The most significant changes to the United States tax code in 30 years were approved by Congress and signed by the President on December 22, 2017, with most provisions effective only a few days later for tax years beginning January 1, 2018.
The tax bill, formerly known as the “Tax Cuts and Jobs Act” (H.R. 1), now is Pub. L. No. 115-97, 131 Stat. 2054 (“Tax Act”). This name was dropped from the final bill, but the name likely will continue to be used, since the official title, “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” is hardly pithy or catchy.
The Tax Act is comprehensive reform, but many of the provisions will sunset. Permanence of the Tax Act is limited because of the so-called “Byrd Rule,” which requires 60 votes in the Senate to enact any tax law reduction that would increase significantly the federal deficit beyond a 10-year term. The Tax Act did not get the 60 votes (51 to 48), so it has expiration dates starting after 2025, which means that most of the temporary changes will affect only eight tax years.
Many advisors recall a similar scenario with the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), passed in 2001. With all due respect to Yogi Berra, it in many ways is “déjà vu all over again” and worse. The entire EGTRRA law sunset after 2010, but the new Tax Act contains both provisions that sunset and others that are permanent. Knowing which ones are planned to sunset (and which ones do not) has major planning implications. And, as if that were not enough, practitioners must take into consideration both the potential changes to the law by future administrations and the probability that an individual client, or the survivor of a married couple, survives the sunset. A crystal ball, similar to the one desired for the planning implications and advising of clients between 2010 and 2012, is again desired. The Tax Act presents significant transfer tax planning opportunities; as advisors, we need to be sensitive, however, to the unintended consequences that could result from any previous planning, as well as to the uncertainty of the current law.
The Tax Act originally was labeled as an endeavor to simplify the tax code, but such aspiration was dropped by the legislators as the Tax Act wound its way through the political system. The effort resulted in some very complex provisions.
So how does one plan for these temporary, complex tax changes? This article will answer this question by focusing on the transfer tax system with sample planning opportunities, but first this article will summarize some (but not all) of the significant changes to the corporate, income, and transfer tax systems. It also will point out a few of the provisions in those tax systems that were not changed.
So, What Does the Tax Act Change?
Corporate (Permanent) and Pass-Through Entity Income Tax (Temporary)
Numerous changes have been made to corporate and pass-through entities. Below are three of the most significant:
- 1. Corporate Tax Rates. Rates are reduced from 35% to 21%.
- 2. Carried Interest. To be taxed as long-term capital gain, a three-year holding period is imposed for certain partnership interests in connection with the performance of services (regardless of whether an IRC § 83(b) election is made).
- 3. Business Income from Pass-Through Entities. A very complicated IRC § 199A provides for a 20% deduction for individuals and trusts and estates on domestic qualified business income from pass-through entities. This change to business income from pass-through entities effectively reduces the top tax rate for those eligible to 29.6% (37% x (1-0.20)).
Wage Limitation to the Deduction. The IRC § 199A deduction is limited to 50% of a taxpayer’s pro-rata share of the total W-2 wages paid by the business. The goal of this limitation is to deter high-income taxpayers from attempting to convert wages or other compensation for personal services to income eligible for the deduction. There is, however, a real estate exception to the wage limitation. Precisely, the limitation is the greater of (1) 50% of W-2 wages and (2) the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis, immediately after acquisition, of all tangible property subject to deprecation.
Specified Service Limitation to the Deduction. The IRC § 199A deduction also is not available to specified service companies, including service businesses in the fields of accounting, actuarial science, athletics, brokerage service, financial service, health, law, performing arts, and any business in which the principal asset is the reputation or skill of one or more of its employees. Said another way, wages paid to owners and certain income from specified (personal) service companies cannot take the 20% deduction.
There is, however, a lower income exception from both the wage and specified service limitations, defined as $315,000 (indexed) for married couples and $157,500 (indexed) for single taxpayers. The limitations are phased in over the next $100,000/$50,000 of taxable income.
As foretold by the inclusion of the wage limitation, the pass-through deduction will affect how many closely held businesses will be structured, as well as trust ownership of interests in such businesses, especially in those industries that do not qualify for the reduction. A prime example that hits home for the readers of this article is law firms. Legal services do not qualify for the deduction, so many firms will consider restructuring to manage the unqualified revenue by either shifting some income to a qualified service entity or separating the income among various taxpayers to meet the lower income exception.
Individual Income Tax: Temporary (most)
The individual income tax highest marginal rate is reduced from 39.6% to 37%. Interestingly, this change offers very little to no savings for some wealthier taxpayers, and a tax increase for other wealthier tax payers because of the loss of many deductions. Additional complexity seems to be imposed for such wealthier taxpayers.
The standard deduction for single individuals is increased from $6,500 to $12,000 and for married couples is increased from $13,000 to $24,000. The personal exemption is reduced from $4,050 to $0.
Although most itemized deductions were deleted, below are seven of the most significant deductions that survived.
- 1. SALT/Real Property Taxes. State and local tax deduction and real property taxes are capped together at $10,000. Individuals with the same income levels may pay different amounts of tax depending on where they live in the country. This limitation sunsets after 2025. There have been interesting discussions whether those most affected might find a “work-around.” For example, could a high income tax state provide some form of credit for voluntary charitable contributions to it? Under this approach, an individual could pay up to $10,000 and make a charitable contribution equivalent to the balance of his state income tax liability, thus converting what would have not been deductible as excess state income tax into a payment deductible as a charitable contribution. There appear to be numerous potential roadblocks to such structures, but much effort will be exerted to help individuals pay the least amount possible.
- 2. Mortgage Deduction. The cap on the deduction for mortgage interest decreases from $1 million to $750,000. Mortgages in place before 2018 are grandfathered under the $1 million limit.
- 3. HELOC. Home equity line interest is no longer deductible, whether new or for existing loans.
- 4. Charitable Contribution Deduction. The AGI limit for cash contributions to qualified charities is increased from 50% to 60%.
- 5. Kiddie Tax. The Kiddie Tax (earned income of a subject child is taxed at the child’s rates, but unearned income is taxed at the parents’ rates, if higher) has been simplified. Instead of the parents’ rates applied to an applicable child’s unearned income, the fiduciary income tax rates (rates of a trust or estate) will apply to both ordinary or capital gains. While simple, this may cause more tax to be due.
- 6. Alimony. Alimony will not be deductible to the payor and taxable to the payee after 2019. This provision applies to divorce or separation agreements executed (or modified) after December 31, 2018. This change in the tax law most likely will have a dramatic effect on all divorces currently in process and will change the landscape for all divorces to come. This provision does not sunset. The Tax Act directly affects marital lawyers and the way they negotiate. Unfortunately, the vast implications to marital law is but one of the many traditional arrangements that will be disrupted by the Tax Act.
- 7. Miscellaneous. Most other traditional deductions are disallowed, particularly the miscellaneous itemized deductions subject to the 2% floor, such as unreimbursed employee expenses, investment advisory fees, and tax preparation fees.
The Tax Act eliminates the coverage and penalty requirements as of 2019 for the individual mandate for health insurance.
Transfer Tax: Temporary (most)
There is no full repeal of the transfer tax, as the entire estate, gift, and GST tax system is left in place. Although most of the transfer tax provisions are retained, a few major changes have been made.
1. Basic Exclusion Amounts. The Tax Act doubles the gift/estate/GST tax exemptions by raising the basic exclusion amount from $5 million to $10 million. Section 11061 of the Tax Act adds a new subsection 2010(C)(3) to the Internal Revenue Code, which reads: “In the case of estates of decedents dying or gifts made after December 31, 2017, and before January 1, 2026, subparagraph (A) shall be applied by substituting ‘$10,000,000’ for ‘$5,000,000.’” This will result in a substantial further reduction in taxable estates, estimated to decline from .02% to .01% of taxpayers (or one in every 10,000 decedents). In fact, it is estimated that the number of taxable estates will drop from around 5,000 in 2017 to fewer than 1,800 in 2018. Said another way, there will be fewer than 36 taxable estates per state in 2018.
Transfer tax rules have become quite volatile over the last few years. To illustrate the swings experienced in the estate tax arena over this very short time period, the chart at left shows the federal estate tax exclusion amounts and the top rate of the estate tax from 2001 to 2018.
2. Index Changed. Although the exclusion amounts continue to be indexed for inflation, the Tax Act now requires the use of the “chained CPI,” which will increase at a slightly slower pace. This is because the chained CPI accounts for the ability of individuals to alter their consumption patterns in response to relative price changes. All the changes regarding transfer tax are temporary, with one exception—the use of the chained CPI is permanent and applies to both income and transfer taxes.
For 2018, the inflation adjusted amount will equal $11.18 million (or $22.36 million per married couple). This amount would have been $11.2 million under the prior CPI inflation index, and the difference from shifting to the chained CPI will continue to increase over the years. The increase in the transfer tax exemption has been scored as reducing revenues by $172.2 billion.
3. Clawback. On January 1, 2026, the basic exclusion amount will return to $5 million, as indexed for inflation from 2010 to 2026. Because of the possible return to a lower exclusion amount, a “clawback” becomes an important factor. A “clawback” occurs when a prior gift that was covered by the gift tax exemption at the time the gift was made results in an estate tax because the estate tax exemption has decreased by the time of the donor’s death. A similar issue arose in 2012, when there was the possibility that the $5 million exemption was going to decrease to $1 million. Congressional staffers had previously indicated that a clawback was not intended, and the Tax Act attempts to deal with it by amending IRC § 2001(g) to add a new IRC § 2001(g)(2), which directs the Treasury to prescribe regulations to address any difference in the basic exclusion amount at the time of a gift and at the time of death. The apparent intent of the Tax Act is that the regulations will clarify that a clawback would not apply if the estate tax exemption is reduced from an exclusion amount applicable to prior gifts. Said another way, a “clawback” is unlikely (but one questions why Congress deferred the issue to Treasury).
Fiduciary Income Tax
Income tax rates for trusts and estates are now 10%, 24%, 35%, and 37% instead of 15%, 31%, 36%, and 39.6%. The ranges of income to which these rates apply do not change much. The ranges start at $2,550, and the top tax rate applies to income levels over $12,700 (instead of $12,500). The lowest bracket rate decreases by 5%, and the highest bracket decreases by 2.6%. The chart on page 44 also illustrates a slight decrease in tax owed at every taxable amount.
Many of the limitations on deductions for individuals also apply to trusts and estates. So, although there is a tax reduction in the brackets, the taxes payable by trusts and estates could increase. Two significant limitations on deductions applicable to trusts and estates are as follows:
- There are no income tax deductions for miscellaneous itemized deductions subject to the 2% floor for the years 2018–2025. Many believe, however, that trusts and estates will continue to be able to deduct expenses not subject to the 2% floor under IRC § 67(e), such as fiduciary commissions and perhaps tax preparation fees, because they “would not have been incurred if the property were not held in such trust or estate.”
- There are no income tax deductions for state and local income taxes in excess of $10,000 for the years 2018–2025. This limitation should not apply to taxes properly reportable on a Schedule C (trade or business) or Schedule E (net income from rents and royalties), however. In certain circumstances, this limitation may encourage clients to create multiple trusts.
So, What Doesn’t the Tax Act Change?
It is important to know the following items that were not changed by the Tax Act.
Individual Income Tax: Long-term capital gains and qualified dividends are retained at 0%, 15%, and 20% (top rate). The exclusion for gain on the sale of a principal residence still is allowed for a gain up to $250,000 (single) and $500,000 (joint) on the sale of a principal residence. Further, the alternative minimum tax (AMT) was not repealed.
Fiduciary Income Tax: The net investment income tax is retained at 3.8%.
Transfer Tax: The transfer tax rate (gift, estate, and GST) is retained at 40%. The federal gift tax annual exclusion is retained, and it is estimated that it will be $15,000 in 2018 despite the “chained CPI.” The federal gift tax annual exclusion was $14,000 in 2017 and is indexed to increase to $15,000 in 2018, regardless of the Tax Act. The annual gift tax exclusion for noncitizen spouses is retained at $152,000. IRC § 1014 (step-up/down in basis) remains unchanged, so estate assets will continue to receive an income tax basis step-up (or down) to the asset’s fair market value at a decedent’s death.
With a solid understanding of what the Tax Act changes and what it does not, this article will touch on some planning opportunities.
1. Review IRAs. Two important aspects of the Tax Act create (or necessitate) planning advice for IRAs.
- a. The IRC § 691(c) deduction survives, but it will be diminished in practice by being helpful to fewer clients. Recipients of inherited traditional and Roth IRAs historically have been able to claim a miscellaneous itemized deduction under IRC § 691(c) for the estate tax paid allocable to the income reported on that year’s return. Of course, with the doubling of the estate tax exemption, fewer IRAs will trigger an estate tax, so the deduction will benefit far fewer beneficiaries.
- b. The IRC § 408A(d)(6) recharacterizations are eliminated. Many clients took advantage of the loosened rules permitting conversion of traditional IRAs to Roth IRAs, relying in part on the ability to recharacterize by the filing of a tax return for the conversion year to transform the Roth IRA back to a traditional IRA. Such a conversion frequently would be triggered in cases in which asset values declined, so income tax would not be paid on the prior, higher value. In fact, many clients converted one traditional IRA into separate-asset class Roths, positioning to recharacterize only those asset classes, if any, that fell in value by the following October 15. For other clients, recharacterizing permitted an opportunity to optimize what income was to be included with the benefit of hindsight for purposes of income tax planning (such as by balancing other income, deductions, and AMT). This strategy is no longer available under the Tax Act. The effective date language “for taxable years beginning after December 31, 2017” is unclear, however. Discussion has ensued whether recharacterizations can be done in 2018 for a 2017 conversion. A close reading of the relevant provisions of IRC §§ 408(d)(3) and (6), and fairness, support the conclusion that the prohibition applies to conversions after December 31, 2017. Treasury has agreed, so recharacterizations of 2017 conversions can be made in 2018 (under the prior due date rules). This interpretation only seems fair to taxpayers who converted relying on the recharacterization authority.
2. Review, and Possibly Revise, Formula Clauses (and Everything Else Done Between 2010 and 2012). The doubling of the exemptions to over $11.18 million necessitates reviewing the flow of a client’s estate plan to ensure the result will achieve the intended goals. For example, the formula clause for many traditional residual marital plans may fund only credit shelter trusts and leave nothing to marital trusts, which can be problematic and result in unintended consequences if the surviving spouse is not also a beneficiary of the credit shelter trust. For those clients not subject to an estate tax, now 99.9% of the population, incorrect formula clauses could have adverse income tax implications, such as loss of a second step-up in basis for married couples. Clients with substantial low-basis assets must be especially sensitive to the step-up in basis rules and their interplay with estate tax planning. Therefore, planning advice also must take into consideration portability and income tax basis management.
3. Think Broadly and Embed Flexibility. The temporarily enhanced GST exemption creates opportunities for many wealthy families who now can, and should, shelter more of their wealth. Even those moderately wealthy families with assets less than the enhanced GST exemption can greatly benefit through the use of numerous long-term trusts—or more assets in such trusts—to which GST exemption now can be allocated when the prior exemption would have been insufficient. GST allocation could be particularly powerful for succeeding generations by virtue of compounding (and imagine the “win” if the exemption is later reduced to a level lower than the family’s net worth with no clawback). Further planning can be implemented by using general powers of appointment and embedding other forms of flexibility into documents designed to create methods to tap into exemptions that otherwise would go unused. For example, granting a general power of appointment to a “poor” parent, who then exercises the power to direct assets to a trust over which he allocates GST exemption that otherwise would have been wasted, which creates long-term estate tax protection, a basis step-up, and imposes the benefits of a trust structure.
4. Use the Temporarily Enhanced $11.18 million ($22.36 million per Married Couple) Gift Tax Exemption Wisely, But Use It! The Tax Act does not change the fact that traditional holistic planning still will be effective through the proactive use of gift and GST exemptions, structuring for discounts (IRC § 2704 seems safe for the moment), using assets with strong appreciation potential, and implementing transfer tax reduction strategies in ways to minimize income tax (or include flexibility to manage tax basis). The Tax Act simply provides more gift and GST exemptions to use.
The use of such exemptions, however, will continue to depend on the client. The estate tax reduction strategies used in planning for wealthy families should be different from those used for moderately wealthy families, who would not be comfortable giving away the new exemption amount of $11.18 million but who have estates greater than the prior exemption amount of $5.49 million. Advisors may find a challenge in using the doubled exemption amount for moderately wealthy clients who still need the use of their assets to maintain their lifestyles. Nonreciprocal SLATS could be a possible solution to ensure the increased exemption amount is not lost. And assuming such moderately wealthy clients survive the sunset, current use of the enhanced gift and GST tax exemptions ensures such clients are not then subject to estate tax. For example, a client with an $11 million net worth would be subject to $0 federal estate tax in 2025, but an estimated $1.8 million of federal estate tax in 2026.
For wealthy clients, continue to use traditional planning strategies designed to limit estate tax exposure. Such strategies, such as irrevocable grantor trusts, sales, GRATs (into grantor trusts with a swap power to manage tax basis), irrevocable dynasty trusts, and SLATs, will continue to be effective. Most important, no matter what strategies are employed, use the enhanced exemptions before they sunset!
5. Split Interest Planning. On the other hand, one will have to “run the numbers” to see if split interest trust planning, such as charitable remainder trusts, makes sense. This is because, for many taxpayers, the value of the income tax deduction will be reduced because of the inability to deduct other previously deductible items, forcing more of the charitable deduction to offset the now increased standard deduction. Further, the decision whether a charitable lead trust should be a grantor trust also will require careful review of the numbers, as well as forecasting future income and income tax laws.
The new Tax Act is a major rewrite of the tax code. Although the Tax Act originally was geared toward simplification (remember the concept of a “postcard return”?), this goal was abandoned and, in many cases, just the opposite resulted. Many of the new provisions are very complex, and it will take time for advisors to work through them, sifting for opportunities. Planning opportunities will develop over time, but it is imperative now to review existing plans to ensure that the client’s assets will flow correctly to meet his or her goals and avoid unintended consequences, with the least amount of long-term estate, GST, and income tax over generations.