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Tax reform and estate planning

Consider these 6 key strategies designed to help reduce taxes and maximize flexibility.

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Key takeaways

  • 2018's tax reform had far-reaching implications, including an increase in the federal estate tax exclusion.
  • The new tax law is even more reason to review any estate planning you have done.
  • But be careful not to simply undo prior planning, as many aspects of the new laws are set to return to pre-2018 laws at the end of 2025.
 

In late 2017, significant tax reform impacting virtually all areas of existing federal tax law was enacted. The sharp increase in the federal estate tax exclusion to $11.14 million for 2018 left some people thinking estate planning was not so important anymore. That could be a dangerous assumption since the higher exclusion is slated to return to only $5 million (inflation indexed) at the end of 2025.

Given the uncertainty, you might want to plan defensively. Here we look at 6 key estate planning considerations to discuss with your attorney and tax advisor. They could save you and your heirs a considerable amount.

1. Review trust funding strategies at death

Prior to 2018, many estate plans included credit shelter trust strategies—which allow married couples to take full advantage of state and federal estate tax exclusions. This trust strategy is often structured so that upon the passing of the first spouse, specified assets (often a dollar value up to the federal estate tax exclusion) pass to the credit shelter trust. These assets then flow to the surviving spouse, but due to the nature of the trust, the surviving spouse never actually owns or takes control of the assets. Therefore, the trust assets are not included in the surviving spouse's taxable estate.

For an estate smaller than the new federal estate tax exclusion amount ($11.4 million for 2019), such a strategy has the potential to transfer the entire estate to the credit shelter trust, which could limit the surviving spouse's flexibility and direct access to the funds.

Furthermore, in states with a state estate tax, having an entire estate pass to a credit shelter trust may also generate state estate taxes at the first spouse's death, unless the trust language limits the assets transferred to the lower of the state or federal estate tax exclusion. Therefore, it may be prudent to review such a strategy with your tax and legal advisors to determine if it still makes sense.1

2. Focus on flexibility

Many of the changes enacted by the Tax Cuts and Jobs Act, including the higher federal estate tax exclusion, are currently set to expire at the end of 2025. As a result, the federal estate tax exclusion amount will be reduced back to $5 million (inflation indexed) after 2025. In light of this, building flexibility into trust arrangements will be important, particularly for estates in the $5 million to $22 million range. It is possible that some trust provisions to reduce estate tax exposure may be unnecessary (or undesirable) for those without estate tax concerns.

Some of the ways to consider adding flexibility to trust strategies include:

  • Allow beneficiaries to make changes
    An individual establishing a trust may choose to enable beneficiaries to change the terms of a trust to benefit their heirs or named charities. For example, a trust may state that upon a beneficiary's passing, all assets will be split equally among the beneficiary's 2 children. However, if the original trust permits, the beneficiary could change these terms so that upon their death, one child would receive 30% and the other would receive 70% of the remaining trust principal.
  • Allow trust assets to be distributed to a new trust, with new terms
    When creating a trust it is also possible to permit the trustee to distribute trust assets to another trust (with different terms) for the benefit of one or more beneficiaries of the first trust. Such flexibility would allow the trustee to modify the terms under certain circumstances.2
  • Give the grantor the ability to substitute trust assets for tax purposes
    It's possible to allow a grantor to pay an irrevocable trust's taxes or substitute low-cost-basis trust assets with high-cost-basis assets in their name to take advantage of a step-up in cost basis at death. This lends a certain level of flexibility to the trust strategy to make changes and help reduce tax liability.
  • Provide special modification powers to trust protectors
    A trust protector is someone who has the authority to perform special duties with regard to a trust. These duties may involve directing trustees in their administration of the trust. Enabling trust protectors to modify certain details of the trust could provide enhanced flexibility, such as changing the physical location of trust assets for the purposes of legal jurisdiction or directing the trustee regarding certain actions, among others.
 

3. Try to maximize a spouse's unused exclusion amount

Portability, a concept introduced in 2010, means that if one spouse dies and does not make full use of their federal estate tax exclusion, the surviving spouse can make an election to add any unused federal estate tax exclusion from the first spouse to their exclusion amount. If the first spouse dies before the last day of 2025, while the federal estate tax exclusion amount is still $11.4 million (inflation indexed), the portability election should leave the surviving spouse with the deceased spouse's unused federal estate tax exclusion of that full amount even when the basic exclusion amount decreases at the end of 2025.3

To illustrate the potential benefit of electing portability, consider the following 2 hypothetical scenarios:

Scenario 1

Judy and Jim are married and have a net worth of $24 million. Jim passes away in 2019 with all of his federal estate tax exclusion left and portability is not elected. All assets are left to his wife, Judy, and no credit shelter trust is used. Judy passes away in 2026 (when the federal estate tax exclusion is scheduled to return to the 2010 level of $5 million, inflation indexed); Judy will only have the pre-tax reform federal estate tax exclusion ($5 million, inflation indexed) to offset federal estate taxes. Assuming that Judy's estate is still worth $24 million, she will have approximately a $7.6 million estate tax liability (see calculation below).

Jim and Judy's estate Jim's death (2019) Judy's death (2026)
$24M No portability election Judy's total estate: $24M
    −Judy's estate tax exclusion: $5M
    $19M x 40% federal estate tax rate
    = $7.6M estate tax liability
 

Scenario 2

Jim passes away in 2019 with all of his federal estate tax exclusion left and portability is elected. Judy passes away in 2026 (when the federal estate tax exclusion is scheduled to return to the 2010 amount, inflation indexed). Judy will have the pre-tax reform federal estate tax exclusion ($5 million, inflation indexed) and $11.4 million of Jim's unused federal estate tax exclusion to offset federal estate taxes. Assuming that Judy's estate is still worth $24 million, she will have an approximate $3 million dollar estate tax liability (see calculation below).

Jim and Judy's estate Jim's death (2019) Judy's death (2026)
$24M  Portability election Judy's total estate: $24M
    −Judy's estate tax exclusion: $5M + $11.4M
    $7.6M x 40% federal estate tax rate
    = $3M estate tax liability
 

For illustrative purposes only. Assumes no state estate tax and no inflation adjustment was made to the federal estate tax exclusion amount.

4. Think twice about undoing prior planning

If the estate tax had been eliminated as part of the Tax Cuts and Jobs Act, as some had expected, some individuals may have considered undoing prior planning they had done to avoid estate taxes. Some individuals may still be considering it given the increase in the federal estate tax exclusion. However, the uncertainty about what will happen after 2025 suggests individuals should exercise caution when it comes to undoing any prior planning because the doubling of the federal estate tax exclusion amount is set to last only 8 years.

Consider the following hypothetical scenario:

Mary and Tom had a net worth of $20 million and formed an irrevocable life insurance trust (ILIT) in 2011 with a guaranteed universal life second-to-die life insurance policy with a face value of $5 million. The rationale at the time was that with a $5 million of federal estate tax exclusion for each of them, their taxable estate would be estimated at $10 million with a $4 million estate tax liability ($20 million less $10 million of federal estate tax exclusion, equals a $10 million taxable estate at a 40% federal estate tax rate). The life insurance proceeds would then be enough to cover the estate tax liability following their deaths.

Estate: $20M
  − $10M federal estate tax exclusion ($5M for Mary and $5M for Tom)
  $10M x 40% federal estate tax rate = $4M estate tax liability
 

For illustrative purposes only. Assumes no state estate tax and no inflation adjustment was made to the federal estate tax exclusion amount.

Fast forward to 2019 (and assume Mary and Tom still have a net worth of $20 million). They now have $22.8 million federal lifetime estate tax exclusion and no estate tax concern. Therefore, they may be inclined to stop paying the premiums on the life insurance policy and collapse the ILIT. However, if Mary and Tom live beyond 2026 when the federal estate tax exclusion is set to go back to $5 million (inflation indexed), cancelling the policy could have dire consequences. Mary and Tom may no longer be insurable if they want to apply for another policy in the future and the policy may be beyond its most heavily commissioned years.

5. Consider upstream gifts of low-cost-basis assets

Individuals whose parents do not have federal estate tax concerns (even if they live past 2025), may be able to make gifts of low-cost-basis assets to their parents, in hopes of getting a step-up in cost basis at the parents' deaths. The assets would then be transferred to children or other beneficiaries, without built-in capital gains. (Note that steps should be taken to protect against potential negative tax consequences in case the donee should die within one year of the gift.4)

Consider the following hypothetical scenario:

Sue and Brian have a net worth of $50 million (and still have their full federal estate tax exclusions). Brian's parents, who are in their late 80s, have a net worth of $500,000 (and they also have their full federal estate tax exclusions). Sue and Brian want to make a gift to their children of 50,000 shares of Apple stock, which they purchased in 2005 for $5 per share. Let's assume that Apple stock is currently worth $167 per share and Sue and Brian have approximately $8.1 million of unrealized gains in the stock.

If Sue and Brian were to gift the stock to their children, their children would assume the same $5 per share cost basis that their parents had and be stuck with significant built-in capital gains. However, if Sue and Brian were to gift the Apple stock to his parents and, in turn, his parents transfer the stock to their grandchildren upon their death, the Apple stock will receive a full step-up in basis and the grandchildren will receive the stock with zero immediate income-tax ramifications.5

6. Be strategic about splitting gifts

Gift splitting allows a lifetime gift made from one spouse to be treated as though it is coming from both spouses. The election is made by reporting the transfer on a federal gift tax return. However, given the higher federal estate tax exclusion amount, in some cases, it may not make sense to gift split.

Consider the following hypothetical scenario:

Jen and Mark are married. If Mark makes a $10 million lifetime gift in 2019 and elects to split the gift, that gift will be treated as coming from both Jen and Mark. Thus, when Jen and Mark die, their estate representatives will need to reduce each of their federal estate tax exclusion amounts significantly (e.g., their $11.4 million federal estate tax exclusions would be reduced by the $10 million lifetime gift that was split, thus reducing each exclusion by $5 million). After 2025, when federal estate tax exclusions revert back to $5 million (inflation indexed), Jen and Mark will have very little, if any, federal estate tax exclusion left.

If, on the other hand, Mark did not gift split in 2019 and chose to make the gift entirely from his own assets, Jen will still have all of her federal estate tax exclusion left after 2025.

For married couples who plan to make significant lifetime gifts and wish to preserve some or all of the surviving spouse's federal estate tax exclusion after 2025, consider if it makes sense to gift split or not prior to 2025. The topics outlined above are some examples of considerations that 2018's tax reform has brought front and center. As a general rule, think about reviewing your estate plans with your tax and legal advisors on a regular basis to make sure your plans still align with current laws and your unique needs.

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