2017 TAX CUTS AND JOBS ACT
The final quarter of 2017 witnessed a Congressional race to pass comprehensive tax legislation in the form of the Tax Cuts and Jobs Act (the “2017 Act”). This new legislation has far-reaching implications both for federal income taxation as well as federal transfer (estate, gift and generation-skipping transfer) taxation. The 2017 Act provides a cornucopia of potential planning opportunities as well as new considerations, despite the possibility of various unanticipated implications, nuances, and consequences that will be revealed in the coming months and years. In particular, the tax issues described below have a significant impact on individuals and businesses alike, and merit consideration.
Doubling of Gift and Estate Exemption Amounts Until 2026
The 2017 Act doubles the basic exclusion amount (the maximum amount that can be transferred free of gift, estate and generation-skipping transfer taxes either during life or upon death, often referred to as the “unified credit”). The basic exclusion amount per taxpayer for 2018 will now be approximately $11.2 million* (i.e., approximately $22.4 million per married couple) instead of the $5.6 million ($11.2 per married couple) under the former law.
Note that the 2017 Act does not repeal the estate, gift or generation-skipping tax. Importantly, this provision of the 2017 Act “sunsets” on January 1, 2026, at which time (barring further legislative action) the basic exclusion amount will revert to $5.0 million (with inflation adjustments). Reportable (taxable) gift transfers occurring during this period are expected to be “grandfathered”; however, the legislation directs the Treasury to prescribe regulations concerning any “claw back” possibility.
A 40% transfer tax rate is still applicable to transfers exceeding the new basic exclusion amount. In addition, the 2017 Act also preserves the step-up in adjusted basis for income tax purposes for assets received from an estate. As our clients assess estate planning next steps in 2018 and beyond, the increased exemption amounts and scheduled sunsetting of such increased amounts necessitate careful consideration of the following:
- Additional Taxable Gifts: With the doubling of exemption amounts, there has never been a better time for making additional gifts of interests in family businesses, securities, investment real property, or promissory notes (i.e., loan forgiveness). When law changes sunset, the higher exemption gift opportunities will be lost.
- Family Installment Sale Planning: Under the new law, existing rules concerning valuation discounts and structuring transactions using closely-held entities remain in place. Interest rates also remain below historical norms. This is a perfect environment for implementing leveraged asset sales to family members or trusts for their benefit.
- Reviewing Formula Gifts: Under the terms of many estate planning arrangements, gifts of assets with a value equal to the deceased person’s “estate tax exemption” sometimes occur upon death. With the doubling of federal exemption amounts, such formula gift planning deserves careful review.
- General Updating: The enactment of the new tax law provides an excellent opportunity to combine tax updating with a consideration of planning arrangements that may be years old and potentially out-of-date.
- Reexamine Income Tax Basis Step-up Opportunities: The federal capital gains tax remains in place under the new law. When assets are set aside under traditional “bypass” (estate tax exemption) trusts upon the death of the first spouse to die, those assets receive one step-up for capital gains purposes upon that person’s death, but no further adjustment occurs upon the subsequent death of the surviving spouse. By inserting special provisions (e.g., an election to include low basis “bypass” assets in the estate of a surviving spouse for capital gains basis step-up purposes), significant income tax savings can be enjoyed by beneficiaries without negative federal estate tax consequences.
Inter vivos transfers to individuals with modest estates could also present an income tax benefit. For example, if a client has a low basis asset, he or she could transfer that asset “upstream” to a grantor trust benefiting his or her parent who has a modest estate. That parent could then possess a testamentary general power of appointment triggering inclusion of the asset in his or her estate (and a step-up in basis) upon death (assuming the recipient parent survives at least one year following the gift). Upon the parent’s death, the asset could return to the client, but now with a stepped-up income tax basis. - Creation of Separate Taxpayer Entities: For many years, much estate planning has centered on creating entities that are “invisible” vis-à-vis the senior generation member for income tax purposes (e.g., “grantor trust” and “disregarded entity” planning). As noted in the second section below, there may now be wisdom in employing multiple separate taxpayer structures to garner previously unavailable income tax benefits.
- Additional Planning Tools: Notwithstanding the most significant tax changes since the 1980s, traditional estate planning tools – including grantor retained annuity trusts (GRATs), qualified personal residence trusts (QPRTs), charitable remainder trusts (CRTs), charitable lead trusts (CLTs), irrevocable life insurance trusts (ILITs) and dynastic generation-skipping gift trusts – all remain alive and well, and deserving of attention as components of a well-planned estate.
- Non-Tax Considerations: Although the media and financial press instinctively focus on tax changes and the implications of the new tax law in the context of estate planning, other planning considerations – such as protecting beneficiaries from the claims of creditors (including divorcing spouses) or from beneficiaries’ own poor judgment, ensuring proper trustee oversight, marital (separate and community) property characterization, and protecting against undue influence or loss of capacity – are more important than ever.
Income Tax Treatment of Pass-Through Entities (Also Until 2026)
The 2017 Act’s impact on the income tax regime is far-reaching and substantial. Many changes have been widely publicized, such as the new limitations on deductibility of state and local taxes and of interest on new mortgages. Perhaps less well-known (but with potentially significant impact) are the changes to income tax treatment for pass-through entities.
Specifically, one of the “headline” features of the 2017 Act is the reduction in the corporate tax rate from 35% to 21% for “C” corporations. In an effort to provide some measure of parity for owners of pass-through entities (such as sole proprietorships, “S” corporations, limited liability companies, and partnerships – the owners of which would otherwise be subject to individual income tax rates as high as 37%), a new 20% deduction was introduced for certain qualified business income.
However, this new deduction for pass-through entities may be unavailable to professional service providers (e.g., persons providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services). For businesses in these professions, full eligibility for this deduction is only available with taxable income of less than $157,500 for individuals (or $315,000 for a married couple), with the benefit phasing down over the next $50,000 for individuals (or $100,000 for a married couple). For other businesses, there is no income limit and the deduction is simply limited to the greater of (i) 50% of W-2 wages paid or (ii) 25% of W-2 wages paid, plus 2.5% of the unadjusted basis of tangible, depreciable property (e.g., real estate businesses with large capital investments but few employees). Trusts and estates would also be eligible for the 20% deduction.
Note that this provision of the 2017 Act is also scheduled to sunset after December 31, 2025.
Additional Income Tax Provisions of Note
The new Act is characterized by extraordinary complexity, and strategies developed in response to the Act may be limited by future IRS guidance and/or litigation.
Nevertheless, initial indications are that this new law will encourage some (i) owners of pass-through entities to consider reorganizing as a C corporation, and (ii) individuals to organize as a pass-through entity (as long as they are not in one of the specified service trades or businesses, or are below the taxable income threshold). The following provisions may also merit further consideration:
- Non-Primary Residence Real Estate Planning: Real estate portfolios are highly favored. In addition to the general pass-through deduction, qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income automatically receive the pass-through deduction, without the wage and adjusted basis limitations noted above.
- Intergenerational Income Shifting: Due to the phasing-in of per-taxpayer ceilings with respect to the pass-through deduction, shifting income to additional taxpayers (e.g., non-grantor trusts) may be useful.
- C Corporations as Ordinary Income Shelters: C corporations are now potential shelters for ordinary income and short term capital gain; however, reorganizing as a C corporation would also introduce a second level of income taxation when earnings are eventually paid out as dividends. In addition, care must be taken to avoid personal holding company, personal services corporation and accumulated earnings tax issues. (These have been neglected areas of the Internal Revenue Code, but could increase in importance.)
Nevertheless, reorganizing with certain management company structures that feature a C corporation general partner may prove extremely useful now that most personal deductions have been eliminated.
There is still much in the new tax law to analyze; however, whether entity reorganization or any other potential strategy would be advantageous would depend on a taxpayer’s particular circumstances.
Conclusion
In summary, as we enter a new year in the context of a tax sea-change, there are elements of the new law that afford significant additional planning opportunities, even as most of the provisions of the existing gift and estate tax regime remain unchanged. As ever in the context of tax law, an existing set of rules only remains “permanent” until later eliminated through sunset rules, or outright repeal. Because the wealth transfer taxes are fundamentally social policy tools, taxpayers should consider them permanent fixtures of the tax planning landscape and plan accordingly.
*Note that one of the uncertainties relates to the use of a different inflation index (chained CPI) as compared to prior law, which some commentators suggest may yield an exemption amount of only $11.18 million per taxpayer. As this Client Alert went to press, the IRS has not yet issued definitive guidance regarding the applicable basic exclusion amount for 2018.
