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Estate proposals would provide

Federal gift and estate tax relief was included in the balanced-budget agreement announced by the White House and congressional Republicans. Two points concerning the agreement were–and continue to be–noteworthy.
First, although both houses of Congress have passed balanced-budget resolutions, the agreement is not law. Congress still must draft and enact and President Clinton must sign the necessary specific legislation. As Senate Majority Leader Trent Lott’s recent comments likening President Clinton to a spoiled brat demonstrate, enactment of the agreement is no sure thing.
Second, the precise details of the gift and estate tax-relief provisions are unclear. The House Ways and Means Committee, however, recently took some steps to clarify those details in the draft of the Revenue Reconciliation Bill of 1997 that the committee just adopted. As might be expected when it came time to crunch some numbers and draft statutory language, the details of the draft bill vary significantly from what was announced in the balanced-budget agreement.
Increased unified credit
The principal relief is in the form of an increase in a gift and estate tax credit called the “unified credit.” For federal purposes, the unified credit permits dispositions totaling up to $600,000 to someone other than a charity or a surviving spouse to pass free of federal gift or estate tax. Dispositions to a charity or a spouse qualify for a separate deduction.
The draft bill calls for an increase in the unified credit from the equivalent of $600,000 in property to $1 million in property over a number of years. There is no logic to the schedule other than the logic of not forgoing too many tax dollars too quickly. Relief starts in 1998 and the unified credit is to reach $1 million in the year 2007. The credit is to be indexed for inflation thereafter.
Assuming that the unified credit is indeed increased, a husband and wife will be able to leave children and grandchildren a total of $2 million without having to pay any federal estate tax. Alternatively, a couple could make lifetime gifts totaling $2 million without having to pay any federal gift tax.
Although the increase proposed in the draft bill is not as large as that announced in connection with the balanced-budget agreement, the proposed increase is nonetheless welcome news. Given the uncertainty about the fate of the draft bill, however, it would appear to make sense not to spend the unified credit that a taxpayer does not have. In other words, if a taxpayer is thinking about making gifts that take advantage of
the increase in the credit, he or she would be well-advised to see what the law specifically provides before making such gifts.
Moreover, it does not appear that the bill should significantly alter current estate planning. Given the long phase-in period for the increase in the unified credit, an estate that is now planned based upon the credit for $600,000 of property, given normal appreciation, may well reach $1 million by the time the phase-in is complete. In short, estate tax planning for those at or near the current $600,000 credit will likely still be required when the increased credit is fully phased in.
Section 6166 changes
A second set of noteworthy changes in this area, at least for business owners, concerns Section 6166. This is an estate tax provision that allows a decedent’s estate to pay the estate tax caused by an interest in a closely held–and presumably illiquid–business in up to 10 annual installments. The actual period of deferral is just short of 15 years because the section also allows an estate to pay only interest for the first five years of the deferral period.
Section 6166 also provides for a reduced interest rate–4 percent–on a portion of the deferred estate tax. The portion of the deferred estate tax essentially is the tax on the first $1 million of estate tax value of the interest in the business. The interest rate on the balance of the deferred tax is at the regular IRS rate for underpayments, currently 9 percent.
In order to qualify for Section 6166, the interest in the closely held business must represent a significant portion of the decedent’s estate, at least 35 percent. The deferral only extends to the interest in the closely held business and not to the estate tax caused by other assets. The federal government is content to be a creditor but only as to the closely held interest.
Apart from averting a forced sale of a business or the necessity of distorting capital decisions to fund the estate tax, the economics of opting for Section 6166 are sometimes attractive because the interest paid on the estate tax is itself deductible for estate tax purposes. Between the deductibility of the interest and the time use of the funds that otherwise would have been paid out earlier in estate tax, an estate may actually wind up paying out smaller total dollars to the government, even after paying the interest on the deferred estate tax.
The draft bill makes several changes to Section 6166. First, the period for the installment payments has been doubled from 10 to 20 years. Second, instead of a reduced rate, the amount of the deferred estate tax on the first $1 million in taxable value of the closely held business would bear no interest. The proposal also takes into account the then-available unified credit. For example, if the available unified credit was $750,000, then the interest rate on the estate tax attributable to the value of the business between $750,000 and $1.75 million would be zero.
Third, the interest rate on the balance of the deferred estate tax would be 45 percent of the IRS rate for underpayments. The interest would not be deductible for estate tax purposes. It appears that Congress wants to remove the economic advantage obtainable in some situations in deferring the estate tax.
Exemption for closely held business interests
The House Ways and Means Committee version of the draft bill did not contain a provision actually entirely exempting some portion of an interest in a closely held business from federal estate tax. Although not available at press time, news reports concerning the version of the draft bill offered by the Republicans on the Senate Finance Committee indicate that its version includes a $1 million exemption from the federal estate tax for closely held business interests.
If the two draft bills are passed by the House and Senate in their current forms, differences between the bills would have to be reconciled in a joint House/Senate committee. The exemption provision would have obvious significance for the owners of many small businesses.
Proposed change to New York gift and estate tax
Finally, the action in this area is not limited to Washington. Another significant proposal involves the New York estate and gift tax. Gov. Pataki’s proposal was announced several months ago, but the legislation is being held up in the annual budget battle in Albany.
The New York estate and gift tax is part of a unified system of transfer taxation. The same rates apply to gifts whether made during life or at death.
There is a New York unified credit equal to $115,000 of property. If the credit is not used up during life, then it is available at death. For purposes of determining where a decedent’s estate falls on the rate bracket, a New Yorker’s taxable estate is added to any lifetime taxable gifts that he or she had made.
The New York gift and estate tax rates run from 2 percent to 21 percent. However, there is a credit available under the federal estate tax for state estate tax paid, so there is an offset effectively available if New York estate tax has to be paid. It is not a complete offset, however. There is no comparable credit for New York gift tax.
The proposal would increase the New York unified credit to $200,000 for gifts made or decedents dying on or after July 1, 1997, and prior to July 1, 1998; to $400,000 for gifts made or decedents dying on or after July 1, 1998, and prior to July 1, 1999; and for decedents dying after July 1, 1999, the New York unified credit would essentially equal the then- available federal unified credit.
For decedents dying on or after July 1, 1999, there still would be a New York estate tax. However, the estate tax would equal the federal credit for state estate tax paid. Because this credit is not available for federal purposes unless state estate tax is paid, a move to this form of estate tax results in no net additional amount of estate tax being payable by an estate.
This form of estate tax is sometimes referred to as a “sop up” tax because it uses, that is, “sops up,” the available federal credit. Florida has this type of estate tax.
The New York gift tax would be repealed for gifts made on or after Jan. 1, 1999.
The proposed federal changes in the House version of the draft bill and New York changes would all be welcome changes. For estates in the $600,000-to- $1 million range, they would eventually present significant tax savings, and possibly simplify some estate plans. For larger estates, some savings would also result, together with great flexibility in some estate tax planning strategies.
While not a “sea change,” then, these proposals would provide some additional planning flexibility. The $1 million exemption for closely held business interests that may be included in the Senate version of the draft bill qualifies as a sea change, if it is enacted. Stay tuned.
(Michael McEvoy is a partner in the law firm of Harter, Secrest & Emery, where he concentrates his practice on tax matters. He was assisted in the preparation of this article by his partner, Martin O’Toole, who concentrates his practice on estate planning and administration. The firm’s tax home page is at www.hsetax.com.)


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