PODCAST: Beth Kaufman Discusses New Tax Act and the Estate Planning Opportunities It Presents
Caplin & Drysdale’s President and Member in the firm’s Private Client Group, Beth Shapiro Kaufman, and Miriam Wogan Henry of New Orleans, LA, are featured speakers on the ACTEC Trust and Estate Talk podcast “Confronting the Challenges of Tax Reform.” Please visit this link to hear the full podcast. The complete transcript is below.
This is Susan Bart, ACTEC Fellow from Chicago, Illinois.
At the end of 2017, President Trump signed a new Tax Act into law. To hit some of the highlights of the new act for estate planners, you will be hearing today from ACTEC Fellows Miriam Wogan Henry of New Orleans, LA, and Beth Shapiro Kaufman of Washington, DC. Welcome Beth; welcome Miriam.
Thank you. The Tax Act was enacted on December 21, 2017. It did not repeal the estate, gift or generation-skipping transfer taxes, rather, it increased the estate, gift, and generation-skipping transfer exemptions but only for the years 2018 through 2025. The basic, unindexed exemption amount was increased from $5 million to $10 million per person. The method of indexing for inflation was changed to a slower-changing index with the result that the exemption for 2018 is $11.18 million, which is projected to leave only a tenth of one percent of decedents paying any estate tax at all. Several of our laws were left untouched: portability is unchanged, the step up or step down basis at death was unchanged, and the annual exclusion was unaffected by the legislation. Even with the slower indexing, the annual exclusion rose to $15,000 for 2018.
All of these provisions in the estate and gift area expire at the beginning of 2026, and the exemption level will revert to prior law, as indexed to 2026 at that time. However, these changes could be made permanent, or they could be terminated early, depending on the political considerations and actions of Congress. Miriam Henry and I are going to discuss some of the estate planning implications of this new Tax Act.
The first thing we recommend is that you review all of the estate planning documents for their use of formula clauses. You want to check to see whether those formulas still work as intended. For example, in a typical AB Trust Will, a credit shelter trust formula might give too much money to the bypass trust and not enough to the marital bequest now, with the higher exemption level. An existing formula clause might not be the optimal formula in a state that has an estate tax with a lower exemption level than the federal exemption. And if a will has a generation-skipping transfer measured by the amount of remaining GST [Generation-Skipping Transfer] exemption, that might direct a lot more assets to the GST trust than the client anticipated and leave and insufficient amount for the children or the spouse. Given the uncertainty of what the exemption amount will be in the future, flexibility is a key in estate planning. Clayton QTIPs and disclaimer trusts are preferred drafting techniques in these uncertain times.
We’re also looking at how the estate tax and the income tax coincide under the new Tax Act. For example, a widow with a funded credit shelter trust holding low basis assets, who has combined trust and outright assets under the exemptions, may want to look at options for bringing those low basis trust assets into her estate for estate tax purposes to get a step up in basis at her death. Can assets be distributed to the widow under the trust instrument? Can the trust be modified to cause it to be included in her estate? We’re also looking at families who have funded and gifted FLP [Family Limited Partnership] interests; they may no longer benefit from a discount to reduce estate tax. Those families may want to unwind the FLP, but FLPs offer a lot of practical benefits for families so they may also look at ways to modify the FLP so the interests are not discounted at the partner’s death, and a 754 election can capture that step up in basis for the FLP assets.
The increased exemption of $11.18 million per person, or $22.36 million for a married couple, raises the question of who’s going to use this exemption. Since the legislation expires in 8 years, clients either have to make gifts or die within that period in order to lock in the benefit of the exemption. Since dying is not a good planning opportunity, we’ve been looking at gifting strategies. Most couples with up to $20 million or even $30 million in assets will probably not want to give away $22 million. And giving away smaller amounts doesn’t appear to produce much benefit if the exemption later reverts to the lower number.
Ultra-wealthy clients will likely use all their increased exemption and perhaps even leverage it with sales to grantor trusts, or using GRATs [Grantor-Retained Annuity Trusts]. All of the estate planning techniques that we’ve been using in recent years are still relevant for them. For the group of married clients who want to take advantage of the increased exemption but need the security of being able to access the assets in the future, the SLAT, a Spousal Limited Access Trust, may be an attractive option. The decision as to whether to make gifts is highly situation dependent and the client’s wealth level, marital status, whether they are in their first or second marriage, state of residence, and age are all factors that have to be considered.
The income tax changes for businesses that families own provoke many planning discussions. The C Corp tax rate has dropped to 21%, now distributions from a C Corp to the hands of the owners are taxed at approximately 40%. Pass-through income enjoys a 20% deduction for qualified income. These apply to businesses taxed as S-Corps and Partnerships with income being taxed at just over 33% in the hands of the owners. Active family businesses taxed as pass-throughs are looking to see if they would benefit from being a C Corporation to make use of the new 21% rate to invest in and grow the business. For example, a family may own a manufacturing company taxed as an S Corp; the matriarch, the children, the grandchildren, a GST grantor trust may all be the owners. It runs an active business and is looking to grow. Management likes the 21% C Corp tax rate and wants to make use of NOLs [Net Operating Losses] to be generated by future investment. The family enjoys distributions and the grantor trust uses distributions to pay the note to matriarch. Planners will want to balance the company benefits with the needs to distribute property out to owners for cash flow, including the note payments. Looking longer term, how will the decision affect the sale of the business in the future? C Corp status can reduce the ultimate proceed amount passing to the owners, either due to a tax bite, or the buyer may demand a discount due to the C Corp structure.
We’re also looking at who benefits from this new 20% pass-through deduction under Section 199A. Generally, the way the deduction works is this: a taxpayer will calculate his bill, calculate his qualified pass-through income, then deduct 20% of the qualified business income and recalculate the tax amount. But not all pass-through income is qualified, the income must come from an active trade or business. The 20% is also limited to the greater of: 50% of the taxpayer share of W-2 income, or 25% of W-2 income plus 2.5% of the value of depreciable assets in service. It must be an active trade or business. Many businesses are categorized such that they will not qualify. Service businesses, such as legal, accounting, health, consulting, investment services, arts, athletics, and reputation- and skills-based companies, generally see further limitations. Higher earners service businesses won’t see the same benefit from the reduced rates for pass-throughs.
Planning can help taxpayers who may otherwise be dinged by these limitations pick up the benefits. Owners of these disfavored types of businesses are looking at ways that they may be able to divide up the businesses into lines that are qualified and lines that aren’t. Taxpayers are considering reorganizing businesses to house certain assets or employees in new ways to minimize limitations. The pass-through act benefits are only in place through 2025, which is another wrinkle, while the corporate rate is permanent.
To wrap up, clients will find many tax benefits under the new act with reduced estate tax exposure and new income tax reductions. But clients will need to act to get the best benefits. The new act doesn’t cure uncertainty – a major hurdle for our clients and their planning. So many benefits go away January 1, 2026, which makes acting now harder for clients as our clients anticipate living and running their businesses past 2026.
Thank you, Miriam. Thank you, Beth for helping us to understand better the new Tax Act and the opportunities that it presents.