RE: 2017 Federal Tax Act; Estate Planning Update
The 2017 tax act doubled the exemption from estate, gift, and generation-skipping transfer taxes (collectively, “transfer taxes”). This memorandum addresses whether that legislative change suggests taxpayers change their estate plans.
(I) Some Background
Last year, the exemption from each of the transfer taxes was $5,490,000 per taxpayer. This year it is roughly $11,200,000 per taxpayer. Just 10 years ago the exemptions from estate and generation-skipping transfer taxes were only $2,000,000 and the exemption from gift tax was only $1,000,000. In 2009, the estate and generation-skipping transfer tax exemptions more than doubled to $5,000,000. Unless Congress acts again, the 2017 tax act as it pertains to transfer taxes will sunset at the end of 2025. If that occurs, and assuming moderate inflation, the exemption from transfer taxes will fall back to something in the range of $6,500,000 for 2026.
Part IV of this memorandum is a fuller description of the current transfer tax environment.
For most Americans, the new transfer tax exemption does not signal a need to do anything. More to the point, this year’s increase (and for that matter, the 2009 increase) signals an opportunity for many taxpayers to simplify estate plans and possibly to undo tax motivated planning from the past.
As the significance of transfer taxes has declined for most taxpayers, the relative significance of tax basis planning has grown.
For a few Americans, the new transfer tax exemption represents an opportunity to reduce future transfer taxes by making very large gifts before 2026. Part III of this memorandum addresses that.
(II) Simplifying Estate Plans; Tax Basis Considerations
This Part II addresses some of the transfer tax motivated tactics that made sense before transfer tax exemption became so large and before the estate tax exemption became portable between spouses, as discussed in Part IV of this memorandum. This Part also addresses planning for tax basis adjustments at death.
“Credit Shelter” and “Bypass” Trusts
For many taxpayers in the past, it made sense on death of a spouse to direct assets to a “credit-shelter” or “bypass” trust for the benefit of the surviving spouse. Although there might also be non-tax reasons to direct assets to trust following the first death, the transfer tax motivation for doing that has evaporated for most taxpayers.
In other words, it might now be appropriate to remove provisions from an estate plan that would direct assets to trust for a surviving spouse when the first spouse dies. That’s contrasted with directing assets outright to a surviving spouse.
Life Insurance Trusts
A decedent’s taxable estate includes proceeds of any insurance on the decedent’s life that the decedent controls at death. For that reason, many taxpayers transferred life insurance policies to irrevocable trusts before 2007 when the estate tax exemption jumped to $5,000,000. The tactic removed insurance from a taxpayer’s potential taxable estate, but might now serve no transfer tax purpose at all.
In many circumstances, it will be possible to terminate the kind of insurance trust mentioned here.
Portability of Estate Tax Exemption
Before portability of the estate tax exemption took effect in 2011, titling of assets between spouses might have had significant transfer tax consequences. The standard pre-2011 advice for married couples facing reasonable possibility of estate tax liability was to minimize assets owned jointly with right of survivorship and to maximize and equalize assets owned by each spouse individually. That advice is no longer appropriate for a majority of taxpayers, and it is much less important even for the very wealthy than it was before portability of the estate tax exemption.
From the standpoint of estate tax planning, most married couples can return to joint ownership of assets.
Tax Basis Planning
Generally, an asset included in a taxpayer’s taxable estate gets a tax basis adjustment at the taxpayer’s death. The asset’s new tax basis is generally its value at time of death, and frequently that new basis is greater than the taxpayer’s basis in the asset.
For that reason, credit shelter or bypass trust funding as mentioned above could carry significant income tax disadvantages. That’s because those kinds of trusts are designed to keep assets out of the taxable estate of a surviving spouse. If an asset isn’t included in the surviving spouse’s estate, it won’t get a basis adjustment at that spouse’s death.
Even if there are non-tax reasons to direct assets to trust following the first death, there are ways to structure that trust to preserve tax basis adjustments at death of the surviving spouse.
In a similar vein, there is usually tax basis motivation to transfer a married couple’s low basis assets to the spouse who is likely to die first, and to do it more than a year before the death. We acknowledge that’s a sensitive topic.
(III) An Eight Year Estate Tax Planning Opportunity.
Broadly speaking, if a taxpayer projects an eventual estate tax liability, there is transfer tax motivation for that taxpayer to make a gift exceeding approximately $6,500,000 before the end of 2025. In other words, there is motivation to use the portion of the current transfer tax exemption that is scheduled to disappear in 2026.
Of course, there are always motivations not to make a large gift. The most important question in considering any transfer tax motivated gift is whether the donor can afford the gift. If the gift will compromise the donor’s financial security, peace of mind or ability to do the things the donor intends, that should be the end of the inquiry.
The following illustrates the point of this Part III. An unmarried taxpayer makes a current $10,000,000 gift to irrevocable trust for the taxpayer’s descendants. The taxpayer remains unmarried and dies in 2028 when the transfer tax exemption is only $7,000,000. The trust, which is excluded from the taxpayer’s estate, in the meantime appreciates 90% to $19,000,000 in value. The taxpayer continues to own $20,000,000 at death, net of debt and expenses of administration. So, the taxpayer’s “taxable estate” is $20,000,000.
The estate tax will apply to the very first dollar of that taxable estate. That’s because the taxpayer’s lifetime gift used up all of the transfer tax exemption that would otherwise have been available on the taxpayer’s death. The estate tax due will be $8,000,000.
If the taxpayer hadn’t made the gift, the taxable estate would have been $20,000,000 + 19,000,000 = 39,000,000, and the available exemption would have been $7,000,000. The estate tax would have been $12,800,000. The lifetime gift saved $4,800,000 of estate tax.
$1,200,000 of that savings stemmed from having made the gift before sunset of the exemption. During lifetime the taxpayer used $3,000,000 of exemption that simply wasn’t available to anyone at the time the taxpayer died. Based on current law, the opportunity for that kind of savings will run out at the end of 2025.
$3,600,000 of the estate tax savings stemmed from the trust’s $9,000,000 of appreciation that occurred after the gift. The gift shunted $9,000,000 out of the taxpayer’s taxable estate. That kind of estate tax planning opportunity has always been available (assuming post-gift appreciation happens). It will continue to be available regardless of future decreases in the exemption.
However, the AMOUNT of appreciation the taxpayer was able to shunt out of the taxpayer’s taxable estate DID depend on the currently large gift tax exemption. The additional appreciation shunt was roughly (10,000,000 – 7,000,000) X 90%, or $2,700,000, and the estate tax on that amount would be $1,080,000.
Estate tax savings frequently result in some loss of income tax savings. That’s because of the general rule mentioned in Part II of this memorandum: an asset in a taxable estate gets a tax basis adjustment so that its new basis equals its value at death. In concept, there is a point at which the estate tax advantage of a current asset transfer outweighs the income tax advantage of holding it at death for a basis adjustment. Before a taxpayer executes a gift like the one in the example above, the taxpayer needs to determine how much post-transfer appreciation is necesssary before death to make the gift net tax-advantageous. Generally, the older the taxpayer, and the lower the tax basis in the asset to be transferred, the less attractive current transfer will be.
The takeaway from this Part III is that if a taxpayer reasonably anticipates an estate tax liability for the taxpayer’s family, the taxpayer needs to consider whether to take steps before the end of 2025 to seize the currently large transfer tax exemption. Generally, a taxpayer whose net worth, plus death benefits that taxpayer controls, does not significantly exceed $11,200,000 and who is reasonably informed about tax planning, will choose not to make any gifts in response to doubling transfer tax exemptions.
The United States imposes three types of transfer taxes, mostly at the maximum rate of forty percent.
The first of the transfer taxes is the estate tax, applicable at death. That tax effectively applies in most circumstances to estates having a net value in excess of roughly $11,200,000. We call that $11,200,000 amount the “Exemption Amount” because it is roughly the amount that the federal credit against the estate tax can currently exempt from that tax. The Exemption Amount is indexed for inflation and so might increase each year.
The second type of transfer tax is a gift tax on lifetime transfers. There is a $15,000 ($30,000 for a married couple) annual exclusion from federal gift taxes (the “annual exclusion”). That means a taxpayer can give any number of persons up to $15,000 per year without any gift tax consequences. The $11,200,000 Exemption Amount is also available as a lifetime exemption for gifts that exceed or don’t qualify for the annual exclusion.
In many circumstances a surviving spouse is permitted to use the unused Exemption Amount of the predeceased spouse. We call that the “portability” of the Exemption Amount. To preserve portability, the estate of the first to die will need to file an estate tax return, regardless of whether any estate tax is due.
There are unlimited marital and charitable deductions against federal estate and gift taxes. That means that married persons, both of whom are United States citizens, can give each other and any number of charities unlimited amounts without incurring any estate or gift taxes. (Deductible gifts to a non-citizen’s spouse will necessarily involve a trust, not discussed here.)
The third type of transfer tax (the “GST tax”) is a tax on transfers to grandchildren and later generations (“generation-skipping transfers”), whether at death or during life. There is a roughly $11,200,000 exemption from GST tax (the “GST Exemption”). The GST Exemption is not portable, but it is indexed for inflation and so might increase each year.
Before the tax act adopted late last year, the Exemption Amount and GST Exemption were roughly half as much as today. The increase in those exemptions will sunset at the end of 2025 unless Congress acts again. If Congress does not act and inflation is moderate, then the Exemption Amount and GST Exemption in 2026 will be in the range of $6,500,000.
We refer to estate, gift and GST taxes as “transfer taxes.” North Carolina no longer imposes any transfer taxes.
For transfer tax purposes, a taxpayer’s assets will be valued at their fair market values, less outstanding debt. Also, any insurance on the taxpayer’s life that the taxpayer controls at death will be valued at the full amount of the death benefits provided.
Please let us discuss with you steps you might take to simplify your estate plan and to anticipate future tax basis adjustments. Regardless of the current transfer tax law, your motivation for some of those steps might be changes in your family circumstances.
Please also let us discuss with you the amount of eventual transfer tax liability your family might face, steps you could take to reduce that, and ways to soften the negative effects of a large current gift, mentioned above.
Thank you for permitting us to assist in your estate planning in the past. We would be honored to help you again as needs arise.