What s News in Tax Analysis that matters from Washington National Tax To Plan or Not to Plan? Estate Planning during Unpredictable Times February 20, 2017 by Scott Hamm and Tracy Thomas Stone, Washington National Tax * Uncertainty regarding the possibility of tax reform may lead some to adopt a wait and see approach and delay estate planning. This article describes a range of potential legislative outcomes that could affect estate planning and considers planning ideas taxpayers may entertain to prepare for the possibility of changes in the tax law. There will be very few occasions when you are absolutely certain about anything. You will consistently be called upon to make decisions with limited information. That being the case, your goal should not be to eliminate uncertainty. Instead, you must develop the art of being clear in the face of uncertainty. ~ Andy Stanley President Trump s ascension into the White House with the Republican Party controlling both houses of Congress has increased the likelihood of meaningful tax reform. However, putting together a tax reform package is more difficult than it might seem at first blush. 1 And even if tax reform becomes law, the process can take substantially longer than might be anticipated. For example, the 1986 Tax Reform Act * Scott Hamm is a managing director in the Estates, Gifts, and Trusts group of Washington National Tax ( WNT ) and Tracy Thomas Stone is the principal-in-charge of that group. 1 For a discussion of the tax reform generally and the difficulties that can be encountered along the way, see the KPMG report: Understanding the Tax Reform Process: FAQ.
To Plan or Not to Plan? Estate Planning during Unpredictable Times page 2 took 13 months from the initial mark up of a bill until President Reagan signed it into law. This means that the status of the tax law could be in limbo for the next year or more. The House Republican Blueprint on Tax Reform (the Blueprint ), 2 the likely starting point for the House s tax reform efforts, calls for the elimination of the estate tax and the generation-skipping transfer ( GST ) tax. Indicating that the president might be at least partly on the same page as House Republicans, during the campaign, candidate Trump proposed repealing the estate tax. However, he also proposed imposing instead a tax on capital gains in excess of $10 million at death, while allowing exemptions for small businesses and family farms. Neither the Blueprint nor the president s campaign proposed changing the gift tax, so its fate is even more uncertain at this point in time. It is also unclear, if the estate tax were repealed, whether the basis of inherited assets would still be equal to fair market value at date of death (a stepped-up basis) or would instead be equal to the decedent s basis (a carryover basis). The president has indicated that he may make an announcement regarding tax reform within the next couple of weeks, so it is possible that more information on his proposals may be forthcoming soon. Not only is there uncertainty as to what any tax reform legislation would include but there are also questions of how and when. If repeal of the estate tax is enacted, the estate tax could disappear instantly or it could be phased out over time. As happened previously, any repeal or other changes could be scheduled to sunset at some point in the future and could bring back rates and exemption amounts potentially less taxpayer friendly than under existing law. And while death and taxes may be the only certainties in life, the specific structure and application of those taxes can be and often is revisited and modified when another party takes control. All this uncertainty may lead some taxpayers and their advisors to take a wait and see approach and put off estate planning. If the estate, gift, and GST taxes were all abolished permanently and the basis step up rule for inherited assets were still retained, doing nothing might actually give you a good result. However, putting the brakes on estate planning could be quite disadvantageous in the event of other possible and perhaps more likely legislative outcomes. For example: The estate tax might not be repealed at all. The estate tax might be repealed (perhaps over some timeframe or all at once) but might subsequently be reinstated (whether because of a change in the composition of Congress or because the repeal must sunset under congressional procedural rules). It might even return in a more burdensome form in the future if some of the changes proposed by the Obama administration lower exemptions, higher tax rates, reduced or eliminated valuation discounts, and restrictions on GRATs and sales to IDGTs (described below) that limit their benefit were adopted at the same time. 2 A Better Way Our Vision for a Confident America (June 24, 2016) (published by the House of Representatives Republican Tax Reform Task Force).
To Plan or Not to Plan? Estate Planning during Unpredictable Times page 3 The estate tax might be repealed but a capital gains tax at death regime might replace it. The capital gains tax at death might be less costly for some taxpayers but more costly for others depending on the specific structure, rates, and exemptions. The same sorts of irrevocable transfers and discount planning structures that reduce estate tax might also reduce exposure to the capital gains tax at death. The estate tax might be repealed but a carryover basis at death regime might replace the current step-up regime. In this case, except to the extent of your costs, estate planning done beforehand may not put you in a worse position than you would have been in if you did nothing because you would not forego a step up in basis. The estate tax might be repealed and the step-up regime might be retained. This may be the one scenario in which planning might not prove advantageous because assets transferred during life would lose the benefit of a step up in basis. However, it may be possible to build flexibility into the estate plan by using grantor trusts, substitution powers, decanting powers, trust protectors, and/or flexible trust terms such that assets could potentially be reacquired before death. Consequently, under many of the potential tax reform scenarios, moving forward with estate planning may still be advantageous. With that said, given the potential chance of repeal, the most prudent planning in the current environment may involve avoiding significant gift tax exposure and keeping the costs of planning reasonable in light of the benefit or value involved. Some specific ideas that may be worth considering include the following: Annual exclusion gifts. Anyone can make an outright gift of $14,000 to any other individual without having to use their lifetime exemption or pay gift tax. The annual exclusion is also available for certain transfers in trust if the beneficiary has a present interest in the property. To the extent not used, the opportunity disappears at the end of each year. Used regularly, lifetime gifting programs utilizing annual exclusion gifts can be an effective means of transferring wealth. Medical and educational expense payments. Taxpayers can make gift tax-free transfers to pay another person s medical or tuition expenses. To obtain this benefit, the transfer must be directly to the medical institution or the educational organization; the transfer cannot be made to the person receiving the medical care or educational services (whether as reimbursement for or to enable them to pay the expenses). Exemption Use. Presently existing gift tax and GST tax exemptions (currently at $5.49 million per individual) may be used to make tax-free transfers outright or in trust. Various trust structures may be utilized, including: Dynasty trust. Multi-generational trust that can be structured to benefit children, grandchildren, great-grandchildren, etc. without inclusion of the trust assets in the estate of the grantor or any of the trust s beneficiaries.
To Plan or Not to Plan? Estate Planning during Unpredictable Times page 4 Intentionally defective grantor trust ( IDGT ). An irrevocable trust typically set up for the benefit of the donor s descendants. The trust assets are treated as owned by the donor for income tax purposes, but are excluded from the donor s estate for estate tax purposes. Spousal access trust. A trust that permits discretionary distributions to the spouse and children of the donor during the spouse s lifetime. Allows the donor to transfer wealth out of the donor s estate while retaining some potential access to the trust property through their spouse. Grantor Retained Annuity Trusts ( GRATs ). A trust that pays an annuity to the donor for a term of years. The annuity payments may be structured such that there is no taxable gift upfront. Any appreciation on the assets in the GRAT over the IRS required interest rate assumption (2.6 percent in February 2017) pass transfer tax free to the beneficiaries of the GRAT. Sales to IDGTs. A sale of assets to an IDGT in exchange for a note can allow a client to freeze the value of an asset and pass the appreciation on to beneficiaries while leveraging the client s gift tax exemption. As noted above, the trust is treated as owned by the grantor and therefore is a disregarded entity for income tax purposes that allows the grantor to sell assets to the trust without triggering capital gains tax. Any appreciation over the interest rate on the note (i.e., the appropriate applicable federal rate, 2.10 percent in February, for a mid-term, annual compounding note) is removed from the grantor s estate and transferred free of gift tax to the trust beneficiaries (typically, children and grandchildren).the IDGT must own property other than the assets it acquires through the sale in order to support the note s viability; it may be possible to use gift and GST tax exemption when funding the trust for this purpose. Valuation planning. For gift tax purposes, property is valued based on the price at which the property would change hands between a willing buyer and a willing seller. A buyer would pay less for a minority interest in a closely held business than a similar interest in a publicly held company, since the buyer would lack the liquidity and protections available for stockholders in publicly traded companies. Often, a minority shareholder has no influence over business policy, timing of dividends, or even liquidation or sale of the company. By giving away non-controlling interests in a business or fractional interests in a real estate parcel over a period of years, an individual can give away his or her entire interest in the property for less tax cost than the family would incur if the entire interest in the property passed through the individual s estate. Valuation planning may also include establishing a family limited partnership to hold various assets of the taxpayer and using interests in the family limited partnership in connection with other estate planning ideas mentioned above. Charitable Giving. In addition to the uncertainty regarding the future of the estate tax, there is some question as to how tax reform efforts might affect the charitable income tax deduction. Thus, taxpayers who are charitably inclined may want to take advantage of current income tax
To Plan or Not to Plan? Estate Planning during Unpredictable Times page 5 benefits as well as the gift tax charitable deduction and make tax-deductible gifts directly to a public charity or through other vehicles, such as: Private foundations. Private foundations are separate legal entities that are supported by a single donor or a limited number of donors. They can help provide an organized structure for a family s long-term charitable activities and allow a donor to take a charitable contribution deduction in the current year but delay the decision regarding which charities should receive the funds to a later date. The donor retains a high level of control over the private foundation s use of the charitable dollars. However, private foundations may involve significant set-up and operating costs, and must closely follow strict rules which limit certain activities and govern charitable grant-making. Donor advised funds ( DAFs ). Just as with a private foundation, if a client wants to take a charitable deduction in the current year, but is unsure which charity to benefit, the client may make a tax-deductible contribution to a donor-advised fund before the end of the calendar year and recommend charities as recipients at a later point in time. DAFs have minimal start-up and operating costs and the fund handles the administration and record-keeping for the donor. However, the donor to a DAF retains only advisory privileges and relinquishes some control over the assets, how they are invested, and to whom they are eventually distributed. Charitable Lead Annuity Trusts ( CLATs ). This method of giving can help meet both current charitable goals and estate planning goals through a single trust vehicle. CLATs are irrevocable trusts that provide one or more chosen charities with payments for a certain number of years. At the end of the term, the remaining property is distributed to (or held in further trust for) the remaindermen (typically, the client s children). If the value of the income interest given to charity is significant enough, the gift to the children may be de minimis (or zeroed out ) such that the transfer does not require payment of gift tax or use of gift tax exemption. During periods of uncertainty, some individuals assume that the conservative position is to take a wait and see approach. However, as noted above, under most of the potential tax reform scenarios such a position may not provide the most favorable long term result from an estate planning viewpoint. Instead, continuing to plan using techniques that do not incur gift tax may generally be more beneficial. Taxpayers should consider making annual exclusion gifts, using their gift tax and GST tax exemptions, creating spousal access trusts, creating GRATs, and entering into sales with IDGTs. KPMG can assist with such planning and its implementation while keeping a close eye on legislative developments in Washington, D.C. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.