The Tax Cuts and Jobs Act (“TCJA”), effective January 1, 2018, made sweeping changes to the Tax Code, including the doubling of the estate, gift and generation skipping transfer tax exemption amounts. These changes should prompt taxpayers to take another look at their estate plans and to update them where appropriate.
The increased exemption amounts are scheduled to “sunset” in 2026, at which time they will return to $5 million per taxpayer, indexed for inflation. However, taxpayers can take advantage of this temporary increase through strategies designed to “lock-in” the current, record-high exemption amount and avoid future transfer taxes permanently.
Taxpayers can now gift $11.2 million (or $22.4 million if married and gift-splitting) without incurring gift tax. The estate tax benefit of making large gifts is that it reduces the overall value of the taxpayer’s estate (assuming that the taxpayer does not die within three years of making the gift). Taxpayers can achieve even greater estate tax savings by gifting highly appreciable assets. For example, if, in 2020, a married couple makes a gift of $14 million worth of stock to a trust for the benefit of their child and, by the time of the last taxpayer’s death eight years later, the stock has doubled in value, the taxpayers have effectively reduced the size of their estate by $28 million while still providing their child with the full value of the asset. This gift of $14 million would not be subject to gift tax even when the gift tax exclusion amount returns to its pre-2018 threshold of $5 million for individuals and $10 million for married couples.
However, because, under the TCJA, inherited property still receives a step-up in basis, taxpayers will want to consider the capital gains tax implications of making gifts. In some cases, the capital gains tax savings of the step-up in basis may outweigh the estate tax savings of a lifetime gift.
Taxpayers may also consider taking advantage of the new exemption amounts by establishing dynasty trusts. Dynasty trusts are irrevocable trusts structured to last the maximum term permitted by law (in perpetuity in some states, such as New Jersey) and to avoid the imposition of transfer taxes – particularly generation-skipping transfer taxes – during the trust term. The generation skipping transfer tax is a tax imposed upon transfers to individuals more than one generation below the transferor (a grandchild, for example). When coupled with the estate or gift tax, further imposition of the generation skipping transfer tax could result in an effective tax rate of up to 64%. As a result, avoidance of the generation skipping transfer tax could result in significant savings.
To maximize tax savings, a taxpayer can transfer the full gift tax exemption amount ($11.2 million) to the dynasty trust and allocate the full generation skipping transfer tax exemption amount (also $11.2 million) to the transfer. The property transferred to the trust can grow without incurring any transfer taxes (and, in some jurisdictions, state income tax) and the taxpayer will have reduced the value of his/her estate by the appreciated value of the transferred property. The taxpayer can further reduce the value of his/her estate by making annual exclusion gifts to the trust (currently $15,000 per year). Dynasty trusts can also be made flexible, to account for changes in the tax laws and in personal circumstances, and can include provisions to allow the taxpayer to be added as a beneficiary at a later date.
The TCJA permanently expands the benefits of 529 education savings plans by allowing for tax-free distributions to be used for elementary and secondary school expenses, not just higher education expenses. These plans are now more valuable to taxpayers – particularly those who pay private school tuition for their elementary- and secondary-school aged children – and can be utilized as an estate planning tool. Contributions to 529 plans are excluded from a taxpayer’s gross estate even though he/she retains the right to change beneficiaries and take back the money. Further, taxpayers can aggregate five years’ worth of annual exclusion gifts into one year – for example, in 2018, when the annual gift tax exclusion is $15,000, a taxpayer engaged in estate planning could contribute $75,000 (or $150,000 for married couples) without triggering gift or generation skipping transfer tax or using up any amount of exemption. A taxpayer could thus reduce his/her gross estate by up to $150,000 per child every five years.
Charitable giving has long been a strategy for reducing a taxpayer’s gross estate, and is attractive because the taxpayer gets the simultaneous benefit of the charitable deduction for income tax purposes. The TCJA increases the charitable deduction limit from 50% of adjusted gross income to 60% of adjusted gross income.
In addition to the increased estate, gift and generation skipping transfer tax exclusion amounts, the TCJA may well trigger the formation of an unprecedent number of pass-through entities, meaning that many taxpayers will have to update their estate plans to account for business succession.
Perhaps the component of the TCJA that has received the lion’s share of attention has been the 20% deduction available to pass-through entities, such as sole proprietorships, partnerships and S Corps. While the effect of this component remains to be seen, it is foreseeable that the number of pass-through entities will increase significantly in the coming years. From an estate planning perspective, it is important that taxpayers organizing themselves as pass-through entities put into place a business succession plan. A business succession plan provides what happens to an owner’s share of the entity upon his/her death. Buy/sell agreements – in which the deceased owner’s estate is obligated to sell, and the remaining owners are obligated to buy, the interest in the entity – are common solutions.
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