The Down and Dirty On The New Tax Rules and Estate Planning

Most articles about the passage of the Tax Cuts and Jobs Act in December buzz about the resulting income tax consequences for individuals and businesses.

But what about the intersection of the TCJA and estate planning?

In a report by Stefi Gascon Hafen, published by AccountingToday, she comes to some interesting conclusions about the TCJA’s significant impact on estate planning.

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.

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. Thus, for some married couples, an “all to the other” approach with a portability election may be preferable.

Portability might seem like the right choice for married couples. But that’s not always the case as Hafen notes:

  • 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.
  • 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.”
  • 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.

Another tricky situation noted by Hafen: 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.

New Opportunities to Transfer Wealth

As Accounting Today observes, 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.

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.

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.
  • Delaying capital gains taxation
  • Selling instead of gifting
  • 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.

Of course, Hafen’s conclusions are for general information purposes only. It is not intended to be used in place of advice received from a suitable professional advisor such as an attorney with an expertise in estates and trusts.

The bottom-line: new rules governing estates and trusts could generate unexpected consequences.