Capital Gains Rate
The most far reaching change in the Act is probably the reduction of the capital gains rate. However, it did not come without its own complexity. Effective July 29, 1997, the 28% capital gains rate was lowered to 20% for assets purchased before 2001 and held for more than 18 months. There is a small window where the holding period continues to be 12 months -- for assets sold after May 6, 1997 and before July 29, 1997. For assets acquired after the year 2000 and held for more than 5 years, the rate will be 18% (8% for taxpayers in the 15% tax bracket).
Gains from the sale or exchange of "collectibles" (art works, stamps, coins, etc.), are still subject to the 28% capital gains rate.
Gone are the $125,000 exclusion for taxpayers over 55 years of age selling their homes and the roll-over provision allowing the deferral of gain where the taxpayer sold the family residence and purchased another within two years at or above the sales price. Instead, a taxpayer may exclude $250,000 from the gain on the sale of the principal place of residence if owned and used by the taxpayer for no less than two of the five years prior to the sale. The exclusion goes up to $500,000 if filing a joint return and the taxpayer's spouse also used (but need not have owned) the property as the spouse's principal place of residence for the required term. The law applies to sales after May 6, 1997. The exclusion may be used no more often than every two years. California was quick to conform its law to the new federal rules on the sale of the family residence.
The Unified Credit
The unified credit which sheltered $600,000 from gift and/or estate taxes for transfers made during life, at death or a combination, is now known as the "applicable credit amount." The amount sheltered will be increased to $1,000,000, but very, very slowly. For the first three years starting in 1998, it increases by $25,000 per year, stays at $675,000 for 2001 before increasing by another $25,000 for 2002, where it again stays at $700,000 for 2003. It increases to $850,000 in the year 2004, increases by $100,000 in 2005 and finally reaches $1,000,000 in 2006. This scheduled increase is not terribly fair or generous considering that we've been at $600,000 since 1987 without adjustment for inflation since then. Still, when fully phased in it will remove more of the populace from the reach of the federal estate tax when one considers that $2,000,000 of the properly planned estate of a married couple will escape taxation at death.
Family Owned Business
The new Act reserves its cruelest "relief" for the small business owner. The complexity in qualifying for the little relief afforded is staggering. First, the relief. If the decedent owned a qualifying trade or business, the estate is entitled to an exclusion which, when added to the applicable credit amount, equals $1,300,000. This means that in 1998, the additional benefit to the small business owner over the amount to which the owner is already entitled, is $675,000 ($1,300,000 less $625,000). In the year, 2006, the relief is only $300,000. This relief amounts to a tax savings of from $135,000 to $250,000 for an estate in the 40% tax bracket depending on the year of death. Of course, the relief may be increased in the future by new legislation, but then there is the complexity of qualifying. In order to qualify as a qualified family-owned business, in general, the decedent must have owned at least a 30% interest in a trade or business which operates principally in the U.S. and was 50% owned by a family, 70% owned by two families, or 90% owned by three families. The decedent's interest in the business must constitute at least 50% of the decedent's adjusted gross estate (taking certain gift made by the decedent during lifetime into account). The decedent must have owned and materially participated in the business for at least 5 of the 8 years preceding the date of death. Further, the business must continue to be operated by qualified heirs who materially participate in the business for a ten year period and if certain events take place following the date of death (including the sale or failure of the business), the tax savings will be recaptured, with interest from the date the relief was first granted, and the qualified heirs will be personally liable for the tax recaptured!
Installment Payments of Estate Tax
If an estate holds an interest in a closely held business and has qualified to pay the estate tax in installments over a 15 year period, there is some further relief -- at a price. For estates where the decedent dies after December 31, 1997, the interest rate on the deferred tax on the first $1,000,000 in value of the closely held business is lowered from 4% to 2%. The interest rate on the tax on the value in excess of $1,000,000 will be 45% of the rate applicable to the underpayment of tax (which is about 9% at this time). The price? Interest paid on the deferred tax will no longer be deductible. However, the elimination of the deduction also eliminates the necessity of filing annual supplemental estate tax returns to recompute the estate tax resulting from the additional deduction for the interest paid in each year following the date of death.
Roth IRAs or IRA Plus
A new IRA -- the IRA Plus or Roth IRA -- can be set up after 1997 by certain taxpayers. Contributions are limited to $2,000 per year based upon the taxpayer's income after taking into account all contributions to all other IRAs. What makes the Roth IRA unique is that qualifying distributions will be tax free, if the IRA has been held for 5 years or more and (i) the distribution is made after age 59 1/2, (ii) on account of disability or (iii) expenses of up to $10,000 of a qualifying first time home owner. The amount that may be contributed is phased out for single taxpayers with adjusted gross income ("AGI") between $95,000 and $110,000 and for married taxpayers filing jointly with AGI between $150,000 and $160,000. Taxpayers with AGI under $100,000 can roll-over existing IRAs into Roth IRAs. However, the roll-overs from the IRAs are taxable income and includable in the taxpayer's income ratably over four years.
Excess Distributions and Accumulations Excise Tax
Taxpayers who enjoy success in investing their retirement accounts are no longer penalized. The 15% excise tax on retirement distributions in excess of $160,000 (adjusted from year to year) and the 15% estate tax on excess accumulations have been repealed. Taxpayers who did not act in the first year of a three year moratorium on the tax granted last year are rewarded for their procrastination!
Qualified Appreciated Stock
Once again, the charitable deduction at fair market value of qualified appreciated stock -- publicly traded stock --contributed to private foundations has been reinstated from June 1, 1997, but, once again, is sunsetting on June 30, 1998. Tax relief by biennial installments?
Charitable Remainder Trusts
In order to curb abuses resulting from short-term charitable remainder trusts (CRTs) with huge (80%) pay-outs, trusts will not qualify as CRTs if the annual pay-out is more that 50% (the annuity or unitrust amount). Further the actuarial value of the charitable remainder when the CRT is established must be at least 10% of the fair market value of the property transferred in trust.
Finality of Gift Tax Return
Prior to the Act, the value of a gift previously reported on a gift tax return on which the Statute of Limitations had run could still be challenged (and increased) in computing the estate tax in the estate of the donor. Now, the value of the gift will be the value as finally determined for gift tax purposes if the Statute has run and the value of the gift is reported or disclosed in a manner adequate to apprise the Internal Revenue Service of the gift. If the gift is not adequately disclosed, the Statute will not run and the Service can move to collect the gift tax (and interest) whenever it wishes.
Generation Skipping Tax and the Predeceased Child
Prior to the Act, a transfer by a grandparent to a grandchild whose parent had died prior to the transfer was not subject to generation skipping taxes if the transfer was a so-called "direct skip" (direct to the grandchild or trust for the grandchild), but was subject to such taxes if the transfer to the grandchild was from a trust in which the child or other person or entity had an interest -- a so-called "taxable distribution" or "taxable termination." Now, the exception for transfers to a grandchild of a predeceased child includes taxable terminations and distributions as well as direct skips.
The $10,000 per donee annual gift tax exclusion, the $1,000,000 generation skipping tax exemption, the $1,000,000 limit on the value of a closely held business, the taxes on which are subject to the special 2% interest rate, and the limit of $750,000 on the value of qualified real property used in farming or a closely held business eligible for special valuation (not discussed here), will all be indexed for inflation for gifts made and estates of decedents dying after December 31, 1998. Why not index the applicable credit amount which shelters estates from the estate tax?
There are also changes relating to traditional IRAs, conservation easements, throwback rules, tax return requirements for gifts to charities, estate and trust administration, pre-need funeral trusts, QDOTS, and the list goes on -- important for the tax practitioner, but not necessarily "highlights."