Journal of Financial Planning: October 2017
David M. Cordell, Ph.D., CFA, CFP®, CLU®, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFA, CFP®, is a professor of business law at Roger Williams University in Bristol, Rhode Island.
There has been much talk about tax reform recently, but little action. The partisan divide that has characterized Washington over the past several years has prevented any meaningful attempts to make substantive changes to the tax code. Since the 2016 election, the new administration and Congressional leaders have indicated that tax reform will be a top priority. While there has been little done on that front as of the date of this writing, Washington insiders are still suggesting that tax reform measures will be passed by the end of the year. On the agenda for reform is the income tax and the estate tax.
What’s the Future of the Estate Tax?
The president and several prominent members of Congress have proposed a complete repeal of the estate tax that would be partially offset by limiting the step-to basis provision of Section 1014. Should this proposal be adopted, this would be a real win for affluent taxpayers.
Currently, up to $5.49 million of transfers made during lifetime and at death is exempt from estate tax, and transfers over this amount are subject to a federal estate tax of 40 percent. Under the proposal, nobody would be subject to estate tax, and all taxpayers would have a capital gains tax exemption of up to $10 million per person. Upon death, appreciation on assets over the first $10 million would be subject to tax at capital gains tax rates, which are currently 20 percent (plus applicable Affordable Care Act surtaxes of up to 3.8 percent), instead of the current 40 percent estate tax.
Because only gains would be taxed under the proposal, a deceased taxpayer’s basis in his or her assets would not be subject to any tax at all. Overall, adoption of this approach would result in significant transfer tax savings for wealthy individuals, completely exempting deceased taxpayers with less than $10 million in appreciation from capital gains tax on that appreciation.
Of course, not everyone is happy with the proposal. Democratic leaders in Congress are opposed to adopting this change because it would result in tax savings for wealthy individuals and would (although minimally) reduce federal revenues. Despite this opposition, Republican leadership seems intent on enacting a repeal. Only time, and D.C. sausage-making, will reveal the outcome.
The Impact on Existing Estate Plans
Let’s assume that Congress repeals the estate tax. Just think how good that will be for some clients. Much of the complex planning that clients had to engage in in the past will no longer be necessary. Many transfers designed primarily to save estate taxes will no longer be required. Life insurance policies purchased to provide liquidity for the estate or to pay estate taxes will no longer be needed. Long-term trusts structured to remove intergenerational wealth from the transfer tax system will become an albatross for the family and can be unwound.
Planners and their clients can move to simplify their wealth transfer plans and unwind the complex, costly structures and insurance policies used to avoid or ease the burden of the estate tax.
After briefly basking in the warm rays of this fantasy, reality slowly starts to set in. Is it wise to unwind the work of the past just because Congress made a change to the tax law? Yes, the estate tax may be repealed and replaced with a less expensive and less complex capital gains tax, but how permanent will that repeal be? Haven’t we seen this before?
In 2001, Congress (which was effectively under the control of the Republicans) passed legislation that increased estate tax exemption over time, leading to a temporary repeal of the estate tax in 2010. The repeal was short lived. Budgetary concerns required the repeal to be subject to a sunset provision, causing the old estate tax to come back into existence in 2011. Congressional leaders, however, could not leave well enough alone.
In 2010, prior to the sunset of the estate tax repeal, Congress (which at that point was under the control of the Democrats), retroactively reinstated the estate tax for 2010 while giving some special planning options for those who died prior to the enactment of the retroactive reinstatement of the tax.
The Taxpayer Relief Act of 2012, passed after Republicans had again gained control of the House of Representatives, increased the estate tax exemption and lowered the estate tax rate. Within three weeks of signing that legislation into law, Democratic President Barack Obama’s annual budget proposed to roll back the estate tax exemption and increase the estate tax rates.
The point, of course, is that changes to law may appear to have permanence, but those changes are only as permanent as Congress wants them to be. If a Republican president and Congress are successful in repealing the estate tax this year, there is a distinct possibility that a future Democratic president and Congress will bring it back.
Don’t Just Do Something, Stand There!
Many wealthy clients have spent a lot of time and resources creating an estate plan and establishing the structures necessary to implement it. Some of these structures, such as life insurance trusts (ILITs), require years to fund and, should they be terminated, may be very difficult to replace.
Terminating a life insurance trust and distributing its value may seem to make sense if the estate tax is repealed. After all, the death benefit will no longer be needed to provide estate liquidity and those resources could be tapped to satisfy other financial goals of the taxpayer.
If an ILIT is terminated, however, and if the estate tax is resurrected in future years, a client may be worse off than if they had left the original arrangements in place. If, for example, the client becomes uninsurable after the trust is terminated, it will be impossible to replace the life insurance policy. Even if a client is insurable, starting from scratch will significantly increase the costs associated with life insurance funding due to the increase in the insured’s age. Furthermore, unwinding irrevocable trusts that provide asset protection as well as estate planning benefits to the taxpayer (such as an ILIT) will subject more of a taxpayer’s wealth to the claims of potential creditors. And don’t forget that the life insurance policy will ultimately add to the estate.
One subject that has been largely ignored in discussing transfer tax change proposals is whether the gift tax and the generation-skipping transfer tax will also be repealed. Some commentators have suggested that those taxes may be retained. Should Congress choose to keep gift and/or generation-skipping taxes in place, clients will have a greater incentive to stick with their original wealth transfer plans—or at least, minimize changes to those plans, because the continued presence of those taxes will require planning to avoid them. With estate tax policy in constant flux, it would be dangerous to quickly undo those structures simply because an apparently permanent repeal of the estate tax is enacted this year.
What Does the Future Hold?
Through its actions over the past 16 years, Congress has created an environment of uncertainty for clients and planners who are concerned with wealth transfer planning. The temporary phase-out of the estate tax that automatically returned upon sunset in the early 2000s, and the constant partisan bickering over the direction of transfer tax policy has made the planning environment a risky place where the transfer tax outcome a client will face may simply be a function of which political party won the last election.
Pardon our cynicism when we suggest that it is perhaps generous to refer to these shifts as policy changes when it has become apparent that the real motivation for the politicians seeking to change the law is a desire to reward those who support them and punish (by increasing taxes on) those who do not.
A stable, policy-oriented transfer tax policy based on economic and societal concerns would provide certainty and reduce planning risk for clients; but, alas, in the current political climate that goal seems unattainable. Given the risks that clients face in a tax-planning environment dictated by the often unpredictable outcomes of political elections, caution is required when making changes to wealth transfer plans, and especially those plans that involve the use of life insurance funding.