Effective January 1, 2018, the Tax Cuts and Jobs Act of 2017 reduces individual and corporate tax rates, eliminates a large number of deductions and credits, and enhances other tax breaks.
However, the law doesn’t repeal the federal gift and estate tax, a provision that was originally included in the US House of Representative’s version of the bill. Instead, the new law temporarily doubles the combined gift and estate tax exemption and the generation-skipping transfer (GST) tax exemption, creating new estate planning opportunities to consider.
Increased Exemptions
For tax years after December 31, 2017, and before January 1, 2026, the gift, estate, and GST tax exemptions have been doubled. For 2018, the exemption is expected to be $11.2 million per individual and $22.4 million for a married couple. It will be adjusted for inflation each year thereafter.
The gift and estate tax exemptions would remain unified so any use of the gift tax exemption during the taxpayer’s lifetime would decrease the estate tax exemption available at death. Absent further congressional action, the exemptions will revert to their inflation-adjusted 2017 thresholds beginning January 1, 2026. The tax rate for all three taxes remains at 40%.
Possible Effects
The increased exemption amounts are projected to reduce the number of US estates subject to estate tax to around 2,000—down from approximately 5,000 previously. While the increased exemption amounts may change the way individuals and families plan their estates, there are still many nontax issues to consider, such as asset protection, guardianship of minor children, family business succession, and planning for loved ones with special needs.
It’s also not clear how states will respond to the federal tax law changes. If someone lives in a state that imposes its own significant estate tax, many traditional tax-reduction strategies will continue to be relevant on a state level.
Since the exemptions are scheduled to revert to their previous levels in 2026, this raises possible claw back concerns that should be considered. There’s also no guarantee that a future administration won’t reduce the exemption amounts even lower than pre-tax reform levels.
Opportunities
Record-high exemption amounts, even if temporary, create a rare opportunity to use strategies that allow individuals to lock in their current exemptions and possibly avoid future transfer taxes. These are three options that will be increasingly useful.
Lifetime Gifts
By using some or all of the increased exemption amount to make additional tax-free lifetime gifts, individuals can transfer significant assets to others and shelter those transfers—together with any future appreciation in value—from taxation in their estate.
However, unlike assets transferred at death, lifetime gifts aren’t entitled to a step-up in tax basis. This can create an unexpected income tax liability for the recipient should they choose to sell a gifted asset. This makes it important to weigh the potential estate tax savings against the potential income tax costs to the recipient of the transferred asset.
Dynasty Trusts
These irrevocable trusts allow substantial amounts of wealth to grow and compound free of federal gift, estate, and GST taxes, providing greater wealth for an individual’s grandchildren and future generations. The longevity of a dynasty trust varies from state to state, but it’s becoming more common for states to allow these trusts to last for hundreds of years—or even in perpetuity.
One of the greatest benefits of establishing a dynasty trust during a period with an increased GST tax exemption is reducing future GST tax burdens. This second layer of tax on transfers to grandchildren or others that skip a generation is also 40%. Without proper planning, the GST tax can quickly consume substantial amounts of wealth as property is distributed from trusts in future years. Accordingly, individuals can transfer assets to their dynasty trust using the increased exemption, and with proper trust administration, avoid any potential GST tax burden in the future.
If an individual hasn’t used any of their gift and estate tax exemption yet, for example, in 2018, they could transfer $10 million to a properly structured dynasty trust. There’s no gift tax on the transaction because it’s within that individual’s unused exemption amount. And the funds, together with all future appreciation, would be removed from their taxable estate.
By allocating the GST tax exemption to trust contributions, individuals can help make sure that any future distributions or other transfers of trust assets to their grandchildren or subsequent generations won’t be subject to GST tax. This is true even if the value of the assets grows well beyond the exemption amount.
Gifts of Low Basis Assets
If a low basis asset is expected to be sold shortly after a death, such as a residence, or a depreciable asset—like rental real estate, for example—there could now be situations where an individual would want to keep the asset as part of their estate.
The tax basis of an asset included in an estate generally receives a step-up to the asset’s fair market value at death, not the original purchase price. Conversely, the tax basis of an asset gifted during life is generally the carryover original purchase price.
Individuals living in high income tax states, such as California, for example, may now be subject to an increased federal income tax rate since the state income and local tax deduction in excess of $10,000 has been repealed. This means individuals with high levels of taxable income in these states may have a higher marginal income tax when compared to the current estate tax rate of 40%.
Other Considerations
The Tax Cuts and Jobs Act includes several other provisions that may have an impact on estate planning strategies as well. Here are some of the most notable changes.
Wills and Trusts
In many cases, taxpayers have language in their wills and trusts directing the executor or trustee to fund a trust—often called a bypass or credit shelter trust—upon death to use any remaining estate exemption before distributing estate assets to others named in the documents. With the increased estate exemption, the potential size of the bypass or credit shelter trust could unintentionally disinherit other intended beneficiaries of the estate.
529 and ABLE Plans
The new law permanently expands the benefits of 529 college savings plans. These plans, which permit tax-free withdrawals for qualified educational expenses, also offer some unique estate planning benefits.
Contributions to a 529 plan are removed from an individual’s estate even though that individual retains the right to change beneficiaries or get their money back. It’s also permissible to bunch five years’ worth of annual gift tax exclusions into one year.
In 2018, for example, when the annual exclusion is $15,000, an individual could contribute $75,000 to a plan—$150,000 for a married couple—without triggering gift or GST taxes or using any of their exemptions.
Beginning in 2018, 529 plans will be even more valuable. Distributions from 529 plans can be used for elementary and secondary school expenses, not just higher-education expenses. A 529 plan can also be rolled over into an ABLE plan, which is designed to help pay for future disability expenses.
Charitable Planning
The limitation on deducting charitable gifts to public charities increased to 60% from 50% of the donor’s adjusted gross income.
Under the previous law, for example, if an individual earned $100,000 in 2017 and made a $70,000 gift of cash, $50,000 of that gift would be tax deductible in the current year. Under the new law, $60,000 would be deductible.
With the increased threshold for gifting and the increase in the federal gift and estate tax exemption, charitable giving may be a less effective estate planning tool from a tax perspective compared to before.
Kiddie Tax
A popular estate planning technique in years past involved individuals transferring investments or other income-producing assets to their children to make use of the children’s lower tax brackets. The enactment of the so-called kiddie tax made this technique more challenging.
Prior to the Tax Cuts and Jobs Act, all but a small portion of a child’s unearned income would be taxed at the parents’ marginal rate—if higher—defeating the purpose of income shifting. The kiddie tax generally applies to children age 18 or younger, as well as to full-time students age 19 to 23, with some exceptions.
The new law makes the kiddie tax even harsher by taxing a child’s unearned income according to the tax brackets used for trusts and estates, which are taxed at the highest marginal rate—37% for 2018—once that child’s 2018 taxable income reaches $12,500. In contrast with all other filers, for a married couple filing jointly, the highest rate doesn’t kick in until their 2018 taxable income exceeds $600,000. In many cases, this means that children’s unearned income will be taxed at higher rates than their parents’ income.
We’re Here to Help
For more information about how these and other tax law changes made by the Tax Cuts and Jobs Act may impact your estate planning strategies, contact your Moss Adams professional. You can also visit our dedicated tax reform page to learn more.