The Tax Cuts and Jobs Act of 2017 represents the most significant alteration of the federal tax code in 30 years, with sharp cuts in income tax rates for corporations as well as more modest reductions for individuals, coupled with limits on deductions for state and local taxes and mortgage interest. Estate, gift and generation-skipping transfer taxes (collectively “transfer taxes” for purposes of this article) have also been affected. Although repeal of the estate tax was on the table, legislators eventually decided to double the federal exemption from transfer taxes to $11.18 million per individual ($22.36 million for married couples) for 2018.1 This exemption (the “lifetime exemption”) covers both lifetime gifts and transfers at death.
Like other reforms applying to individuals, the change expires after 2025, bringing the lifetime exemption back to previous levels.2 Meanwhile, the annual gift tax exclusion (the amount you can give away tax-free to another individual without cutting into the lifetime exemption) has moved from $14,000 in 2017 to $15,000 for 2018 due to inflation indexing.3
Overall, the jump in the lifetime exemption is great news for taxpayers, reducing the number of Americans subject to federal estate taxes from an estimated 5,000 to 1,800 this year.4 However, this change comes with some important strategic ramifications—not only for those who may now be fully exempted, but for those still in the tax “bull’s eye.”
Assessing Your Situation
Typically, you should review your estate plan every three to five years, or when there has been a change in your personal circumstances or applicable laws. The update to the transfer tax regime is one such change that should prompt consultation with your attorney to assess your planning framework and how your will and trusts may be affected from both federal and state tax perspectives.
In our view, the new, higher lifetime exemption suggests that the tax focus of many estate plans should change. In the past, a key goal was to move assets out of the estate so as to avoid paying estate tax, with a couple of potential negative consequences: losing access and control over the gifted assets and subjecting them to capital gains tax (as more fully discussed below). Now, for many whose assets are under the federal lifetime exemption amount, the bias may shift to retaining assets because they may not be subject to transfer tax and are likely to avoid capital gains tax at death.
Consequently, we believe the key steps in current estate plan assessments should include:
1) Reviewing your will and trusts to see if the increased lifetime exemption distorts your plans.
2) Considering whether your plan should shift its focus from saving transfer taxes (the typical tax goal) to saving income taxes, and, if so, seek to manage tax basis.
3) Creating additional flexibility to navigate transfer and income tax challenges by establishing trusts.
The rest of this article addresses each of these steps.
1) Checking Your Documents
Many wills and trusts employ formulas based on federal or state lifetime exemption amounts to make bequests outright or through so-called “credit shelter” or “exemption” trusts. These bequests seek to capture the unused lifetime exemption of the first spouse to die, so as to remove the assets from the transfer tax “net” of the second spouse. With the exemption now doubled, the application of the formula could automatically increase these bequests, altering the distribution of estate assets in unintended ways. For example, what previously may have been an appropriate set-aside for children of a first marriage may now leave no remaining funds for the surviving second spouse. Moreover, if you live in a state with estate taxes and an exemption that is not in sync with the federal lifetime exemption, the formula may result in unnecessary state-level estate taxation.
Given the large lifetime exemption and the “portability” that is part of the federal estate and gift tax regime (the unused exemption of the first spouse to die may be claimed by the second spouse), some may now decide an exemption bequest is no longer necessary. Please note, however, that neither the generation-skipping transfer tax exemption nor the exemption from state estate tax is portable. If these exemptions apply to you, using the lifetime exemption at your death may remain very important from a tax perspective.
2) Managing Tax Basis
Lifetime gifting to family members and others on a tax-free basis has been a popular way to transfer assets down a generation and reduce the size of an estate. A key consideration when making gifts has always been the tax basis of the gifted assets, and with tax reform, the importance of managing basis has only increased.
When you make a lifetime gift, the value of which is determined as of the day of transfer, your cost basis (and any imbedded capital gains tax liability) of that asset is generally transferred to the recipient. In contrast, at death, your estate generally receives a step-up in basis on your assets to current market value, eliminating the built-in gains tax liability. As a result, it is typically better to give away high-basis assets (those which have not appreciated) or cash during your lifetime, and continue to hold low-basis (highly appreciated) assets.5
The step-up rules lead to an analysis where you might weigh the imbedded capital gains tax liability to the donee of a lifetime gift of an appreciated asset against the potential transfer tax benefit of removing the asset and its future appreciation from your estate. Now, if your assets are below the lifetime exemption amount, the transfer tax concern is eased—although to a lesser extent for those in New York, Connecticut and other states with high estate tax rates, and for those who are concerned about the 2025 sunset.6
In addition, commentators have speculated about a potential “claw-back” whereby the IRS would seek to tax transferred assets above the prior lifetime exemption amount (i.e., $5.49 million), should the current higher exemption amount expire before the individual passes away. Such an action appears to be contrary to stated legislative intent, which should be confirmed in pending regulations. Still, political winds can change. It is conceivable that a Democratic majority could rescind the law in a few years and mandate a claw-back.
It may come as a nice surprise that, of those states with a transfer tax, the vast majority (excluding Connecticut) impose no tax on lifetime gifts. This means that generally you can make unlimited gifts to relatives and others above the federal exemption amount, and they won’t be included when determining your state estate tax at death. Of course, you still need to contend with federal gift tax limitations.
Some variations apply. For example, New York has a look-back provision in which gifts above the annual exemption amount made within three years prior to death are included in the decedent’s estate. However, the look-back does not include gifts made before April 2014 or (importantly) after December 2018—suggesting that a delay in gifting until next year may be appropriate for those New York residents for whom state-level tax is a key concern. Note that while New York currently provides for an estate tax exclusion of $5.25 million per person, above that amount the tax benefit quickly unwinds. Estates valued at 105% of the exclusion amount receive only a $1 million exclusion, reinforcing the benefits of lifetime gifts for state estate tax purposes.
Certain trusts can help contend with any discrepancy between the federal lifetime exemption and state exemptions, and also give comfort that the funds can be accessed in the future. For example, a spousal lifetime access trust (or SLAT) is an irrevocable lifetime gifting technique that removes assets from the estate of the grantor (or trust creator), but keeps them available to his or her spouse after the transfer. The trust purposely does not qualify for the marital deduction, so typically it is not funded beyond the available federal exemption amount so as to avoid any transfer tax when established. Thus, this trust removes the assets (and their appreciation) from your estate, but gives you access to the funds through your spouse should you need them. Note that this technique only works if your spouse does not predecease you and you don’t divorce.
3) Adding Flexibility With Trusts
Having an effective strategy to deal with appreciated assets can be critical, and trusts can be a valuable part of that effort. In some cases, it may make sense to gift assets to a trust that is excluded from your taxable estate, but has the flexibility to make those assets subject to the transfer tax of a beneficiary if it turns out to be advantageous—for example, to capture the step-up in basis that occurs at the beneficiary’s death if his or her estate is below the lifetime exemption amount.
Powers of Appointment
One technique that can provide this flexibility is a “general power of appointment” provision within a trust. This power can give the beneficiary the right to designate (appoint) the property in the trust to his estate, his creditors or the creditors of his estate. A typical scenario where you could see this general power of appointment is an exemption trust for the lifetime of the spouse or a lifetime trust for a child. The power can be subject to limitations, such as requiring the trustee’s consent to its exercise, thus avoiding disruption of the trust’s plan for the disposition of assets in the event the power is exercised.
The mere existence of such a power (and not its actual exercise) causes the trust assets to be included in the beneficiary’s estate for transfer tax purposes, and thus available for a step-up in basis. The trust can be drafted so that the general power only comes into existence when circumstances warrant. This tool provides an opportunity to evaluate—potentially years after the trust was established—what action is most appropriate in light of transfer tax implications. These considerations may include the available exemption amount at that time, income tax and generation-skipping transfer tax consequences, and the risk that creditors might seek to reach the assets.
Intentionally Defective Grantor Trusts
If you wish to make lifetime gifts to bring your estate within the federal or state transfer tax exemptions, Intentionally Defective Grantor Trusts (including the SLATs noted above) are another useful planning option. Transfers to these irrevocable trusts are usually completed gifts designed to remain outside the estate of the grantor, although he or she retains responsibility for paying the income taxes on the trust. This results from the grantor (or his or her spouse) keeping certain administrative powers over the trust, one of which can be used to swap out low-basis assets in the trust for high-basis assets of equivalent value that he or she owns directly. This power enables the grantor to move assets to where they provide the biggest tax benefit. Notably, the IRS does not pay attention to imbedded gains in this circumstance; it only matters that the assets are of equal market value. The technique is especially effective for older individuals who expect to hold on to the appreciated assets until death.
The legislative changes governing federal transfer taxes have been relatively straightforward, but their consequences may not be. It is important to contact your attorney to assess your current estate plan and make any changes necessary to adapt to the new regime. Keep in mind that while we have focused only on tax issues in this article, there are many non-tax reasons to establish and periodically revisit your estate plan—whether to take care of family members, protect assets from creditors or fulfill your charitable ambitions. Taking a comprehensive look at your situation is essential in setting an effective course toward achieving your long-term financial and legacy goals.
Charitable Giving Techniques
The new tax law includes a small number of provisions that facilitate charitable giving. Previously, cash contributions to certain charities were limited to 50% of adjusted gross income; that figure has increased to 60%. Lawmakers also repealed the “Pease limitation,” which had capped charitable deductions for high-income taxpayers. In light of these and other changes, it could be worthwhile to revisit your charitable giving strategy overall. Below are some options to consider.
Fewer taxpayers will be itemizing in the future given the higher standard deduction ($24,000 for married couples in 2018), the elimination of miscellaneous itemized deductions and reduced deductions for state and local taxes, and mortgage interest. However, with planning, charitable gifts can still provide meaningful savings.
If you are on the cusp of itemizing deductions, it may make sense to aggregate several years’ planned donations into a single year. For example, combining three annual $15,000 payments into one $45,000 payment for 2018 creates a deduction that is $21,000 over the standard deduction for married couples—a premium that (assuming no other deductions) would be lost if the transfers were made individually in succeeding years.
Even if you want to make a large donation in one year to utilize the charitable deduction, you may be unsure of which charities to benefit, or prefer to stagger the timing of your gifts. In either case, giving to a Donor-Advised Fund (or DAF) may be appropriate. A DAF is a public nonprofit that receives donations and then dispenses them to various charities. Your donation is immediately tax deductible, and you can choose from multiple investment options in order to grow your giving pool. When ready, you recommend to the DAF which organizations you wish to receive gifts and how much to give them. Although the DAF makes the final decision, your preferences are typically honored.
As in the past, if you are over age 70½ you can avoid federal income taxes on distributions of up to $100,000 donated directly from a traditional IRA to a public charity.7 This benefit is available whether or not you itemize deductions on your tax return, and is appealing particularly for those who must take, but do not need, the required minimum distributions from those accounts.