Journal of Financial Planning: November 2018
Randy Gardner, J.D., LL.M., CPA, CFP®, is the founder of Goals Gap Planning LLC, delivering financial education to individuals and employer and professional groups.
Leslie Daff, J.D., is a state bar certified specialist in estate planning, trust, and probate law and the founder of Estate Plan Inc.
The tax cuts and jobs act, which was signed into law in December 2017, is complex and impacts numerous tax specializations, including individual, corporate, and international planning. Of course, estate planning has also been impacted by the Tax Cuts and Jobs Act. Although transfer tax changes made by tax reform are few, the doubling of the exclusion amount with a sunset will significantly affect estate planning for the next eight years.
The tax changes made, or not made, by the Tax Cuts and Jobs Act (TCJA) can be summarized in three bullet points:
- TCJA increases the basic exclusion amount for the gift, estate, and generation-skipping transfer taxes (the transfer taxes) from $5.59 million to $11.18 million ($22.36 million for a married couple), indexed for inflation. In 2026, the basic exclusion amount reverts to the 2017 amount of approximately $5.49 million, adjusted for inflation between now and then using the slower, newly enacted chained-CPI approach.
- The gift, estate, and generation-skipping transfer tax rates remain at 40 percent.
- The income tax basis rules for gifts and inherited property are retained. In other words, the donor’s holding period for and income tax basis in gifted property generally carry over to the donee, and the decedent’s income tax basis in property passed to heirs steps up or down to the property’s value on the date of death or the alternate valuation date six months later. Inherited capital assets are automatically treated as being held for longer than a year.
The Estate Planning Road Map
More than 99 percent of our clients will not owe a transfer tax, but every client is concerned with: (1) making sure they have decision makers in place when they are incapacitated; and (2) passing their property to loved ones or charities efficiently and at minimal cost when they pass away.
These and other non-tax estate planning goals are summarized in the table below. These goals are primarily accomplished through the documents in a basic estate plan, including a funded revocable living trust; a pour-over will that names an executor to deal with property not in the trust and a guardian for minor children; a durable power of attorney for finances naming a decision-maker to handle financial affairs and make final arrangements during incapacity; and a durable power of attorney for health care, a living will, and HIPAA authorization to enable a decision-maker to handle medical affairs when the client is not able to do so.
With these common estate planning goals in mind, estate planning documents should be reviewed to ensure the goals that the client considers most important are addressed. In particular, trusts that mandate the establishment of bypass trusts should be discussed with the grantors. Many documents executed before 2010 required the funding of bypass trusts up to the maximum amount possible without incurring estate taxes. This formula approach means that a client with a $3 million estate (even though the estate is not likely to be subject to estate tax now or in the future) will pass $3 million, the entire estate, to an irrevocable bypass trust.
Income Tax Planning Remains the Focus of Estate Planning
Although most of our clients will not owe transfer taxes, without thoughtful planning, their loved ones could owe income tax when they sell the property they inherited or received as gifts. The best strategy for most clients is to hold on to property until death to take advantage of the stepped-up income tax basis rules that apply to inherited property. Additionally, to the extent possible, the family may want to unwind estate-tax avoidance strategies to ensure income-tax avoidance.
Here are common income tax situations and strategies for handling them:
Situation: Terminally ill clients with properties that have declined in value from their purchase prices.
Strategy: The income tax basis of these properties could “step down” to the value of the property at the client’s death, meaning income tax basis is lost. It may be that the family will never sell the property and no adverse income tax outcome will occur. However, if the property will be sold after the client’s death, terminally ill clients with estates of less than $11.18 million in property will want to make sure they either sell or gift properties that have declined in value prior to their deaths, even if it means a gift tax return may need to be filed.
This approach will preserve for the survivors the potential of taking advantage of capital losses or recovering the donor’s basis. If transfer taxes will be owed when the client dies, the family needs to evaluate whether it is more beneficial to avoid income tax or transfer tax.
Situation: Securing stepped-up basis in appreciated property for the spouse and other beneficiaries.
Strategy: Bequests of appreciated property to children outright or in trust will step up at the decedent’s death. Bequests of appreciated property to spouses qualify for a full or partial step-up in income tax basis when the first spouse dies, avoid transfer taxes because of the marital deduction, offer the opportunity to make a portable exclusion election, and make it possible to receive an additional, full step-up in income tax basis when the surviving spouse dies. The bequest can be outright, but usually the transfer is to a survivor’s trust or QTIP trust.
Situation: Avoiding the creation of bypass trusts and getting property out of already-funded irrevocable trusts.
Strategy: By design, property held in bypass trusts generally does not receive a stepped-up basis when the surviving spouse dies. Clients who have revocable trusts that call for the creation of a bypass trust after the first death should make sure this approach still meets their needs and possibly restate their trusts to make funding of a bypass trust optional.
If a client currently has a survivor’s trust and bypass trust because the first spouse has died or because of planning from 2012 and other periods when transfer tax exclusions were lower, the property in the bypass trust or other irrevocable trust will generally not receive a stepped-up basis when the surviving spouse dies. The descendants may pay income tax on capital gains from the sale of property after the surviving spouse dies.
Some states allow all the beneficiaries of the bypass trust to agree to rescind the bypass trust, releasing the property to the surviving spouse, making it possible for the remainder beneficiaries to receive a stepped-up basis when the surviving spouse dies. In other states, a court petition may be needed to execute these strategies.
Situation: Irrevocable trust modifications.
Strategy: Other strategies for achieving a stepped-up basis for property in a bypass trust or other irrevocable trust include: (1) modifying the terms of the trust to provide the primary beneficiary with a general power of appointment; or (2) shifting the trust assets to a trust with more desirable terms (decanting).
In order to make these modifications, some families change the trust situs from a state with strict laws to a state with more favorable laws.
Situation: Upstream gifts—this is children gifting appreciated property to their parents in order to receive a stepped-up basis when the parent dies.
Strategy: With the higher gift tax exclusion, it may make sense for a child to gift low-basis/high-value property to a terminally ill parent to receive a stepped-up basis when the parent bequests the property back to the child. The idea has merit: the child uses part of his or her gift tax exclusion, but incurs no gift tax, and could avoid a significant income tax with the stepped-up basis.
For this strategy to work, however, there are obstacles to overcome. First, the parent will own the property; the child must trust that the parent will bequeath the property back to the child. Second, the parent must live for at least one year before the property is passed back to the child. This one-year requirement can be avoided and an additional benefit obtained by bequeathing the property to an irrevocable trust for the benefit of the child, rather than directly to the child. The stepped-up basis is still obtained, but in addition, the irrevocable trust protects the property originally owned by the child from the risks of the child’s creditors, divorce, and predators.
Planning for the 1 Percent Who Will Likely Owe Estate Tax
Some of our clients will die owning assets in excess of $11.18 million ($22.36 million for married couples). If Congress does not change the law, after 2025, these amounts revert to $5.49 million ($10.98 million for married couples), adjusted for inflation.
What about “clawback”? Clawback refers to the possibility that a gift made between 2018 and 2025 might result in estate tax, if the estate tax basic exclusion amount is decreased after 2025 and is lower than the amount of gifts made during the eight-year period at the time of the donor’s death.
The current statute is ambiguous about clawback, while the Form 706 estate tax return instructions appear to require clawback. The difference in 2018 from 2012 is TCJA directs the Treasury department to release regulations that address any difference in the basic exclusion amount at the time of the gift and at the time of death.
Some estate planners say clawback is a concern until Congress clarifies the statute; others say clawback is not an issue, because Congress did not intend for it to occur; and still others say clawback will not be an issue, because the basic exclusion amount has never decreased (although it was supposed to in 2012 and is currently scheduled to decrease in 2026). Without certainty, many financial planners and tax advisers are hesitant to recommend—and clients are reluctant to make—large gifts during this eight-year period.
If Treasury guidance eliminates clawback as a concern, these clients will likely engage in traditional income-tax and estate-tax avoidance strategies as soon as possible, because the law could be changed back as soon as the next round of elections.
Traditional Tax-Avoidance Techniques
The following strategies avoid estate tax at the expense of stepped-up basis and possibly higher income tax.
Situation: Transfer tax avoidance.
Strategy: Remove appreciating assets from the estate during life by establishing irrevocable trusts for the spouse (spousal lifetime access trusts, or SLATs), children (qualified personal residence trusts, or QPRTs), and charities (charitable remainder trusts, or CRTs).
Remove appreciating assets from the estate at death by electing portability when appropriate and taking advantage of irrevocable trusts, such as bypass trusts, which incorporate generation- skipping language.
Situation: Liquidity planning.
Strategy: Life insurance strategies, such as irrevocable life insurance trusts (ILITs), and section 6166 payment deferral elections will continue to be used.
Situation: Exemption leveraging.
Strategy: Form entities, such as family limited partnerships and limited liability companies, and engage in gifts and sales that freeze the value of assets and take advantage of discount opportunities. Examples of this include transfers to grantor retained annuity trusts (GRATs) and intentionally defective grantor trusts (IDGTs).
Situation: Income tax avoidance.
Strategy: Take advantage of strategies that lead to a stepped-up basis, such as using QTIPS rather than bypass trusts and formula general power of appointment clauses.
Financial planners will need to help clients optimize the level of estate tax and income tax using the post-mortem planning paths built into the estate planning documents. Although many clients may have removed estate tax planning from their to-do lists because of the high exclusion amounts, planners should carefully review their clients’ estate planning documents and project their estate values to see if there are planning opportunities during the next eight years.