In addition to overhauling the taxation of income of partnerships, corporations, and individuals, the Tax Cuts and Jobs Act signed into law by President Trump on December 22, 2017 ushered in significant changes to the wealth transfer tax system. These changes will create major new opportunities to minimize the tax cost of transferring wealth, beginning in 2018.
Increased Exemption Amounts
Under the new law, effective January 1, 2018, the federal estate, gift, and generation-skipping transfer (GST) tax exemption amounts increased to approximately $11.2 million per individual, up from $5.49 million per individual in 2017. These exemption amounts will continue to be indexed for inflation each year, but by a different, less generous measure than applicable under prior law. The change will reduce the number of multimillion-dollar estates that are subject to the 40 percent federal estate tax. However, the increased exemption amounts only apply for the next 8 years, and there is no assurance that they will not be changed by future legislation, particularly if Democrats regain control of Congress or President Trump does not win re-election in 2020. In the absence of further legislation, on January 1, 2026, the exemption amounts will revert to their pre-2018 exemption levels of $5 million, adjusted for inflation.
The “portability” of a deceased spouse’s unused exclusion amount is still available to a surviving spouse, meaning spouses with a combined estate up to approximately $22.4 million in value at the time of the survivor’s death will not pay estate tax with the proper planning and estate tax return elections. The basis step-up rules, which adjust the basis of any asset passing from a decedent to the fair market value of that asset as of the decedent’s date of death, continue to apply.
The increased exemption amounts available between 2018 and 2025 present a unique opportunity for estate planning. The doubling of the exemption base translates into an opportunity starting in 2018 for those who have already used their entire $5.49 million exemptions through 2017 to transfer an additional approximately $5.7 million (in the case of an individual) or an additional approximately $11.4 million (in the case of a married couple) without the imposition of current gift tax or future estate or GST taxes. For those who have not already used all of their exemptions through 2017, the unused amount will also continue to be available.
Review Existing Wills and Revocable Trusts
Given the dramatic increases in the federal estate, gift, and GST tax exemption amounts, it is critically important to review the terms of your existing estate planning documents to make sure they still comport with your wishes and to ensure that they do not create unintended state estate tax liabilities. Many Wills and Revocable Trusts create trusts that will be funded according to formula clauses tied to the applicable exemption amount in effect on the date of your death, and in some cases, these trusts will be created for your children, to the exclusion of your surviving spouse. If you die before 2026, these trusts may be funded with significantly larger amounts than you were expecting when the documents were signed, and if your children (and not your spouse) are the beneficiaries of these trusts, your surviving spouse may be left with much less than you anticipated. If you are financially secure and reasonably confident of your ability to maintain your standard of living indefinitely, we recommend that you consider taking advantage of the increased gift tax exemption amount and possibly the GST tax exemption amount by making gifts to children and/or grandchildren either outright or to new or existing trusts. You may also want to consider leveraging your gift and GST tax exemption amounts by making intra-family loans, sales to grantor trusts, or by utilizing other techniques, such as grantor retained annuity trusts (GRATs) and split-interest charitable trusts. These techniques typically work better in times such as these when interest rates are low, so it may be advantageous to act in the near future before interest rates rise further.
If you are married and interested in making a substantial gift to lock in estate tax savings, but are concerned about your ability to maintain your standard of living into the foreseeable future, you may want to consider the possibility of making a gift to a “lifetime credit shelter trust” for the benefit of your spouse (and possibly children). Traditionally, a credit shelter trust is created under a Will or Revocable Trust to shelter the estate tax exemption amount of the first spouse to die from estate taxes in the surviving spouse’s estate. A lifetime credit shelter trust is simply a credit shelter trust created during lifetime, rather than at death. The trust could allow very broad control to your spouse, but would not be included in your spouse’s estate for estate tax purposes, and could also have the incidental advantage of providing creditor protection to you and your spouse.
By making gifts now, you will lock in the estate tax savings available under the new law, even if the exemption amount is lowered in future legislation or reverts back to the lower pre-2018 exemption levels in 2026. Another advantage of making gifts sooner rather than later is that all of the future appreciation on the gifted asset will also be removed from your taxable estate and exempt from estate tax. For residents of states that impose an estate tax at the state level (including Maryland and the District of Columbia, but currently not Virginia or Florida), the estate tax savings of utilizing the $11.2 million federal gift tax exemption are even higher because in addition to saving estate taxes at the federal level, the gift will also save estate taxes at the state level. However, keep in mind that gifted assets will not receive a stepped-up basis at your death, so it is important to carefully consider which assets to gift.
In addition to the increased exemption amounts discussed above, the amount each person may give annually to as many individuals as he or she desires without gift tax consequences will increase to $15,000 in 2018 (up from $14,000 in 2017). As a result, beginning in 2018, a married couple may make “annual exclusion gifts” of up to $30,000 to an unlimited number of recipients. In addition to making gifts using your lifetime gift tax exemption and annual exclusion amounts, you can make payments of tuition directly to an educational institution on behalf of a student, and payments of medical expenses directly to a medical provider on behalf of an individual, in unlimited amounts and with no gift tax consequences.
State Estate Tax Law Changes
In states with estate tax laws that are independent from the federal law, the increased federal estate tax exemption could create an unintended state estate tax liability, depending on how your estate planning documents were drafted. In addition to the federal tax law changes, possible changes in state laws should also be monitored. As a result of the difference between federal and state exemptions, and the lack of "portability" for some state laws (unlike federal law), it is necessary to properly structure the estate plans of married residents of these states to maximize the use of the state exemption and the marital deduction. Clients who live in, or own property in, the following states, among others, should be cognizant of potential changes in state laws that may arise:
Maryland. Maryland has no gift tax. The maximum Maryland estate tax rate is 16 percent. For 2018, the Maryland estate tax exemption is $4 million. Under legislation passed in Maryland in 2014, the Maryland estate tax exemption is scheduled to equal the federal estate tax exemption by 2019. However, the Democratic majority in the Maryland legislature may take steps in 2018 to ensure this never happens. When the Maryland legislators agreed in 2014 to tie the Maryland estate tax exemption to the federal estate tax exemption by 2019, it is safe to say that none of them anticipated that the federal estate tax exemption would be doubled to $11.2 million. Several Maryland legislators support a Maryland estate tax exemption of no more than the $5.49 million cap that lawmakers expected when they voted in 2014 to follow federal guidelines, and Maryland Del. Jimmy Tarlau said he would sponsor a bill in 2018 to exempt only the first $4 million of an estate from Maryland estate taxes.
District of Columbia. DC has no gift tax. The maximum DC estate tax rate is 16 percent. As modified by legislation passed in 2017, beginning in 2018 the DC estate tax exemption will match the federal estate tax exemption. However, when the legislation tying the DC estate tax exemption to the federal estate tax exemption was passed in 2017, the federal estate tax exemption was $5.49 million, and no one on the DC City Council expected the federal exemption would double to $11.2 million in 2018. It remains to be seen whether the DC City Council will allow the DC estate tax exemption to continue to be tied to the federal exemption, or take steps to reduce the DC estate tax exemption for 2018 and subsequent years to something in the range of the old federal exemption of $5.49 million. If you are no longer likely to have a taxable estate due to the increased estate tax exemption, we should discuss possible changes to your estate plan to eliminate unnecessary complexity or to achieve a step-up in basis for income tax purposes to fair market value at your death on assets that have appreciated. For a surviving spouse, this may include making distributions from an existing credit shelter trust to move assets back into your estate. However, many clients still need to consider the impact of state estate taxes.
Change of Domicile
The recent changes in the tax law are prompting many people to consider a change in domicile to reduce or eliminate income tax and/or estate tax liability at the state level.