- The U.S. House of Representatives and Senate ushered H.R. 1, the Tax Cuts and Jobs Act (the Act), through conference committee, and President Donald Trump signed the Act into law on Dec. 22, 2017.
- Most of the Act's provisions are effective as of Jan. 1, 2018.
- Because the Act doubles the estate, gift and generation-skipping transfer (GST) tax exemptions, it is important for clients to review their existing estate plans, reconsider current strategies and explore new planning opportunities.
Republicans in Congress passed the Tax Cuts and Jobs Act in just less than two months, achieving sweeping tax reform. Although clients will surely benefit from many modifications to the existing transfer tax regime, those same changes may produce unintended results when applied to estate plans implemented before 2018. The Act was passed in the U.S. Senate along party lines and did not garner the required 60-vote supermajority required by the Byrd provision; therefore, its duration is limited to 10 years. Further, due to budget considerations, a number of the Act's provisions with respect to transfer taxes – including, but not limited to, the increased estate, gift and GST exemptions – are effective only until Dec. 31, 2025. If Congress takes no further action, these provisions will sunset and prior law will be reinstated as of Jan. 1, 2026.
Highlighted below are the key transfer tax provisions of the Act. Additionally, potential revisions that should be made to many clients' core estate planning documents are reviewed and additional planning opportunities that should be considered are summarized.
2. The Tax Cuts and Jobs Act
The Act makes the following modifications to the current transfer tax regime.
- It doubles the exemption for gift, estate and GST taxes from $5 million to $10 million per person, indexed for inflation occurring after 2011. Though there was a technical change in the index used to calculate inflation, most observers believe that the adjustments will closely match the figure previously announced by the IRS for 2018: $5.6 million per person. Accordingly, as of Jan. 1, 2018, a married couple can likely shield $22.4 million from transfer tax. The change is effective through Dec. 31, 2025.
- None of the estate, gift or GST taxes are repealed by the Act. The transfer tax regime will continue, but it will apply to fewer estates due to the significantly increased exemption amounts.
- Taxpayers will continue to receive a full step-up in basis for inherited property included in the decedent's taxable estate.
- The estate, gift and GST tax rates remain at 40 percent.
3. Impact Analysis and Planning Considerations
The Act presents obstacles and opportunities that must be considered. Headlines trumpet the substantially expanded exemption amounts, but for clients with existing estate plans, the increased exemptions could produce unintended consequences that may result in costly post-death disputes. At the same time, the proposed changes present a once-in-a-generation opportunity to significantly minimize, and potentially eliminate, the impact of transfer taxes. All of this must be approached with the view that tax reform is opening a window, not removing a wall. The transfer tax benefits terminate within eight years. Meanwhile, the U.S. Department of the Treasury has not yet addressed how the scheduled contraction of the exemption amount will be handled. Moreover, if the balance of power shifts in Congress, Democrats may revisit the changes sooner than 2025. Thus, clients should not delay in availing themselves of the Act's many benefits.
Formula Funding Concerns
Many existing estate planning documents include what is known as a "formula funding clause," which divides assets between a "bypass trust" and a "marital trust" upon the death of the first spouse. A formula funding clause can take many forms but often is structured to retain in the bypass trust the "greatest amount that can pass free of federal estate tax," with the balance passing to the marital trust. For clients executing estate plans prior to 2018, they likely intended to fund the bypass trust with the deceased spouse's $5.6 million exemption, with the balance passing to the marital trust.
Given the significantly increased estate tax exemption provided by the Act, if clients take no action to revise existing estate plans, significantly fewer assets will pass to the marital trust in those plans where a formula funding clause has been utilized. As a result, the surviving spouse might receive less than his or her mandatory statutory minimum inheritance, possibly even resulting in the surviving spouse being disinherited entirely. For example, consider a married couple with a combined potential estate of $20 million, with $10 million owned by each spouse. Based upon the new law, this couple can avoid all federal estate taxes due to the increased exemption. If, however, the couple has a pre-2018 estate plan with a formula funding clause, the formula funding clause would direct the deceased spouse's entire $10 million estate to the bypass trust. In this scenario, no amount would pass to the marital trust. This unintended result is reason for significant concern, especially where there are second marriages and/or "blended families."
Clients should consider the purpose and nature of certain deductible bequests in light of the potential changes. Certain techniques – such as "charitable lead" or "charitable remainder" trusts – minimize estate tax by splitting the interests in a trust between charitable and non-charitable beneficiaries. Those techniques often were incorporated into estate plans based on a conscious decision by clients to shift assets that would otherwise have gone to the U.S. Treasury to one or more charities. Clients should revisit such plans and consider whether the size and nature of those bequests are still appropriate, especially in plans where the interests of their heirs might be unnecessarily delayed.
For clients who have already used their lifetime exemptions, the Act presents an incredible opportunity to further advance such wealth planning. Additional planning considerations include the following:
- Plan Now to Hedge Against the Scheduled Sunset or Potential Repeal of the Act. Since the Act does not repeal the estate tax, ultra-high-net-worth clients should continue to aggressively plan for an estate tax. Even taxpayers with a more "moderate" net worth should consider expanding existing gift planning in the event that the transfer tax exemptions revert to pre-2018 amounts – or lower – in the future.
- Engage in New Transfer Tax Planning Strategies. Clients whose estates will be subject to estate tax even at the increased exemption amount should take advantage of the expanded exemption in leveraged transactions to maximize their wealth transfers. For example, sales to irrevocable grantor trusts outside of the grantor's estate will continue to be a popular planning mechanism, particularly where there is an opportunity to further leverage the increased exemption amount. Further, because the IRS withdrew the proposed Internal Revenue Code (IRC) Section 2704 Treasury Regulations, additional discounting of the transferred assets may be possible, thereby increasing the efficiency of such wealth transfer techniques.
- Revisit and Refine Existing Tax Planning. For existing planning transactions that were accomplished with promissory notes of relatively modest value, clients should consider whether is advantageous to use the additional exemption to lower or eliminate the promissory note through a gift. For promissory notes that exceed the available increased exemption amount, it may be beneficial to give additional assets to the purchaser trust to increase that trust's asset base to assist that trust's repayment of the note.
- Maximize GST Planning. Continued and expanded use of GST exempt trusts for gift-giving should be considered. This strategy can take the form of a current allocation of GST exemption to existing trusts that have not yet received an allocation of GST exemption. Alternatively, the increased exemptions provide an opportunity to further expand the advantages of multi-generational wealth transfer planning. For clients with funded non-GST exempt trusts, there is an opportunity to move assets from the non-exempt GST trust to an exempt GST trust structure. For example, a gift could be made of the increased exemption amount to a new GST exempt trust, and that new trust could then acquire the assets from the old non-GST exempt trust.
- New Basis Planning Considerations. Clients will be required to balance the use of the increased exemption applicable to gift transactions against the loss of a step-up in basis in transferred assets at death. While this has long been a concern for clients with "borderline" taxable estates, the Act dramatically, albeit temporarily, refocuses that issue. Ultra-high-net-worth clients will need to consider whether it is feasible to use the newly increased exemption amount to give away high-basis assets, while retaining low-basis assets in their estates. The Act's sunset – and potential for early repeal – add to the difficulty of this calculation.
- Alternative Planning Techniques. Clients should consider alternative uses of the increased exemption, such as forgiving existing loans to family members and terminating unworkable split-dollar life insurance agreements. For example, an economic benefit split-dollar arrangement that has become prohibitively expensive based upon the insured's age may be terminated by using the donor's increased exemption to give away the split-dollar receivable.
The Act significantly lessens the burden of transfer taxes on most families. Ultra-high-net-worth clients that will continue to have a taxable estate with the increased exemption amounts should immediately engage in additional planning to take full advantage of the Act's transfer tax benefits. Even those clients with more modest estates should consider taking swift action to avail themselves of the increased exemption amounts and expanded planning opportunities now available before the Act's transfer tax provisions sunset at the end of 2025.