The down and dirty on the new tax rules and estate planning
Ever since the passage of the Tax Cuts and Jobs Act in December, the headlines have been buzzing about the resulting income tax consequences for individuals and businesses, but what about the intersection of the Act and estate planning? After all, nothing is more certain than death and taxes.
Under the Act, the estate, gift and generation-skipping transfer taxes remain in effect with double the unified federal gift and estate tax exemption and the GST tax exemption (from $5 million to $10 million). These amounts are indexed for inflation. For 2018, the gift and estate tax exempt amounts and GST tax exempt amount is expected to equal $11.18 million ($22.36 for married couples). However, the increased exemption sunsets in 2026.
Estate, gift and GST taxes continue to be set at a flat 40 percent rate.
The Act left portability unchanged. If a spouse dies without exhausting his or her lifetime gift and estate tax exemption, so long as the decedent’s executor makes the proper election on an estate tax return, the unused exemption is credited or “ported” to the surviving spouse for use during life or at death. The deceased spouse’s unused exemption at the survivor’s death will be combined with the survivor’s own estate tax exemption to offset any estate tax liability in the survivor’s estate. Thus, for some married couples, an “all to the other” approach with a portability election may be preferable.
When “All to the Other” May Be All Wrong
While at first blush, portability might look like the right answer for married couples, there are instances in which this approach may not be recommended:
• Blended family or other intended beneficiaries: For blended families, the traditional “QTIP” trust or bypass trust may still be a better strategy to ensure that the children of the first-to-die are remainder beneficiaries at the second death. The survivor may not change the final beneficiaries of the trusts. Both the QTIP and bypass trust can also be used to provide for other family members, friends or charities chosen by the first-to-die.
• Creditor issues: The “all to the other” approach provides that the assets of the first-to-die will be allocated to the survivor. Because the survivor has full control over the assets, the survivor’s creditors can also reach the assets. If there is concern about creditors, a QTIP trust or bypass trust may be ideal.
• Dynasty planning: Because portability does not apply to the GST tax exemption, the GST tax exemption of the first-to-die is lost with “all to the other.” If a couple wishes to engage in multiple generational planning, then dynasty trusts designed to fully utilize the GST tax exemption of each spouse should be used.
• High appreciation potential: While the “all to the other” approach provides a step-up in basis at the death of each spouse, there are instances where removing the assets and all future appreciation out of the second-to-die’s estate produces the best results, in which case a bypass trust should be used.
• Clawback: It is not clear what will happen if an estate elects portability and the exemption subsequently decreases at the death of the second spouse. The IRS may attempt to clawback the unused exemption of the first-to-die spouse over the lower exemption amount applicable at the death of the second-to-die spouse. However, if a bypass trust is used, the assets funded into the bypass trust never become a part of the estate of the second-to-die, and thus, should not be clawed back into the estate of the second-to-die.
“But, That’s Not What Was Meant!”
Many family trusts (especially those drafted before portability) use tax formulas to fund a bypass trust. Such formulas were likely drafted when the exemption amount was much lower. (It was $1.5 million in 2005!) With the increased exemption, the formula could serve to overfund the bypass trust. Even further, some plans may base residuary or other bequests off the exemption amount, and the increased exemption could botch the plan.
Jump On It – New Opportunities to Transfer Wealth
For those who exhausted their exemption up to the 2017 $5.49 million limit, they now have another $5.69 million (or $11.38 million for a married couple) to use. However, given the sunset provision, this opportunity may only be available until 2026. Short of dying during this period, the only way to lock in the increased exemption is to engage in lifetime transfers before the laws change. (Of course, assets gifted during life will lose the benefit of the step-up in basis at death, so careful consideration should be given to estate tax versus income tax savings.)
And Income Tax Becomes King
In 2017, of the 2.7 million estates, only 5,190 are expected to owe federal estate tax. With the increased exemption, some predict this number to drop to 2,000.
On the other hand, while the top federal individual income tax rate is 37 percent and the top capital gains rate is 20 percent, the 3.8 percent net investment income tax remains in effect. For residents of high income and property tax states like New York and California, the state and local tax deduction cap at $10,000 is especially painful.
Thus, high net worth individuals may prefer to engage in strategies that both reduce their total income tax and transfer wealth to their descendants with as little transfer tax as possible. Some techniques include:
• Shifting income: Gift high income-producing assets to a trust that distributes taxable income to a beneficiary in a lower tax bracket.
• Charitable giving: The Act increased the charitable contribution limit to 60% of adjusted gross income. Some taxpayers who have lost deductions like the state and local deduction can make up the difference by contributing more to charity.
• Delaying capital gains taxation: Gift appreciated assets that are to be sold to a charitable remainder trust, a tax-exempt trust. A sale by the CRT avoids immediate capital gains taxation, and 100 percent of the proceeds are reinvested. Distributions from the CRT each year will be taxed to the beneficiary, but may avoid income taxation at top rates.
• Selling instead of gifting: Use installment sales to defective grantor trusts and zeroed-out Grantor Retained Annuity Trusts, preserving the gift and estate tax exemption amount for use against assets in the decedent’s estate while still reducing the taxable estate.
• Exploit basis step-up: Cause low-basis assets to be included in a decedent’s nontaxable estate, receiving a step-up in basis and reducing capital gains tax at a subsequent sale.
No one knows what will happen with the next administration, and many tax saving strategies are most beneficial if employed over time. Furthermore, current estate plans may not have the intended consequences under the new rules, and no one should wait for a death to find out. Professionals should engage their clients in discussions regarding their estate plan to take advantage of the laws available today and ensure flexibility for future changes.