Consider these 6 key strategies designed to help reduce taxes and maximize flexibility.
Key takeaways
-
2018's tax reform had far-reaching implications, including an increase in the federal estate tax exclusion.
- The new tax law is even more reason to review any estate planning you have done.
-
But be careful not to simply undo prior planning, as many aspects of the new laws are set to return to
pre-2018 laws at the end of 2025.
In late 2017, significant tax reform impacting virtually all areas of existing federal tax law was enacted. The
sharp increase in the federal estate tax exclusion left some people thinking estate planning was not so important
anymore. That could be a dangerous assumption since the higher exclusion is slated to return to only $5 million
(inflation indexed) at the end of 2025.
Given the uncertainty, you might want to plan defensively. Here we look at 6 key estate planning considerations
to discuss with your attorney and tax advisor. They could save you and your heirs a considerable amount.
1. Review trust funding strategies at death
Prior to 2018, many estate plans included credit shelter trust strategies—which allow married couples to take
full advantage of state and federal estate tax exclusions. This trust strategy is often structured so that upon
the passing of the first spouse, specified assets (often a dollar value up to the federal estate tax exclusion)
pass to the credit shelter trust. These assets then flow to the surviving spouse, but due to the nature of the
trust, the surviving spouse never actually owns or takes control of the assets. Therefore, the trust assets are
not included in the surviving spouse's taxable estate.
For an estate smaller than the new
federal estate tax exclusion amount
, such a strategy
has the potential to transfer the entire estate to the credit shelter trust, which could limit the surviving
spouse's flexibility and direct access to the funds.
Furthermore, in states with a state estate tax, having an entire estate pass to a credit shelter trust may also
generate state estate taxes at the first spouse's death, unless the trust language limits the assets transferred
to the lower of the state or federal estate tax exclusion. Therefore, it may be prudent to review such a strategy
with your tax and legal advisors to determine if it still makes sense.1
2. Focus on flexibility
Many of the changes enacted by the Tax Cuts and Jobs Act, including the higher federal estate tax exclusion, are
currently set to expire at the end of 2025. As a result, the
federal estate tax exclusion amount
will be reduced back to $5 million (inflation indexed) after 2025. In light of this, building flexibility into trust arrangements
will be important, particularly for estates in the $5 million to $25 million range. It is possible that some trust
provisions to reduce estate tax exposure may be unnecessary (or undesirable) for those without estate tax
concerns.
Some of the ways to consider adding flexibility to trust strategies include:
-
Allow beneficiaries to make changes
An individual establishing a trust may choose to enable beneficiaries to change the terms of a trust to benefit
their heirs or named charities. For example, a trust may state that upon a beneficiary's passing, all assets
will be split equally among the beneficiary's 2 children. However, if the original trust permits, the
beneficiary could change these terms so that upon their death, one child would receive 30% and the other would
receive 70% of the remaining trust principal.
-
Allow trust assets to be distributed to a new trust, with new terms
When creating a trust it is also possible to permit the trustee to distribute trust assets to another trust
(with different terms) for the benefit of one or more beneficiaries of the first trust. Such flexibility would
allow the trustee to modify the terms under certain circumstances.2 -
Give the grantor the ability to substitute trust assets for tax purposes
It's possible to allow a grantor to pay an irrevocable trust's taxes or substitute low-cost-basis trust assets
with high-cost-basis assets in their name to take advantage of a step-up in cost basis at death. This lends a
certain level of flexibility to the trust strategy to make changes and help reduce tax liability.
-
Provide special modification powers to trust protectors
A trust protector is someone who has the authority to perform special duties with regard to a trust. These
duties may involve directing trustees in their administration of the trust. Enabling trust protectors to modify
certain details of the trust could provide enhanced flexibility, such as changing the physical location of trust
assets for the purposes of legal jurisdiction or directing the trustee regarding certain actions, among others.
3. Try to maximize a spouse's unused exclusion amount
Portability, a concept introduced in 2010, means that if one spouse dies and does not make full use of their
federal estate tax exclusion, the surviving spouse can make an election to add any unused federal estate tax
exclusion from the first spouse to their exclusion amount. If the first spouse dies before the last day of 2025,
while the
federal estate tax exclusion amount
(inflation indexed), the portability election
should leave the surviving spouse with the deceased spouse's unused federal estate tax exclusion of that full
amount even when the basic exclusion amount decreases at the end of 2025.3
To illustrate the potential benefit of electing portability, consider the following 2 hypothetical scenarios:
Scenario 1
Judy and Jim are married and have a net worth of $24 million. Jim passes away in 2021 with all of his federal
estate tax exclusion left and portability is not elected. All assets are left to his wife, Judy, and no credit
shelter trust is used. Judy passes away in 2026 (when the federal estate tax exclusion is scheduled to return to
the 2010 level of $5 million, inflation indexed); Judy will only have the pre-tax reform federal estate tax
exclusion ($5 million, inflation indexed) to offset federal estate taxes. Assuming that Judy's estate is still
worth $24 million, she will have approximately a $7.6 million estate tax liability (see calculation below).
Jim and Judy's estate
|
Jim's death (2021)
|
Judy's death (2026)
|
$24M
| No portability election |
Judy's total estate: $24M
|
|
|
−Judy's estate tax exclusion: $5M
|
|
|
$19M x 40% federal estate tax rate
|
|
| = $7.6M estate tax liability |
Scenario 2
Jim passes away in 2021 with all of his federal estate tax exclusion left and portability is elected. Judy passes
away in 2026 (when the federal estate tax exclusion is scheduled to return to the 2010 amount, inflation indexed).
Judy will have the pre-tax reform federal estate tax exclusion ($5 million, inflation indexed) and Jim's unused
federal estate tax exclusion to offset federal estate taxes. Assuming that Judy's estate is still
worth $24 million, she will have an approximate $3 million dollar estate tax liability (see calculation
below).
Jim and Judy's estate
|
Jim's death (2021)
|
Judy's death (2026)
|
$24M
| Portability election |
Judy's total estate: $24M
|
|
| −Judy's estate tax exclusion: $5M + $11.7M(for year 2021) |
|
|
$7.3M x 40% federal estate tax rate
|
|
| = $2.92M estate tax liability |
4. Think twice about undoing prior planning
If the estate tax had been eliminated as part of the Tax Cuts and Jobs Act, as some had expected, some
individuals may have considered undoing prior planning they had done to avoid estate taxes. Some individuals may
still be considering it given the increase in the federal estate tax exclusion. However, the uncertainty about
what will happen after 2025 suggests individuals should exercise caution when it comes to undoing any prior
planning because the doubling of the
federal estate tax exclusion amount
is set to last only till the end of 2025.
Consider the following hypothetical scenario:
Mary and Tom had a net worth of $20 million and formed an irrevocable life insurance trust (ILIT) in 2011 with a
guaranteed universal life second-to-die life insurance policy with a face value of $5 million. The rationale at
the time was that with a $5 million of federal estate tax exclusion for each of them, their taxable estate would
be estimated at $10 million with a $4 million estate tax liability ($20 million less $10 million of federal estate
tax exclusion, equals a $10 million taxable estate at a 40% federal estate tax rate). The life insurance proceeds
would then be enough to cover the estate tax liability following their deaths.
Estate: | $20M |
|
− $10M federal estate tax exclusion ($5M for Mary and $5M for Tom)
|
|
$10M x 40% federal estate tax rate = $4M estate tax liability
|
Fast forward to 2021 (and assume Mary and Tom still have a net worth of $20 million). They now have $23.4 million
federal lifetime estate tax exclusion and no estate tax concern. Therefore, they may be inclined to stop paying
the premiums on the life insurance policy and collapse the ILIT. However, if Mary and Tom live beyond 2026 when
the federal estate tax exclusion is set to go back to $5 million (inflation indexed), cancelling the policy could
have dire consequences. Mary and Tom may no longer be insurable if they want to apply for another policy in the
future and the policy may be beyond its most heavily commissioned years.
5. Consider upstream gifts of low-cost-basis assets
Individuals whose parents do not have federal estate tax concerns (even if they live past 2025), may be able to
make gifts of low-cost-basis assets to their parents, in hopes of getting a step-up in cost basis at the parents'
deaths. The assets would then be transferred to children or other beneficiaries, without built-in capital gains.
(Note that steps should be taken to protect against potential negative tax consequences in case the donee should
die within one year of the gift.4)
Consider the following hypothetical scenario:
Sue and Brian have a net worth of $50 million (and still have their full federal estate tax exclusions). Brian's
parents, who are in their late 80s, have a net worth of $500,000 (and they also have their full federal estate tax
exclusions). Sue and Brian want to make a gift to their children of 50,000 shares of Apple stock, which they
purchased in 2005 for $5 per share. Let's assume that Apple stock is currently worth $167 per share and Sue and
Brian have approximately $8.1 million of unrealized gains in the stock.
If Sue and Brian were to gift the stock to their children, their children would assume the same $5 per share cost
basis that their parents had and be stuck with significant built-in capital gains.
However, if Sue and Brian were to gift the Apple stock to his parents and, in turn, his parents transfer the stock to their grandchildren upon
their death, the Apple stock will receive a full step-up in basis and the grandchildren will receive the stock
with zero immediate income-tax ramifications!5
6. Be strategic about splitting gifts
Gift splitting allows a lifetime gift made from one spouse to be treated as though it is coming from both
spouses. The election is made by reporting the transfer on a federal gift tax return. However, given the higher
federal estate tax exclusion amount
, in some cases, it may not make sense to gift split.
Consider the following hypothetical scenario:
Jen and Mark are married. If Mark makes a $10 million lifetime gift in 2021 and elects to split the gift, that
gift will be treated as coming from both Jen and Mark. Thus, when Jen and Mark die, their estate representatives
will need to reduce each of their
federal estate tax exclusion amounts
significantly federal estate tax exclusions would be reduced by the $10 million lifetime gift that was split, thus reducing each
exclusion by $5 million. After 2025, when federal estate tax exclusions revert back to $5 million (inflation
indexed), Jen and Mark will have very little, if any, federal estate tax exclusion left.
If, on the other hand, Mark did not gift split in 2021 and chose to make the gift entirely from his own assets,
Jen will still have all of her federal estate tax exclusion left after 2025.
For married couples who plan to make significant lifetime gifts and wish to preserve some or all of the surviving
spouse's federal estate tax exclusion after 2025, consider if it makes sense to gift split or not prior to 2025.
The topics outlined above are some examples of considerations that 2018's tax reform has brought front and center.
As a general rule, think about reviewing your estate plans with your tax and legal advisors on a regular basis to
make sure your plans still align with current laws and your unique needs.
1. Note that assets outside of the credit shelter trust will pass to the surviving spouse tax-free (but of
course will then be part of their estate).
2. Note that many state statutes require an independent trustee to have sole and absolute discretion to
distribute income and principal in order to decant trust assets.
3. See Treasury Regulation § 20.2010-2(c) that describes computation. Note that while the regulation supports
the position that the portability election should leave the surviving spouse with a DSUE of the full amount, the
statute appears to limit the surviving spouse's DSUE to the basic exclusion in effect at the time of their
death, per Internal Revenue Code § 2010(c)(4)(A). However, the regulation is binding at least as long as it
remains in place.
4. Section 1014(e) of the IRC provides carryover basis to any donor or donor's spouse who receives a gift back
from a donee within one year of the gift measured from the time of the donee's death.
5. Note that this strategy assumes that Sue's parents live in a state without a state estate tax.