  • Taxpayers may elect to take advantage of the 18% rate on property acquired before 2001 by "marking to market" on January 1, 2001, and paying the resulting capital gains tax on any such appreciation as of said date. The 18% rate would then apply to any further appreciation, provided the property is held for more than five years thereafter.

  • Taxpayers in the 15% bracket will be eligible for an 8% maximum rate on capital assets sold on or after January 1, 2001, and held for five years without marking to market property acquired before 2001.

  • The 28% maximum rate continues to apply to the sale of collectibles held for more than one year.

  • Effective for sales after August 5, 1997, gains from the sale of certain small business stock held more than six months can be rolled over tax-free if the seller reinvests the proceeds in new qualifying small business stock. Qualifying small business stock generally means any C corporation stock issued after August 10, 1993, provided the C corporation did not have aggregate gross assets exceeding $50,000,000 on the date of issuance. Such stock must have been acquired by the taxpayer in exchange for money or other property (excluding stock) or as compensation for services provided to the corporation other than underwriting services. Currently, individuals may exclude 50% of the gain on the sale of small business stock. Under the Act, the lower capital gains rates do not apply to the includible portion of any gain from the qualifying sale of small business stock. Thus, the maximum rate of tax on such a sale is 14%. Also, the excluded portion is no longer subject to the alternative minimum tax.

  • Capital gains of up to $250,000 ($500,000 for joint filers) on the sale of a principal residence may be excluded from gross income as often as every two years.

  • In order to avoid forcing many taxpayers into an alternative minimum tax ("AMT") position by reason of the new preferential capital gains tax rates, the Act makes the AMT capital gain rates the same as the new regular capital gain rates.

Short Sales Against Box and Other Constructive Sales Now Immediately Taxed
Any short sale of securities by a taxpayer which the taxpayer already owns (a "short sale against the box") after June 8, 1997, will now be treated as an actual sale of the original shares. Under prior law, the proceeds of such a sale were not considered received, and thus no capital gain resulted until the short position was closed out by replacing the securities that were borrowed to make the short sale. The new constructive sale rule also applies to an "equity swap," a transaction in which the owner of securities exchanges the return on such securities for the return on a pool of securities held by another or for the return on an indexed portfolio for an agreed-upon period of time. The Internal Revenue Service and the Treasury Department are also examining other transactions which effectively allow taxpayers to "lock in" the value of appreciated financial positions without actually disposing of the appreciated assets.

Estate and Gift Tax Relief
Increase in the Unified Credit Against Federal Gift and Estate Taxation. The unified estate and gift tax credit will gradually increase beginning in 1998 to permit each U.S. citizen to make tax-free transfers of up to $1,000,000. The amount of taxable transfers sheltered by the unified credit, currently $600,000, will increase to $625,000 in 1998; $650,000 in 1999; $675,000 in 2000 and 2001; $700,000 in 2002 and 2003; $850,000 in 2004; $950,000 in 2005; and $1,000,000 in 2006. Thus, with proper planning, a married couple may make otherwise taxable transfers of up to $2,000,000 beginning in 2006 without paying federal wealth transfer tax.

Family-Owned Business Exclusion. For an individual dying after December 31, 1997, whose estate includes qualified family-owned business interests, the executor can elect to exclude the value of all or a portion of such business interest in excess of the unified credit amount in effect at the time of death from the decedent's estate for federal estate tax purposes, up to a maximum exclusion amount of $1,300,000. For example, the amount which may be sheltered from federal estate tax by the unified credit available to a decedent dying in 1998 is $625,000. Thus, the amount of the family-owned business exclusion available to such a decedent is $675,000 ($1,300,000 less $625,000). If the same decedent were to die instead in 2006, the amount of the exclusion would be only $300,000 ($1,300,000 less the then-available unified credit equivalent amount of $1,000,000). In order to qualify for this exclusion, the family-owned business or farm must meet, among others, the following requirements:

  • The decedent must at death be a U.S. citizen or resident.

  • The trade or business must have its principal place of business in the United States.

  • At least 50% or more of the business must be owned by the decedent and members of the decedent's family, and if more than one family owns an interest in the business, either 70% or more must be owned by members of two families or 90% or more must be owned by three families.

  • No stock or other security of the company (or a controlled group of which the company is a member) can have been publicly traded within three years of the decedent's death.

  • The decedent (or a member of the decedent's family) must have owned and materially participated in the business for at least five of the eight years prior to the decedent's death.

  • The business interest must pass to a qualified heir.

The benefit of the exclusion is subject to recapture, with interest, if within 10 years of the decedent's death (and before the qualified heir's death) one of the following events occurs with respect to the family-owned business: (i)the material participation requirements are not met; (ii)a qualified heir disposes of a portion of the business interest to a non-family member; (iii)the qualified heir loses U.S. citizenship; or (iv)the principal place of business ceases to be the U.S.

Increase in Gift Tax Annual Exclusion. Beginning in 1999, the annual gift tax exclusion, which currently permits an individual to make gifts totaling $10,000 per donee per calendar year (or $20,000 as a split gift made by spouses) without paying gift tax or using unified credit, will be adjusted for inflation based on $1,000 increments.

Finality of Gift Tax Valuation. Under prior law, the value of gifts made in a preceding period could not be revalued by the IRS if the statute of limitations had expired and a gift tax was assessed or paid in the preceding period. This bar did not exist when an individual made a nontaxable gift or used a portion of his or her unified credit and no tax was actually paid. Under the Act, the IRS is now precluded from adjusting the value of a lifetime gift which was properly reported on a gift tax return for which the statute of limitations has expired. This rule will apply whether or not an individual actually paid a gift tax or merely used annual exclusions or a portion of the unified credit. Gifts made before the enactment are not subject to the new law.

Charitable Giving - Donations of Appreciated Stock to Private Foundations
A taxpayer's ability to deduct the fair market value of appreciated publicly traded stock which is donated to a private foundation has been retroactively restored and extended through June 30, 1998. The deductibility of such amounts had previously expired for contributions after May 31, 1997.

Individual Retirement Accounts ("IRAs")
The Act changed the rules governing existing IRAs, expanded the availability of IRAs, created new types of IRAs altogether and significantly broadened the range of penalty-free IRA distributions.

Increased Deductibility of IRA Contributions. Beginning in 1998, an individual who is not an active participant in a qualified retirement plan (such as a nonworking spouse or an employed spouse who is not covered by a pension plan) can contribute and deduct up to $2,000 per year to an IRA, even if the individual's spouse is an active participant in a qualified plan. The deduction is phased out for families with Adjusted Gross Income ("AGI") between $150,000 and $160,000.

If both spouses are active participants in a qualified plan, deductible IRA contributions are phased out over an AGI range between $40,000 and $50,000. Beginning in 1998, the phaseout range is adjusted to between $50,000 and $60,000. For subsequent years, the range is gradually adjusted upward until it is between $80,000 and $100,000 in 2007 and subsequent years.

For single filers, the current AGI phaseout range of $25,000 and $35,000 increases in 1998 to $30,000 and $40,000. In subsequent years, the phaseout range will be gradually increased to between $50,000 and $60,000 in 2005 and subsequent years.

Roth IRAs. Beginning in 1998, taxpayers may contribute to a new type of IRA called a "Roth IRA." Contributions to a Roth IRA are nondeductible, but like existing IRAs, earnings on Roth IRAs are not immediately subject to federal income tax. Moreover, a contributor to a Roth IRA may withdraw funds, including both contributions and earnings, from a Roth IRA tax-free beginning at age 59-1/2 if at least five years have passed since the first contribution to the Roth IRA.

The limit on the amount of a taxpayer's permitted annual contribution to a Roth IRA is the lesser of the taxpayer's earned income or $2,000 reduced by any contributions to traditional IRAs. A nonworking spouse is also permitted to contribute up to $2,000 annually to a Roth IRA. A taxpayer's ability to contribute to a Roth IRA is phased out at AGI levels between $150,000 and $160,000 for joint filers and between $95,000 and $110,000 for single filers.

Unlike traditional IRAs, a Roth IRA does not require a contributor to begin making withdrawals at age 70-1/2. Further, a taxpayer may continue to make contributions to a Roth IRA following age 70-1/2 in compliance with the other contribution guidelines.

Education IRAs. Also beginning in 1998, parents may establish an Education IRA for each child and make annual nondeductible contributions of up to $500 per IRA, provided the child for whose benefit the IRA is established is under the age of 18. Permitted contributions to an Education IRA are in addition to the limits placed on contributions to traditional IRAs and Roth IRAs. Earnings by Education IRAs accumulate tax-free, and tax-free withdrawals may be used to pay qualified education expenses. Any balance remaining in an Education IRA at the time the beneficiary reaches age 30 is required to be distributed. Qualified education expenses include post-secondary tuition, fees, books, supplies, equipment and basic room and board charges.

The $500 contribution limit to an Education IRA is phased out at AGI levels between $150,000 and $160,000 for joint filers and between $95,000 and $110,000 for single taxpayers.

Penalty-Free Withdrawals for Education and First Home Buyers. Beginning in 1998, withdrawals from traditional IRAs can be made for a taxpayer's qualified higher education expenses and those of the taxpayer's spouse, dependent child or grandchild without being subject to the 10% penalty tax that generally applies to withdrawals before age 59-1/2. Such withdrawals are, nevertheless, subject to federal income taxation and Alternative Minimum Tax, if applicable. Qualified expenses include tuition, room and board, fees, books and equipment required for enrollment or attendance at an eligible educational institution.

Also beginning in 1998, penalty-free withdrawals from traditional IRAs of up to $10,000 over a taxpayer's lifetime may be made to help finance a first-time home purchase by the taxpayer, the taxpayer's spouse, child, grandchild, or an ancestor of the taxpayer or of the taxpayer's spouse.

Repeal of 15% Penalty Tax on Excess Retirement Plan Distributions and Accumulations
Effective January 1, 1997, the 15% penalty tax on certain large lifetime distributions from IRAs and other qualified retirement plans is repealed. This tax was temporarily suspended for 1997 through 1999 by last year's tax legislation. The Act also repealed the 15% penalty on excess accumulations in IRAs and other qualified retirement plan accounts effective for estates of decedents dying on or after January 1, 1997.

Modification of Estimated Tax Requirements
Under present law, an individual with an AGI of more than $150,000 as shown on the return for the preceding taxable year generally does not have an underpayment of estimated tax if he or she makes timely estimated tax payments at least equal to (i)110% of the tax shown on the return of the individual for the preceding year or (ii)90% of the tax shown on the return for the current year. The Act changes the 110% safe harbor amount to 100% for tax years beginning in 1998, 105% for tax years beginning in 1999, 2000 and 2001, 112% for tax years beginning in 2002 and 110% for tax years beginning in 2003 and thereafter.

Alternate Minimum Tax
Small Business Exemption From Corporate Alternative Minimum Tax ("AMT"). For tax years beginning after December 31, 1997, the Act provides an exemption from the corporate AMT for small businesses, defined as those with average annual gross receipts of less than $5,000,000 for the three-year period beginning January 1, 1995. A corporation continues to qualify for this exemption as long as its average annual gross receipts do not exceed $7,500,000.

Depreciation. The Act conforms the depreciable life of property placed in service after 1998 for AMT purposes to the depreciable life of such property used for regular corporate income tax purposes.

Corporate Organizations and Reorganizations
The Act limits certain previously tax-free "spin-off" transactions in which a corporation distributes to its shareholders stock of a controlled corporation. Effective for such transactions entered into after April 16, 1997, gain is recognized at the corporate level on a spin-off which is part of a plan or series of related transactions in which one or more persons acquire 50% or more of the vote or value of stock of either the distributing corporation or the controlled corporation. Any such gain is recognized immediately before the distribution equal to the amount which the distributing corporation would have recognized had the stock of the controlled corporation been sold at fair market value on the date of the distribution.

ESOP, Pension and Employee Benefit Provisions
The Act repeals the application of the unrelated business taxable income rules to S corporation income which is allocated to an ESOP-shareholder. Thus, employee stock ownership plans may be shareholders of S corporations in post-1997 tax years. The new law also increases the prohibited transaction excise tax for qualified plans and disqualified pensions from 10% to 15%. Further, the Act requires wider diversification by 401(k) plans and investment of elective deferrals in stock of the 401(k) employer.

Modification of Rules Regarding Net Operating Loss ("NOL")
Subject to certain limited exceptions, the Act limits the NOL carryback period to two years rather than the three years permitted under prior law and extends the NOL carryforward period from 15 years to 20 years effective for NOLs derived from tax years beginning after August 5, 1997.

Buchanan Ingersoll's Tax Group advises publicly held and private business entities, affluent individuals and families, and key executives in a full range of tax, employee benefits and dispute resolution matters at federal, state and local levels. We also counsel clients in the areas of wealth preservation and business succession planning. For more information, contact Tax Group Chairman Francis A. Muracca, II, at 412-562-3950 or by email at