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In their first major legislative victory since President Trump took office, the GOP passed through the House and Senate earlier this week what is touted to be the most extensive reform of the U.S. tax system since 1986. President Trump officially signed the bill into law this morning before leaving Washington for Mar-A-Lago.
This Article will address some of the key provisions of the Tax Cuts and Jobs Act, formally entitled “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (the “Tax Act”), that impact wealth transfer planning.
Transfer Tax Provisions
The revisions to the current transfer tax regime are important, but not extensive. The primary change is that for gifts made and deaths occurring after December 31, 2017, the basic exclusion amount is increased from $5 million to $10 million per person and indexed for inflation from 2010 using the Chained Consumer Price Index (“Chained CPI”) rather than the standard Consumer Price Index. The Chained CPI assumes consumers will modify their behavior as prices increase (i.e., purchase items that have not increased in price as much as the items they typically would have purchased or purchase less of those items), which has the effect of moderating price increases and, in turn, inflation. Therefore, the use of the Chained CPI will produce slower growth of the basic exclusion amount than would have occurred using the standard CPI under existing law.
As of the publication of this article, the IRS has yet to release the inflation adjusted basic exclusion amount that will be in effect for 2018 as a result of the Tax Act, but some estimates have shown the number to be slightly below $11.2 million per individual. Currently, the inflation-adjusted basic exclusion amount is $5.49 million per individual and was scheduled to increase to $5.6 million per individual in 2018.
The amount of the lifetime exemption from the generation-skipping transfer (GST) tax is determined by reference to the basic exclusion amount for estate and gift tax purposes. Thus, the growth of the GST exemption amount will mirror that of the basic exclusion amount for estate and gift taxes.
The amount of the gift tax annual exclusion will be indexed for inflation from 1997 using the Chained CPI. In 2017, the gift tax annual exclusion amount was $14,000 and was scheduled to increase to $15,000 in 2018. Even though the inflation adjustment will be made using the Chained CPI under the Tax Act, some estimates show the gift tax exclusion amount will still increase to $15,000 in 2018 as it would under current law using the standard CPI. With respect to a gift to a spouse who is not a citizen of the United States, the gift tax annual exclusion amount under current law was scheduled to be $152,000 in 2018. At this time, however, the IRS has not issued the inflation adjusted gift tax annual exclusion amounts for 2018 using the Chained CPI under the Tax Act.
The estate tax valuation deduction for certain farm property under Section 2032A also will be indexed for inflation from 1997 using the Chained CPI. Under current law, the maximum deduction was scheduled to be $1,140,000 for 2018. However, switching to the Chained CPI could lead to a smaller estate tax deduction for farm property in 2018 than was projected under current law, but we will not know for sure until the IRS releases that figure.
Even though the Tax Act sunsets all individual income tax reforms, it does not sunset the replacement of the standard CPI with the Chained CPI to adjust transfer tax exemptions and exclusions (as well as other tax benefit items) for inflation. As a result, this will cause some taxpayers to pay higher taxes down the road as the standard CPI outpaces the Chained CPI.
Importantly, the Tax Act provides that all tax reforms for individuals, including estate, gift and GST tax reforms, will expire on December 31, 2025, bringing back the current tax rules. Thus, the $10 million basic exclusion amount will revert back to $5 million (adjusted for inflation) for transfers made and deaths occurring in 2026 and thereafter. The disappearing transfer tax exemption raises difficult and unclear tax issues. For example, if a taxpayer uses his or her transfer tax exemption and that exemption later vanishes, will there be some form of recapture tax if the taxpayer makes additional gifts or when the taxpayer dies? This issue was extensively considered when the transfer tax exemption amount was scheduled to fall back to $1 million in 2013, but the results could not be definitively determined because the transfer tax exemption amount had never before been reduced. The drafters of Tax Act acknowledged this unknown issue, but did not provide a solution. Rather, the Tax Act provides authority to the IRS to issue regulations appropriate to carry out estate tax calculations with respect to any difference between the basic exclusion amount in effect at death and when a gift was made.
Deduction for Qualified Business Income for Pass-Thru Entities
A discussion of the complex deduction for qualified business income of partnerships, limited liability companies and S corporations will be included in a subsequent article. However, it is important to note that estates and trusts that own interests in pass-thru entities can qualify for this deduction, which is a change from a prior version of the Tax Act that had alarmed many people who held such interests in trust.
In addition, the Tax Act had to incorporate special provisions to make the labyrinth of rules for this deduction apply appropriately to estates and trusts holding interests in a pass-thru entity. To briefly summarize, the deduction for qualified business income is subject to certain limitations based in part on W-2 wages and the unadjusted basis immediately after acquisition of all qualified property. Those items must be apportioned among the beneficiaries of the estate or trust for purposes of applying the limitations on the deduction for qualified business income.
Tax Rates and Brackets
The income tax rate tables applicable to estates and trusts have been amended. Prior to the Tax Act, estates and trusts would have been subject to rates of 15%, 25%, 28%, 33% and 39.6% in 2018, with the top rate of 39.6% applying to taxable income in excess of $12,700. Under the Tax Act, estates and trusts will see the following rate brackets for 2018, with inflation adjustments each year thereafter through 2025:
|Taxable income||Rate bracket|
|Not over $2,550||10%|
|Over $2,550 but not over $9,150||24%|
|Over $9,150 but not over $12,500||35%|
As with the changes to the personal income tax rates, the above rates for estates and trusts will expire at the end of 2025, and revert back to rates ranging between 15% to 39.6% for tax years beginning January 1, 2026 or later.
Suspension of Miscellaneous Itemized Deduction
The Tax Act provides for the suspension of miscellaneous itemized deductions under Section 67 for 2018 through tax years beginning prior to January 1, 2026. The term “miscellaneous itemized deductions” refers to itemized deductions other than 12 enumerated deductions, including Section 163 interest, Section 164 taxes, Section 165 casualty and theft losses, Section 170 charitable deductions, and Section 213 medical expenses. Under current law, miscellaneous itemized deductions have been deductible by individuals, estates and trusts to the extent they exceed 2% of the taxpayer’s adjusted gross income.
In the estate and trust context, the administration expenses that fall within the scope of “miscellaneous itemized deductions” has not always been clear. In fact, this dispute went all the way to the U.S. Supreme Court in the 2007 case of Knight v. Commissioner. Following Knight, Treasury issued final regulations for tax years of estates and trusts that began on or after January 1, 2015, which generally provide that administration costs of estates and trusts will be miscellaneous itemized deductions if they commonly or customarily would be incurred by a hypothetical individual holding the same property. The broad test promulgated under the final regulations means that routine investment advisory fees charged for services akin to what an individual would incur are captured as miscellaneous itemized deductions under Section 67.
The suspension of Section 67 miscellaneous itemized deductions under the Tax Act means that individuals, estates and trusts are no longer permitted to deduct any portion of miscellaneous itemized deductions, such as routine investment advisory fees, for 2018 through 2025. Those costs incurred by an estate or trust, however, which would not have been incurred if the property were not held in trust, such as appraisal fees, fiduciary accounting fees, estate tax return preparation fees, or the portion of fiduciary fees that is unrelated to routine investment advice, will continue to be deductible as they have been under current law.
Estates and trusts historically have been permitted to claim a deduction under Section 642(b) in lieu of claiming a personal exemption under Section 151. While the personal exemption for individual taxpayers has been suspended under the Tax Act, the Section 642(b) deductions for estates and trusts will remain unchanged ($600 for estates; $100 for complex trusts; and $300 for simple trusts). The deduction for disability trusts will be $4,150, indexed for inflation after 2018. Pursuant to Section 67(e)(2), these items are not miscellaneous itemized deductions and therefore will not be suspended under new Section 67(g) of the Tax Act
The Tax Act (i) increases the charitable deduction threshold from 50% of an individual’s contribution base to 60% of an individual’s contribution base for gifts of cash to a public charity and (ii) repeals the exception to the contemporaneous written acknowledgement requirement for gifts of $250 or more to a charity when the charity files a tax return that includes the information that would otherwise be included in the contemporaneous written acknowledgement.
The Tax Act suspends the overall limitation on itemized deductions under Section 68 (Pease Limitation) for certain upper-income taxpayers until January 1, 2026. Generally, under the Pease Limitation, the otherwise allowable total amount of itemized deductions is reduced by three percent of the amount by which the taxpayer’s adjusted gross income exceeds a threshold amount. For 2017, the threshold amount for the Pease Limitation is $318,800 for married couples filing jointly. Since Section 67 miscellaneous itemized deductions are suspended under the Act, the suspension of the Pease Limitation should ensure that upper-income taxpayers receive the full benefit of their itemized deductions that are not miscellaneous itemized deductions, including their charitable contributions.
ABLE Accounts and 529 Plans
The amount of contributions that may be made by the designated beneficiary of an ABLE account, which are tax-favored savings programs for disabled individuals, is increased to the lesser of (i) the amount of the Federal poverty line for a one-person household or (ii) the individual’s compensation for the taxable year. The designated beneficiary will also be allowed a “savers credit” for contributions made to the ABLE account. The increased contribution limit is in addition to the general overall limitation on contributions to a donee’s ABLE account (i.e., the annual gift tax exclusion, or $14,000 for 2017).
Under the Tax Act, a designated beneficiary of a 529 plan will be allowed to rollover a qualified tuition program (e.g., 529 Plan) to his or her ABLE account or one for a member of his or her family. Any amounts that are rolled to an ABLE account will count towards the overall limitation on amounts that can be contributed to an ABLE account within a taxable year.
Under prior law, 529 plans were limited to use for a beneficiary’s qualified higher education expenses (e.g., college tuition, mandatory fees and room and board). The Tax Act modifies 529 plans to allow tax free distributions from such plans for up to $10,000 per year of tuition expenses incurred for elementary or secondary education.
The definition of qualified beneficiaries of an electing small business trust (“ESBT”) has been expanded. An ESBT, along with certain other trusts (e.g., grantor trust and qualified subchapter S trust), is an eligible shareholder of a subchapter S corporation (an “S Corporation”). Under current law, a non-resident alien may not be an S Corporation shareholder or a potential current beneficiary of an ESBT. The Tax Act now permits a non-resident alien to be a beneficiary of an ESBT. Because an ESBT (and not the non-resident alien) pays Federal income tax on its S corporation income, the interests of the government will not prejudiced by this change.
In addition, the Tax Act provides that an ESBT’s charitable deduction will be determined under the rules applicable to individual taxpayers, as opposed to the more restrictive trust rules. Thus, the percentage limitations and carryforward provisions applicable to charitable contributions made by an individual taxpayer will now apply to ESBTs.
Under current law, individuals with adjusted gross incomes (AGI) exceeding certain limits are not permitted to make a contribution directly to a Roth IRA (for 2017 the phase out starts at $118,000 for single persons and $186,000 for married persons filing jointly). However, an individual can make a contribution to a traditional IRA and then convert the traditional IRA to a Roth IRA. Generally, the amount of pre-tax contributions and earnings converted from the traditional IRA to the Roth IRA is includible in the taxpayer’s income as if a withdrawal from the traditional IRA had been made.
In addition, if an individual makes a contribution to an IRA (traditional or Roth) for a taxable year, the individual is permitted to recharacterize the contribution as a contribution to the other type of IRA (traditional or Roth) by making a trustee-to-trustee transfer to the other type of IRA before the due date for the individual’s income tax return for that year. Both regular contributions and conversion contributions to a Roth IRA can be recharacterized as having been made to a traditional IRA.
When planning for a Roth conversion, an individual may establish multiple Roth IRAs, for example, with different investment strategies, and divide the amount being converted among the IRAs. If the value of the assets in a particular Roth IRA declines after the conversion, the conversion can be reversed within a limited period of time by recharacterizing that IRA as a traditional IRA. The individual may then later convert that traditional IRA back to a Roth IRA (referred to as a reconversion), including only the lower value in income. Certain rules apply, however, to prevent a reconversion occurring soon after a recharacterization.
Under the Tax Act, an individual may still make a contribution to a traditional IRA and convert the traditional IRA to a Roth IRA. An individual may also make a contribution for a year to a Roth IRA and, before the due date for the individual’s income tax return for that year, recharacterize it as a contribution to a traditional IRA (e.g., if an individual exceeded the $118,000 AGI threshold for a contribution to a Roth IRA, the individual would be permitted to recharacterize the contribution as having been made to a traditional IRA). However, under the Tax Act, recharacterizations cannot be used to unwind a Roth conversion. In other words, once a traditional IRA is converted to a Roth IRA, the funds cannot be re-characterized back to a traditional IRA if the Roth IRA declines in value.
Under current law, alimony payments from an individual to a former spouse generally have been deductible on the income tax return of the payor spouse, and includible in income on the tax return of the payee spouse. This benefit was often utilized in divorce settlement negotiations to squeeze additional alimony from the wealthier spouse, who often was in a higher tax bracket than the payee spouse and materially benefitted from the deduction. Under the Tax Act, however, alimony payments made pursuant to a divorce or separation instruments executed after December 31, 2018 will no longer be deductible by the payor spouse, nor will they be includible in the income of the payee spouse. This new rule of non-deductibility will also apply to divorce or separation instrument executed on or before December 31, 2018 if the instrument is modified or amended after such date to expressly provide that the new law shall apply. Therefore, you may see a push by wealthy spouses near the end of 2018 to settle alimony claims before the new law takes effect. At the same time, a spouse who is expecting to receive an alimony payment may not be as motivated to settle prior to end of 2018.
Alimony obligations are not always paid directly by individuals who have or benefit from complex estate plans. Rather, parties sometime agree to use funds from existing or newly created trusts as a source to provide support payments to an ex-spouse in divorce settlements. If the source trust is a “grantor trust” for income tax purposes, meaning the income, gains and other tax items are includible on the personal income tax return of the grantor spouse, then under current law, Section 682 operated to shift trust income to the ex-spouse’s personal tax return to the extent the ex-spouse was entitled to receive income from the trust. As a consequence, the tax result to the payor spouse was essentially the same regardless of whether the alimony payments were made from the payor individually or from a grantor trust of the payor. With the repeal of the alimony deduction for individuals under the Tax Act, Section 682 also has been repealed in order to maintain consistency for tax purposes regardless of the source of the alimony payment.
The changes under the Tax Act to the tax treatment of alimony are ultimately a revenue raiser for the government because payors of alimony often find themselves in a higher marginal income tax bracket than their payees. However, another (perhaps unanticipated) consequence of the changes may be that payees will receive less alimony now that payors must use after-tax income, rather than pre-tax income, to make alimony payments.
At first glance, the provisions of the Tax Act directly impacting estate planning do not appear to be extensive (other than the increased transfer tax exemptions) when compared to the remaining provisions of the bill. However, changes contained in the Tax Act to the corporate and pass-through entity taxation system are sure to have a significant impact in the planning world, as estate plans often utilize entities as a principal component to income and transfer tax planning. Therefore, taxpayers should review their estate plans to see how the Tax Act impacts their personal situation and what new planning opportunities may be available. Stay tuned to our blog for additional analysis of key provisions of the Act that may have substantial impact on your, and many of your clients’, estate plans.