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Revenue Reconciliation Act page2

TITLE III . SAVINGS AND INVESTMENT INCENTIVES

A. Individual Retirement Arrangements (secs. 301-304 of the bill and secs. 72 and 408 of the Code and new sec. 408A of the Code)

Present Law

Under present law, an individual may make deductible contributions to an individual retirement arrangement ("IRA") up to the lesser of $2,000 or the individual's compensation if the individual is not an active participant in an employer-sponsored retirement plan (and, if married, the individual's spouse also is not an active participant in such a plan). If the case of a married couple, deductible IRA contributions of up to $2,000 can be made for each spouse (including, for example, a home maker who does not work outside the home) if the combined compensation of both spouses is at least equal to the contributed amount.

If the individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the $2,000 deduction limit is phased out over certain adjusted gross income (" AGI ") levels. The limit is phased out between $40,000 and $50,000 of AGI for married taxpayers, and between $25,000 and $35,000 of AGI for single taxpayers. An individual may make nondeductible IRA contributions to the extent the individual is not permitted to make deductible IRA contributions. Contributions cannot be made to an IRA after age 70-1/2.

Amounts held in an IRA are includible in income when withdrawn (except to the extent the withdrawal is a return of nondeductible contributions). Amounts withdrawn prior to attainment of age 59-1/2 are subject to an additional 10-percent early withdrawal tax, unless the withdrawal is due to death or disability, is made in the form of certain periodic payments, is used to pay medical expenses in excess of 7.5 percent of AGI , or is used to purchase health insurance of an unemployed individual.

In general, distributions from an IRA are required to begin at age 70-1/2. An excise tax is imposed if the minimum required distributions are not made. Distributions to the beneficiary of an IRA are generally required to begin within 5 years of the death of the IRA owner, unless the beneficiary is the surviving spouse.

A 15-percent excise tax is imposed on excess distributions with respect to an individual during any calendar year from qualified retirement plans, tax-sheltered annuities, and IRAs. In general, excess distributions are defined as the aggregate amount of retirement distributions (i.e., payments from applicable retirement plans) made with respect to an individual during any calendar year to the extent such amounts exceed $160,000 (for 1997) or 5 times that amount in the case of a lump-sum distribution. The dollar limit is indexed for inflation. A similar 15-percent additional estate tax applies to excess retirement accumulations upon the death of the individual. The 15-percent tax on excess distributions (but not the 15-percent additional estate tax) does not apply to distributions in 1997, 1998 or 1999.

IRAs may not be invested in collectibles. A collectible is defined as any piece of art, rug or antique, metal or gem, stamp or coin, alcoholic beverage, or other personal property as specified by the Treasury. This prohibition does not apply to coins issued by a State.

Reasons for Change

The Committee is concerned about the national savings rate, and believes that individuals should be encouraged to save. The Committee believes that the ability to make deductible contributions to an IRA is a significant savings incentive. However, this incentive is not available to all taxpayers under present law. Further, the present-law income thresholds for IRA deductions are not indexed for inflation so that fewer Americans will be eligible to make a deductible IRA contribution each year. The Committee believes it is appropriate to encourage individual saving and that deductible IRAs should be available to more individuals.

In addition, the Committee believes that some individuals would be more likely to save if funds set aside in a tax-favored account could be withdrawn without tax after a reasonable holding period for retirement or certain special purposes. Some taxpayers may find such a vehicle more suitable for their savings needs.

The Committee believes that providing an incentive to save for certain special purposes is appropriate. The Committee believes that many Americans may have difficulty saving enough to ensure that they will be able to purchase a home. Home ownership is a fundamental part of the American dream.

The Committee believes that individuals who are unemployed for a substantial period of time should have access to their retirement saving.

The Committee believes that the present-law rules relating to deductible IRAs penalize American homemakers. The Committee believes that an individual should not be precluded from making a deductible IRA contribution merely because his or her spouse participates in an employer-sponsored retirement plan.

Finally, the Committee believes that IRAs should not be precluded from investing in bullion.

Explanation of Provision

In general

The bill (1) increases the AGI phase-out limits for deductible IRAs, (2) provides that an individual is not considered an active participant in an IRA merely because the individual's spouse is an active participant, (3) provides an exception from the early withdrawal tax for withdrawals for first-time home purchase (up to $10,000) and long-term unemployed individuals, and (4) replaces present-law nondeductible IRAs with a new IRA called the IRA Plus. All individuals may make nondeductible contributions of up to $2,000 annually to an IRA Plus. No income limitations apply to IRA Plus accounts; however, the $2,000 maximum contribution limit is reduced to the extent an individual makes deductible contributions to an IRA. An IRA Plus is an IRA which is designated at the time of establishment as an IRA Plus in the manner prescribed by the Secretary. Qualified distributions from an IRA Plus are not includible in income.

Increase income phase-out ranges for deductible IRAs

The bill increases the AGI phase-out range for deductible IRA contributions as follows:

                      

Phase-Out
 
Range

   Taxable years                             Single          Joint

   beginning in:                           Taxpayers        Returns

   1998 and 1999                        $30,000-$40,000 $50,000-$60,000

   2000 and 2001                        $35,000-$45,000 $60,000-$70,000

   2002 and 2003                        $40,000-$50,000 $70,000-$80,000

   2004 and thereafter                  $50,000-$60,000 $80,000-$100,000

Active participant rule

The bill provides that an individual is not considered an active participant in an employer-sponsored plan merely because the individual's spouse is an active participant.

Modifications to early withdrawal tax

The bill provides that the 10-percent early withdrawal tax does not apply to withdrawals from an IRA (including an IRA Plus) for (1) up to $10,000 of first-time homebuyer expenses and (2) distributions for long-term unemployed individuals.²⁷

Under the bill, qualified first-time homebuyer distributions are withdrawals of up to $10,000 during the individual's lifetime that are used within 120 days to pay costs (including reasonable settlement, financing, or other closing costs) of acquiring, constructing, or reconstructing the principal residence of a first-time homebuyer who is the individual, the individual's spouse, or a child, grandchild, or ancestor of the individual or individual's spouse. A first-time homebuyer is an individual who has not had an ownership interest in a principal residence during the 2-year period ending on the date of acquisition of the principal residence to which the withdrawal relates. The bill requires that the spouse of the individual also meet this requirement as of the date the contract is entered into or construction commences. The date of acquisition is the date the individual enters into a binding contract to purchase a principal residence or begins construction or reconstruction of such a residence. Principal residence is defined as under the provisions relating to the rollover of gain on the sale of a principal residence.

Under the bill, any amount withdrawn for the purchase of a principal residence is required to be used within 120 days of the date of withdrawal. The 10-percent additional income tax on early withdrawals is imposed with respect to any amount not so used. If the 120-day rule cannot be satisfied due to a delay in the acquisition of the residence, the taxpayer may recontribute all or part of the amount withdrawn to an IRA Plus prior to the end of the 120-day period without adverse tax consequences.

Under the bill, the 10-percent early withdrawal tax does not apply to distributions to an individual after separation form employment if the individual has received unemployment compensation for 12 consecutive weeks under any Federal or State unemployment compensation law and the distribution is made during any taxable year during which the unemployment compensation is paid or the succeeding taxable year. This exception does not apply to any distribution made after the individual has been employed for at least 60 days after the separation of employment. To the extent provided in regulations, the provision applies to a self-employed individual if, under Federal or State law, the individual would have received unemployment compensation but for the fact the individual was self employed.

IRA investments in bullion

Under the bill, IRA assets may be invested in certain bullion. The bill applies to any gold, silver, platinum or palladium bullion of a fineness equal to or exceeding the minimum fineness required for metals which may be delivered in satisfaction of a regulated futures contract subject to regulation by the Commodity Futures Trading Commission. The provision does not apply unless the bullion is in the physical possession of the IRA trustee.²⁸

IRA Plus accounts

Contributions to IRA Plus accounts

The maximum annual contribution that may be made to an IRA Plus is the lesser of $2,000 (reduced by deductible IRA contributions) or the individual's compensation for the year. As under the present-law rules relating to deductible IRAs, a contribution of up to $2,000 for each spouse may be made to an IRA Plus provided the combined compensation of the spouses is at least equal to the contributed amount.

Contributions to an IRA Plus may be made even after the individual for whom the account is maintained has attained age 70-1/2.

Taxation of distributions

Qualified distributions from an IRA Plus are not includible in gross income, nor subject to the additional 10-percent tax on early withdrawals. A qualified distribution is a distribution that (1) is made after the 5-taxable year period beginning with the first taxable year in which the individual made a contribution to an IRA Plus ²⁹ , and (2) which is (a) made on or after the date on which the individual attains age 59-1/2, (b) made to a beneficiary (or to the individual's estate) on or after the death of the individual, (c) attributable to the individual's being disabled, or (d) a qualified special purpose distribution. Qualified special purpose distributions are distributions that are exempt from the 10-percent early withdrawal tax because they are for first-time homebuyer expenses or long-term unemployed individuals.

Distributions from an IRA Plus that are not qualified distributions are includible in income to the extent attributable to earnings, and subject to the 10-percent early withdrawal tax (unless an exception applies). The same exceptions to the early withdrawal tax that apply to IRAs apply to IRA Plus accounts.

An ordering rule applies for purposes of determining what portion of a distribution that is not a qualified distribution is includible in income. Under the ordering rule, distributions from an IRA Plus are treated as made from contributions first, and all an individual's IRA Plus accounts are treated as a single IRA Plus. Thus, no portion of a distribution from an IRA Plus is treated as attributable to earnings (and therefore includible in gross income) until the total of all distributions from all the individual's IRA Plus accounts exceeds the amount of contributions.

Distributions from an IRA Plus may be rolled over tax free to another IRA Plus.

Conversions of an IRA to an IRA Plus

All or any part of amounts in a present-law deductible or nondeductible IRA may be converted into an IRA Plus. If the conversion is made before January 1, 1999 , the amount that would have been includible in gross income if the individual had withdrawn the converted amounts is included in gross income ratably over the 4-taxable year period beginning with the taxable year in which the conversion is made. The early withdrawal tax does not apply to such conversions.³⁰

A conversion of an IRA into an IRA Plus can be made in a variety of different ways and without taking a distribution. For example, an individual may make a conversion simply by notifying the IRA trustee. Or, an individual may make the conversion in connection with a change in IRA trustees through a rollover or a trustee-to-trustee transfer. If a part of an IRA balance is converted into an IRA Plus, the IRA Plus amounts may have to be held separately.

Effective Date

The provision is effective for taxable years beginning after December 31, 1997 .

B. Capital Gains Provisions

1. Maximum rate of tax on net capital gain of individuals (sec. 311 of the bill and sec. 1(h) of the Code)

Present Law

In general, gain or loss reflected in the value of an asset is not recognized for income tax purposes until a taxpayer disposes of the asset. On the sale or exchange of capital assets, the net capital gain is taxed at the same rate as ordinary income, except that individuals are subject to a maximum marginal rate of 28 percent of the net capital gain. Net capital gain is the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for the year. Gain or loss is treated as long-term if the asset is held for more than one year.

A capital asset generally means any property except (1) inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business, (2) depreciable or real property used in the taxpayer's trade or business, (3) specified literary or artistic property, (4) business accounts or notes receivable, or (5) certain U.S. publications. In addition, the net gain from the disposition of certain property used in the taxpayer's trade or business is treated as long-term capital gain. Gain from the disposition of depreciable personal property is not treated as capital gain to the extent of all previous depreciation allowances. Gain from the disposition of depreciable real property is generally not treated as capital gain to the extent of the depreciation allowances in excess of the allowances that would have been available under the straight-line method of depreciation.

Reasons for Change

The Committee believes it is important that tax policy be conducive to economic growth. Economic growth cannot occur without saving, investment, and the willingness of individuals to take risks. The greater the pool of savings, the greater the monies available for business investment. It is through such investment that the United States ' economy can increase output and productivity. It is through increases in productivity that workers earn higher real wages. Hence, greater saving is necessary for all Americans to benefit through a higher standard of living.

The Committee believes that, by reducing the effective tax rates on capital gains, American households will respond by increasing saving. The Committee believes it is important to encourage risk taking and believes a reduction in the taxation of capital gains will have that effect. The Committee also believes that a reduction in the taxation of capital gains will improve the efficiency of the capital markets, because the taxation of capital gains upon realization encourages investors who have accrued past gains to keep their monies "locked in" to such investment even when better investment opportunities present themselves. A reduction in the taxation of capital gains should reduce this "lock in" effect.

Explanation of Provision

Under the bill, the maximum rate of tax on the net capital gain of an individual is reduced from 28 percent to 20 percent. In addition, any net capital gain which otherwise would be taxed at a 15 percent rate is taxed at a 10 percent rate. These rates apply for purposes of both the regular tax and the minimum tax.

The tax on the net capital gain attributable to any long-term gain from the sale or exchange of collectibles (as defined in section 408(m) without regard to paragraph (3) thereof) will remain at 28 percent; and any gain from the sale or exchange of section 1250 property (i.e., depreciable real estate) to the extent of the gain that would have been treated as ordinary income if the property had been section 1245 property will be taxed at a maximum rate of 24 percent.

Effective Date

The provision applies to taxable years ending after May 6, 1997 .

For a taxpayer's taxable year that includes May 7, 1997 , the lower rates will not apply to an amount equal to the net capital gain determined by including only gain or loss properly taken into account for the portion of the year before May 7, 1997 . This generally has the effect of applying the lower rates to capital assets sold or exchanged (or installment payments received) on or after May 7, 1997 , and subjecting the remaining portion of the net capital gain to a maximum rate of 28 percent.

In the case of gain taken into account by a pass-through entity (i.e., a RIC , a REIT, a partnership, an estate or trust, or a common trust fund), the date taken into account by the entity is the appropriate date for applying the rule in the preceding paragraph to the individual taxpayer's taxable year which includes May 7, 1997 .

2. Small business stock (secs. 312 and 313 of the bill and secs. 1045 and 1202 of the Code)

Present Law

The Revenue Reconciliation Act of 1993 provided individuals a 50-percent exclusion for the sale of certain small business stock acquired at original issue and held for at least five years. One-half of the excluded gain is a minimum tax preference.

The amount of gain eligible for the 50-percent exclusion by an individual with respect to any corporation is the greater of (1) ten times the taxpayer's basis in the stock or (2) $10 million.

In order to qualify as a small business, when the stock is issued, the gross assets of the corporation may not exceed $50 million. The corporation also must meet an active trade or business requirement.

Reasons for Change

The Committee believes it is important to maintain a larger exclusion for stock in small, start-up enterprises. Such enterprises are inherently risky and may not have easy access to the capital necessary to launch a new venture. The Committee believes that it is important to foster such entrepreneurial activities and believes targeted reduction in capital gains taxation will help provide access to needed capital.

The Committee also understands that the present law restrictions on working capital may often be inappropriate in the context of a venture start up enterprise.

Explanation of Provision

Under the bill, the 50-percent exclusion will apply to small business stock (other than stock of a subsidiary corporation) held by a corporation. The minimum tax preference is repealed. Under the bill, in the case of a qualifying sale of small business stock by an individual, the maximum rate of tax (taking together the 50-percent exclusion and the maximum 20-percent capital gains rate added by the bill) will be 10 percent.

The bill increases the size of an eligible corporation from gross assets of $50 million to gross assets of $100 million. The bill also repeals the limitation on the amount of gain a taxpayer can exclude with respect to the stock of any corporation.

The bill provides that certain working capital must be expended within five years (rather than two years) in order to be treated as used in the active conduct of a trade or business. No limit on the percent of the corporation's assets that are working capital is imposed.

The bill provides that if the corporation establishes a business purpose for a redemption of its stock, that redemption is disregarded in determining whether other newly issued stock could qualify as eligible stock.

The bill allows a taxpayer to roll over gain from the sale or exchange of small business stock otherwise qualifying for the exclusion where the taxpayer uses the proceeds to purchase other qualifying small business stock within 60 days of the sale of the original stock. If the taxpayer sells the replacement stock, the gain attributable to the original stock is eligible for the small business stock exclusion and the capital gain rates, and any remaining gain is eligible for the capital gain rates if held more than one year and the small business exclusion if held for at least five years. In addition, any gain that otherwise would be recognized from the sale of the replacement stock can be rolled over to other small business stock purchased within 60 days.

Effective Date

The increase in the size of corporations whose stock is eligible for the exclusion and the provisions applicable to corporate shareholders applies to stock issued after the date of the enactment of the proposal. The remaining provisions apply to stock issued after August 10, 1993 (the original effective date of the small business stock provision).

3. Exclusion of gain on sale of principal residence (sec. 314 of the bill and secs. 121 and 1034 of the Code)

Present Law

Rollover of gain

No gain is recognized on the sale of a principal residence if a new residence at least equal in cost to the sales price of the old residence is purchased and used by the taxpayer as his or her principal residence within a specified period of time (sec. 1034). This replacement period generally begins two years before and ends two years after the date of sale of the old residence. The basis of the replacement residence is reduced by the amount of any gain not recognized on the sale of the old residence by reason of this gain rollover rule.

One-time exclusion

In general, an individual, on a one-time basis, may exclude from gross income up to $125,000 of gain from the sale or exchange of a principal residence if the taxpayer (1) has attained age 55 before the sale, and (2) has owned the property and used it as a principal residence for three or more of the five years preceding the sale (sec. 121).

Reasons for Change

Calculating capital gain from the sale of a principal residence is among the most complex tasks faced by a typical taxpayer. Many taxpayers buy and sell a number of homes over the course of a lifetime, and are generally not certain of how much housing appreciation they can expect. Thus, even though most homeowners never pay any income tax on the capital gain on their principal residences, as a result of the rollover provisions and the $125,000 one-time exclusion, detailed records of transactions and expenditures on home improvements must be kept, in most cases, for many decades. To claim the exclusion, many taxpayers must determine the basis of each home they have owned, and appropriately adjust the basis of their current home to reflect any untaxed gains from previous housing transactions. This determination may involve augmenting the original cost basis of each home by expenditures on improvements. In addition to the record-keeping burden this creates, taxpayers face the difficult task of drawing a distinction between improvements that add to basis, and repairs that do not. The failure to account accurately for all improvements leads to errors in the calculation of capital gains, and hence to an under- or over-payment of the capital gains on principal residences. By excluding from taxation capital gains on principal residences below a relatively high threshold, few taxpayers would have to refer to records in determining income tax consequences of transactions related to their house.

To postpone the entire capital gain from the sale of a principal residence, the purchase price of a new home must be greater than the sales price of the old home. This provision of present law encourages some taxpayers to purchase larger and more expensive houses than they otherwise would in order to avoid a tax liability, particularly those who move from areas where housing costs are high to lower-cost areas. This promotes an inefficient use of taxpayer's financial resources.

Present law also may discourage some older taxpayers from selling their homes. Taxpayers who would realize a capital gain in excess of $125,000 if they sold their home and taxpayers who have already used the exclusion may choose to stay in their homes even though the home no longer suits their needs. By raising the $125,000 limit and by allowing multiple exclusions, this constraint to the mobility of the elderly would be removed.

While most homeowners do not pay capital gains tax when selling their homes, current law creates certain tax traps for the unwary that can result in significant capital gains taxes or loss of the benefits of the current exclusion. For example, an individual is not eligible for the one-time capital gains exclusion if the exclusion was previously utilized by the individual's spouse. This restriction has the unintended effect of penalizing individuals who marry someone who has already taken the exclusion. Households that move from a high housing-cost area to a low housing- cost area may incur an unexpected capital gains tax liability. Divorcing couples may incur substantial capital gains taxes if they do not carefully plan their house ownership and sale decisions.

Explanation of Provision

Under the bill a taxpayer generally is able to exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. The exclusion is allowed each time a taxpayer selling or exchanging a principal residence meets the eligibility requirements, but generally no more frequently than once every two years. The bill provides that gain would be recognized to the extent of any depreciation allowable with respect to the rental or business use of such principal residence for periods after May 6, 1997 .

To be eligible for the exclusion, a taxpayer must have owned the residence and occupied it as a principal residence for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these requirements by reason of a change of place of employment, health, or unforseen circumstances is able to exclude the fraction of the $250,000 ($500,000 if married filing a joint return) equal to the fraction of two years that these requirements are met.

In the case of joint filers not sharing a principal residence, an exclusion of $250,000 is available on a qualifying sale or exchange of the principal residence of one of the spouses. Similarly, if a single taxpayer who is otherwise eligible for an exclusion marries someone who has used the exclusion within the two years prior to the marriage, the bill would allow the newly married taxpayer a maximum exclusion of $250,000. Once both spouses satisfy the eligibility rules and two years have passed since the last exclusion was allowed to either of them, the taxpayers may exclude $500,000 of gain on their joint return.

Under the bill, the gain from the sale or exchange of the remainder interest in the taxpayer's principal residence may qualify for the otherwise allowable exclusion.

Effective Date

The provision is available for all sales or exchanges of a principal residence occurring on or after May 7, 1997 , and replaces the present-law rollover and one-time exclusion provisions applicable to principal residences.

A taxpayer may elect to apply present law (rather than the new exclusion) to a sale or exchange (1) made before the date of enactment of the Act, (2) made after the date of enactment pursuant to a binding contract in effect on the date or (3) where the replacement residence was acquired on or before the date of enactment (or pursuant to a binding contract in effect of the date of enactment) and the rollover provision would apply. If a taxpayer acquired his or her current residence in a rollover transaction, periods of ownership and use of the prior residence would be taken into account in determining ownership and use of the current residence.

TITLE IV. ESTATE, GIFT , AND GENERATION-SKIPPING TAX PROVISIONS

A. Increase in Estate and Gift Tax Unified Credit (sec. 401(a) of the bill and sec. 2010 of the Code)

Present Law

A gift tax is imposed on lifetime transfers by gift and an estate tax is imposed on transfers at death. Since 1976, the gift tax and the estate tax have been unified so that a single graduated rate schedule applies to cumulative taxable transfers made by a taxpayer during his or her lifetime and at death.³¹ A unified credit of $192,800 is provided against the estate and gift tax, which effectively exempts the first $600,000 in cumulative taxable transfers from tax (sec. 2010). For transfers in excess of $600,000, estate and gift tax rates begin at 37 percent and reach 55 percent on cumulative taxable transfers over $3 million (sec. 2001(c)). In addition, a 5-percent surtax is imposed upon cumulative taxable transfers between $10 million and $21,040,000, to phase out the benefits of the graduated rates and the unified credit (sec. 2001(c)(2)).³²

Reasons for Change

The Committee believes that increasing the amount of the estate and gift tax unified credit will encourage saving, promote capital formation and entrepreneurial activity, and help to preserve existing family-owned farms and businesses. The Committee further believes that indexing the unified credit exemption equivalent amount for inflation is appropriate to reduce the transfer tax consequences that result from increases in asset value attributable solely to inflation.

Explanation of Provision

The bill increases the present-law unified credit beginning in 1998, from an effective exemption of $600,000 to an effective exemption of $1,000,000 in 2006. The increase in the effective exemption is phased in according to the following schedule: the effective exemption is $625,000 for decedents dying and gifts made in 1998; $640,000 in 1999; $660,000 in 2000; $675,000 in 2001; $725,000 in 2002; $750,000 in 2003; $800,000 in 2004; $900,000 in 2005; and $1 million in 2006. After 2006, the effective exemption is indexed annually for inflation. The indexed exemption amount is rounded to the next lowest multiple of $10,000. Conforming amendments to reflect the increased unified credit are made (1) to the 5-percent surtax to conform the phase out of the increased unified credit and graduated rates, (2) to the general filing requirements for an estate tax return under section 6018(a), and (3) to the amount of the unified credit allowed under section 2102(c)(3) with respect to nonresident aliens with U.S. situs property who are residents of certain treaty countries.

Effective Date

The provision is effective for decedents dying, and gifts made, after December 31, 1997 .

B. Indexing of Certain Other Estate and Gift Tax Provisions (sec. 401(b)-(e) of the bill and secs. 2032A, 2503, 2631, and 6601(j) of the Code)

Present Law

Annual exclusion for gifts. --A taxpayer may exclude $10,000 of gifts of present interests in property made by an individual ($20,000 per married couple) to each donee during a calendar year (sec. 2503).

Special use valuation. --An executor may elect for estate tax purposes to value certain qualified real property used in farming or a closely-held trade or business at its current use value, rather than its "highest and best use" value (sec. 2032A). The maximum reduction in value under such an election is $750,000.

Generation-skipping transfer ("GST") tax. --An individual is allowed an exemption from the GST tax of up to $1,000,000 for generation-skipping transfers made during life or at death (sec. 2631).

Installment payment of estate tax. --An executor may elect to pay the Federal estate tax attributable to an interest in a closely held business in installments over, at most, a 14-year period (sec. 6166). The tax on the first $1,000,000 in value of a closely-held business is eligible for a special 4-percent interest rate (sec. 6601(j)).

Reasons for Change

The Committee believes that it is appropriate to index for inflation the annual exclusion for gifts, the ceiling on special use valuation, the generation-skipping transfer tax exemption, and the ceiling on the value of a closely-held business eligible for the special low interest rate, to reduce the transfer tax consequences that result from increases in asset value attributable solely to inflation.

Explanation of Provision

The bill provides that, after 1998, the $10,000 annual exclusion for gifts, the $750,000 ceiling on special use valuation, the $1,000,000 generation-skipping transfer tax exemption, and the $1,000,000 ceiling on the value of a closely-held business eligible for the special low interest rate (as modified below), are indexed annually for inflation. Indexing of the annual exclusion is rounded to the next lowest multiple of $1,000 and indexing of the other amounts is rounded to the next lowest multiple of $10,000.

Effective Date

The provision is effective for decedents dying, and gifts made, after December 31, 1998 .

C. Estate Tax Exclusion for Qualified Family-Owned Businesses (sec. 402 of the bill and new sec. 2033A of the Code)

Present Law

There are no special estate tax rules for qualified family-owned businesses. All taxpayers are allowed a unified credit in computing the taxpayer's estate and gift tax, which effectively exempts a total of $600,000 in cumulative taxable transfers from the estate and gift tax (sec. 2010). An executor also may elect, under section 2032A, to value certain qualified real property used in farming or another qualifying closely-held trade or business at its current use value, rather than its highest and best use value (up to a maximum reduction of $750,000). In addition, an executor may elect to pay the Federal estate tax attributable to a qualified closely-held business in installments over, at most, a 14-year period (sec. 6166). The tax attributable to the first $1,000,000 in value of a closely-held business is eligible for a special 4-percent interest rate (sec. 6601(j)).

Reasons for Change

The Committee believes that a reduction in estate taxes for qualified family-owned businesses will protect and preserve family farms and other family-owned enterprises, and prevent the liquidation of such enterprises in order to pay estate taxes. The Committee further believes that the protection of family enterprises will preserve jobs and strengthen the communities in which such enterprises are located.

Explanation of Provision

The bill allows an executor to elect special estate tax treatment for qualified "family-owned business interests" if such interests comprise more than 50 percent of a decedent's estate and certain other requirements are met. In general, the provision excludes the first $1 million of value in qualified family-owned business interests from a decedent's taxable estate.

This new exclusion for qualified family-owned business interests is provided in addition to the unified credit (which presently effectively exempts $600,000 of taxable transfers from the estate and gift tax, and will be increased to an effective exemption of $1,000,000 of taxable transfers under other provisions of the bill), the special-use provisions of section 2032A (which permit the exclusion of up to $750,000 in value of a qualifying farm or other closely-held business from a decedent's estate), and the provisions of section 6166 (which provide for the installment payment of estate taxes attributable to closely held businesses).

Qualified family-owned business interests

For purposes of the bill, a qualified family-owned business interest is defined as any interest in a trade or business (regardless of the form in which it is held) with a principal place of business in the United States if ownership of the trade or business is held at least 50 percent by one family, 70 percent by two families, or 90 percent by three families, as long as the decedent's family owns at least 30 percent of the trade or business. Under the provision, members of an individual's family are defined using the same definition as is used for the special-use valuation rules of section 2032A, and thus include (1) the individual's spouse, (2) the individual's ancestors, (3) lineal descendants of the individual, of the individual's spouse, or of the individual's parents, and (4) the spouses of any such lineal descendants. For purposes of applying the ownership tests in the case of a corporation, the decedent and members of the decedent's family are required to own the requisite percentage of the total combined voting power of all classes of stock entitled to vote and the requisite percentage of the total value of all shares of all classes of stock of the corporation. In the case of a partnership, the decedent and members of the decedent's family are required to own the requisite percentage of the capital interest, and the requisite percentage of the profits interest, in the partnership.

In the case of a trade or business that owns an interest in another trade or business (i.e., "tiered entities"), special look-through rules apply. Each trade or business owned (directly or indirectly) by the decedent and members of the decedent's family is separately tested to determine whether that trade or business meets the requirements of a qualified family-owned business interest. In applying these tests, any interest that a trade or business owns in another trade or business is disregarded in determining whether the first trade or business is a qualified family-owned business interest. The value of any qualified family-owned business interest held by an entity is treated as being proportionately owned by or for the entity's partners, shareholders, or beneficiaries. In the case of a multi-tiered entity, such rules are sequentially applied to look through each separate tier of the entity.

For example, if a holding company owns interests in two other companies, each of the three entities will be separately tested under the qualified family-owned business interest rules. In determining whether the holding company is a qualified family-owned business interest, its ownership interest in the other two companies is disregarded. Even if the holding company itself does not qualify as a family-owned business interest, the other two companies still may qualify if the direct and indirect interests held by the decedent and his or her family members satisfy the requisite ownership percentages and other requirements of a qualified family-owned business interest. If either (or both) of the lower-tier entities qualify, the value of the qualified family-owned business interests owned by the holding company are treated as proportionately owned by the holding company's shareholders.

An interest in a trade or business does not qualify if the business's (or a related entity's) stock or securities were publicly-traded at any time within three years of the decedent's death. An interest in a trade or business also does not qualify if more than 35 percent of the adjusted ordinary gross income of the business for the year of the decedent's death was personal holding company income (as defined in section 543). This personal holding company restriction does not apply to banks or domestic building and loan associations.

The value of a trade or business qualifying as a