- · Property tax deductions appear to be limited to $10,000/year. For wealthy taxpayers, especially those with large homes and vacation homes in high tax states, this change could be quite costly. In contrast, a wealthy taxpayer in a low tax state may be affected to a much lower extent.
- · State and local income taxes will no longer be deductible. For high income earners in high tax states this could prove quite costly.
- · The maximum tax rate remains high. It might be that for some taxpayers the result is little or no savings, and for some, a tax increase, especially when the many other changes in the Act are factored into the analysis.
- · The Federal estate, gift and GST tax exemption immediately increases by $5 million. The exact amount of the new exemption amount could be $11.2 million (or just under $11 million), depending upon how inflation adjustments are calculated. A married couple can transfer $22.4 million dollars gift, estate and GST tax free with the use of inter-vivos planning or portability. A mere .02% of taxpayers pay estate tax before the Act. With the increase in the exemption, the percentage will be lower. Likely less than 1,000 estate tax returns will be filed per year with a tax due if the Act becomes law.
- · Permanent repeal of the estate and generation-skipping transfer (GST) taxes in 2024. This is, however, subject to the risk that a future administration repeals the repeal, or that the taxes are readopted later. Under IRC Sec. 2611, the term “Generation-Skipping transfer” includes a taxable distribution, a taxable termination and a direct skip. In other words, upon repeal of the GST tax, after December 31, 2023, for any trusts to which GST exemption had not been previously allocated, distributions could be made to “skip persons” without incurring a GST tax. What happens to assets already transferred to trusts that are not already exempt from GST taxes? Would taxpayers be able to make distributions to skip persons without triggering a GST tax? It would seem so.
- · Retention of the Gift tax on gifts over the exemption amount made after December 31, 2023 with a top tax rate of 35%. Additionally, with the increased exemption to $11.2 million under the proposal, practitioners should consider whether transfers should be made from any trusts to which GST exemption had not been allocated to take advantage of the additional exemption amount. To the extent that these transfers are made from trusts which had been previously funded, no additional transfer tax would be incurred. To maximize the potential for this strategy of taking advantage of the increased GST exemption, practitioners should consider whether distributions may be made from non-exempt trusts to GST trusts. While there had been some speculation as to whether the gift tax would be retained when candidate Trump made his initial recommendations as to the transfer tax system, the Act appears to confirm what most advisers thought, that the gift tax will remain intact.
- · Assets held by the decedent at death appear to still obtain a stepped-up to date of death value as under current law.
- · For any QDOT created on or before December 31, 2023, there will be no tax on distributions made to the surviving spouse after the 10th anniversary of the creation of the QDOT. If the surviving spouse dies after December 31, 2023, there will be no tax on the value remaining in the QDOT.
- · For any QDOT made created after December 31, 2023, distributions will not be taxable and the value remaining in trust will not be subject to the estate tax.
- · Certainly, if asset protection or other non-estate tax benefits might alone be worthwhile, the new exemption should be used as soon as feasible.
- · For those with estates over $10-12 million, consideration should be given to using the new exemption. As the level of net worth increases, the incentive to proactively plan should increase.
- · For large estates, the increased exemption, if enacted, should be used.
- · For clients who have previously consummated note sale transactions, consideration should be given to immediately funding additional gifts to the purchasing trusts to shore up the economics of those sale transactions. If the practitioner subscribes to the mythical 10% seed gift theory, an additional $5 million gift (perhaps $10 million with gift splitting, and perhaps more if the inflation adjustment in fact applies) can support an additional $90-$100 million of the sale transaction (depending on whether the practitioner subscribes to the 9:1 or 10:1 application of this construct). On those transactions, consideration might be given to evaluating the need for the existing guarantees. On much larger transactions, the additional trust “capital” might be supportive, but have no meaningful impact on guarantees. On smaller note sale transactions, that additional $5 million gift might be used to pay off a portion or all of a note, thereby eliminating the IRS IRC Sec. 2036 string argument as to the note.
- · Powers of appointment and related planning should be evaluated. If, for example, a client created a trust and named a not-so-wealthy elderly relative to have a general power of appointment over the trust, or even more so if a client had considered such planning but did not proceed because of the size of the relative’s estate, the increased exemption available next year to that poorer relative might enable using a general power of appointment to obtain a large basis step-up on that relative’s demise for the client’s asset in that trust. This is precisely the type of basis planning that one wonders if those scoring the tax consequences to the federal fisc in the summary addressed.
- · Annual exclusion gifts.
- · Gifts of the exemption amounts including the possible increased (double) exemption the Act might make available in 2018.
- · Grantor retained annuity trusts (GRATs) which can have an automatic adjustment mechanism.
- · Note sales using defined value mechanisms. The type and application of the defined value mechanism should be considered in light of the IRS’s continued attack on such techniques. True v. Comm’r, Tax Court Docket Nos. 21896-16 and 21897-16 (petitions filed Oct. 11, 2016).
- · New life insurance should favor flexible policies to facilitate adjustment to new developments. For example, it might be advantageous to consider policies that build a cash value so that there is an exit strategy if the policy is no longer needed.
- · Additionally, with the increased exemption to $11.2 million under the proposal, practitioners should consider whether transfers should be made from any trusts to which GST exemption had not been allocated to take advantage of the additional exemption amount. To the extent that these transfers are made from trusts which had been previously funded, no additional transfer tax would be incurred. To maximize the potential for taking advantage of the increased GST exemption, practitioners should consider whether distributions may be made from non-exempt trusts to GST trusts. For taxpayers with estates of a size that there is no need to preserve the new GST exemption, it might be prudent to make late allocate of GST exemptions to existing trusts so that if a future administration rolls back the Act’s benefits, those trusts will already be exempt (barring some type of clawback).
- · Practitioners might encourage all clients to revisit will and revocable trust dispositive schemes. In particular, how might language in existing documents be interpreted under the proposed legislation? Might the client’s intended dispositive plan be disrupted? Even if uncertainty abounds, might it be advisable in some instances to take a precautionary stance and revise documents now? If existing documents make a bequest of an amount equal to the exemption amount how might the doubling of the exemption amount in 2018, should the Act become law, affect the distributions under those existing documents?
- · If a client has a long-term GRAT or note sale transaction in place, the contractual obligations to continue payments may or may not be affected by repeal. If a court ordered modification is obtainable, for example, as the GRAT no longer serves its purpose, will that trigger a gift tax as of the inception of the transfer if the gift tax isn’t repealed? Will the result differ if the gift tax is repealed? What about the fiduciary duty of the trustee? Would a court even permit the modification of an irrevocable trust that’s valid under state law because of a post-funding change in tax law? For existing note sales, making an additional gift of the increased exemption might facilitate, in smaller note sale transactions, repaying the note and concluding the transaction.
- · Discretionary trust distribution standards should replace mandatory income distribution standards because these won’t be required to qualify for qualified terminable interest property (QTIP) requirements under IRC Sections 2056(b)(7) and 2523(f).
- · Consider including powers of appointment so that assets can be re-vested in the grantor (or perhaps another person) if it proves advantageous under the new post-repeal planning rules to obtain a basis step-up. The provisions should permit inclusion but not mandate or force inclusion.
- · How might practitioners contemplate the repeal of repeal, or the reinstatement of an estate tax, in drafting new documents? With so much uncertainty, is it even advisable to endeavor to anticipate reinstatement in documents? What might be done with a tax apportionment clause for documents anticipating a future reinstatement of an estate tax? This situation is similar to what practitioners considered as 2010 approached with the law providing for no estate tax in that year. Practitioners had to construct their documents to say, in effect, “I leave my assets this way if there is an estate tax in effect when I die, but that way if there is none.” This will require careful thought in structuring and drafting. And, as indicated above, even if the estate tax is repealed, the repeal may be cancelled before the 2024 date, if not earlier, by a change in the White House and the Congress.
- · Since the estate tax might be reinstated, planning that removes assets from the client’s estate (with the powers to cause inclusion if that proves advantageous) might protect the family from the estate tax if it comes back in the future.
- · The corporate tax rate is reduced to 20% from the current 35%. The difference between the maximum corporate and individual tax rate may be significant such that evaluating business structures may be advisable. Might C corporations may be more favorable to use than in the past? One important issue may be whether an S corporation should elect C corporation status or whether an entity taxed as a partnership (or proprietorship) should elect C corporation status.
- · The optimal form of business may change for some clients.
- · A sale of 50% or more of a partnership will not terminate the partnership.
- · Expensing of otherwise depreciable assets other than buildings will be expanded significantly. The new rules are to be effective from September 28, 2017 to December 31, 2022. The $500,000 limitation on IRC Sec. 179 expensing would be increased to $2 million and the phase-out limitation for property placed in service exceeding $2 million would be increased to $20 million.
- · The deduction for net interest expense would be limited to 30% of the business taxable income.
- · Net operating losses (“NOLs”) would be deductible only up to 90% of taxable income, (it is 100% under current law). NOL carryforwards arising after 2017 would be increased by an interest factor
- · IRC Sec. 1031 like kind exchanges would be limited to transfers of real property. Is there a motive to preserve this for real estate developers despite the broad goal of simplification?
- · Deductions for entertainment expenses will be disallowed, but the 50% limitation on deductions for meals would continue to apply.
- · Standard Deduction. The standard deduction under current law is $12,700 for married taxpayers filing jointly, and $6,350 for single taxpayers. The Act will increase the standard deduction to $24,000 for married taxpayers filing jointly, and $12,000 for single taxpayers. While this change will simplify tax compliance for tens of millions of Americans, and lower their tax burdens, it will have wide ranging impact. Industries that have historically relied on deductions to fuel their business models may be adversely affected. Only the specifically identified deductions noted below will remain.
- · Exemptions. The personal exemption for a taxpayer, the taxpayer’s spouse, and any dependents would be eliminated.
- · Entertainment. Expenses for entertainment will not be deductible. Act. Sec. 3307.
- · Adoption. Adoption expenses are eliminated. Act Sec. 1406.
- · Mortgage Interest. Home mortgage interest will continue to be deductible at a reduced level. Under current law, interest incurred on up to $1 million of mortgage debt is deductible, but under the Act that amount will be halved to $500,000. How might this affect the value of clients in the home construction business? Might it enhance the value of clients owning rental apartment buildings? Might it prove more advantageous for trusts to own homes and permit beneficiaries to use them if both mortgage interest and property tax (see below) deductions are reduced substantially? Might there be a means to convert vacation homes into rental properties and thereby transform the deductibility of interest and taxes?
- · SALT. State and local taxes would only be deductible to the extent that they were paid in connection with carrying on a trade or business. The reduction in SALT taxes will have a very disparate and potentially profound impact.
- · Property Taxes. Real property taxes would continue to be deductible, but only to the extent of $10,000 per year. This could have a significant and costly impact on wealthy taxpayers in high tax states that own multiple homes. What impact might this have on communities with high property taxes? Are there alternative options as noted above to restructure ownership to make taxes deductible?
- · Tax preparation. Repeal of deduction for tax preparation expenses. Under the provision, an individual would not be allowed an itemized deduction for tax preparation expenses. The provision would be effective for tax years beginning after 2017. Under current law, these expenses are miscellaneous itemized deductions only deductible in excess of 2% of AGI, so few likely got the benefit in any event.
- · Medical Expenses. Repeal of deduction for medical expenses. While there is not much time left before year end, taxpayers who might benefit from costly elective surgery not covered by insurance, or in particular, those contemplating home modifications to make a home accessible in light of medical issues, should all endeavor to plan before year end.
- · Employee expenses. Denial of deduction for expenses attributable to the trade or business of being an employee. If this provision of the Act passes, employee/taxpayers should endeavor to take deductions in 2017 or there will be no deduction.
- · Retirement plans. Although there had been discussion of restricting 401(k) plans, the Act generally retains the current rules for 401(k) and other retirement plans. The one change in this area is more intended to close a loophole. Taxpayers who have converted regular IRAs to Roth IRAs in 2017 intending to reconsider this conversion after reviewing the level of appreciation or depreciation in the account at year-end had better do so before year end. Some taxpayers had converted regular IRAs to Roths and then invested aggressively in order to benefit from any gains (which are never subject to tax) by leaving them in the Roth, but then retroactively reversing the conversion if they incurred a loss inside the new Roth to avoid income taxes on some or all the converted amount. This strategy will no longer be feasible.
- · Investing. Private activity bonds will no longer be able to be issued. The net investment income tax (“NIIT”) was to have been repealed but is not being repealed. Tax advantages of carried interest do not appear to have been restricted under the Act. The relative benefits of municipal bonds will be diminished as marginal tax rates for many taxpayers are reduced.
- · AMT. The Alternative Minimum Tax is eliminated.
- · The 50% of AGI limitation that applies for cash contributions to public charities and private operating foundations would be increased to 60%. While this is a positive for very wealthy taxpayers who can afford to gift to such levels it is curious why this provision was added to the Act.
- · The provision would retain the 5-year carryover period to the extent that the contribution amount exceeds 60 percent of the donor’s AGI.
- · The amount deductible per mile driven in service to a charitable organization would be adjustable for inflation.
- · Under current law, private foundations are subject to a 2% excise tax on net investment income. However, they may reduce this excise tax rate to 1 percent by making distributions equal to the averages of their distributions from the previous five years plus 1 percent. The act streamlines the excess tax to a single rate of 1.4 percent. Additionally, the rules providing for a reduction in the excise tax rate from 2 percent to 1 percent would be repealed. The provision would be effective for tax years beginning after 2017.
- · Under current law, private operating foundations, which are a form of private foundation that may use tax-free donations to fund their own activities rather than make grants to other charities, are exempt from a 30-percent excise tax on certain undistributed earnings that other private foundations must pay. Under the Act, an art museum claiming the status of a private operating foundation would not be recognized as such unless it is open to the public for at least 1,000 hours per year. The provision would be effective for tax years beginning after 2017.
- · Under current law, an entity exempt from tax under Code section 501(c)(3) is prohibited from “participating in, or intervening in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.” This language, known as the Johnson amendment, is qualified so that entities described under section 508(c)(1)(A) would not fail to be treated as organized and operated exclusively for a religious purpose, assuming the speech is in the ordinary course of the organization’s business and its expenses are de minimus. This provision would be effective for tax years ending after date of enactment.
- · After 2017, no new contributions could be made to Coverdell education savings accounts.
- · The Hope Scholarship Credit will be eliminated in which case it might be advantageous to pay certain bills before year end.
- · The American Opportunity Tax Credit remains intact and is expanded to permit a 5th year of post-secondary education.
- · Student loan debt forgiveness will not be taxable in some situations.
- · The qualified expenses which can be paid under a 529 plan will include elementary and high school education of up to $10,000 per year. For those sending their children to private schools, this could be a useful tax advantage. For taxpayers who have accumulated larger then needed colleges funds in a 529 plan, that might be a useful outlet.
- · The mortgage interest deduction will be severely limited. Taxpayers may continue to claim an itemized deduction for interest on acquisition indebtedness. For debt incurred after the effective date of November 2, 2017, the $1 million limitation would be reduced to $500,000. Interest would be deductible only on a taxpayer’s principal residence. Like the current-law AMT rule, interest on home equity indebtedness incurred after the effective date would not be deductible. If a mortgage is refinanced prior to November 2, 2017 it would be treated as incurred on the same date that the original debt was incurred for purposes of determining the limitation amount applicable to the refinanced debt.
- · The deductibility of property taxes will be capped at a mere $10,000. Act Sec. 1303. The aggregate amount of taxes (other than taxes which are paid or accrued in carrying on a trade or business or an activity described in IRC Sec. 212 considered for any taxable year shall not exceed $10,000 ($5,000 in the case of a married individual filing a separate return). Might this change the calculus as to whether a taxpayer should claim a deduction for a home-based business to secure some portion of the property taxes? Might more taxpayers formalize home based businesses to address this and other limitations?
- · Homeowners will continue to be able to exclude up to $500,000 of gain ($250,000 if single) from the sale of a qualified principal residence. However, to qualify as a principal residence, the homeowner must use the home as a principal residence for 5 out of 8 years instead of the current 3 out of 5. Further, a taxpayer may only use the exclusion once every five years. For homeowners contemplating a sale and meeting the 3 of 5 year but not the 5 of 8-year requirement it may be advantageous to sell the home prior to the end of 2017 if feasible.
- · In another blow to the housing industry (and moving and relocation businesses), the deduction for moving expenses is eliminated.
- · Deduction for personal casualty losses is eliminated. While this is not limited to hurricane, flood, fire, theft and other losses on homes, it is likely that this change will be felt most acutely by those owning homes.
- · Alimony payments will not be deductible by the payor spouse, but will also not be included in income of the payee ex-spouse. Act Sec. 1309. For agreements being negotiated now, this could be a significant impact. The effective date indicates that this new rule will apply to any divorce or separation instrument as defined in IRC Sec. 71(b)(2) of the in effect before the date of the enactment of this Act) executed after December 31, 2017, and any divorce or separation instrument (as so defined) executed on or before such date and modified after such date if the modification expressly provides that the amendments made by this section apply to such modification. Practitioners should consider adding a provision to any agreement in process that if the law is changed as provided in the Act, the agreement can or must be renegotiated. It might, in some instances, be worth addressing the terms of the agreement with or without the change of the Act. It is also important that if the Act becomes law, both matrimonial practitioners and accountants should put all divorced clients paying or receiving alimony on notice that they can modify the agreement to bring it under the new law if that proves advantageous for them. Making all prior agreements under prior law able to be modified and brought under the new tax paradigm is anything but simplification.
- · The elimination of the personal exemption for dependents is eliminated under the Act. What becomes of the divorce agreements where the parties expressly negotiated who would benefit from the exemptions? If the arrangement was to divide or split, or alternate each year the exemptions, then perhaps the economic impact is equal between the ex-spouses and simply a tax benefit lost. But what if one spouse negotiated the benefit? Is that a basis to revisit or adjust the agreement?
- · As noted above, the qualified expenses under 529 plans will include elementary and high school education of up to $10,000 per year. Will this undermine the intent of existing matrimonial settlement agreements that may have provided funding or confirmed balances in 529 plans for college which might now be dissipated for earlier education expense contrary to the parties’ intent? The governing agreements should be reviewed to ascertain whether the agreement specified college only expenses be paid from an acknowledged 529 plan and whether that would suffice to restrict the ex-spouse account owner from using funds earlier.
House Proposed Tax Cuts and Jobs Act: Impact on Estate Planning and Ancillary Planning Areas
By Martin M. Shenkman, Esq. and Joy Matak, JD, LLM
Since the election of Donald J. Trump as President, there has been intense buzz among estate tax planning professionals wondering whether and when the new Administration and the Republican controlled House and Senate might eliminate the federal estate tax. On November 2, 2017, the House Ways and Means Committee issued H.R.1 called “Tax Cuts and Jobs Act.” The proposed bill itself is about 430 pages, and the summary about 82 pages. The provisions appear to affect almost every aspect of tax, estate and other planning, far more than what anyone anticipated. While there has certainly not been adequate time to even make a cursory review of the proposal, there seem to be significant proposed changes, some never previously discussed, that require immediate action by practitioners just in case they are enacted. Other provisions may not require current action, but at least might warrant consideration.
No doubt some of the comments in this article will be outdated quickly by new changes proposed. Nonetheless it seems worthwhile to review and analyze the current provisions to properly guide clients now, and understand the trajectory tax reform is taking.
Comprehensive, But Still Just a Proposal
The Proposal just rolled out by the House Ways and Means Committee is still subject to reconciliation and will likely face revisions before it lands on the President’s desk for signature. However, regardless of the many possible flaws of the Act noted in this article (and there are likely myriads of others), given the Republican majorities in both houses of Congress, some form of the current GOP Tax Plan might well be signed into law.
Nonetheless, since the Republicans have a slim 52-seat majority in the Senate, the permanence of any such plan is very much in question because of the so-called Byrd provision which requires 60 votes (a filibuster-proof majority) to enact any law beyond 10 years. Further, since the GOP Tax Plan doesn’t provide for full repeal of the estate tax until 2024 – after the next presidential election – there is a possibility that a new administration will replace the law before full repeal.
In short, there may be a limited window to take advantage of the significant transfer tax planning opportunities presented by this GOP Tax Plan. The non-transfer tax provisions in the Act raise a myriad of other issues, which, given the limited time to evaluate them, are noted later in this article.
Will the Act Achieve Simplification?
While the stated goal is tax simplification and lower taxes, it is not clear that either goal is fully achieved. While eliminating deductions and raising the standard deduction will clearly simplify tax planning and tax return preparation for large numbers of taxpayers, simplification will certainly not be achieved for many. The new rules on pass through entities appear to be incredibly complex, creating new concepts and planning implications. These rules might have a significant impact on how closely held business entities are structured, perhaps even when people choose to retire.
As another example, the elimination of the tax deduction for alimony for the payor on new divorce agreements, as well as not including alimony as income to the payee, appears on the surface to simplify tax planning and compliance. But does it in the broader sense achieve simplification? By changing the fundamental tax implications of divorce agreements that have been in force for a very long time, will this really achieve simplification or will it create complexity and potential problems for matrimonial practitioners and the many taxpayers who divorce each year? Will it create new issues that everyone must digest and evaluate on how property settlement components of a divorce need to be negotiated relative to alimony payments? How will judges synthesize the new dynamics when handling matrimonial cases?
Will the Act Cut Taxes?
Although President Trump referred to the Act as the “Cut, Cut, Cut bill” it does not appear that the Act will in fact provide a tax reduction for all taxpayers.
No doubt many taxpayers will have their tax bills lowered. But others, especially wealthier taxpayers, may not find that the results overall are favorable. Worse for some, the determination as to the tax impact will not be easy to evaluate. The impact might also be quite disparate. For example:
The proposed Act might mitigate one worry that had existed for ultra-high net worth clients. That was whether the Senate Finance Committee Report that was issued in October and demonized practitioners for guiding clients to pursue tax planning ranging from annual gifts to more advanced techniques. The United States Committee on Senate Finance, “Estate Tax Schemes: How America’s Most Fortunate Hide their Wealth, Flout Tax Laws, and Grow the Wealth Gap,” October 12, 2017. While it might still be possible that any final tax bill could toughen the transfer tax rules to raise revenue for other tax reduction, that seems less likely, considering the Act excluding any mention of this.
The most likely to be hurt by the proposals are moderately wealthy taxpayers who live in high tax states that had heretofore benefited from large SALT (state and local property tax and income tax) deductions on their federal income tax returns, and who do not have estates large enough to benefit from the increased transfer tax exemption. There will be those in a “sweet spot” of net worth who might benefit significantly from the increase in the exemption. Those with very ultra-high net worth may not benefit in a significant way from what, relative to their estates, is an insignificant bump in the exemption, and who face loss of deductions. This latter statement assumes that the ultimate repeal of the estate tax may never occur so that the very ultra-high net worth taxpayers will never actually realize that benefit. Again, the tax implications to wealthy taxpayers may in fact vary considerably depending on the circumstances.
How Will the Act Really Affect Revenue?
The 82-page “Tax Cuts and Jobs Act H.R. 1 Section-by-Section Summary” includes fiscal impact estimates of each provision. It seems a wonder how some of these estimates could be made so quickly. It seems even more questionable how provisions, such as the impact of the pass-through entity maximum tax rate, could be fiscally scored when the implications are so complex and uncertain. By way of example, the change resulting in the taxation of certain employee awards is scored to generate over $3 billion in 10 years. Is that realistic? Other estimates seem potentially unrealistic as well.
The increase in the transfer tax exemption is scored as reducing revenues by $172.2 billion. It seems incredible that this change would be enacted given the other potential costs of the Act and the fiscal and societal issues facing America now. There is no indication how this figure was estimated. Is this merely a tally of lost estate and gift taxes or does it also include a reasonable evaluation of the likely potentially significant decline in capital gains tax revenue? All but the very ultra-high net worth clients should be able to avoid paying capital gains tax by maximizing the wide range of basis maximization planning techniques practitioners have been discussing for the past several years. If the capital gain tax loss is not realistically factored into the scoring, the impact of this change on the federal fisc over time will grow dramatically costlier.
The inflation adjustments in the tax laws appear to be modified to index for inflation using a so-called “chained CPI” instead of CPI to lessen future increases.
Another accommodation to the economic realities of the tax cut proposals, the political talk of tax reductions being retroactive to the beginning of 2017 has been dropped and most changes only take effect in 2018, likely to endeavor to present the Act as having less of a negative impact on the budget.
Do the Estate Tax Changes Really Help “Small” Business?
The rationale for the doubling of the exemption (not to mention the inflation kicker as well) was stated in the Summary as follows: “By repealing the estate and generation-skipping taxes, a small business would no longer be penalized for growing to the point of being taxed upon the death of its owner, thus incentivizing the owner to continue to invest in more capital and hire more employees.” Has any entrepreneur ever consciously not grown their business because of a perceived penalty of the estate tax impact on that business on their death? The premise of this rationale is so questionable that the purported positive economic impact seems implausible. How can the phrase “small business” be used with figures of this magnitude? The statement implies that “small businesses” are wiped out by the estate tax which ignores the current planning left in place, the ability to defer estate tax under IRC Sec. 6166 and a range of other provisions. For some closely held businesses, the complexity of the new pass-through entity rules and the negative tax impact on principals of losing SALT deductions may pose a far greater hardship then the estate tax ever did.
With the estate tax not scheduled to be repealed until 2024 would any business owner, of any size, prudently rely on the elimination of the estate tax to make current business decisions to grow their business?
Displacement, Change, Uncertainty
Simplification is good. Few could argue with that. But dramatic changes to long-time tax laws that have been embedded in economic decision making for years may have disruptive consequences that are difficult to evaluate, especially on the hyperdrive time frame the President is using to push through tax reform. Removing the tax impact of alimony, for example, could have dramatic impact on every divorce currently in process, and will change the landscape for all future divorces in ways that may not be readily determined or determinable. The emasculation of the SALT deductions will have very different impact on taxpayers depending on their state of residence and circumstances. Lower income tax rates might make it difficult for states struggling from the SALT changes to raise funds in that manner as well. While that is hard to predict, perhaps more worrisome is the impact on the high tax states that may face a tax-driven exodus by their wealthy citizens, thereby eroding their fiscal condition. Some of the states that may be affected are currently in questionable fiscal health, so might this change push them to the brink? There appears to have been inadequate analysis of the possible implications of this. Many of the other changes in the Act, even if simplifying in terms of the tax law, may prove disruptive to the industries affected, or the specific taxpayers.
Disruption, change and uncertainty are not likely to prove boosts to the economy. Practitioners will have to be careful not to draw general conclusions from the impact of the Act, or whatever version (if any) is enacted, as the implications to each client might vary significantly, but much of the impact may prove indirect and more difficult to ascertain.
Summary of the Transfer Tax Changes (and Not) of the Act
Transfer Tax Exemption
The proposal changes the Basic Exclusion amount as set forth in IRC Sec. 2010(c)(3)(A) from $5 million to $10 million. The effect of this change is that the exclusion is deemed to have increased per IRC Sec. 2010(c)(B) each year by cost-of-living adjustments so that, assuming the law is enacted and becomes effective as of January 1, 2018, the Exclusion Amount appears that it will be $11,200,000, based on the following table:
Exclusion Amount Under Current Law:
Cost of Living Adjustments:
Deemed Exclusion Amounts under GOP Tax Plan:
Qualified Domestic Trusts and Non-Citizen Spouses
Under current law, the estate tax is imposed upon any distributions made from a Qualified Domestic Trust (“QDOT”) to the surviving spouse and upon the value remaining in the QDOT on the death of the surviving spouse. The Act will eliminate these taxes as follows:
Transfer Tax Planning if the Act becomes Law
With the doubling of the exemption amounts, clients have an opportunity to accomplish significant gifting after the effective date of the GOP Tax Plan. Caution should be exercised by Connecticut residents who might face a state gift tax for transfers over $2 million. Assuming that repeal of the estate tax will be temporary or never become effective, making gifts will enable these clients to remove further assets from their taxable estates and exempt any future appreciation from transfer taxation. Further, with no assurance that a future administration will not only negate the repeal of the estate and GST, but might perhaps lower the exemption amounts, planning should not be deferred for wealthy clients. Will there be a clawback if there is a future change of excess exemption? While that hopefully will not occur, practitioners might caution clients making new exemption gifts of this possible risk. As to what level of wealth is appropriate to plan for will depend on a myriad of factors.
What clients might be willing to do with respect to planning, and how practitioners approach and advise different clients, will in part depend on how far client planning has progressed.
How to Plan Now Before the Act Becomes Law (or Not)
Apart from the tax issues, those who have not completed, or even started meaningful planning should nonetheless act now. Estate planning never should have been only about estate taxes. For most people, more wealth is dissipated from elder financial abuse, lawsuits, divorce, spendthrift heirs and other risks than from estate taxes. Properly crafted modern trusts can address all of these concerns and provide more flexibility no matter what results from the Act. Given that the tax laws are still in flux, the best course is to infuse flexibility into plans. The Act defers repeal until 2024 leaving open the possibility of unfavorable changes by a future administration. By way of example, married clients should consider forming non-reciprocal, spousal lifetime access trusts (“SLATs”) to which gifts or sales transfers might be made. Single clients might consider self-settled domestic asset protection trusts (“DAPTs”) or hybrid DAPTs (a dynastic trust that has a mechanism to add the settlor back as a beneficiary so that the trust at inception is not a DAPT).
Example 1: Client began a plan to create two non-reciprocal SLATs in late 2016 out of concern about adverse tax changes but put the planning on hold after the Trump election victory. The client should evaluate whether additional gifts may be made to these trusts after enactment of the GOP Tax Plan to take advantage of the higher exemption amounts. So long as the gifts contemplated to each trust are under the exemption amount, this planning might be viewed as having no downside gift tax risk, so there should be no reason not to complete the planning. The non-tax benefits of the structure, e.g. asset protection and divorce protection, etc., also remain.
Example 2: Client is quite concerned about malpractice suits. The estate includes significant holdings in an investment LLC and has a value of approximately $20 million. The client’s attorney drafted non-reciprocal SLATs to which the clients contemplated gifts of discountable assets. Part of the motivation is asset protection planning. While the need to secure those discounts might appear academic considering the significant increase in exemption amounts, the clients will assuredly benefit from the asset protection benefits of the irrevocable trusts regardless of whether there are estate and gift tax benefits. If the plan has not yet been implemented the trusts might be modified to incorporate additional flexibility (for example, naming a non-fiduciary to add the grantors back as beneficiaries in the event of premature death of one spouse, etc.). Perhaps the level of transfers might be reduced somewhat to lessen the gift tax exposure until more is known about the future tax legislation. However, if the client resides in a decoupled state, perhaps the planning should continue unabated. Another option might be to amend and restate the LLC operating agreement negating discounts.
Example 3: Client whose net worth is about $8 million owns a valuable building held in a limited liability company (LLC). Planning had begun and shifted $2 million worth of the LLC interests to irrevocable DAPT in order to secure discounts. The client is quite old and infirm and is domiciled in a non-DAPT decoupled state. Now that we know that repeal of the estate tax will not happen until 2024 (if at all), the planning might need to be modified. Since the estate tax exemption could be more than $11 million when the client passes – and since all the assets owned by the client at death will be eligible for a basis step-up – it might be advisable for the client to retain sufficient incidents of ownership such that the assets may be includable in his estate. Depending upon the risks of asset depletion, the practitioner may wish to consider whether it would be advisable to prepare an action by the trust protector now to move the situs and governing law of the trust to the client’s non-DAPT home state in order to cause estate inclusion.
Example 4: Client owns a large family business. The family is involved in a complex note sale (installment sale to a grantor trust) transaction that involves several tiers of transactions. Should the plan be abandoned? Likely not. Safeguarding and preserving the family business is the major goal. Leaving stock in the family business exposed to possible transfer, remarriage, creditor risks, etc. would not be prudent, nor would that be acceptable to the family. Stock that’s held in an irrevocable trust that is not GST exempt might be better protected in a dynastic trust. To the extent that the transaction has progressed reasonably far down the planning continuum, and regardless of the outcome of the estate tax repeal, it may be advantageous to have the family business stock shifted to the dynastic GST exempt trust. The risk of death before repeal in 2024 is a concern. While the risk of a worsening estate tax environment is not as material as when planning began, the efforts and cost to complete the transaction are worthwhile when weighed against the potential benefits to be gained and are insignificant relative to the value of the business. Most importantly, the family has no confidence that even if the Act becomes law in its current form, or some modified version, that the estate tax repeal will not be overturned by a future administration.
With the possibility of repeal on the horizon, avoiding a gift tax remains paramount. Because the fate of the Act is uncertain, the following planning remains worth considering regardless of whether and in what form the Act is enacted:
Example 5: Client has a $25 million-dollar estate and has made no taxable gifts. She gifts $5 million of marketable securities to a self-settled trust in 2017, and plans to make another $5 million gift in 2018 if the Act increased exemption becomes law. This is very low or no risk in terms of gift tax. There are no valuation issues, and the gift is below the client’s exemption. The practitioner may wish to encourage the client to gift more to the trust to take advantage of the higher exemption. What if the GOP Tax Plan is repealed by a new administration in 2020? Might there be a clawback of amounts gifted?
Example 6: Clients have a $30 million-dollar estate, $10 million of which is comprised of an LLC that owns marketable securities and $10 million of which is a real estate LLC that owns commercial rental property. They have not made any prior taxable gifts. Wife gifts $5 million of discounted membership interests in the marketable securities LLC to a SLAT. Thirty days later, she sells $5 million of discounted interests to the SLAT. Is this likely to be minimal risk in terms of gift tax exposure. There are potential valuation issues so some type of valuation mechanism might be appropriate. But given the remaining exemption she has preserved in 2017, would a Wandry approach suffice? Since the Act’s version of estate tax repeal does not include repeal of the gift tax, what will happen to these planning structures? If the client is audited and faces an audit adjustment, the gift tax exposure on that audit may have been for naught because if the client had waited, the repeal of the estate tax may have obviated the need for planning. Should this planning be pursued? Does a Wandry clause make the transaction lower risk? What if a different type of defined value mechanism were used instead? Does lowering the discount rates lower the risk profile of the plan? Would it be more advantageous to wait until 2018 and make a gift of perhaps $8 million when the exemption may be $11.2 million? The reality is that determining the risk profile of any transaction is quite subjective, fact sensitive and will vary as each practitioner weighs these factors.
Since the GOP Tax Plan is certain to face significant opposition, even if some variation of the Act becomes law, estate tax repeal may not extend past the next few election cycles. Nonetheless, practitioners should consider alerting clients of the possible unintended consequences and planning considerations that might result from proposed repeal of the estate tax:
State Estate Tax Systems
What will the impact of the many provisions of the Act be on different states? Evaluating the impact of the state income tax issues and loss of SALT deductions could be devastating for high tax states. State income tax rate could be 40% higher for wealthy taxpayers in high tax states (39.6% maximum federal rate + 3.8% NIIT) of a deduction will be lost. In other words, a higher federal tax paid on state income tax. This might result in state income and property taxes pressuring wealthier people to move their residences to states without income tax and with lower property taxes. Might we see a migration to low/no income tax states?
What will this do to state budgets? There could be a dramatic shift in tax burdens. There could be dramatic difference in how different people are affected by the interplay of all these changes.
What is interplay of the Act’s $10 million inflation adjusted exemption and state estate tax systems? What about New York estate tax cliff? Under New York law if an estate slightly exceeds the exemption amount, the exemption is lost and the entire tax is incurred on the entire estate. While a higher exemption amount would obviate the issue for many New Yorkers, the magnitude of the cliff will create an incredibly costly penalty for moderate wealth clients that only modestly exceed the exemption. In 2019 New York is supposed to equal the federal. Will it be $10 million, or will New York be forced to amend its estate tax law to maintain its revenue base? How will other states react? Only about 14 states have independent state estate tax. How will this affect them? What will states with estate tax systems do if the Act becomes law? Will they retain their estate taxes? Will it be cost-effective with a $10 million inflation adjusted exemption amount for a state that parallels the federal estate tax to retain an estate tax? For non-decoupled states will they feel an increased pressure to repeal their estate tax system if so few residents will be subject to tax?
With recent leniency provided by the IRS on filing late portability elections, will clients be willing to incur any cost with the prospect of the exemption doubling? Revenue Procedure 2017-34, Internal Revenue Bulletin 2017-26, dated June 26, 2017. In the future, will clients even be willing to listen to recommendations to file a federal estate tax return if the exemption is doubled? Certainly, fewer moderately wealthy clients may be willing to do so. For those clients affected, in the event that the estate tax is reinstated as expected, loss of portability from failure to file an estate tax return on the death of the first spouse can create greater estate tax on the death of the survivor.
Those taxpayers with portable exemptions from a prior deceased spouse might consider using those exemptions before a future administration may negatively affect them. This could take the form of using that DSUE to fund a DAPT. If a future administration negatively affects the portable exemption it will have already been used. By using a DAPT the client may not be prevented from accessing the wealth so transferred.
Non-Tax Estate Planning
More moderately wealthy clients may choose simplistic outright bequests if there’s no tax incentive. The term “moderate” may again be redefined relative to the new doubled exemption amounts. Practitioners will have to educate clients as to the obvious (to the practitioner, but not necessarily to the client) benefits of continued trust planning, such as divorce and asset protection benefits. In the absence of any transfer taxes, this may become the primary goal for many trust plans. With increased longevity, the likelihood of remarriage following the death of a prior spouse likely will increase. The need for trusts on the first death to protect those assets may be more important than many realize.
While trusts may afford tax planning opportunities by sprinkling income to whichever beneficiary is in the lowest income tax bracket, will the lower income tax brackets provided under the Act reduce this benefit sufficiently enough to mitigate against this use of trusts? The distributions carry out income under the distributable net income rules of IRC Sections 651-652 and 661-662. Might it make more sense for trusts to make non-interest-bearing loans to beneficiaries to repay mortgages the interest on which is no longer deductible under the new Act?
Trust planning may also be modified to reflect the potential repeal of the estate tax:
Wealthy taxpayers should consider undertaking arrangements that have low gift and income tax risk and low cost and significance non-estate tax benefits (e.g., asset protection, income tax shifting, etc.). Ultra-high net worth clients should proceed with planning because the deferral of repeal until 2024 does not appear to provide sufficient certainty to ignore planning. These options, including an installment sale to a grantor trust or a GRAT as described above, are two of many that can be implemented. Obviously, these will work best to remove assets from an estate tax system, if the assets perform well from a financial viewpoint. Consider creating these arrangements under the laws of a domestic asset protection state so the grantor may be able to continue to enjoy them if desirable.
Business and Entity Income Tax and Planning Considerations
There are a host of changes made that affect corporations and other business entities, and therefore create business planning opportunities:
Pass Through Entities
Introduction. The Act lowers the maximum income tax rate on business income from small and family-owned pass-through entities (sole proprietorships, partnerships, LLCs taxed as partnerships, and S corporations) to 25%. Act Sec. 1004. Net income earned from passive business activity would be fully eligible for the 25% business income tax rate. This can create issues for clients who had taken steps to support and document that they were material participants in a business to avoid the passive loss rules. Those businesses may not have to be evaluated differently under the new tax paradigm if the Act becomes law. Net income earned by equity holders actively participating in the business will be determined based on their capital percentage of income derived from active activities. Thus, active income will be taxed at the general tax rates, not the favorable lower 25% rate. This construct, which is a new approach to taxation will introduce incredible complexity thereby negating the advertised simplicity, certainly for taxpayers affected. To simplify the analysis, a safe harbor approach is provided for owners and shareholders that actively participate in a business. Taxpayers can assume that 30% of their business income is derived from passive activities and 70% of their business income is derived from active efforts so that 30% of business income would be eligible for the special 25% business income rate. Taxpayers/business owners can, however, use an alternate facts and circumstances calculation.
Personal Service Entities. Owners of personal service entities are not eligible for the special business income tax rate and all income from the personal service business would be taxed at his or her individual income tax rates. Affected endeavors would include: businesses involving the performance of services in the fields of law, accounting, consulting, engineering, financial services, or performing arts. So generally, an ultra-high net worth client earning millions of dollars per year from passive business endeavors will be taxed at a lower income tax rate than their advisers working 2,000+ hour years. Is there something inherently unfair in this approach? Is this an unfair advantage provided to those with so much wealth that they can earn substantial income passively? What is the magnitude of this tax benefit for the super-wealthy?
Under the Act, the default capital percentage for certain personal services businesses would be zero percent. As a result, a taxpayer that actively participates in such a business generally would not be eligible for the 25- percent rate on business income with respect to such personal service business. However, the provision would allow the same election to owners of personal services businesses to use an alternative capital percentage based on the business’s capital investments. This election would be subject to certain limitations. Is this possibly simplification?
Bifurcation of Entity Income. A portion of net income distributed by a pass-through entity to an equity holder may be characterized as “business income” subject to a maximum tax rate of 25%. The portion of income not characterized as business income would be deemed compensation and subjected instead to the higher ordinary individual income tax rates. This new tax paradigm will introduce new complexity to bifurcate income of a pass-through entity and to deal with new terms and calculations created by the Act.
Default Capital Return Calculation. It appears that if an equity holder is passive, she should be taxed at the maximum special 25% rate. If, however, an equity owner is actively engaged in the business, a portion of her income would be subject to the lower rate while a portion of her income would continue to be subject to the general individual income tax rules. An equity owner that is active part or all of the time would have her economic benefits taxed as ordinary income using a 70/30 default allocation. Thus, an equity owner generally may elect to apply a capital percentage of 30% to the net business income derived from active business activities to determine their business income eligible for the 25-percent rate. That determination would leave the remaining 70% subject to ordinary individual income tax rates.
Facts and Circumstances Capital Calculation. Alternatively, an active equity owner can apply a formula based on the facts and circumstances of their business. This facts and circumstances tests requires that an imputed return on capital should be calculated. This is done by taking the federal short-term interest rate plus 7%. This assumed rate of return is multiplied by the capital used in the business to calculate a return on capital. That figure is presumed to be the passive return on capital taxed at 25% maximum rate with the remainder of the economic return subject to tax at the regular individual rates. If the taxpayer opts for the facts and circumstances approach, rather than the 70/30 approach, that election would be binding for a five-year period.
Questions Abound. How will these calculations be made? What is “capital” for purposes of the calculation?How will capital investment in business be determined if most or all equipment is deducted under the expanded IRC Sec. 179 expensing provisions? Is it economic basis or might we need appraisals? If an operating agreement provides for the payment of a guaranteed payment might there be an incentive to renegotiate that agreement? If a senior family member continues to draw a salary post-retirement but provides modest services, might that arrangement be reviewed and perhaps reconsidered so that if she is fully retired the 25% maximum tax would apply to all earnings? How will the quantum of services that can be provided without tainting the return on the pass-through entity as partially taxed at higher rates be determined? What will the impact of this be on buyout agreements, post-sale or post-retirement consulting agreements? How might the result of these calculations impact wages for retirement plan contributions or for Social Security tax or benefits? A special rule would apply to prevent the recharacterization of actual wages paid as business income. An owner’s or shareholder’s capital percentage would be limited if actual wages or income treated as received in exchange for services from the pass-through entity (e.g., a guaranteed payment) exceeds the taxpayer’s otherwise applicable capital percentage.
Is the Equity Owner Active? The determination of whether a taxpayer is active or passive with respect to a particular business activity would rely on current law material participation and activity rules within regulations governing the limitation on passive activity losses under IRC Sec. 469. Under these rules, the determination of whether a taxpayer is active generally is based on the number of hours the taxpayer spends each year participating in the activities of the business. Unfortunately for estate planners, there is little guidance on whether or how a trust can materially participate. The new rules will exacerbate the need for clearer guidance in this regard.
Exclusions from Calculations. Income subject to preferential rates, such as net capital gains and qualified dividend income, would be excluded from any determination of a business owner’s capital percentage. Such income would not be recharacterized as business income for these purposes and would retain its character. Certain other investment income that is subject to ordinary rates such as short-term capital gains, dividends, and foreign currency gains and hedges not related to the business needs, would also not be eligible to be recharacterized as business income. Interest income properly allocable to a trade or business would be eligible to be recharacterized as business income. Is this a working capital analysis? How much working capital is necessary for business needs? While there is logic to these rules the appear to add additional layers of complexity to the taxation of flow-through entities.
Individual Income Tax Changes and Planning Considerations
Many deductions will be modified or eliminated. The deduction for medical home improvements will be eliminated as part of the medical expense deduction elimination. Any elderly or disabled taxpayers considering or needing home improvements should make these modifications before year end, in order to secure a tax deduction. This is more important than the general media discussions of accelerating deductions that may be eliminated because of the quantum of the costs to modify a home. In many instances, these costs can run from tens to hundreds of thousands of dollars.
Trust Income Tax Considerations
Trust tax brackets will be $2,550, $9,150 and last $12,500. The inflation adjustment begins after 2018. Estate or trust that would have reached the maximum tax bracket at $12,700 under current law but the Act moves it back to $12,500 and no inflation adjustment until 2018. This is another nitpick that illustrates detailed small modifications to replace revenues affected by tax cuts.
As noted above, the new rules on pass-through entities will raise issues for trusts owning such interests. It has been common in estate and asset protection planning to create layers of trusts and entities. Now, the characterization of the trustee as a material participant under IRC Sec. 469, and issue on which there is scant law and no clarity, may impact the application of the new 25% maximum tax on passive returns form flow-through entities.
Charitable contributions will continue to be deductible. But for most taxpayers, the doubling of the standard deduction would appear to mean no incremental tax benefit from donations. For many taxpayers, e.g. retirees, if they will be precluded by the Act from deducting state income taxes, only be afforded a property tax deduction up to $10,000, and limited mortgage interests (which many retirees don’t have), itemized deductions may be unlikely in future years. That is, in fact, an intent of the Act. Many taxpayers will not be able to itemize deductions after 2017 so it might be advantageous for those affected to contribute to donor advised funds (“DAF”) before the end of 2017 and obtain a charitable contribution deduction now. Then, in future years they can use that DAF to make contributions in later years. The result will be that few people will likely get a charitable contribution deduction after 2017 other than high income earners with substantial deductions in the categories that remain deductible.
Education Tax Considerations
Several changes are made by the Act that effect planning to pay for education costs:
If the Act becomes law, practitioners who have provisions in durable powers of attorney or revocable trusts permitting gifts to Coverdell accounts might wish to revise their language.
Residential Real Estate
There are a host of adverse changes that will impact residential real estate and vacation homes.
The larger macro implications of these and other changes on residential real estate are uncertain. For example, for ultra-wealth taxpayers, these changes may be insignificant. For most Americans, they may be irrelevant. But for a large swath of what might be loosely referred to as moderately wealthy or wealthy Americans, these changes could have a substantial and unfair impact on the carrying costs of homes and vacation homes and perhaps undermine the values of those properties at the same time.
Sport Related Changes
The Act eliminates the deduction available for up to 80% of the amount paid for the right to purchase athletic tickets. Deductions for entertainment expenses will be disallowed under the Act. The Act also eliminates tax exemption on bonds used to finance sports stadiums. The term ‘professional stadium bond’ means any bond issued as part of an issue any proceeds of which are used to finance or refinance capital expenditures allocable to a facility (or appurtenant real property) which, during at least 5 days during any calendar year, is used as a stadium or arena for professional sports exhibitions, games, or training. Act Sec. 3604.
Might these changes be intended to convey a personal message from the President to the NFL?
The Act includes several changes that could significantly impact matrimonial/divorce agreements. These provisions directly affecting divorce are in addition to the many indirect changes (e.g., impact on itemized deductions, SALT limits, etc. that may have a significant direct impact, positive or negative, on the ex-spouses):
Should Practitioners Inform Clients Now?
There is little time to act before year end. Taking action in some instances might be critical to secure important tax benefits. On the other hand, at the time of this writing, the Act is merely a proposal that might change significantly before enactment, or perhaps nothing will be enacted this year. The puzzle for practitioners then is what to advise clients.
Some firms are sending mailings to clients highlighting planning opportunities and inviting clients to come in for meetings. Some are including a year-end planning checklist. But there is an opposing view among noted commentators as well. There is no means of guesstimating the likelihood that anything you inform clients now will reflect what is ultimately enacted. With this continued uncertainty, how do practitioners advise clients? As but one example, while the Act and the buzz around it promote across-the-board tax cuts, is that really the case? Will the 39.6% rate, coupled with SALT restrictions or eliminations effectively result in a tax increase or decrease? It is not clear for all taxpayers whether they will have an increase or decrease.
While the likelihood of the Act becoming law, or what changes that might be made, is unknown, the changes are dramatic and practitioners should begin considering the impact on clients and whether and to what extent to notify clients or modify planning and documents.