The Tax Cuts and Jobs Act introduced this month contains sweeping changes to the federal tax code.
The most significant change from an estate planning perspective is the repeal of the estate tax after December 31, 2023, under the House version of the Act. While the possibility of a repeal of the estate tax is an exciting development, there are some important considerations to keep in mind:
- Only the House version of the Act repeals the estate tax. The current Senate version of the Act does not repeal the estate tax;
- The Act is still subject to several steps of the legislative process before enactment and it is likely to undergo significant revisions during the process;
- Even if the estate tax is ultimately repealed by the Act, the estate tax could be reinstated in the future;
- The Act is only applicable to the federal estate tax. It would not affect any estate or inheritance taxes imposed at the state level; and
- Estate planning itself is still an important planning component even if the estate tax is repealed. People commonly equate the need for estate planning solely with the estate tax. This is not the case. The estate tax is only one of many drivers for estate planning. There is also a need for incapacity planning, probate avoidance, inheritance planning for minors and special needs beneficiaries, charitable planning and asset protection planning.
The repeal of the estate tax under the House version of the Act is not effective for almost five years, but there is partial interim relief with an increased estate tax exemption. The estate tax exemption is the amount of assets that a person can pass estate tax-free at death. The current estate tax exemption for 2017 is $5,490,000 per person, or $10,980,000 for a married couple. If the Act is not passed into law, the inflation-adjusted exemption amount for 2018 will be $5,600,000 per person, or $11,200,000 for a married couple.
Under interim relief provisions of the House version of the Act, the 2018 estate tax exemption doubles to $11,200,000 per person, or $22,400,000 for a married couple, and will increase annually for inflation going forward. The estate tax rate, which is the rate of tax imposed on assets in excess of the exemption, remains at 40% under the Act until the repeal becomes effective. In addition to the repeal of the estate tax, the House version of the Act also repeals the generation-skipping transfer tax for transfers occurring after December 31, 2023.
While the Senate’s version of the Act does not repeal the estate tax or the generation-skipping transfer tax, it does double the current estate tax exemption for 2018 to $11,200,000 per person, or $22,400,000 for a married couple, along with increases annually for inflation going forward.
The repeal of the estate tax under the House’s version of the Act is not surprising. The repeal was a part of the current administration’s campaign platform. However, the current administration’s platform also included a capital gains tax that would be imposed on appreciated assets at death as a replacement for the estate tax. The Act does not include this capital gains tax, nor does it include any change to the basis step-up.
Most assets held at death, other than retirement accounts, pass to beneficiaries with a stepped-up basis. This means that the beneficiaries receive a tax basis in the inherited assets equal to the fair market value of the assets on the date of the decedent’s death. As a result, the beneficiaries can liquidate the inherited assets and avoid income tax on any appreciation that occurred prior to the date of death. The basis step-up exists to ensure that estate tax and income tax are not simultaneously imposed on appreciated assets at death, other than retirement accounts. If the estate tax is repealed, it would make sense that the basis step-up would be repealed as well. However, the Act does not eliminate or modify the basis step-up.
Despite the repeal of the estate tax, the House version of the Act does not repeal the gift tax. The reason is presumably a hedge against income tax manipulation. If there was no gift tax, appreciated assets could be transferred from a higher bracket taxpayer to a lower bracket taxpayer for sale. After sale and payment of taxes at the lower bracket, the net assets could be transferred back to the original owner. Even though the House version of the Act does not repeal the gift tax, it does reduce the current gift tax rate of 40% to 35% for gifts made after December 31, 2023, and the increased exemption described above for the estate tax prior to its repeal would be available for gifts.
There had been concern that the Act would limit the use or availability of stretch for retirement accounts. This is the ability for long-term tax-deferral after the account owner passes away. Essentially, the beneficiary of a retirement account can elect to pay taxes slowly over his or her projected life expectancy. The Act does not contain any provisions that limit or otherwise affect the ability to stretch retirement accounts.
Time will tell if the estate tax portions of the Act are toned-down as it winds through the legislative process, but the current House and Senate versions of the Act are extremely favorable for clients and their beneficiaries. We will closely monitor the progress of the Act and notify clients when new planning opportunities become available or when existing planning needs to be revisited or revised.
