A Look Ahead: Estate Planning and Taxation in 2019

The Tax Cuts and Jobs Act (P.L. 115-97), passed late in 2017, made 2018 another lively year in estate planning. By now, estate planning professionals have become inured to political uncertainty and an ever-shifting legal environment. Next year promises to be no less interesting. Below are some thoughts and speculations on where some matters are headed.

Estate Tax Repeal

Although the Republican “Unified Framework for Fixing Our Broken Tax Code” released September 2017 included repeal of estate and generation-skipping transfer taxes, the TCJA, as enacted, included merely a temporary doubling of the gift and estate tax exclusion amounts. With the Democrats assuming control of the House in January 2019, it appears that estate tax repeal is unlikely.

It may be that 2017 will be remembered as the last chance for estate tax repeal. Outgoing House Speaker Paul D. Ryan, R-Wis., famously credited Ayn Rand with inspiring him to enter politics and framed the fundamental political divide as between individualism on one hand and collectivism on the other. For all his success in helping to pass the TCJA, Ryan is likely to see his agenda, which aimed to cut taxes and scale back entitlements, destined for the ash heap of history. As the Republican Party continues to lose wealthy voters, it inevitably must adjust its policy menu to the reality that it is the party of the working class rather than the rich. Not Lockean individualism but Millian fellow feeling and national cohesion will become the GOP’s future governing philosophy. The movement for estate tax repeal may become a casualty of that evolution.

Estate Tax Reform

The prospects of estate tax reform have brightened. Proposals to curb the use of grantor-retained annuity trusts and irrevocable grantor trusts have been discussed for years. Most recently, both Sen. Elizabeth Warren, D-Mass., and Sen. Cory A. Booker, D-N.J., have proposed estate tax reform to pay for ambitious policy proposals on housing and savings, respectively. Warren’s bill, as drafted, contains significant technical flaws, including a presumably inadvertent “cliff” tax that would impose a tax of $100 million on the first $1 above $1 billion. These flaws could be fixed, however, and Warren’s reforms could end up being included in compromise legislation.

Clawback

As expected, Treasury and the IRS recently issued proposed regulations to ensure that gifts made before 2026, if they use up the temporarily increased gift and estate tax exclusion amount, will not become subject to estate tax if the donor dies after 2025 when the exclusion amount is lower. The regulations eliminate uncertainty, if there ever was any, regarding whether the IRS will claw back tax on gifts that use up the temporarily increased exclusion amount. Of course, a future Congress could always reduce the exclusion amount and perhaps even override the regulations if they are finalized.

No Reverse Clawback Risk

Some commentators have argued that if gift taxes were paid on gifts made in years before recent increases in the gift and estate tax exclusion amount, there would be no credit for those taxes if the donor dies in a year when the exclusion amount has increased. As a result, under this theory, the gifts would effectively be double taxed — first as gifts for the year when made, and a second time when added back to the computation of estate tax under section 2001(b)(1). Known as reverse clawback, the theory posited that the IRS would disavow its own long-standing instructions on the computation of estate tax to achieve a result that arbitrarily punishes taxpayers who paid gift tax.

Loosed like a savage boar into the tranquil forests of estate planning, the theory of reverse clawback was welcomed by neither practitioners nor government officials. Fortunately, Treasury has now driven a well-aimed stake through the heart of the theory. In the preamble to the regs, the proposed anti-clawback provisions correctly explain that a credit for gift taxes payable remains available in future years (for computing gift taxes) and at death (for computing estate tax), despite increases in the exclusion amount. The reverse clawback beast is slain and practitioners need fear it no more.

Planning With the Increased Exclusion Amount

Wealthy taxpayers will be advised to take advantage of the exclusion amount before it expires in 2026. Of course, that leaves over seven years to respond, which lessens the sense of urgency. Perhaps some will deliberately wait to see if Congress acts; when the December 31, 2025, deadline approaches, taxpayers can make gifts then and rely on disclaimers to unwind the gifts if they turn out to be unnecessary to use up the increased exclusion amount. Whenever the wealthy make gifts, it will be advisable to use up not only the base exclusion amount but also inflation adjustments through 2025, as increases caused by inflation will be lost if not used before 2026.

Painless Means of Using Up Exclusion Amount

Taxpayers whose wealth is greater than the lower exclusion amount that will be available after 2025 ($5 million, plus inflation adjustments, or $10 million for a married couple), but less than the temporarily increased exclusion amount available before then, may be reluctant to make gifts to use up the temporarily increased exclusion amount. Fortunately, the proposed anti-clawback regulations, although not explicit on this point, appear to make it possible to make taxable gifts that use up the exclusion amount but permit the donor to retain access to the property transferred.

For example, a donor could create an irrevocable grantor-retained income trust that deliberately runs afoul of the requirements of section 2702 and artificially increases the size of the donor’s taxable gift, while still giving the donor the right to income for life. Other strategies for making large but painless taxable gifts include gifts of common interests in a preferred partnership that intentionally violate the rules of section 2701 or artificial taxable gifts made by triggering section 2519 in the case of a qualified terminable interest property or QTIP trust.

It is even possible, under a long line of authority dating back to the genesis of the estate and gift tax system, to lock in increased exclusion by making a binding promise to transfer property to the donee in the future. The authority for a gift by promise is so well established that it may well be, despite its novel applications this decade, the oldest estate tax planning strategy available to taxpayers today. If the promise is binding, a taxable gift occurs when the promise is made, rather than later when it is satisfied. Meanwhile, under the proposed anti-clawback regulations, the gift by promise should successfully lock in the temporarily increased exclusion amount. The gift by promise, which became briefly famous in 2012 before the $5 million (at the time) exclusion amount was scheduled to expire, will likely attract renewed attention in coming years.

Basis of Grantor Trust Assets at Death

There is much controversy over what becomes of the basis of grantor trust assets after grantor trust status ends at death. A closely related question is whether gain is recognized when debts — which until death are either ignored or treated as debts of the grantor under Rev. Rul. 85-13, 1985-1 C.B. 184, and its progeny — are deemed to be assumed by the trust after grantor trust status terminates at death. The answers to these questions affect many wealthy taxpayers who have successfully transferred large amounts of wealth to irrevocable grantor trusts that will pass free of estate tax at their deaths.

Treasury and the IRS have for several years promised guidance on calculating the basis of grantor trust assets at death. As Ron Aucutt of McGuireWoods LLP has astutely observed, the omission of that project from the agenda of the Office of Information and Regulatory Affairs suggests that Treasury and the IRS plan to issue subregulatory guidance, such as a revenue ruling. If that is the case, Treasury and the IRS face a difficult technical challenge, given that, as this author has written, Treasury’s own well-entrenched position is not based on any code section that obviously determines the basis of grantor trust assets at death. Treasury and the IRS could, however, hold that section 1015(b) compels carryover basis. There is a good chance, in any event, that Treasury and the IRS will not address whether gain can be recognized at death.

Section 199A Proposed Regulations

The estate planning bar have generally objected to a proposed rule that would require trusts and estates to compute the section 199A taxable income threshold without regard to distribution deductions that are normally allowed to a trust or estate when amounts of principal or income are paid or required to be paid to beneficiaries. Under this rule, the same taxable income will count twice against the threshold amount — first in the hands of the trust and a second time when distributed to beneficiaries. This approach, some have sardonically claimed, appears premised on the view that trusts are evil.

Treasury and the IRS will likely be unmoved by the complaints. Trusts are, in fact, evil, at least in the section 199A context. The rules of subchapter J are unique in that they permit fiduciaries to disperse items of taxable income to different beneficiaries, or instead cause items to be taxed at the trust level. Although these rules have already created some planning opportunities, such as shifting capital gains to the taxpayer who has offsetting capital losses, opportunities for federal income tax planning are somewhat limited by several factors, such as the compressed bracket structure imposed on trusts and estates (which limits the advantages of accumulating income at the trust level).

Section 199A potentially generates new opportunities to fine-tune the taxable incomes of trusts and beneficiaries to maximize the use of the statutory threshold. Treasury and the IRS thus had strong policy reasons to limit application of the subchapter J rules in the section 199A context. (It is sometimes said that section 199A includes a statutory definition of taxable income, but that is not true; section 199A(e)(1) contains one technical clarification but does not include a definition of taxable income generally.) Section 199A gives Treasury broad authority to carry out the purposes of the statute. One purpose was arguably to prevent shifting of income to maximize the use of the threshold. In this view, Treasury has broad authority to impose guardrails beyond those specifically contemplated in the legislation.

That said, Treasury and the IRS should probably modify their approach somewhat. Specifically, the section 199A regulations should distinguish between distribution deductions that arise under sections 651 and 661 as amounts required to be distributed currently, and distribution deductions that arise because amounts are paid over or credited to beneficiaries in the discretion of the fiduciary. Only the latter distribution deductions create a significant potential for manipulation, and therefore only those distribution deductions should be ignored when computing the taxable income threshold.

Section 199A Antiabuse Rule

The section 199A regulations contain a stand-alone rule designed to inhibit the creation of trusts to secure additional section 199A benefits. The rule provides that “trusts formed or funded with a significant purpose of receiving a deduction under section 199A will not be respected for purposes of section 199A.” Expect Treasury and the IRS to clarify that this rule can apply even if a single trust is created for the purpose of claiming an additional section 199A deduction, such as by doubling the threshold amount. Treasury and the IRS are also likely to revise the rule to clarify what it means for a trust not to be respected. The simplest approach would be to deny the trust any benefit of the threshold. A deduction for qualified business income would still be available, but not for income from a specified service trade or business and always subject to the wage and unadjusted basis limitations.

A rule to prevent the artificial shifting of business income is justified as a policy matter and is likely to be retained in the final regulations. The multiple trust rule of section 643(f) is insufficient to curb abuse, as it only applies when two or more trusts are created, a principal purpose was tax avoidance, and the grantors and beneficiaries are substantially the same.

Section 643(f) Multiple Trust Rules, SALT

Over 30 years after the multiple trust rule of section 643(f) was enacted, Treasury and the IRS have finally proposed regulations implementing the rule. Some commentators have objected to the failure of the proposed regs to include a grandfathering provision that would allow multiple trusts created or funded before the rule was enacted to escape application of the rule, even in future tax years. The lack of grandfathering, however, appears justified given that the only grandfathering authorized by Congress applies to trusts that were irrevocable March 1, 1984. Grandfathering of taxpayers against new income tax rules in future years would be unusual. The proposed regulations significantly dampen any enthusiasm there might have otherwise arisen for creating trusts to multiply the section 164(b)(6) limitation on the state and local income tax deduction. That said, it seems that at least one trust could be created for that purpose.

Basis Consistency

The gulf between practitioners and government is perhaps no wider than on the need for rules to mandate consistency between estate tax values and the section 1014 income tax basis of property acquired from a decedent. Practitioners see little room for abuse; even before Congress enacted section 1014(f) at Treasury’s request, the law generally required basis consistency. Consequently, taxpayers who have attempted to disavow the estate tax value of property for basis purposes have almost always lost.

Treasury and the IRS, by contrast, not only requested and obtained from Congress a rigid statutory mandate of basis consistency but thereafter issued proposed regulations that take a draconian approach to enforcement. In particular, the proposed regulations require basis to be reported to potential beneficiaries even when the actual recipient of the decedent’s property has not been identified, require beneficiaries to file supplemental reports in some cases long after receipt of a decedent’s property, and deprive taxpayers of basis altogether when property is omitted, even innocently, from the estate tax return.

Commentators have rightly objected to these rules, and Treasury and the IRS have promised through their priority guidance plan that the final regulations will be “burden reducing.” That said, the government seems to regard basis consistency as a major, money-winning policy reform. Practitioners should keep their expectations low.

Generational Split Dollar

Generational split dollar is a strategy designed to generate very large valuation discounts for what are essentially cash-equivalent assets. In a case involving generational split dollar planning, Estate of Cahill v. Commissioner, T.C. Memo. 2018-84, the Tax Court denied a taxpayer’s summary judgment motion, but did so in a way that seemed to leave no doubt that the government ultimately can deny all valuation discounts for the arrangement. Not surprisingly, the case soon settled on terms favorable to the government.

Cahill is by no means the last word on generational split dollar, not least because similar cases are still pending. Its reasoning could, perhaps, be distinguished with a different design. Cahill was a major victory for the government and will diminish the appetite that taxpayers and planners might have otherwise had for this kind of planning. Meanwhile, Treasury and the IRS have been surprisingly mute on whether guidance will be issued to shut down the strategy. Perhaps they are waiting to see if enforcement efforts suffice.

Dormant Guidance

Several important guidance projects that once appeared on the priority guidance plan have been dropped two years in a row. For example, section 2801, which imposes a tax on U.S. recipients of some gifts and bequests from covered expatriates, was enacted over 10 years ago. Not only has the IRS effectively stayed enforcement of the tax, but no guidance appears to be coming soon. Perhaps Treasury and the IRS are hoping Congress will give up and simply repeal the tax.

Other dormant but important projects include guidance on material participation by trusts and estates and the valuation of promissory notes for wealth transfer tax purposes. Resource limitations appear to have pushed these projects off the short-term agenda.

Excess Deductions on Termination

If deductions of an estate or trust exceed gross income for a tax year, the excess is normally lost unless a carryover, such as for net operating losses or capital losses, is specifically permitted. Somewhat anomalously, however, section 642(h)(2) allows the excess deduction to pass through to beneficiaries, but only in the year of termination. That was the rule for over 60 years. Now, thanks to the TCJA, the excess deduction on termination is denied because it is technically classified as a miscellaneous itemized deduction suspended by section 67(g) through 2025.

Surprisingly, Treasury and the IRS apparently have decided to restore the anomaly of excess deductions preserved in the final year. Notice 2018-61, 2018-31 IRB 278, announces that Treasury and the IRS are considering effectively unbundling the section 642(h)(2) excess into its component costs, some of which if passed through to beneficiaries could be deducted by beneficiaries either against adjusted gross income or as itemized deductions. In either case, section 67(g) would not deny the passthrough deductions to the beneficiaries because the deductions would escape classification as miscellaneous itemized deductions.

It has been a long time — with the partial exception of section 1411 net investment income tax regulations, which simply build on the existing subchapter J chassis — since there was a revision to the computational procedures of subchapter J. Any carryout of unbundled excess deductions must address technical issues such as how the deductions are allocated against items of income in the final year, how the character or flavor of the deductions is determined in the hands of the beneficiaries, and how the deductions are allocated among multiple beneficiaries. It may take significant effort for Treasury and the IRS to formulate rules for how unbundling of the section 642(h)(2) excess will work. It is possible that they will attend to more pressing priorities.