Tax Reform has not been enacted at the time this article is written, but it appears likely that some variation of the House and Senate proposals will be enacted. Because the legislation will so dramatically impact estate planning, it seems worthwhile to go out on the proverbial writing limb and discuss planning points practitioners should consider. Whether or not the estate tax is scheduled for repeal, if the exemption is doubled as is proposed under each bill the practical result for most clients is that the federal estate tax will be largely irrelevant. But that does not mean that planning is irrelevant, only different and for most clients, independent of estate tax. The following are ideas that will hopefully help practitioners transition the estate planning services they provide to clients in light of these changes. Exercise caution to confirm the final outcome of the tax legislation:
Estate Planning Documents
►Old Wills: Client’s wills and revocable trusts need to be reviewed. If the estate tax exemption doubles, or is even repealed at some future date, how will that effect the client’s dispositive scheme? Many clients have never updated their documents and plans to address the ongoing changes of the exemption amount and the consequences for some are minor but for others disastrous. If the client has not reviewed these provisions with their estate planning attorney in recent years this vital issue may have not been considered.
►New Wills: These should be rethought if we have a $10 million post-Tax Reform estate tax exemption. Most dispositive schemes were structured to meet tax law requirements that simply will be irrelevant for most clients. So, for new documents the planning should begin with and focus on what the client wishes. But, without the necessity for trusts for tax planning purposes many clients may opt for simple outright bequests. While that is seductive from a cost and ease of handling perspective, it could be damaging for beneficiaries in that the protection afforded trusts will be lost. Thus, practitioners should educate clients about the importance of the continued use of trusts in their documents for non-estate tax reasons. Finally, while it may be a hard sell for many clients considering a $10 million exemption, trusts might still be useful in the event the estate tax laws change again in the future. Many commentators have speculated that in 2020 there may be a revision of the tax laws rolling back the favorable estate tax changes being considered as part of Tax Reform. Thus, however unpleasant clients might find continued tax planning, it may well prove like the old adage, “better safe than sorry.” Thus, including more traditional tax oriented planning in wills, even if the current exemptions seem “out of sight” for many clients might be prudent. If the cost of doing so is nominal, the only downside might be a slightly longer document.
► Existing Credit Shelter Trusts: When a client’s spouse died years ago a bypass or credit shelter trust may have been formed with assets equal to the then federal exemption amount (or the state exemption amount if lower). Many of the wills (or revocable trusts) governing this were created when the federal estate tax exemption was much lower, perhaps $1 million. Does this trust make sense to retain now? If Tax Reform doubles the exemption it may make even less sense to retain as the old credit shelter trust might just keep assets outside the estate missing a basis step up on death. That trade-off, missing out on the basis step up to avoid capital gains tax in exchange for saving an estate tax, may have made sense when the estate was expected to face an estate tax of 50%+. Now, with no estate tax savings but a loss of basis step-up it may be a terrible tax result. For some, it may be feasible to terminate and distribute credit shelter trust assets thereby assuring a basis step up and avoiding future professional fees to administer the trust. Be certain to discuss all the pros and cons with the client before taking action. If the client has health or aging challenges the trust may be a helpful safeguard. If the assets are distributed and the beneficiary receiving the assets is sued or divorced the assets may be lost. Try to educate clients about the pros and cons of retaining existing irrevocable trusts for divorce and asset protection even if they no longer serve their initial estate tax minimization purpose.
► Existing Life Insurance Trusts: Unlike credit shelter trusts there should be no basis step up issues for life insurance trusts (since insurance does not face that issue) but evaluate what clients should do with old life insurance trusts holding life insurance intended to pay an estate tax that may never be relevant. While the simple answer might be cancel the insurance, and terminate the useless trust, that will likely be too simplistic an approach for several reasons. The liquidity the insurance might provide may be useful if the estate includes a family business or real estate holdings. Perhaps the insurance can be repurposed into something else. Might exchanging a life insurance policy for an annuity meet current financial or retirement goals? If so does the trust reasonably permit the distributions necessary to make that feasible if the insurance issues can be resolved? If in fact cancelling the insurance is the right answer there may be several options. The policy might be converted into a paid-up policy at a lower face amount thus reducing the plan which may be more appropriate given the loss of estate tax rationale. Perhaps the policy can be sold into a secondary market?
► Existing Irrevocable Trusts: Bear in mind that trusts that are supposedly irrevocable might be changed in many ways through decanting (merging) under state law into a new trust that has different administrative provisions (investment provisions, C corporation provisions, distribution provisions, etc.). So that an old trust can be updated to the new tax environment by not only changing assets as discussed in preceding paragraphs, but by re-writing many portions of the trust. If you find that this will be useful confer with the client’s estate planner to see how far the re-write can reasonably be taken and the costs involved.
►Powers of attorney: Most forms include gift provisions. A common gift provision is to permit annual exclusion gifts to all descendants. Some even include the right to make gifts for tuition and medical expenses of permissible donees. Is this appropriate or necessary? Most of these forms were created when the estate tax exemption was a mere $600,000. At this juncture that gift provision may be irrelevant for estate tax purposes as the client is unlikely to ever face an estate tax. But it may provide an Achilles heel for elder financial abuse. If so, suggest the client meet with their estate planner and sign new powers of attorney that prohibit gifts.
► New Irrevocable Trusts: New trusts should include more flexibility. The tax laws remain uncertain. Most significantly, with the new high estate tax exemptions clients might well transfer larger portions of their wealth into irrevocable trusts to use as much exemption as they can. This will make sense for wealthy clients that want to lock in the new higher gift tax exemption before a future Congress changes it to a less favorable level. However, this will require that clients have as much access as feasible to the trust assets. Thus, domestic asset protection trusts (“DAPTs”) and spousal lifetime access trusts, in which the client or the client’s spouse respectively are named beneficiaries will be more common.
Income tax planning for trusts might be dramatically affected. For clients living in high tax states, the loss of state and local tax deductions might make it advisable for some new trusts to be structured as non-grantor trusts to avoid high state income taxes that won’t be deductible. The ING trusts, intentionally non-grantor trusts, might not be the optimate approach for many of these clients as they will benefit from using gift tax exemption now to protect that exemption from future adverse legislative changes. This might push for a new type completed non-grantor trust that differs from the more traditional ING approach.
►C versus S Corporation: The new tax laws, depending on their final form, might change the calculations as to whether particular businesses should be operated as S corporations or C corporations. If the format of the entity is changed be certain that any appropriate changes are made to the client’s estate planning documents. For example, if specific bequests are made in interests in a named entity and that entity changes, the bequest will have to be changed (e.g. the will updated). Also, only certain types of trusts (grantor, QSST, ESBT) can hold S corporation shares so if an S corporation format is opted for the estate planning documents may have to be updated for that as well.
► Pass-Through Entities: It is not clear at the time of this article being written what rules will be adopted as to pass-through entities. The House and Senate proposals are quite different. Practitioners should review and understand the final format and then consider the many options for how planning may be impacted. The key appears to be what steps may be advisable to secure or maximize the lower tax rates potentially available to pass-through entity income. The House version provided that 30% of income deemed to be earned from an active business activity will be taxed at a favorable rate of 25% and 70% of income will be taxed as compensation. This may affect whether a client should be or remain active, retire or take other steps. As to trusts decisions and changes may have to be made to qualify for this benefit. If the trustee is active in the business might that have a different result under the House version than a trust for which the Trustee is inactive? How will directed trusts be treated for these purposes? Might changing trustees to someone who is not active in the business provide a different result?
The Senate version specifically states that the favorable 23% deduction wouldn’t apply to business income earned by trusts and estates. It’s unclear whether the business income would retain its character as business income eligible for the 23% deduction when distributed to a beneficiary. If a trust is a QSST and income flows through to the beneficiary from the trust might that affect the result? Will in contrast income of a business held in an ESBT be trapped at the costlier trust level without benefit of this rule whereas S corporation stock owned outside of a trust would benefit from the lower more favorable tax rate? What this all might mean is uncertain at present. If the Senate version is enacted, it would create a significant tax disadvantage for trust owned businesses. Perhaps some trusts might be dissolved if feasible, but for most the loss of estate tax (assuming repeal does not in fact occur) and asset protection benefits would make dissolution unpalatable. Might pass-through entities owned by trusts structure consulting or other agreements with non-trust owned entities to endeavor to qualify some portion of the income earned for the more favorable tax rate?
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.