The Tax Cuts and Jobs Act: Changes to the Transfer Tax

On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the “Act”). The Act makes significant changes to federal tax law. As a result of these changes, your estate plan should be examined to determine whether your estate plan remains consistent with your dispositive intent and whether your estate planning documents produce optimal tax results. This is particularly true for married couples with a combined net worth in excess of $5 million. Under the Act, there is no “one size fits all” approach. Rather, the approach needs to be tailored to a client’s individual situation and wishes.

Tax Law Changes

The Act doubles the unified estate and gift tax exemption and GST tax exemption from $5 million to $10 million. This amount is indexed for inflation. Thus for, 2018, this amount is $11.18 million. The increased exemption sunsets (goes away) in 2026 and the prior exemption amounts will be restored. As a result of these increases, fewer taxpayers will be subject to transfer tax.

No change is made to the exemption amounts available to nonresident aliens. Unless a treaty applies, the estate tax exemption available to a nonresident alien is $60,000.

The Act changes the inflation index so that future inflation adjustments will be smaller. Further, this change in the inflation index will not sunset in 2026.

The Act makes no change to the 40% federal estate gift and GST tax rate, the full “step-up” in the basis of a decedent’s assets for income tax purposes or the portability of a married decedent’s unused estate and gift tax exemption [1] amount that was introduced in 2011.

Review Formula Gifts

Many estate plans use formula clauses that are tied to these exemption amounts. These formula clauses should be reviewed to ensure that they remain consistent with intent and are necessary as a result of portability.

For example, a typical estate plan in the past was for married clients to provide in their estate plan that the exemption amount passed to a “family” or “credit shelter” which permitted current distributions to both the surviving spouse and the descendants and the balance of the deceased spouse’s asset to a marital trust which only permitted current distributions to the surviving spouse. With the increase in the exemption, much less or even no assets at all may pass to the marital trust leaving the surviving spouse’s lifestyle in jeopardy.

Further, an estate plan for some clients might leave the GST exemption amount to trusts for grandchildren and the balance to trusts for children. With the increase in exemption, the children may now be disinherited.

These formula clauses should be examined to ensure that a client’s intent is being carried out. Clients may want to consider imposing caps. Alternatively, and perhaps necessitating the greatest number of changes in current estate plans, married clients may decide that achieving a step up in basis on the second death is important and decide to have all assets pass to a marital trust to minimize the imposition of unnecessary federal income tax.

For example, let us assume that Husband dies owning a piece of property that was purchased for $600,000 but is worth $2,000,000 upon Husband’s death. If his surviving spouse sold the property for $2,000,000, because the basis of such property “steps up” to the fair market value at the time of Husband’s death, there would be no income tax gain. However, upon Wife’s death, if the property passed to the Credit Shelter Trust, had not yet been sold and was worth $3,000,000 at her death, there would be a $1,000,000 income tax gain (the difference between $3,000,000 and $2,000,000). If instead the property were placed in the Marital Trust, the property would receive a basis step up for a second time upon the Wife’s death.   For married clients whose assets are worth between $5,000,000 and $20,000,000 attention to this change in the tax law is perhaps most critical.

Finally, it will be important in the future to build flexibility into estate plans as the transfer tax rules will change in 2026, if not earlier.

Planning with Increased Exemptions

In making planning decisions concerning the increased exemptions, taxpayers need to consider the potential tradeoffs. With gifted assets, the donee takes the donor’s income tax basis, while assets retained until death receive a step-up in income tax basis. Thus, in making gifting decisions, priority should be given to using high basis assets.

If a taxpayer is holding promissory notes from prior estate planning transactions, forgiving these notes should be given consideration as a manner of using this increased basis.

If a trust holds assets that are subject to GST tax, consideration should be given to making a late allocation of GST exemption. Further, if a trust does not provide for generation-skipping, consideration should be given to decanting the assets to a new trust which is a generation-skipping trust.

Selling assets to grantor trusts will continue to be a viable technique as will establishing a grantor retained annuity trust (“GRAT”). With a sale to a grantor trust, a taxpayer sells an interest in a family business entity to a grantor trust in exchange for a promissory note. A grantor trust is a trust where the trust assets are treated for federal income tax purposes as owned by the grantor. Thus, the sale is ignored for federal income tax purposes, as is the payment of interest by the grantor trust to the grantor. A minimum interest rate must be charged based upon treasury obligations. All growth in the value of the sold assets in excess of this minimum interest rate passes tax free.

With a GRAT, a donor makes an immediate gift of an asset to a trust where the donor retains an annuity interest for a term of years. The amount of the gift is the actuarial value of the remainder interest, which can be made very small. The IRS assumes that the assets will grow at a certain rate which varies monthly based upon treasury obligations. The April 2018 assumed rate is 3.2%. Any growth in excess of 3.2% passes tax-free to the remainder beneficiaries.

Finally, making gifts will remain an option. While taxpayers may not want immediately to make gifts, if the law has not changed by 2025, then taxpayers who will be affected by a decline in the exemption will need to consider whether gifting is appropriate in order to be able to lock in the benefit of the increased exemption before the exemption returns to pre-Act levels. This will be similar to the situation that taxpayers faced in 2012 when the $5 million transfer tax exemption was scheduled to fall to $1 million. Congress did not act to retain the $5 million exemption until January 1, 2013.

529 Plans

The Act expands the benefits of 529 plans. For distributions after December 31, 2017, the definition of “qualified higher education expenses” has been expanded to include tuition at an elementary or secondary public, private, or religious school, and various expenses associated with home school, up to a $10,000 limit per tax year.

[1] With portability, the surviving spouse’s exemption is increased by the unused portion of the deceased spouse’s exemption.