Important Tax and Estate Planning Update
Published: October 18, 2019
You may have heard by now that the Gift and Estate Tax exemption amount was increased by the Tax Cuts and Jobs Act of 2017, which became effective on January 1, 2018. This article is to highlight some of the key estate planning issues under the new tax law.
In 2019, the Gift and Estate Tax exemption as adjusted for inflation is $11.4 million, and in 2020, the exemption amount will be increased to $11,580,000. Historically, this is the highest the exemption has ever been. The exemption will continue to increase incrementally due to a built-in inflation adjustment until January 1, 2026, when, absent an act of Congress, the exemption will be decreased to about $6 million. The value of a decedent’s estate in excess of the available exemption upon death will be subject to a 40% estate tax.
This dramatic increase (and future expected decrease) in exemption poses a range of estate planning issues which affect all clients, regardless of the amount of your wealth. There are also some opportunities for tax savings.
Income Tax Issues
Married couples with assets under $6 million in value (per spouse, if applicable) who had taxable estates under the previous estate tax laws – in 2008, the exemption was only $2 million, and in 2000, it was only $1 million! – may wish to update their estate plans for current income tax planning considerations.
For many years, it has been the practice of estate planners to prepare estate plans to minimize estate tax. The standard estate plan that has been developed for this purpose divides a couple’s assets upon the first spouse’s death into a Bypass Trust (also sometimes referred to as a Credit Shelter Trust), Marital Deduction Trust and Survivor’s Trust.
Generally, the Bypass Trust is funded with assets equal in value to the deceased spouse’s available exemption amount and is exempt from estate tax in the surviving spouse’s estate. The Marital Deduction Trust receives the balance of the deceased spouse’s assets. The Survivor’s Trust receives the surviving spouse’s assets.
Upon the death of the first spouse, all of the couple’s community property and the deceased spouse’s separate property receive a new income tax basis equal to the fair market value on the date of death. This is often referred to as a “stepped up” basis. Upon the death of the surviving spouse, the assets of the Survivor’s Trust and Marital Deduction Trust receive a second step up in basis; but the assets of the Bypass Trust do not generally receive a second step up in basis.
Under the current law, many estates are now well below the exemption levels, meaning that all of a deceased spouse’s assets will pass to the Bypass Trust. The Bypass Trust is exempt from estate tax and will not be included in the survivor’s estate for estate tax purposes, but that is beside the point if the assets are not expected to be subject to estate tax to begin with. Unfortunately, due to this bypassing feature, the Bypass Trust assets will not receive a second step up in income tax basis to the fair market value on the surviving spouse’s death. This is a missed opportunity for income tax savings.
Some couples may wish to remove the Bypass Trust altogether, leaving the assets to the surviving spouse outright. This is typically referred to as a “Sweetheart Trust”. However, there may be non-tax benefits to keeping the trust structure such as creditor protections and ensuring that assets pass to the deceased spouse’s intended beneficiaries upon the surviving spouse’s death.
Another option is to include provisions in the Bypass Trust to permit the surviving spouse to elect to take a marital deduction from estate tax with respect to the assets passing to the Bypass Trust. If the election is made by the survivor, the assets of the Bypass Trust will be included in the survivor’s estate upon his or her death and will receive a second step up in basis. The surviving spouse may consider, based on the tax law then in effect, whether it makes more sense to shelter the assets from estate tax (depending on the available estate tax exemption at that time) or to receive a second step up in basis.
In general, clients may wish to review their estate plans to add flexibility for tax planning by the surviving spouse, given the changing estate tax laws in the past several years. For example, the surviving spouse may be given a power to withdraw 5% of the Bypass Trust per year with little tax effect. This may come in handy if the surviving spouse wishes to selectively include assets in his or her estate for purposes of receiving the second step up in basis.
Note About Funding Pecuniary Bequests
If the revocable trust provides for a division into subtrusts upon the death of the first spouse, an outdated formula bequest may cause unintended income tax consequences.
The formula bequest between a Bypass Trust and Marital Trust typically provides for a dollar amount to be funded to one trust – this is a “pecuniary” bequest – and the balance to go to the other trust. When the pecuniary trust is funded, the transfer of assets to that trust is treated as a sale and will trigger income tax gain if an asset has appreciated in value from the date of death when the basis was stepped up. When the residuary trust is funded, any appreciation in value is not subject to income tax or estate tax.
The increase in estate tax exemption may cause all or the majority of a deceased spouse’s assets to pass to the Bypass Trust. If the Bypass Trust is a “pecuniary” trust, the surviving spouse may be advised to fund that trust quickly to avoid gain on funding if the assets appreciate in value from the date of death.
However, the funding formula may be amended in the estate planning documents to provide for the “pecuniary” amount to be distributed to the subtrust which is expected to be of lesser value (i.e. typically, now with the larger exemption amount, the Marital Deduction Trust) and the balance of the deceased spouse’s share of assets to the subtrust receiving the majority of the deceased spouse’s assets (i.e. typically, now the Bypass Trust). This will be different for each couple depending on the value of the estate and the available estate tax exemption.
Generation Skipping Transfer Tax Planning
Many estate plans include continuing Exempt Family Trusts to utilize the Generation Skipping Transfer (“GST”) tax exemption. The GST tax is imposed on transfers to grandchildren or more remote descendants and unrelated persons who are at least 37 ½ years younger than the grantor. Exempt Family Trusts are not subject to estate tax or GST tax and therefore are typically held in trust for the life of the beneficiary. This is to avoid inclusion of the assets in the beneficiary’s estate for estate tax purposes.
The GST tax exemption amount currently mirrors the estate tax exemption amount. In 2019, the GST tax exemption is $11.4 million per person, and in 2020, it will be increased for inflation to $11,580,000. The GST tax exemption is scheduled to be reduced to $6 million beginning January 1, 2026.
Under the prior lower exemption levels, many clients planned for both Exempt Family Trusts and non-exempt shares that would pass outright to children and/or grandchildren upon attaining a certain age. However, if the value of an estate does not exceed the new exemption levels it may be that all of the assets pass to the Exempt Family Trusts. Because the assets will not be included in the beneficiary’s estate, whether or not such estate tax planning is warranted, the assets will not receive the step up in basis upon the beneficiary’s death.
Clients may wish to review their estate plans to make sure the provisions for funding Exempt Family Trusts continue to reflect their wishes. There are non-tax benefits to assets passing in trust, such as creditor protections; however, clients may wish to designate a certain amount to go outright to their children and/or grandchildren.
In addition, the estate planning documents may be amended to add flexibility to address changing tax laws. For example, the beneficiary may be given a power to withdraw 5% of the trust per year in order to selectively include assets in his or her estate for purposes of receiving the basis step up. Also, provisions may be added for someone other than a beneficiary, such as a special trustee or trust protector, to have the power to address changes in tax laws.
Gift and Estate Tax Planning with an $11.4 Million Exemption
On January 1, 2026, any unused exemption in excess of $6 million will simply “disappear”. Clients with taxable estates under the current law (i.e. clients with assets valued at over $11.4 million, per spouse if applicable) may wish to consider making gifts in excess of the future $6 million exemption amount before 2026 in order to utilize the disappearing exemption amount.
Clients that do not have taxable estates under the current law, but who have assets valued at over the $6 million threshold (per spouse, if applicable) that will be implemented in 2026, may also wish to consider making gifts in order to take advantage of the disappearing exemption amount.
When considering making large gifts, clients are encouraged to prioritize maintaining sufficient assets to meet their own income needs. However, certain assets can be gifted with little effect on income, such as a residence or vacation property. For example, a gift to a Qualified Personal Residence Trust allows the grantor to live in or use the residence rent-free for a term and then for the rest of the grantor’s life pursuant to a rental agreement.
There are also charitable giving strategies available which provide a source of income to the grantor, such as a Charitable Remainder Trust. A CRT may be of interest to clients who have named charitable beneficiaries upon death but want to be able to take advantage of the charitable deduction from income tax during life, or to offset capital gain on the sale of a property or business.
This article in no way covers all of the potential tax issues or options available to you. We are pleased to review your estate plan at any time.