With a new tax law, it may be time to review or revise your Estate Plan.
The new federal tax law of 2017, The Tax Cuts and Jobs Act (the “Act”), modifies U.S. taxation for individuals and business. Estate Plans written prior to the enactment of this law will likely be affected by the significant changes to the federal estate, gift, and generation skipping transfer tax (each a “Transfer Tax” and collectively the “Transfer Taxes”) system.
This article examines some provisions of the tax code and important changes and continuities that may have an effect on your estate plan.
ESTATE AND GIFT TAX
Before January 1, 2018, transfers of assets during life or at death were subject to Transfer Taxes levied by the federal government. The law provided for an exemption from the estate and gift tax equal to $5,000,000 per individual, or $10,000,000 per married couple (also known as the “Applicable Exclusion Amount”). This exemption was indexed annually for inflation (for instance, the 2017 inflation adjusted exemption was $5,490,000 per individual). Prior to the Act, 2018 expected to see the exemption amount increase to $5,600,000 (or $11,200,000 for a married couple).
Gifts to individuals and certain trusts are not taxed until they exceed the annual exclusion ($14,000 in 2017 and $15,000 in 2018). Gifts in excess of this amount that are not subject to the marital or charitable deduction and are not made to cover qualified tuition or medical expenses become subject to a gift tax of 40% of their fair market value.
The amount of gift tax exemption consumed by an individual in his or her lifetime is deducted from the estate tax exemption available to that individual at the time of their death.
EXAMPLE: “Individual A” made taxable gifts of $1,500,000 in 2017. Consequently, Individual A’s available estate tax exemption was reduced to $3,990,000 (the $5,490,000 exemption minus the $1,500,000 of taxable gifts). If Individual A’s estate exceeded such amount upon death, the excess would be taxed at a 40 percent rate.
The Act has not affected the amount or application of the annual exclusion on gifts; the exclusion has been indexed to $15,000 for inflation according to schedule. The Act has, however, had a significant impact on the estate and gift tax exemption, which has been temporarily (through December 31, 2025) doubled to $10,000,000 per individual ($20,000,000 per married couple) to be indexed annually for inflation, rather than being indexed to $5,600,000 as scheduled. Now, should “Individual A” give $1,500,000 of taxable gifts in 2018 (and no others in his lifetime), the estate tax exemption available to him or her upon death is $8,500,000.
GENERATION SKIPPING TAX (“GST”)
The Act also temporarily doubles the exemption amount of the Generation Skipping Tax (“GST”) – a separate tax that applies to transfers to, or in trust for the ultimate benefit of, individuals two or more generations below the transferor (generally, grandchildren and more remote descendants). Although the amount of the exemption from the GST tax follows that of the gift and estate tax exemption, it is a separate exemption that is applied differently. If a transfer is subject to the GST tax and is not sheltered by a current or previous allocation of GST exemption, the GST tax is imposed at a rate of 40 percent. It is possible for both a gift or estate tax and a GST tax to apply to the same transfer, in which case the effective tax rate would be as high as 64 percent.
“Portability” is a term for the allowance of any estate tax exemption unused by a deceased spouse to be claimed by the surviving spouse. If the allowable exemption of the first spouse to die is not used following that spouse’s death (for example, because the deceased spouse’s taxable estate is not sufficiently large), it is deemed “portable” to the surviving spouse. This spouse may make use of the exemption either during lifetime or at death (or both), subject to certain requirements. The Act did not change the concept of portability.
Note: The GST tax exemption is not portable, and titling of assets is critical when a married couple’s estate plan is designed to utilize their GST exemption.
Commonly, when an individual dies, the assets that are included in his or her gross estate receive an income tax basis equivalent to their value at their date of death.
Note: There are certain important exceptions to the assets which receive a basis equal to their date of death value, such as retirement plans and IRA accounts.
If the assets have increased in value over time, the basis will increase (a “Step-Up”). Conversely, if the assets have decreased in value, the basis will decrease (a “Step-Down”). This basis is used to determine gain or loss on an asset’s subsequent sale or disposition after the decedent’s death.
The Act did not change the Step-Up for income tax purposes for assets included in a decedent’s gross estate to date of death values. This is a boon for millions of families, particularly for individuals with estates below the increased exemption amount who will not be subject to Transfer Tax but will nonetheless receive a significant income tax savings as a result of Step-Up.
Example A: Individual A purchases a stock at $15, and then sold it for $70. The basis would be $15 and the gain would be $55. Individual A would have to pay a capital gains tax on the $55.
Example B: Individual B purchases a stock at $15 and dies still owning the asset. The value of that stock at the date of Individual B’s death is $70. His or her beneficiaries would receive the asset with a Step-Up in basis to $70, eliminating the $55 gain and therefore there is no capital gains tax that would be imposed upon a gain resulting from a sale if sold at $70 or less.
PROJECTED ANNUAL INFLATION INDEX
The inflation adjusted exemption amount for the gift, estate and GST exemptions is expected to be approximately $11,200,000. The actual amount, however, will depend on how inflation is calculated under the Act.
Note: The final day of increased exemptions is December 31, 2025. On January 1, 2026, the exemption amounts will return to $5,000,000, indexed for inflation to 2026. This presents difficult planning problems as one might want to retain assets in one’s estate to obtain a Step-Up in basis based on today’s exemption amount but might request that if the exemption were lowered.
EVERY CLIENT SHOULD REVIEW THEIR ESTATE PLAN
The Act impacts each individual plan differently, and each plan should at least be reviewed and, perhaps, revised in light of the changes made by the Act.
The information contained in this article is summarized and synthesized from various sources. It is not intended to be, and should not be construed as, a substitute for professional legal or financial advice as completeness cannot be assured. Discuss your estate planning needs with us today.