Estate and Gift Tax Aspects of the 1997 Budget Act

Years of promises of estate tax relief were finally fulfilled, in part, by the “Taxpayer Relief Act of 1997” and the 1997 Budget Act.


Since 1987, federal estate taxes have been imposed on the estate of any person who dies leaving assets worth more than $600,000 (excluding bequests to a surviving spouse or charity). In some cases, a married couple can leave $1.2 million to their heirs tax-free, but only if a special “exemption” or “bypass” trust is created pursuant to a will or living trust at the time of the first spouse’s death. Only about 8% of estates owe any estate taxes; estate taxes generate about 1% of federal tax revenue.

In 1994, the Republican “Contract With America” pledged to increase the amount of the “unified credit” to $750,000 over a three-year period, and to increase it annually thereafter based on the inflation rate. That promise was one of the first to be abandoned — probably because “dead people don’t vote.”

Bills have been introduced in Congress every year, seeking to increase the “unified credit” for estate and gift taxes (or in some cases to repeal the tax entirely), but the bills have historically died in committees because no one could suggest ways to offset the lost tax revenue. More than 50 bills to alter estate and gift taxes have been introduced in the current 105th Congress.

In early May, the Clinton administration and Congressional leaders reached a budget agreement “in principal” which promised an immediate increase in the “unified credit” that would exempt estates of up to $1.2 million from federal estate taxes. By mid-June, this eroded to a strangely-staggered increase to $1 million over a ten-year period.

The New Law

As of August 1, it appears that President Clinton was preparing to sign two bills passed by Congress, comprising the 1997 budget law, which would make a number of changes to the estate and gift tax laws. Although some of these changes will result in substantial tax savings for many Americans, almost all of these changes will increase the complexity of the law. Nearly every provision seems to have a different effective date; some are retroactive to various dates in 1997, while some are effective on the date of enactment, and others won’t be effective until future years (assuming they are not modified or repealed in the interim as new budget deals are struck). This article discusses ONLY changes in the law affecting estate and gift taxes. View for information on general taxes.

1997: $600,000
1998: $625,000
1999: $650,000
2000-01: $675,000
2002-03: $700,000
2004: $850,000
2005: $950,000
2006 + $1,000,000

In “Unified Credit” Increase and corresponding “Exemption Equivalent”: The estate tax rates and unified credit are not changed for decedents dying in 1997. Under Section 501 of TRA ’97, the amount of the “unified credit” is scheduled to be increased in subsequent years, so that the “exemption equivalent” will be as indicated in the table at right.

Note that the increases are tiny in the first 7 years of the table, when the numbers are being used to project a balanced budget, and then accelerate in the last 3 years. You should expect that future budgets will defer or erode those increases. (Congress is famous for breaking its promises: the tax law contained provisions for nearly a decade promising to reduce the top estate tax bracket from 55% to 50%, but that provision was delayed each year and eventually abandoned.)

It’s also important to recognize that although this increase in the “unified credit” will substantially reduce the number of estates subject to federal estate taxes, the bulk of federal estate taxes are collected on the largest 1% of estates, and in the largest estates (above $21 to $25 million), the entire “unified credit” and all of the under-55% estate tax brackets are rescinded, so that the estate tax is unchanged for large estates, even under the new law.

In addition, it’s important to recognize that changes in the amount of the “unified credit” should not result in any fundamental changes in estate planning techniques. Most existing estate plans that include tax planning (including many Wills and “living trusts”) will automatically adjust to the larger exemption. (But note that most Wills and “living trusts” do not include any tax-planning provisions.)

Cost-of-Living Increases for Annual Gift Tax Exclusion Amount (and GSTs): The first $10,000 of gifts are excluded from gift taxes under current law; starting in 1999, that amount will be increased based on the cost of living. However, the increases will only be made in $1,000 increments, so that no increase is likely until the year 2001. The $1 million exemption from generation-skipping transfer (GST) taxes would also be increased starting in 1999, rounded to the nearest $10,000 increment (other provisions exempt some additional transfers from GST taxes). There is no language in TRA ’97 that would extend a similar cost-of-living increase to the estate tax “exemption equivalent” after it reaches $1 million in the year 2006.

Family-Owned Business Exclusion

Owners of “qualified family-owned businesses” will receive an additional exemption so that their estates may exclude up to $1.3 million from estate taxes. (Section 502 of TRA ’97.) In contrast to the long deferral of the increase in regular estate tax exemption, this $1.3 million exemption (for these generous, mostly-Republican, campaign contributors) is effective for all decedents dying after December 31, 1997. (To qualify, the decedent (or members of her family) must have owned and materially participated in the business for at least 5 of the 8 years immediately preceding death; the exemption may be “recaptured” if the heirs sell the business within 10 years after the date of death. Many other technical requirements also apply.) This exemption, which gives business owners more than twice the exemption of non-business owners dying in 1998, does not contain language that would index the $1.3 million amount for inflation.

Gift Tax Returns Binding on IRS

Section 506 of TRA ’97 contains a provision that will give relief to many tax advisors: it provides that the IRS may not attempt to revalue gifts made in years before death, if gift tax returns were filed and the statute of limitations has expired on those returns. This solves the problem of having the IRS assert, at the time an estate tax return is filed, that the decedent’s unified credit was eroded or gift taxes are owed for gifts made many years (or decades) earlier. It will impose an extra burden on the IRS to review and audit gift-tax returns for which no tax is due, if there is any possibility that the value of the gifted property has been understated (for example, when valuing limited family partnership interests which are subject to “valuation adjustments” or “discounts” for various reasons). While the law will probably increase the audit rate for gift tax returns, it will provide more certainty to taxpayers and their advisors.

Capital-Gains Exemption of $500,000 from Sale of Residence

As widely reported, the new law contains provisions that will exempt the first $250,000 (single) or $500,000 (married couple) of profits from the sale of property used as the principal residence (for 2 of the past 5 years) from capital gains taxes. While this provision does not directly affect the estate or gift tax laws, it will alter the computation of benefits from certain estate planning techniques, and it may dramatically change behaviors and thus impact estate planning. Many taxpayers have remained in homes much larger than they need because they wanted to avoid capital gains taxes that would be incurred if they “moved down” to a smaller and less expensive home. The new law is much more expansive than the former one-time $125,000 exclusion for persons over 55.

Repeal of Excess Distribution and Excess Retirement Accumulation Tax

Section 1073 of TRA ’97 repeals (retroactive to 1/97) Internal Revenue Code section 4980A, which imposed a 15% penalty on portions of certain large withdrawals (“excess distributions”) and on the balance of “over-funded” (“excess accumulation”) retirement accounts at death. This came as a surprise, since last year’s budget act had partially suspended the “excess distribution” provisions of section 4980A for lifetime distributions, for three years only, in an effort to induce some taxpayers to accelerate distributions (and thus ordinary income tax payments). By also repealing the excess accumulation provisions, Congress has eliminated an incentive to accelerate lifetime distributions. (With the growth of IRA and 401(k) plans, these taxes complicated retirement planning for millions of Americans, so their repeal is welcome.)

Charitable Remainder Trusts

In a move that surprised the charitable and legal communities, Congress included section 1089, which disqualifies any charitable deduction for any “charitable remainder trust” for which the computed charitable remainder interest is less than ten percent. As a practical matter, this completely precludes the use of these trusts (and the resulting charitable gifts) by persons younger than 35, and precludes the use of such trusts with reasonable annuity rates for persons under age 50. (See for a table showing the ages and interest levels now disallowed.) No hearings were held and no public comment was ever sought for these provisions, which were simply inserted by committee staff in the final days of budget negotiations.

Funeral Trust

Certain estate tax provisions would not apply to contributions of up to $7,000 to a “qualified funeral trust,” which can only be administered by “a person engaged in the trade or business of providing funeral or burial services or property necessary to provide such services.” By excluding third-party trust arrangements from this favorable tax treatment, this provision appears to be special-interest legislation rewarding an industry with a long history of abuse of such “prepaid funeral trusts”. (Section 1309 of TRA ’97.)