The Tax Cuts and Jobs Act of 2017 (the “Act”) was signed into law by the President on December 22, 2017, and represents one of the most significant rewritings of the federal tax code since 1986. Among its many changes to the tax laws, the Act doubles the estate, gift and generation-skipping transfer “GST” tax exemptions, which could affect estate planning decisions and tax planning strategies.
The increases to the estate, gift and GST tax exemptions took effect on January 1, 2018, but those changes are temporary and are currently set to expire at the end of 2025.
The key changes made to the transfer tax rules under the Act are summarized below:
Transfer Tax Exemptions: The Act increases the estate, lifetime gift and GST tax exemptions from a base of $5 million to a new base of $10 million (indexed for inflation). After taking into account inflation, in 2018, the exemption will be $11,180,000 (or a combined $22,360,000 for a married couple). These increases will only last until the end of 2025, at which time the exemptions will revert to the amounts under the current law with a base of $5 million (indexed for inflation).
Transfer Tax Rates: The top marginal tax rate for the federal estate, gift and GST tax are not impacted by the Act and will remain at 40 percent.
Portability: The portability rules for married couples will also remain unchanged under the Act. The portability rules allow a surviving spouse or his or her estate to make use of any unused estate and gift tax exemption remaining from the estate of the first spouse to die.
New 20 Percent Pass through Deduction on Qualified Business Income
Annual Gift Tax Exclusion: While not part of the Act, the annual gift tax exclusion increased from $14,000 in 2017 to $15,000 in 2018 (or $30,000 for married couples). The annual exclusion is the maximum amount that a donor can give to another individual without incurring gift tax consequences. In future years the annual exclusion amount may increase after adjustment for inflation.
The Act creates a new deduction of up to 20 percent of Qualified Business Income (“QBI”) for owners of pass-through entities. This new deduction will be available for business owners to take on their 2018 income tax returns.
The requirements for utilizing this deduction are summarized below:
Available only to Pass-Through Entities: This new deduction is available exclusively to owners of pass-through entities such as partners of partnerships, members of limited liability companies, shareholders in S corporations, and sole proprietors.
Qualified Business Income: QBI is the net income from the business throughout the year as determined by deducting all of your business deductions from your business income. QBI does not include compensation received from the business. If a taxpayer is an owner of multiple pass-through entities, QBI is calculated separately for each entity.
Limitations on the Deduction: In order to claim the deduction, you must have taxable income. A taxpayer is allowed the entire 20 percent deduction if the taxpayer’s income is below $157,500 individually ($315,000 if married filing jointly). If the taxpayer’s income exceeds the stated limits, the deduction is phased out. For taxpayers who are service business owners (health, law, accounting, etc.), the deduction is phased out completely when the taxpayer’s income exceeds $207,500 for an individual ($415,000 if married filing jointly). For non-service providing taxpayers, whose income is greater than $207,500 for an individual ($415,000 if married filing jointly), the deduction is limited to the lower of A) the 20 percent deduction; or B) the greater of (1) 50 percent of their share of W-2 employee wages paid by the business; or (2) 25 percent of their share of W-2 wages, plus 2.5 percent of their share of the acquisition cost of depreciable business property. There are additional phase out rules for income between $157,500 and $207,500 for an individual ($315,000-$415,000 if married filing jointly).
Qualified Tuition Programs (529 Plans)
Historically, 529 Plans could only be used to pay expenses at colleges and universities. Under the Act, 529 Plans may now be used to also cover expenses at public, private, or religious elementary and secondary schools, however distributions to the expanded educational institutions is limited to 10,000 per year per beneficiary.
Before the passage of the Act, a child’s unearned income was taxed at the parents’ income tax brackets and rates. Starting in 2018, the Act will tax the unearned income in excess of $2,100 at the rates applicable to trusts and estates, which are often higher than the parent’s rates.
New Planning Opportunities under the Act
The increase in the exemption amount from $5 million to $10 million (adjusted for inflation) creates an immediate need to review previously drafted estate planning documents. The higher exemption amount has also created several new planning opportunities for both those who are subject to Federal Estate Tax (under the new Act, or at the end of 2025 when the increased exemption expires), and for those who are not subject to Federal Estate Tax.
A few concerns regarding previously drafted documents, as well as several of the new planning opportunities are summarized below:
Formula Clauses: Formula clauses currently included in planning documents should be carefully reviewed. Many formula clauses leave the amount of the exemption in trust for the children, and the remainder to the surviving spouse. With the increased exemption amount, a $11 million estate would be pass entirely to the children with nothing remaining for the surviving spouse. The same formula clause in December 2017, under the prior exemption amount, would have divided the estate and left $5,490,000 to the children and $5,510,000 to the surviving spouse. A formula clause can cause unintended results, such as disinheriting a surviving spouse, and should be carefully reviewed.
Opportunities for Individuals who are subject to the Federal Estate Tax: The increase in the exemption amount provides individuals with an opportunity to make large gifts to use the increased exemption prior to its sunset at the end of 2025, or an act of Congress repealing the Act. While the IRS has not yet released guidance regarding this issue, many commentators believe that large gifts made while an increased exemption is in effect will not be added back into the donor’s estate. Making a gift during this time period could significantly reduce the future tax burden on the estate in the event the exemption returns to $5 million (adjusted for inflation) at the end of 2025 as is the case under the Act.
Opportunities for Individuals who are NOT subject to the Federal Estate Tax: Individuals who are not subject to Federal Estate Tax should also review their estate plans. There are income tax planning opportunities, such as planning to achieve an additional step-up in basis at the death of a spouse/beneficiary, which an individual may choose to focus on in light of the increased exemption amounts. Upon an individual’s death, their property receives a basis adjustment to the date of death value of the property, often times resulting in significant income tax savings. In past years when the estate tax exemption was lower, the plan was often to exclude property from a decedent’s estate to reduce the estate tax liability. With an $11 million exemption, many individuals can focus on planning for income tax savings instead of estate tax savings.
One planning technique is to simplify the estate plans of those who are not subject to the estate tax by ensuring their assets will be includable in their spouse/beneficiary’s estate, thus allowing for an additional step up in basis upon the death of the spouse/beneficiary. The combination of the increased estate tax exemption and the ability to receive a step up in basis necessitates the need to review traditional estate planning techniques to determine if including property in an individual’s estate results in a greater income tax benefit than excluding it may have had for estate tax purposes under the prior (lower) exemption amounts.