Reaping the benefits and navigating the challenges of US tax reform
The major change to estate and gift taxes in the Tax Cuts and Jobs Act of 2017 is a doubling of the integrated estate and gift tax exemption to approximately $11.2 million1 for decedents dying and gifts made in 2018. A married couple has the benefit of two exemptions for a total of approximately $22.4 million in 2018. The new law also doubles the exemption from the generation-skipping tax (GST) in 2018 to approximately $11.2 million for an individual and approximately $22.4 million for a married couple. These exemptions will continue to be adjusted annually for inflation.
These changes sunset after the end of 2025 and (unless there is further legislation to extend them) in 2026 these exemptions will revert to an inflation adjusted amount that is currently estimated to be approximately $6.3 million per person (assuming an inflation rate of two percent between now and then).
Many people have Wills or Revocable Trusts that create a trust of the amount of property that would be exempt from estate tax at the creator's death. Often this amount is expressed in a formula based on the tax law, rather than an exact amount (because the amount of this exemption changes and the exemption that is available is reduced by lifetime gifts). If your estate planning documents contain a clause or clauses with a formula related to the US estate and gift tax exemption (or the generation-skipping tax exemption), the doubling of this exemption by the 2017 Tax Act may result in unintended consequences. For example, an individual whose Will or Revocable Trust Agreement leaves the federal exemption amount to his/ her children, either outright or in Trust, with the balance payable to his/her spouse would have a very different result as to the disposition of assets based on the new tax law, than would have been the case last year. Another unwelcome surprise might occur for an individual whose Will or Revocable Trust Agreement created a sprinkle trust in the federal exemption amount for the benefit of surviving spouse and children with the residue passing to the surviving spouse. Depending upon the size of the Estate of the first spouse to die, under the new tax law there might not be any assets passing to the surviving spouse at all. Therefore, it is important that you consult with your estate planning attorney to review how these changes will affect your estate plan.
For people with larger estates, this change will provide more planning opportunities. The larger exemption will make additional gifting possible. However, as there was in 2011 and 2012, when it was unclear if the newly enacted $5 million estate and gift tax exemption would be made permanent, there is again the risk of a "clawback tax"2 if gifts are made before 2026 which exceed the exemption available to an individual dying after that date. It is uncertain under the new Tax Act whether a "clawback tax" would apply in such circumstances.
People who have essentially used up their exemptions and who have used low-interest loans to make additional assets available to family members are now able to eliminate those loans by making completed gifts sheltered by the increased gift tax exemption.
The increased gift tax exemption will also allow people to engage in more life insurance planning, as substantial additional premiums can be funded without incurring gift taxes.
Married individuals wishing to take advantage of the increased exemption but also wishing to keep assets available at their generational level may create trusts where a spouse has access to the trust property—a so-called Spousal Lifetime Access Trust (SLAT). A husband and wife may decide to create SLATs for each other (although the trusts would need to have substantially different provisions in order to avoid the "reciprocal trust doctrine"), thus sheltering up to approximately $22.4 million of their assets (in 2018) from estate and gift taxation.
Maintaining the status quo
The 2017 Tax Act did not affect standard estate planning techniques, such as Qualified Personal Residence Trusts, Grantor Retained Annuity Trusts or sales to Intentional Grantor Trusts. The larger exemptions provided by the 2017 Tax Act will mean that these techniques can be used to transfer even more assets free from gift taxes. For example, a tax-free gift of $11 million to an Intentional Grantor Trust could be used as a down payment for a purchase of $110 million worth of assets by this trust from the grantor, removing income and appreciation on those assets from the grantor's taxable estate.
The new tax law did not change the portability provision, which allows unused estate and gift tax exemption to pass to a surviving spouse. As a result, people with even larger estates will be able to simplify their estate plans and eliminate trusts for the exemption amount. However, portability is not available for the generation-skipping transfer tax exemption, and most states that have estate taxes do not recognize portability. Therefore, exemption-trust planning will still be important for people planning for dynastic dispositions or living in a state that has a state estate tax.
The rules that adjust the income tax basis of property included in a decedent's estate to the property's estate-tax value were not changed by the 2017 Tax Act. Given the much larger exemptions created by the new Tax Act, increasing the basis in appreciated property so as to save income taxes may be a more important family goal than protecting property from estate taxation. It may be wise to have appreciated property held in a trust that is otherwise exempt from estate taxation intentionally included in a decedent's estate, in order to obtain a basis step-up. However, because the estate tax exemption is scheduled to decrease again in 2026, any such planning must be carefully crafted. If the trust is a Grantor Trust, the grantor can swap high-basis assets the grantor owns for low-basis assets of equal value held in the trust. The low-basis assets will receive a basis step-up if held by the grantor at death.
Opportunities abound for most taxpayers
The equally substantial increase in the GST exemption has also presented important planning opportunities. Taxpayers who have created trusts that are not entirely exempt from the GST should consider allocating newly available GST exemption to those trusts, making them fully exempt. People whose estate planning documents already contain GST planning provisions should review those provisions with their estate planning attorney to understand how they are effected by the new Tax Act. People who have used their old GST exemption now have the ability to do additional planning. These greatly increased estate and gift tax exemptions do not apply to the estates of non-resident aliens whose estate tax exemption with respect to US—situs property is still limited to $60,0003.
The favorable provisions for business income received from pass-through entities will apply to such income that is received by an estate or trust.
State estate and inheritance tax considerations must also be taken into account.
For New York residents and persons dying during 2018, the New York estate tax exemption is $5.25 million. As of April 1, 2019, the New York estate tax law is designed to conform with the applicable US estate tax law. However, that provision as enacted refers specifically to the US estate tax law as it was in effect in 2014, before enactment of the 2017 Tax Act and its increased exemption. Therefore, after April 1, 2019 the New York exemption will be approximately $5.6 million4. As of this writing, it is unclear whether New York will allow its exemption to conform to federal law, or whether the state will take steps to enact changes and some other specific state estate tax exemption amount.
New York's estate tax is a modified "cliff tax," as estates that exceed the New York estate tax exemption by more than five percent pay tax on the entire taxable estate, as if there were no exemption. Therefore, for New York couples with substantial wealth, it is important that the Will of the first spouse to die either create an "exemption trust" in an amount equal to the available New York estate tax exemption or give the New York estate tax exemption to individuals other than the surviving spouse. The New York estate tax exemption is not portable from one spouse to another.
The New Jersey estate tax for decedents dying after January 1, 2018, has been reduced to zero percent. However, New Jersey continues to impose an inheritance tax. Transfers from a decedent to a parent, grandparent, descendant, children and their descendants, spouses, civil union partners, domestic partners and charities are exempt from the inheritance tax. Transfers from a decedent to any other beneficiary are subject to the inheritance tax. There is a $25,000 per-person exemption for transfers to siblings, sons-in-law and daughters-in-law. The tax is imposed at graduated rates ranging from 11 percent to 16 percent, depending upon the relationship of the decedent to the beneficiary.
Connecticut has a graduated estate and gift tax rate system. It is also the only state that imposes a gift tax. The exemption for persons dying in 2018 is $2.6 million, which increases to $3.6 million for persons dying in 2019. In 2020, Connecticut's exemption for gift and estate purposes will match federal law.
Florida continues to be one of the most advantageous states in the US since it does not have a state estate tax, and also has no state income tax.
Pennsylvania residents no longer face a state estate tax. However, Pennsylvania does impose an inheritance tax based upon the relationship of the decedent and the person to whom the property is bequeathed. Inheritance tax on the transfer of non-jointly-held property to spouses is levied at zero percent, the transfer of property from children 21 years of age or younger to their parent, either natural, step- or adopted, is also taxed at zero percent. All other transfers to lineal heirs are taxed at 4.5 percent. Transfers of assets to siblings, defined as those having at least one parent in common with the decedent related by blood or adoption, are subject to a tax at 12 percent. Transfers to all other persons are taxed at a rate of 15 percent.
Applicable Illinois law provides a $4 million estate tax exemption for state estate tax purposes, with a marginal rate of 16 percent. Recent changes have also significantly increased Illinois' marginal income tax rate.
For Midwestern snowbirds looking to relocate to Arizona, we note that Arizona does not have an estate tax, nor an inheritance or gift tax.
As of this writing, California does not have a state estate tax nor an inheritance tax.
1 The exact amount of the current exemption, based on inflation adjustments, has not yet been released by the IRS.
2 A "clawback tax" would be an additional estate tax imposed at death on lifetime gifts that exceeded the estate and gift tax exemption that was available at a decedent's death (even though that exemption was not exceeded when the gift was made).
3 This amount is NOT adjusted annually for inflation and does not apply for gift tax purposes
4 The exact amount will depend on the appropriate inflation adjustment.
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