Tax Reform Estate Planning Opportunities and Pitfalls

6 min

On December 22, 2017, President Trump and Congress enacted comprehensive federal tax reform through H.R. 1 (the Act). The Act provides the most comprehensive change to the Internal Revenue Code since 1986 and includes several provisions that could have significant impact on existing estate plans and future estate planning. Clients should consult with their tax advisors to consider the new estate planning opportunities and pitfalls created by the Act.

Key Changes

Provision  Prior Law H.R. 1 Changes
Transfer Tax Rates 40% top rate No change
Annual Gift Tax Exclusion $14,000 $15,0001
Gift/Estate & GST Tax Exemptions $5 million basic exclusion amount, annually adjusted for inflation (2017: $5.49 million; $10.98 million for a married couple) $10 million basic exclusion amount, annually adjusted for inflation (2020: approximately $11.58 million; approximately $23.1 million for a married couple2). Provision to sunset January 1, 2026.
Inflation Indexing Consumer Price Index for All Urban Consumers (CPI-U) "Chained" Consumer Price Index for All Urban Consumers (C-CPI-U). The change to the chained C-CPI-U is expected to produce smaller inflation adjustments.
Portability of Unused Gift/Estate Tax Exemption at First Spouse's Death Yes No Change
Basis Step-up at Death Yes No Change
Deduction for State and Local Taxes Itemized deduction for all state and local taxes paid in the taxable year. Itemized deduction for state and local tax payments limited to $10,000.
Charitable Deduction Limited to 50% of adjusted gross income. Limited to 60% of adjusted gross income.
Pass-Through Income Income attributable to a pass-through (partnership, LLC, S corporation) generally taxed at the owner's individual rate. Deduction in the amount of 20% of the taxpayer's net qualified business income.3

Estate Planning Opportunities and Considerations

Window of Opportunity

  • The temporary increases in the federal estate and gift tax exemption and the GST tax exemption will be adjusted annually for inflation until December 31, 2025, and are scheduled to revert to prior law ($5 million basic exclusion amount, as adjusted for inflation) in 2026.
  • The Act directs the IRS to issue regulations to address the issue of clawback – the possibility that the basic exclusion amount will drop in the future, resulting in additional federal estate tax liability for an individual who made lifetime gifts below the basic exclusion amount at the time of the gifts, but in excess of the basic exclusion amount at the time of such individual's death. In the coming months and years, the expected regulations may eliminate the clawback issue, making lifetime gifting even more attractive.

Increased Giving

  • The near doubling of the basic exclusion amount for gift, estate, and GST tax purposes provides unique opportunities for additional giving. Clients should consider seizing the opportunity to make additional transfers that pass increased portions of their wealth to children, grandchildren, and future generations through outright gifts, gifts in trust, and forgiveness of family loans to utilize the higher exclusion amounts.
  • Installment sales can be utilized to "wait and see." Significant assets can be transferred through small gifts now. Clients can then consult with their tax advisors before the higher basic exclusion amounts are scheduled to sunset to determine whether promissory notes should continue to be paid (to avoid using the gift and estate tax exemption) or forgiven (to fully utilize the higher gift and estate tax exemptions).

Income Tax Basis Planning

  • With the increase in the federal estate and gift tax exemption and the GST exemption to approximately $23.1 million for a married couple, only the wealthiest of Americans will be subject to federal estate, gift, and GST tax.
  • Most beneficiaries of an estate will benefit from assets being includable in the estate of a decedent, since such assets will receive a full basis step-up at the decedent's death. Pursuant to the tax rules, an asset that is included in a decedent's gross estate (with certain limited exceptions) receives a new income tax basis equal to such asset's fair market value at the decedent's date of death (known as a "step-up in basis"). In contrast, recipients of assets that have been gifted during life receive the donor's cost basis in such asset. Therefore, when assets are included in the gross estate of a decedent (particularly in the case of low-basis assets), beneficiaries will receive significant income tax savings as a result of the increase in basis for the asset to its date of death value.
  • Trustees should consider distributing low-basis assets from an irrevocable trust which would not otherwise be subject to estate tax. Additionally, clients may wish to grant "general powers of appointment" or unwind sale transactions to cause inclusion in the beneficiaries' estates. This would result in a step-up in basis at the beneficiary's death, which may ultimately reduce overall taxes by eliminating or decreasing capital gains.

State Estate Tax Considerations

  • Although it may be advantageous to make gifts before 2026 for federal estate and gift tax purposes, careful consideration should be given to clients who reside in states that have state gift and estate tax laws. Gifting should be strategically timed based on scheduled updates to state tax laws.
  • Additionally, estate plans should be drafted to avoid the imposition of state estate tax at the first spouse's death.

Formula Clauses

  • Formula clauses are trust provisions that provide for the disposition of property by reference to federal tax provisions, such as the basic exclusion amount. For example, a formula clause might provide for all of a deceased spouse's assets up to the amount of the federal estate and gift tax exemption to be allocated to a trust for children, with the remainder to a marital trust. With the significant increase in the estate and gift tax exemption, these formula clauses may result in unintended consequences, such as all of a decedent's estate being allocated to the children's trust rather than among the children's trust and the marital trust.
  • Clients should review their estate planning documents to determine whether their documents continue to reflect their intent after the changes in the tax law.

Generation-Skipping Transfer (GST) Planning

  • Unlike the federal estate and gift tax exemption, the federal GST exemption is not portable. In some cases, this may mean that the federal GST exemption will be wasted if the decedent spouse has insufficient assets in his or her name to fully utilize the GST exemption.

Charitable Planning

  • The Act increases the deductibility limitation for cash contributions to public charities from 50% of adjusted gross income (AGI) to 60% percent of AGI. However, because of the increase in the standard deduction for individuals under the Act, many clients may lose the income tax benefit of making charitable gifts. Therefore, charitable plans should be reviewed to ensure they still comply with a client's philanthropic desires. Clients can consult with their tax advisors regarding the creation of various charitable planning vehicles, such as donor advised funds, private foundations, and charitable trusts.

Action Items

  • Review Your Estate Plan – The Act may impact each client's estate plan differently. Accordingly, clients should review their estate plans to make sure that the plans continue to make sense in the new tax environment. Additionally, clients should consider adding additional flexibility to their estate plans to allow their plans to evolve with changes in the tax law.
  • Consult Tax Advisors – Clients should consult with their tax advisors to be sure that all opportunities and risks created by the Act are given proper consideration in their unique circumstances.

[1] As noted herein, the increase in the federal exclusion and exemption amounts is based on inflation adjustments that were also amended by the Act. The figures cited above are estimates and are subject to computation based on pending announcements by the Internal Revenue Service of the actual inflation-adjusted exclusion and exemption amounts.

[2] See above.

[3] The 20% deduction is subject to several limitations. Please consult your tax advisor for additional details.