MEMORANDUM

TO:  Our Clients and Friends
DATED:  October, 1997
RE:  Taxpayer Relief Act of 1997

This memorandum summarizes the more significant aspects of the Taxpayer Relief Act enacted this summer which may affect your financial and estate plans.

Capital Gains Changes

     The Act cuts the top tax rate on certain net capital gains recognized by individuals, estates and trusts after July 28, 1997. Formerly, these taxpayers' long term capital gains were taxed at the same rate as ordinary income, with a maximum rate of 28%. Under the new law, the maximum rate for many capital gains has been reduced to 20%. Taxpayers in the 15% tax bracket pay only a 10% tax on their capital gains.

     These new rates apply only upon the sale of long term capital assets, that is, assets held for more than 18 months, and do not apply to the sale of collectibles (for example, antiques, artwork, gems, stamps and coins). Short term gains on assets held for a year or less continue to be taxed at ordinary income rates, and mid-term gains on assets held more than a year but less than 18 months continue to be taxed at a maximum rate of 28%.

     Beginning with purchases made after the year 2000, capital gains tax rates on the sale of some assets will be even lower. The maximum capital gains rate for certain assets held more than five years will be only 18% and only 8% for taxpayers in the 15% tax bracket.

Exclusion for Gain on Sale of Residence

     A new exclusion for gain on the sale of a principal residence replaces prior rollover rules and the $125,000 one time exclusion for taxpayers over age 55. For home sales after May 6, 1997, any seller who has owned and used the home as a principal residence for at least two of the five years prior to sale can exclude only up to $250,000 of gain on the sale from income. In general, this exclusion can be used once every two years. Married persons filing jointly for the year of sale may exclude up to $500,000 so long as either spouse owned the home for at least two of the five years prior to sale, both spouses used the home as a principal residence for this period of time and neither spouse has used the exclusion within the two-year period. A partial exclusion is available to taxpayers who fail to meet either the "two out of five year ownership" rule or the "once every two years" rule due to employment, health or certain other unforeseen circumstances.

Estimated Income Taxes

     Individuals with an adjusted gross income in excess of $150,000 will be required to pay more in estimated income taxes. Starting in 1998, the applicable percentage will be indexed as follows:

If the preceding taxable year begins in: The applicable percentage is:

1998 100%
1999, 2000 105%
2001 112%
2002 or thereafter 110%

Individual Retirement Accounts

     There are numerous new, complex rules relating to IRAs, including entirely new types of IRAs. There are specific requirements for, and pros and cons of, each type of IRA. The decision as to the type of IRA appropriate for a particular individual will not always be an obvious one. However, the changes generally do not apply to an individual whose adjusted gross income exceeds $110,000 or a married couple whose adjusted gross income on a joint return exceeds $160,000.

Other Beneficial Changes to Laws Governing Retirement Plans

     Under prior law, taxpayers who had accumulated large balances in their retirement plans were subject to a 15% tax on excess distributions from qualified retirement plans, tax-sheltered annuities and IRAs and to a 15% estate tax for excess retirement accumulations. Recently, Congress had suspended the 15% tax on excess distributions made in 1997, 1998 and 1999. The new law now completely repeals the 15% excess distribution tax and the 15% estate tax on excess accumulations.

Changes Affecting Charitable Gifts

     A gift tax return is no longer required to be filed to report most charitable gifts. The filing requirements for gifts of partial interests in property to charity remain unchanged.

     The law that allows contributions of publicly traded stock to a private foundation to be deductible at fair market value has been extended through June 30, 1998.

     In general, a charitable remainder trust (CRT) makes a periodic payment to one or more named individuals for life or a period of time and then pays all remaining trust property to charity. Transfers to CRTs are eligible for income, gift or estate tax charitable deductions in the amount of the present actuarial value of the charitable remainder interest. CRTs generally pay no income tax, although income taxes are paid by the individuals on trust distributions to the extent of income, including capital gain income, realized by the trust. A CRT must meet numerous detailed requirements, including a rule that the annual payment to the non-charitable beneficiary(ies) must be in the form of an annuity or a unitrust amount (a stated percentage of the trust's value determined each year), with certain variations, or at least 5%, which in the case of an annuity trust applies to the trust's initial value. The new law makes the following changes: For transfers to charitable remainder trusts after June 18, 1997, the non-charitable pay-out cannot exceed 50% of the value of the trust assets annually.

For transfers to charitable remainder trusts after July 28, 1997, the present actuarial value of the charitable remainder must be at least 10% of the value of the property transferred to the trust as of the date of the transfer. This means that charitable remainder trusts simply cannot be created for the life of non-charitable beneficiaries below certain ages. As the number of non-charitable beneficiaries increases, the threshold ages get older. For example, using the assumptions in effect for August, 1997, a charitable remainder unitrust cannot be created for the life of a 20-year-old, for the joint lives of two individuals, such as a husband and wife, age 34 and 32, or for the joint lives of two individuals, such as parent and child, age 49 and 24.

Annual Gift Tax Exclusion and the Unified Credit

     Currently, each individual may give $10,000 each year to each of any number of individuals without incurring any gift taxes. Beginning in 1999, this annual exclusion amount will be indexed annually for inflation.

     The unified estate and gift tax credit of $192,800 effectively exempts the first $600,000 of cumulative transfers. The effective exemption is being increased as follows:

For gifts made for decedents dying in: The amount exempted by the Unified Credit is:

1998 $  625,000
1999 650,000
2000 and 2001 675,000
2002 and 2003 700,000
2004 850,000
2005 950,000
2006 1,000,000

     Most of our clients who have wills or revocable trusts in which they make gifts of the maximum unified credit amount (either to someone other than the surviving spouse or to a trust that may benefit the spouse but will not be taxed in the spouse's estate) will not have to revise their wills to take advantage of this change because the formula we routinely use is geared to the maximum available unified credit. However, sometimes clients have geared the division of their estates to a specific number and not to a formula, and those clients may want to consider revising their wills. Similarly, some clients may decide that using the unified credit to divide property between a surviving spouse and, for example, children from a prior marriage, no longer makes sense. Because of the gradual increase, it is unlikely that such clients will feel any urgency to make a change, however, and an argument can be made that the unified credit increase merely adjusts for inflation.

Generation-Skipping Transfer Tax

     Several notable changes have been enacted in the area of the generation- skipping transfer tax. Currently, $1,000,000 in property may be passed to a person two or more generations below the transferor without the transfer being subject to a 55% generation-skipping transfer (GST) tax. Under the new laws, this exempt amount will be indexed annually for inflation after 1998.

     Beginning after 1997, the exception from the generation-skipping transfer tax that applies when the parent of a beneficiary is deceased at the time of a transfer is expended in two limited ways. Unlike existing law, it will apply under certain circumstances (1) to charitable lead trusts and to other trusts in which there are current beneficiaries in the same generation as, or in an older generation than, the deceased parent and (2) to certain transfers to grandnieces and grandnephews.

Qualified Family-Owned Businesses

     Under the Act, Congress has provided some estate tax benefits for persons dying with an interest in a family-owned business. For individuals dying after 1997, if more than 50% of the estate consists of qualified family-owned business interests, an election can be made to exclude up to $675,000 in value of the interest from the decedent's gross estate. The requirements for qualifying for this estate tax exclusion are numerous and complex, and even after qualifying for this exclusion, the benefits may be lost if one or several "recapture events" occurs. Below is a summary of the most relevant aspects of this new law.

     It is important to note that the exclusion amount will decrease over the next several years, since the sum of this exclusion and the amount exempted by the unified credit may not exceed $1,300,000. For example, in the year 2006, when the unified credit will be $1,000,000, only $300,000 of the interest in a qualified family- owned business could be excluded from a decedent's gross estate. To qualify for the exclusion, the business must have its principal place of business in the United States, be owned at least 50% by one family, 70% by two families, or 90% by three families, and the decedent and his or her family (including the decedent's spouse, ancestors, children, grandchildren, cousins or the spouses of any of them) must hold at least 30% of any interest in the business. In addition, the decedent must have materially participated in the business for five of the eight years preceding his or her death, and his or her family must do so after the decedent's death.

     As to the business itself, additional requirements must be met. If more than 35% of the adjusted ordinary gross income of the business for the year of the decedent's death is personal holding company income, no exclusion will be allowed. The value of the business will be reduced to the extent it holds passive assets, excess cash or marketable securities. And as mentioned above, if within 10 years after qualifying for this exclusion one of several specified recapture events occurs, an additional tax will be imposed. Qualification for this benefit may be too complex for the relatively small amount of tax relief.

Installment Payments of Estate Tax on Closely Held Business

     Certain estates owning an interest in a closely held business are eligible to pay the estate tax attributable to the interest over a period of 14 years and at a special interest rate of 4% for the first $1,000,000 in value of the business. Under the new law, a 2% interest rate will apply for deferred estate taxes attributable to the first $1,000,000 in value of the closely held business in excess of the exemption amount provided by the unified credit. This $1,000,000 ceiling for eligibility will be indexed annually for inflation. Therefore, in 1998, when the unified credit will allow you to transfer $625,000 at death tax free (assuming that none of the credit has been used for making gifts during life), any estate tax attributable to the value of a closely held business up to $1,625,000 will be eligible for the special 2% interest rate. For the estate tax attributable to the value of the business in excess of $1,625,000, the interest rate will only be 45% of the rate applicable to underpayments of tax, but no estate tax deduction will be allowed for interest paid as currently permitted.

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This memorandum greatly simplifies the complex rules involved in this Act. This memorandum is intended to inform you of these recent developments and to provide information of general interest. It is not intended to give you legal advice regarding your specific situation and should not be relied upon as such. We would, of course, welcome the opportunity to consult with you on these or any other aspects of the new law.

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