The Future of the Federal Estate Tax and Implications for Estate Planning

Overview

In recent days, I have often been asked the question by lawyers, CPAs as well as farmers and ranchers of what the impact of the election of Donald Trump as President will be on the future of the federal estate tax.  The President-elect has proposed far-reaching changes to the tax system that will impact practically all taxpayers.  Consequently, tax advisors will be busy keeping up with the changes and determining how to implement them for their clients.  This is particularly true for practitioners trying to determine how to estate plans for clients.  In addition, it’s likely that the President-elect will be able to get many of his proposed tax changes through the Congress given the fact that the Republicans maintained control of both the U.S. House and Senate. 

What About Repeal?

The President-elect has proposed a full repeal of the federal estate tax.  With the ramp-up in recent years of the estate tax exemption to $5 million and the indexing of it to inflation such that it is at $5.45 million for deaths in (and gifts made in) 2016, the tax doesn’t generate much revenue and impacts relatively few estates.  IRS data for 2015 indicates that that just under 5,000 estates (out of 2,626,418 deaths) owed federal estate tax and generated approximately $17 billion in federal estate tax revenue.  That’s 0.6 percent of all federal revenue in 2015, but is an average tax liability of $3.4 million per taxable estate.  That is a huge number for those estates impacted by the tax, but the total revenue generation is less than one percent of all federal revenue in 2015.  Also, about forty-four percent of that amount came from 266 estates.  So, clearly, the estate tax is not much of a revenue-raiser, and it also hasn’t done a good job at minimizing the concentration of wealth – the purported primary reason for the creation of the tax.  Just based on these facts, there doesn’t appear to be much merit in keeping the tax around.

So, if the federal estate tax were to be repealed, when might it occur?  The options are that repeal could be effective January 1, 2017, or perhaps put off until the beginning of 2018.  Another option is that repeal could be phased-in over a certain period of time.  Also, while it appears at the present time that any repeal would be “permanent,” that’s not necessarily a certainty.  Similarly, it’s not known whether the current basis “step-up” rule would be retained if the estate tax is repealed.  That’s particularly a big issue for farmers and ranchers.  It will probably come down to a cost analysis as to whether step-up basis is allowed.  The President-elect has already proposed a capital gains tax at death applicable to transfers that exceed $10 million (with certain exemptions for farms and other family businesses).  One factor to keep in mind is that a repeal bill would require 60 votes in the Senate to avoid a filibuster unless repeal is done as part of a reconciliation bill.  In that event, however, the repeal of the federal estate tax would have to “sunset” in ten years.

Would the federal gift tax also be repealed?  Under current law, the gift tax and the estate tax are “coupled.”  That means that the exemption of $5.45 million can be used to offset taxable gifts during the donor’s life or offset taxable estate value at death.  The President-elect has proposed repealing the gift tax along with repeal of the estate tax.  That’s really interesting because the gift tax is not just simply tied into the estate tax, it also has income tax implications.  For instance, if there is no estate tax and no gift tax, it becomes much easier to shift income with zero tax cost to another person in the family (likely a child) who is in a lower tax bracket.  So, if a parent, for example, wishes to sell an asset, the tax-saving technique would be to gift the asset to the child in the lower tax bracket, have the child sell the asset and recognize the gain and then gift (tax-free) the proceeds of sale back to the parent.  Remember, the strategy works because capital gain tax rates are tied to the income tax rate of the seller.  The lower the income tax rate the seller is in, the lower the applicable capital gain rate on sale of an asset.  But, also remember, with the high level of the gift tax exemption currently, this strategy is largely possible already.  But, what a repeal of the gift tax would do is allow the easy transfer of assets into irrevocable trusts for asset protection planning purposes without gift tax complications.  But, if a capital gains tax at death is imposed will the transfer avoid the tax?  That’s a big question for planners to worry about and determine what to do with existing plans involving trusts particularly in light of planning that might already have been engaged in anticipating the finalization of the proposed I.R.C. §2704 regulations.   Relatedly, what should be done if basis step-up is retained and there is no estate tax?  That would mean that inclusion of property value in the estate at death won’t cause a tax problem, but exclusion would create an income tax problem!

So, with the gift tax in the mix, what are the possible legislative options?  One option is the permanent repeal, effective January 1, 2017, of the estate, gift and generation-skipping transfer tax.  Another option is that all of those taxes would be permanently repealed on a phase-out basis over a period of years.  Still another option is estate tax repeal with the retention of the gift tax.  Or, there could be an estate tax repeal and no step-up in basis.  Or, the estate tax could be repealed and a capital gains tax imposed on death (with certain exceptions). 

Planning Implications

An estate planning option, as always, is to simply wait and see what happens.  Perhaps the only downside to this approach would be an untimely death.  Even in that event it’s hard to see the downside given that the current exemption is relatively high and it doesn’t appear likely that the proposed I.R.C. §2704 regulations will actually get finalized (and even if they do, they will likely get removed by the new Administration).  For those clients that have already started the estate planning process, they could simply stop for the time being and adopt the wait and see approach.  But, there still might be the need for asset protection for high-wealth clients which could be accomplished by following through with the process to completion. 

Should existing plans be modified?  At this point, it’s too early to modify.  If (perhaps more likely, “when”) the estate tax is repealed, there will be many issues to be addressed by planners.  For instance, one of the issues I am addressing at the tax schools this fall concerns the use of Grantor Retained Annuity Trusts (GRATs).  What if one of those is already in place?  Would the note-sale transaction and the related contractual obligations be impacted by repeal?  What if the GRAT no longer serves its purpose and it is modified by a court?  Would that trigger gift tax (assuming the gift tax is retained)?  What’s the responsibility of the trustee in this situation?  What if a GRAT is presently under IRS audit?

For existing wills and revocable trusts, repeal of the estate tax will require a review of those documents.  Estate tax repeal would call into question the purpose and relevance of marital deduction/credit shelter trusts in wills.  Funding language will have to be examined.  Existing language that funds the credit shelter trust with the maximum amount resulting in no federal estate tax could result in wiping out the credit shelter trust.  Does the client want that result?  Practitioners will have to revisit their clients’ goals and objectives.  If there is a capital gains tax at death, will the courts view it as a “federal estate tax” such that the credit shelter trust would still be funded? 

For irrevocable trusts that were set up to minimize or eliminate federal estate tax, does the client still want the trust solely for asset protection purposes?  In addition, how will trust (and will) provisions utilized under prior law be interpreted under a new transfer tax system that wasn’t thought of at the time the language was drafted? 

Continuing with trusts for the moment, what about qualified terminable interest property (QTIP) trusts that have to pay out at least annually to qualify for the marital deduction?  Is that still what the client wants when it no longer has to be done?  Will a court grant any request to end the income interest? 

What about life insurance?  Don’t let clients drop it!  Even if the estate tax is repealed, it could be re-enacted by a subsequent Administration and a new Congress.  Plus, the client has already incurred the cost of getting the policy and is getting a build-up of wealth without income tax.  For many clients, life insurance is a pretty good investment right now. 

Also, factoring into the planning discussion is state-level death taxes.  For those states that have an estate tax, the repeal of the federal estate tax will also kill-off the state death tax.  States, such as Nebraska for example, that have an inheritance tax will still have that tax, but may be forced to reconsider whether they should because they will be putting themselves on a rather small “island” of states having such a tax. 

But, trust planning and usage will remain.  Asset protection from creditors and in the event of divorce (or death and remarriage) indicate why trusts will remain beneficial even without any federal estate tax.  Plus, trusts can be used to distribute income to beneficiaries in lower income tax brackets.  Irrevocable trusts can also be beneficial to provide protection and control to an older client suffering from failing health to help prevent loss of wealth by unscrupulous family members, supposedly trusted professionals and others.  But, from a technical standpoint, any mandatory income distribution provisions should be changed to discretionary.  After all, it won’t be necessary to have mandatory distributions to meet QTIP requirements.  Also, discretionary powers of appointment should be used to get the assets back into the grantor’s estate to get a basis step-up if that rule is retained.  Also, flexible trust language should be used to produce the intended result – inclusion in the estate when that is desired and exclusion when that is desired. 

What To Do Now

Common year-end planning is still the thing to do.  Make annual exclusion gifts to fund an I.R.C. §529 plan, make Crummey-type transfers, or make a zeroed-out gift to a GRAT.  From an income tax perspective, accelerate deductions to 2016 and defer income to 2017 because 2017 rates are likely to be lower than 2016.  One way to accelerate deductions would be to make some of the charitable contributions in 2016 that would have been made in 2017, contribute to retirement plans, and pay state and local taxes this year.

If you had a family member die this year and the estate tax return has not yet been filed (if Form 706 is due, it is due within nine months from the date of death), the return probably should be put on extension to determine whether the extra cost associated with a portability election should be incurred.

Conclusion

The repeal of the estate tax will significantly change estate planning for many clients.  We’ll have to wait and see exactly how repeal shapes up and what is included with it.  But, clients will be asking questions.  Are you prepared to provide them answers?  Hopefully, today’s post helps on that point.