United States: Use It Or Lose It: Tax Planning Under The Tax Cuts And Jobs Act

On December 22, 2017, President Trump signed into law the "Tax Cuts and Jobs Act" (the Act). The Act contains a significant benefit to high net worth individuals in the form of a temporary increase in the federal transfer (estate, gift, and generation-skipping transfer) tax exemption. Further, the Act's changes to income tax provisions, including the reduction or disallowance of certain deductions, should also encourage individuals to revisit their planning to maximize opportunities while they remain available.

I. Transfer Tax

A. Federal Transfer Tax

Prior to the Act, every individual had a $5 million exemption from gift and estate taxation indexed for inflation (i.e., $5.49 million for 2017). Lifetime and testamentary transfers in excess of this exemption amount were subject to tax at a 40 percent rate. Therefore, in 2017, each couple could transfer up to $10.98 million of assets before being subject to the gift and estate tax.

Under the Act, the federal transfer tax exemption was roughly doubled. As a result, each individual can currently transfer assets up to $11.18 million (up to $22.36 million per married couple) in 2018. However, under the Act, this increased exemption is scheduled to sunset at the end of 2025, and there is no certainty the provision will be extended or made permanent. In addition, the Act itself was passed along a party line vote, so any shift away from the current Republican Congressional majorities could result in a ratcheting back of the exemption amount to $5 million (indexed for inflation or even lower.)

For those who have already used all or a portion of the prior exemptions and those who are considering wealth transfer planning, the temporary increase in exemption provides a limited window of opportunity for leveraged gifting, especially for individuals who are likely to survive beyond the sunset of the increased exemption in 2025. One common technique is to transfer property with a fair market value (applying any eligible valuation discounts) equal in value to your remaining exemption amount to an irrevocable trust for the benefit of your descendants. Once the property is given away, the property plus all earnings and appreciation on that property will be outside of your taxable estate, which makes taking advantage of this temporary increase in exemption sooner rather than later all the more compelling. We can also discuss ways to ensure that the trusts are flexible in the face of unknown future circumstances.

B. State Transfer Tax

Prior to the Act, many of the states that imposed state-level estate tax and a lower state level estate tax exemption amount were generally moving towards unifying their state estate tax regime with the federal estate tax regime.

For example, the District of Columbia and Maryland currently define their estate tax exemptions with reference to the federal exemption. However, as a result of the increased federal exemption, lawmakers in both DC and Maryland have proposed legislation to "decouple" from the federal exemption and implement a lower state level exemption (with some proposals even lower than the state exemption that was available prior to the Act).

New York's estate tax exemption has steadily increased over the past few years and was slated to match the pre-Act federal estate tax exemption in 2019 ($5 million indexed for inflation). Unlike DC and Maryland, the New York exemption amount is not calculated with reference to the federal exemption, and would, without further state legislation, remain at $5 million (indexed to inflation) regardless of the increase in federal exemption. Lawmakers in New York, however, have proposed increasing the state exemption to match federal exemption provided under the Act.

We are monitoring these and other transfer tax developments at the state level in all states and are tailoring plans to respond to this uncertainty.

II. Income Tax

A. Managing Tax Basis

Under the Act and under prior law, when an asset is given away during life, the recipient steps into the shoes of the donor and receives the donor's basis in the asset (often referred to as "carry over basis"). No tax is due until the asset is sold by the recipient, providing for the deferral of any gain recognition. The basis of property transferred at death is adjusted to property's fair market value on the date of death. As a result, appreciated property receives a "step-up" in basis to the current fair market value, thereby eliminating income tax on the accumulated gain.

The Act does not impact the availability of the step-up in basis for assets includible in a decedent's estate at death, and the increased exemption may even provide compelling opportunities for income tax planning. For example, if appreciated property is owned by a senior member of the family whose own assets are well under the exemption amount, including such appreciated property in the senior family member's estate will not trigger any additional estate tax and the appreciated property will receive a step-up in basis. As a result, the recipients of the property at the senior family member's death may freely dispose of the property without gain. In order to maximize the availability of the basis step-up and the increased exemption, existing planning should be reviewed to ensure that sufficient flexibility exists to trigger estate tax inclusion if circumstances warrant.

B. State and Local Tax Deductions

While the Act provides significant transfer tax advantages, the changes to income tax provisions are mixed and may result in increased or decreased income tax liability, based on the characteristics of the taxpayer. While the top rate under the Act is lower than under prior law, the Act has significantly restricted the availability of certain deductions.

Notably, the Act significantly limits the availability of the state and local tax deduction. Under the Act, the deduction for state and local taxes is limited to $10,000 per married couple. For taxpayers in high income or property tax states, additional planning may be desirable:

  • For individuals who already spend significant time or own residential property in states without income tax (e.g., Florida), it may be useful to discuss an official change in domicile.
  • In cases where an individual cannot change domicile, incomplete non-grantor (ING) trusts are available in some jurisdictions to move income-producing assets out of high tax jurisdictions.
  • For existing irrevocable trusts, it may be beneficial for the trust to become a separate taxpayer and for the trust to then relocate to a more favorable jurisdiction for tax purposes.

Whether these strategies will be effective depends on your particular facts and circumstances, as well as the applicable state law. We can discuss these and other ways to potentially reduce your income tax liability.

With the passage of the Act, now is a chance to review your estate plan to take advantage of the temporary increase in transfer tax exemption and to make sure it contains the flexibility needed to respond to any future changes. It may also be an opportune time to evaluate your income tax position and options to minimize your tax burden. Please reach out to your Arnold & Porter attorney with any questions about your current estate plan, how it might be impacted by the Act, and how we can help you take advantage of current tax planning opportunities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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