February 6, 2023

Volume XIII, Number 37


February 06, 2023

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February 03, 2023

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Plan for the Present, Hope for the Best: 2017 Year-End Estate Planning

Tax Law Update

Estate Tax Reform! Maybe?

On November 16, 2017, the House of Representatives passed H.R.1, known as the Tax Cuts and Jobs Act, despite zero Democratic votes. The Senate Finance Committee then voted (also along party lines) to approve their markup of the House tax proposal, a prelude to consideration by the full Senate. Nothing is certain to pass: Senate Republicans can afford no more than two defections, and the Alabama Senate election on December 12 could make their position even more tenuous. Still, tax reform might provide significant estate and gift tax planning opportunities (the operative word, however, being “might”).

The House proposal doubles the unified estate and gift tax exemption to $11,200,000 beginning in 2018. The exemption would increase in subsequent years due to inflation adjustments. The estate tax and the generation-skipping transfer tax would be completely repealed beginning in 2024. The gift tax would remain, but with an increased lifetime exemption ($11,200,000 in 2018, adjusted for inflation going forward) and a lower top rate (35%, down from 40% under current law). The Senate proposal also doubles the estate and gift tax exemption but does not repeal the estate tax. Both proposals retain the step-up (or step-down) in cost basis at death for assets that are included in an individual’s gross estate for estate tax purposes.

If tax reform passes, where will that leave taxpayers?

First, state estate tax planning will become even more critical. The $4,000,000 estate tax threshold for Illinois is not indexed for inflation, meaning that the gap between the Illinois and federal exemptions will grow wider every year. Further, if the federal exemption increases to $11,200,000, Illinois estate tax will become the primary concern for all but a few Illinoisans. Individuals who already spend part of the year in a state with no estate tax—Florida being the classic example—will find changing residency very appealing. However, taxpayers should expect Illinois to aggressively question whether residency has in fact changed. Fortunately, Much Shelist’s Wealth Transfer & Succession Planning attorneys regularly advise clients on the steps necessary to establish residency in another state.

Second, taxpayers should not assume that any tax reform is permanent. Estate and gift tax laws have changed numerous times over their history, and the next change will likely not be the last. Congress could reinstate the estate tax and return the exemption amount to current or even lower levels, and there is no way to know whether such measures would provide any relief for prior transfers made during a period when the exemption amount was higher. In short, estate tax planning will remain an issue for high net worth individuals.

Third, if estate tax repeal occurs, taxpayers will face different tradeoffs between paying estate tax and paying income tax. For example, if the House proposal passes, then beginning in 2024, Illinois residents would face a top marginal total estate tax rate of 16% (the current top Illinois estate tax rate) but a top marginal total income tax rate of 44.55% (39.6% federal plus 4.95% Illinois, with no federal deduction for state income tax). At this margin, taxpayers may prefer to keep appreciated assets in their gross estates for estate tax purposes, pay the Illinois estate tax and obtain a step-up in basis for income tax purposes.

Valuation Discounts Remain a Viable Technique, but Caution Is Warranted

Family-controlled entities are often discounted for estate and gift tax valuation purposes, a technique that can give rise to tax planning opportunities. The year 2017 saw the withdrawal of proposed Treasury regulations that would have been disastrous for the continued use of these discounts. However, the case of Estate of Powell v. Commissioner shows that courts and the IRS remain skeptical of discounting techniques.

In the last year of the Obama administration, the Department of the Treasury released proposed regulations under Section 2704 of the Internal Revenue Code that would have disregarded certain restrictions common to family-owned entities that generate discounts for estate and gift tax purposes. These regulations were criticized by commentators as vague and overreaching. However, in response to an executive order from the Trump administration to identify regulations that impose “undue financial burdens” and add “undue complexity,” the Treasury withdrew the proposed regulations.

Still, the Powell case reminds us that valuation discounts are not guaranteed. In Powell, Nancy Powell’s son Jeffrey, acting on her behalf through a power of attorney, created a family limited partnership (FLP), the members of which were Nancy, Jeffrey and Nancy’s other son. Jeffrey, acting on Nancy’s behalf, gave Nancy’s interest in the FLP to a charitable lead annuity trust. Nancy died seven days later. Jeffrey filed a gift tax return for Nancy, claiming a 25% discount for the gifted FLP interests. Not surprisingly, the IRS disallowed the discount and issued a notice of deficiency for Nancy’s gift tax return and for her estate tax return. The IRS’s position was generally upheld by the United States Tax Court.

The Tax Court’s reasoning was intricate, but the takeaway from Powell is that aggressive death-bed tax planning will likely be challenged by the IRS. The fact that Nancy Powell died seven days after the FLP was formed made it difficult to argue that the FLP was a real entity that should be respected for tax purposes. Valuation discounts still provide planning opportunities in certain situations, but taxpayers should ensure that family entities serve a substantial non-tax purpose and that legal formalities are respected.

Planning Opportunities That Don’t Depend on Congress

Annual Exclusion Gifts

Often overlooked, annual exclusion gifts are one of the most powerful estate planning techniques. The annual exclusion is the amount that an individual can give to another individual in a year without using any estate and gift tax exemption. This amount is indexed for inflation, but only increases in increments of $1,000. After many years of being stuck at $14,000, the annual exclusion amount will increase to $15,000 in 2018.

The power of annual exclusion grows as families grow. Take, for example, a married couple with three children (each of whom is married) and six grandchildren. If the couple includes their children’s spouses in their gifting, they can give away $360,000 every year without using any estate and gift tax exemption. The benefits of this technique compound as subsequent investment growth occurs outside of the couple’s estates.

Tuition and Medical Payments

Individuals can make unlimited tax-free transfers by paying qualifying tuition expenses directly to a school or by paying qualifying medical expenses directly to the provider.

Transfer Tax Exemption and GST Exemption

Even if no tax reform passes, the exemption amount that individuals can transfer by gift and at death without being subject to federal transfer taxes will increase from $5,490,000 in 2017 to $5,600,000 in 2018. The maximum federal estate tax rate will remain at 40%. As noted above, the Illinois estate tax is based on a $4,000,000 threshold (which is not indexed for inflation). The top Illinois estate tax rate is 16%, but due to the complicated method by which Illinois estate taxes are calculated, the actual effective marginal tax rate for estates only slightly above the $4,000,000 threshold is higher than 16%. Under current law, a federal estate tax deduction is allowed for Illinois estate taxes (reducing the effective impact of the Illinois tax to approximately 8%). Both federal and Illinois estate tax laws allow a marital deduction for assets passing outright to a spouse or to a qualifying trust for a spouse’s benefit. Illinois allows this deduction even if a marital deduction is not elected for federal tax purposes.

To prevent taxpayers from circumventing the estate tax, the generation-skipping transfer (GST) tax is imposed at a rate equal to the highest estate tax rate on transfers to or for the benefit of grandchildren or more remote descendants. However, every taxpayer has a separate GST tax exemption equal to the federal transfer tax exemption ($5,490,000 in 2017 and $5,600,000 in 2018).

Valuation Discounts

As noted above, minority-interest, lack-of-marketability and lack-of-control discounts can sometimes be applied to interests in family-controlled entities. Such discounts yield estate and gift tax savings by reducing the value of the transferred interests. However, these techniques should be approached with caution, as they may be challenged by the IRS.

Gifts in Trust

Despite potential tax savings, many individuals are hesitant to make outright gifts to their family members. These concerns can be addressed by structuring gifts in trust, which allows the donor to determine how the assets will be used and when the beneficiary will receive the funds. Trusts also provide beneficiaries with a level of creditor protection (including protection from a divorcing spouse) and additional transfer tax leverage. This is particularly effective when coupled with applying the GST exemption to the trust and making it a grantor trust for income tax purposes (a concept discussed further below).

The gift trust technique is not limited to trusts for descendants, but may also include a spouse as a beneficiary (or as the sole primary beneficiary). Making a spouse the beneficiary of a gift trust (generally referred to as a spousal lifetime access trust, or SLAT) provides the spouse indirect access to the trust assets while allowing the accumulated income and appreciation of the trust assets to pass free of estate and gift taxes.

One of the most powerful estate planning strategies is a grantor trust, in which the creator of the trust (the grantor) pays the income tax on the income earned by the trust. This allows the grantor to indirectly pass additional funds to the trust beneficiaries free of gift, estate and income taxes, as the grantor’s payment of the trust’s income taxes is considered his or her legal obligation and not a taxable gift.

Historically Low Interest Rates

Despite repeated forecasts to the contrary, interest rates have remained historically low. Taxpayers can take advantage of these low rates through a variety of estate planning techniques. For example, when properly structured, a grantor retained annuity trust (GRAT) can remove investment appreciation over a certain hurdle rate (2.6% as of December 2017) from a taxpayer’s estate. Intra-family loans bearing the minimum statutory interest rate (1.52%, 2.11% or 2.64% as of December 2017, depending on the term of the loan) can be similarly effective.

Year-End Review

There is no time like the present to ensure that your estate plan reflects your current wishes and appropriately uses the techniques discussed above. This is especially important if there has been a birth, death, marriage or divorce in your family over the past year. Also consider reviewing beneficiary designations for your insurance policies and retirement accounts, as these assets pass independently of the terms of your will and trust.

© 2023 Much Shelist, P.C.National Law Review, Volume VII, Number 334

About this Author

Gregg M. Simon Succession Planning Attorney Much Shelist

Gregg is a respected authority on estate and trust matters with more than 30 years of experience in taxation and wealth preservation strategies. He represents individuals, families, and fiduciaries on estate planning, federal estate and gift taxation, generation-skipping transfer taxes, probate, and trust administration.

Gregg also advises business owners on effective succession planning and tax structures. He knows that the goals of individual family members are sometimes out of sync, and when family conflicts come into play, he applies his...