Techniques fiduciaries need to consider.
On Jan. 1, 2018, the provisions of the 2017 Tax Cuts and Jobs Act (the Act) became effective. The impact of this comprehensive law won’t be felt by many taxpayers until April 2019, when they file their 2018 tax returns. But, for professional fiduciaries, planning for these tax changes began immediately. Several of the provisions—both estate and income tax related—have a profound impact on fiduciaries. All of these provisions are scheduled to sunset at the end of 2025, thus placing an urgency on the implementation of some planning strategies.
Increased Exclusion Amount
One change is the increase in the applicable exclusion amount. What had formerly been an applicable exclusion amount of $5 million indexed for inflation became a $10 million exclusion amount indexed for inflation. For 2019, the applicable exclusion amount is $11.4 million for an individual and $22.8 million for a married couple. The result of increasing these exclusions is that there will be far fewer taxable estates than ever—far fewer executors will need to file federal estate tax returns.
An important consequence of the increased exemption is the need for fiduciaries to analyze with their trust beneficiaries the potential of subjecting to estate tax otherwise non-estate taxable trust assets. For example, if a trust has a value of $3 million and the trust beneficiary has a taxable estate of $5 million, including the $3 million in the taxable estate won’t create any federal tax liability. It will, however, provide for a potentially valuable step-up in basis of the assets. Say, for example, that the $3 million of the trust’s assets have an income tax cost of only $1 million. If the trust is includible in the estate of the beneficiary, then the trust’s assets’ income tax cost will become $3 million due to the step-up. This will provide a capital gains tax savings on the $2 million of built-in gains, without incurring any estate tax.
This technique has several caveats. Importantly, one must understand the impact of any state estate taxes. So, for example, if the beneficiary lives in a state such as New York, increasing the beneficiary’s estate by the trust assets might subject the estate to significant New York taxes that wouldn’t otherwise have to be paid. Another caveat is the method for including the trust assets in the beneficiary’s estate. An outright distribution is one method; however, the fiduciary must be mindful of the rights of the remainder beneficiaries. Would the property pass to those same remainder beneficiaries at the death of the current beneficiary? If not, or if there’s uncertainty, an outright distribution isn’t advisable. Another caveat is that the law is set to sunset after 2025. If a beneficiary’s estate is increased above the current exemption amount, any excess may be subject to estate tax if death occurs after the anticipated sunset.
General Powers of Appointment
To provide the best potential result, some fiduciaries are considering amending trusts when possible—for example through a decanting or reformation—to include general powers of appointment (GPOAs) that will spring up for a beneficiary to the extent that having that power doesn’t increase the estate taxes (both federal and state) that the beneficiary would otherwise pay. These are similar to the types of springing GPOAs that fiduciaries are used to seeing in trusts that aren’t exempt from generation-skipping transfer taxes and may need a GPOA. Often, these powers can be exercised only in favor of creditors of the estate.1
SALT Deduction Limit
On the income tax front, the $10,000 limitation on state and local tax (SALT) deductions has provided fiduciaries with the need to engage in additional planning. For example, should a fiduciary consider moving a trust out of a state with a state income tax into a state with no income tax? While this has always been a consideration, the need for this planning has heightened with the SALT limitation. Again, this type of planning isn’t without its problems. For example, a close and trusted family member may need to resign as trustee to accomplish this result—and that may not be appropriate because it may be important for the family member to retain control. Additionally, smaller trusts may not be capable of moving because there may not be a fiduciary willing to take on a smaller trust in the jurisdiction selected.
Another issue that may prevent the fiduciary from eliminating state income taxes on a trust is that there may be state-sourced income that will require state income taxation on the trust regardless of the trust’s jurisdiction or the domicile of the trustee. Fiduciaries may wish to consider separate trusts for these types of assets so that the state-sourced income assets are in one trust, and the other assets are in another trust, not subject to state income taxes.
Opportunity Zones
Fiduciaries also have the ability to consider whether to defer gains by taking advantage of the opportunity zone funds (OZFs) reinvestment strategy contemplated by the Act.2 Briefly stated, an opportunity zone is an economically distressed community, designated by a state and certified by the U.S. Treasury Secretary, to receive preferential tax treatment. On the realization of capital gains, a taxpayer can invest all or a part of the gain into an OZF and defer the taxes on the gains until 2026, with some additional benefits, depending on how long the fund investment is held. For a fiduciary, the decision as to whether and to what extent to defer gains by investing in an OZF is complicated by a fiduciary’s obligations under the applicable prudent investor act.
IRS Clarifications
The elimination of miscellaneous itemized deductions caused headaches for many fiduciaries throughout last year as we debated whether this elimination also eliminated the deduction for fiduciary commissions. Happily, the Internal Revenue Service clarified that commissions remain fully deductible.3
Another headache eliminated was the notion of clawback of the exemption. A clawback would result if a gift of $11 million was made in 2018 and death occurred in 2026, when the exemption had sunsetted back to the $5 million amount adjusted for inflation. Would the excess of $11 million over the 2026 exemption be subject to estate tax—in effect, clawed back into the estate and taxed? The IRS eliminated that headache and confirmed that there would be no clawback.4
So, 2018 came upon us with opportunities and challenges. The Act that was supposed to lower taxes may actually have increased taxes for individuals and trusts through the elimination of many deductions formerly available. And, for some income levels, tax rates have actually risen because of the change in certain tax brackets.5 Once again, as we progress more deeply into winter, the allure of the sunshine states that have no state income and estate taxes becomes even more enticing.
Endnotes
1. Charles A. Redd, “Tips From the Pros: Don’t Overlook the Power of Powers,” Trusts & Estates (September 2016); Internal Revenue Code Section 2041(b)(1).
2. IRC Section 1400Z-1, et al.
3. Internal Revenue Service Notice 2018-61.
4. Proposed Treasury Regulations Section 20.2010-1.
5. For example, a single taxpayer earning $250,000 was in the 33 percent tax bracket under old law and is now in the 35 percent tax bracket.