Saturday, September 24, 2022
The Tax Cuts and Jobs Act (TCJA) has made estate planning much easier for most farm and ranch families. Much easier, that is, with respect to avoiding the federal estate tax. Indeed, under the TCJA, the exemption equivalent of the unified credit (i.e., the “basic exclusion amount”) was doubled from its prior level of $5 million and then indexed for inflation. For deaths in 2022, it is is $12.06 million per decedent. When that is combined with the unlimited marital deduction and the ability to “port” over the unused exclusion (if any) at the death of the first spouse to the surviving spouse, very few estates will incur federal estate tax. Indeed, according to the IRS, there were 3,441 federal estate tax returns filed in 2020, and only 1,275 of those represented returns where federal estate tax was due.
The TCJA also retains the basis “step-up” rule. That means that property that is included in the decedent’s estate at death for tax purposes gets an income tax basis in the hands of the recipient equal to the property’s fair market value as of the date of death. I.R.C. §1014.
But, with the slim chance that federal estate tax will apply, should estate planning be ignored? What are the basic estate planning strategies for 2022 (and into 2023), and for the life of the TCJA through 2025?
Married Couples (and Singles) With Wealth Less Than $12.06 Million.
Most people will be in this “zone.” For these individuals, the possibility and fear of estate tax is largely irrelevant. But, there is a continual need for the guidance of estate planners. The estate planning focus for these individuals should be on basic estate planning matters. Those basic matters include income tax basis planning – utilizing strategies to cause inclusion of property in the taxable estate so as to get a basis “step-up” at death.
Existing plans should also focus on avoiding common errors and look to modify outdated language in existing wills and trusts. For example, many estate plans utilize "formula clause" language. That language divides assets upon the death of the first spouse (regardless of whether it is the husband or the wife) between a "credit shelter trust," which utilizes the remaining federal estate tax exemption amount, and a "marital trust," which qualifies for the (unlimited) federal estate tax marital deduction. The intended result of the language is to cause that trust’s value to be taxed in the first spouse’s estate where it will be covered by the exemption and create a life estate in the credit shelter trust property for the surviving spouse that will “bypass” the surviving spouse’s estate upon death. As for the martial trust assets, tax on those assets is postponed (if it is taxed at all) until the surviving spouse dies.
But, here’s the rub. As noted above, the TCJA’s increase in the exemption could cause an existing formula clause to “overfund” the credit shelter trust with up to the full federal exemption amount of $12.06 million. This formula could potentially result in a smaller bequest for the benefit of the surviving spouse to the marital trust than was intended, or even no bequest for the surviving spouse at all. It all depends on the value of assets that the couple holds. The point is that couples should review any existing formula clauses in their current estate plans to ensure they are still appropriate given the increase in the federal exemption amount. It may be necessary to have an existing will or trust redrafted to account for the change in the law and utilize language that allows for flexibility in planning.
In addition, for some people, divorce planning/protection is necessary. Also, a determination will need to be made as to whether asset control is necessary as well as creditor protection. Likewise, a consideration may need to be made of the income tax benefits of family entities to shift income (subject to family partnership rules of I.R.C. §704(e)) and qualifying deductions to the entity. The entity may have been created for estate and gift tax discount purposes, but now could provide income tax benefits. In any event, family entities (such as family limited partnerships (FLPs) and limited liability companies (LLCs)) will continue to be valuable estate planning tools for many married couples in this wealth range.
Most persons in this zone will likely fare better by not making gifts and retaining the ability to achieve a basis step-up at death for the heirs. That means income tax basis planning is far more important for most people. Also, consideration should be made to determine whether insurance is still necessary to fund any potential estate tax liability It also may be possible to recast insurance to fund state death taxes (presently, 11 states retain an estate tax and five states have an inheritance tax (one state (Maryland) has both)) and serve investment and retirement needs, minimize current income taxes, and otherwise provide liquidity at death.
Note: In those states that have either an inheritance tax or an estate tax (or both in the case of Maryland), the exemption from tax is typically much lower than the federal exemption. This fact requires additional planning for decedents in these states.
Other estate planning points for moderate wealth individuals include:
- For life insurance, it’s probably not a good idea to cancel the policy before having that move professionally evaluated. That’s particularly the case for trust-owned life insurance. For pension-owned life insurance, for those persons that are safely below the exemption, adverse tax consequences can likely be avoided.
- Evaluate irrevocable trusts and consider the possibility of “decanting.” On the decanting issue, see my recent blog article here: https://lawprofessors.typepad.com/agriculturallaw/2022/09/modifying-an-irrevocable-trust-decanting.html
- For durable powers of attorney, examine the document to see whether there are caps on gifted amounts (the annual exclusion is now $16,000) and make sure to not have inflation adjusting references to the annual exclusion.
Note: The present interest annual exclusion for federal gift tax purposes is projected to be $17,000 per donee for gifts made in 2023.
- For qualified personal residence trusts (QPRTs) that were created when the estate tax exemption was $2 million, the conventional advice was to deed the house from the QPRT to the children or a remainder trust (which might have been a grantor trust), with a written lease agreement in favor of the parent/donor who would continue to live in the house. Now, it may be desired to have the home included in the estate for basis step-up purposes and the elimination of gain on sale.
- While FLPs and LLCs may have been created to deal with an estate tax value-inclusion issue, it may not be wise to simply dismantle them because estate tax is no longer a problem for the client. Indeed, it may be a good idea to actually cause inclusion of the FLP interest in the estate. This can be accomplished by revising the partnership or operating agreement and having a parent document control over the FLP. Then, an I.R.C. §754 election can be made which can allow the heirs to get a basis step-up.
Other Planning Issues
While income tax basis planning (using techniques to cause inclusion of asset value in the estate at death) is now of primary importance for most people, asset protection may also be a major concern. Pre-nuptial agreements have become more common in recent decades, and marital trusts are also used to ultimately pass assets to the heirs of the first spouse to die (who may not be the surviving spouse’s heirs) at the death of the surviving spouse. A “beneficiary-controlled” trust has also become a popular estate planning tool. This allows assets to pass to the beneficiary in trust rather than outright. The beneficiary can have a limited withdrawal right over principal and direct the disposition of the assets at death while simultaneously achieving creditor protection. In some states, such as Nebraska, the beneficiary can be the sole trustee without impairing creditor protection.
Powers of attorney for both financial and health care remain a crucial part of any estate plan. For a farm family, the financial power should be in addition to the FSA Form 211 and give the designated agent the authority to deal with any financial-related matter that the principal otherwise could.
Impact of Inflation
The rampant inflation in the economy caused by numerous bad political choices over the past 20 months means that the inflation adjustment for the basic exclusion amount is projected to be $12.920,000 per decedent for deaths in 2023. That is a significant increase, and it is likely that the basic exclusion amount will be in the $14 million range for 2025 (the last year of the TCJA). On the flip side, the same disastrous political choices have caused the stock market to drop significantly. So, not only are retirement savings being lost, but the remaining dollars are also being devalued by inflation. However, for the few with significant wealth that would potentially be subjected to federal estate tax at death, it is imperative to not waste the higher exemption. This is particularly true given that the IRS has taken the position that gifts made during a year when the unified credit is high will not be clawed back into the donor’s estate at death if the credit is lower at that time.
While estate planning has been made easier by the TCJA, that doesn’t mean that it is no longer necessary. Reviewing existing plans with an estate planning professional is important. Also, the TCJA is only temporary. The estate and gift tax provisions expire at the end of 2025. When that happens, the exemption reverts to what it was under prior law and then is adjusted for inflation. For deaths in 2026, the federal estate and gift tax exemption is estimated to be somewhere between $7 and $8 million dollars. While those numbers are still high enough to cover the vast majority of people, they are a far cry from the present $12.06 million amount. One thing is for sure – a great deal of wealth is going to transfer in the coming decades. One estimate is that approximately $30 trillion in asset value will transfer over the next 30-40 years. That’s about a trillion per year over that timeframe. A chunk of that will involve farm and ranch real estate, livestock, equipment and other personal property.