David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Worldwide Tax Daily. They say the only two things that are certain are death and taxes. Well, today, we're going to talk about them both. The estate tax, that most polarizing of levies that has been labeled by its opponents as the “death tax,” has seen some changes in the most recent tax bill. How has it changed, and how are future taxpayers responding? Tax Notes Today reporter Jonathan Curry is here to talk about it. Jonathan, welcome to the podcast.
Jonathan Curry: Thanks, Dave. It's good to be back.
David Stewart: So, what's new in estate taxes?
Jonathan Curry: Well, the Tax Cuts and Jobs Act has substantially changed tax planning for a lot of industries, and estate planning is one of them. A lot of people are rethinking old estate plans or they are seeing the chance for new opportunities. One practitioner I talked to said that estate tax planning was entering the “Wild West” because estate planners are having to consider strategies that they've never given much thought to before.
David Stewart: Before we get into the details, how about a lesson on how the estate tax works?
Jonathan Curry: Okay, that's a very good idea. So first, you can't talk about the estate tax without talking about the gift tax, because they are, in fact, directly linked. The gift tax applies on large transfers of property or assets to heirs while you're still alive. And the estate tax applies on the remaining total of the assets still left in your estate at the time of your death. The good news for your kids is that Congress has generously provided taxpayers with an exemption so that the estate and gift tax only applies to the very wealthy in society. They've also provided an annual gift tax exclusion amount, which is $15,000 per donee in 2018. So that way, you can make separate individual gifts of $15,000 to as many different beneficiaries as you want without using up your gift tax exemption. Now, unless you're a hermit who's been living in an island cave on a remote planet in a galaxy far, far away for the past year —
David Stewart: Star Wars references are always welcome.
Jonathan Curry: I know, and I haven't even seen the last movie. Well, you know that we had a big overhaul of the tax code recently. And one thing that that overhaul did was double the estate tax exemption amounts. It was $5 million per person in 2017; now it's $10 million per person. And plus, there's an inflation adjustment, so it's actually more like $11.2 million. And because the exemption is portable, which means that the unused exemption amounts can be transferred to a spouse, a couple's estate really has about $22.4 million in exemption to go around.
So the best way I came up with to think about this is that every person has an estate and gift tax exemption bucket. And every time you make a gift to someone, you start to fill up that bucket. So let's say, during your lifetime you made $6 million in gifts . . .
David Stewart: That would leave you with a little over $5 million in exemption should you kick the proverbial bucket at that point.
Jonathan Curry: Yep, that's exactly right. And then here's another important fact. There's also something called the generation-skipping transfer tax that applies to gifts or transfers of assets to the second generation, so that would be grandkids and great grandkids, and so on. And yes, this has an exemption as well. And in fact, that exemption mirrors the gift and estate tax exemption amount itself. But here's the thing, the generation-skipping transfer tax gets its own, separate bucket. So, really, it's like a bonus exemption amount. Now, if you're one of those wealthy folks that has had the terrible misfortune of having to worry about owing estate taxes when you die, you might think this doubled exemption is great news for you. And, it is. But, there is a catch. The exemptions only last until 2026 because Congress attached an expiration date to the provision in the new tax law. So, unless lawmakers do something about this, either by extending it or making it permanent, those exemptions are going to snap back to their 2017 level. And as it happens, that can make planning to die just a little bit more complicated.
David Stewart: It sounds like the estate tax changes from a legislative perspective are pretty minor, just tweaking little language here and there, but that the consequences are more far-reaching.
Jonathan Curry: Yeah, that's right. I mean, if you were to look at the legislative text itself, out of this big, massive new tax bill, only a couple provisions are direct changes to the estate tax. And then there's a couple of conforming amendments scattered throughout. But the new exemption levels really do have the potential to scramble things up for estate planners. A lot of clients whose estates have been taxable in the past, but now fall into that $10 [million] to $20 million exemption range, believe that they no longer have any need for all that careful estate tax planning that they did before. But that's really only true if you and your spouse are definitely, 100 percent certain that you're going to die before the higher exemptions expire.
David Stewart: Timing is, as always, the trickiest part. What about if you're superwealthy? Then is this just business as usual?
Jonathan Curry: Yeah, I mean if you got a $15 million estate, you get to treat the new law as saving you an extra $5 [million] or $10 million. I guess, rather it's more like letting your kids save it.
David Stewart: Got it. So this leaves some estate planning clients on sort of an exemption bubble. What does this mean for them?
Jonathan Curry: Well, a lot of planners say their clients need to take advantage of the higher exemptions while they're still in effect. You gotta use it or lose it. And estate tax rates and exemption levels have shifted around quite a bit over the last two decades, so not many people are counting on the assumption that things are going to stick around and become permanent or become extended. In fact, some people are actually concerned that the new exemption levels might not even last for that full eight years. Even though the public is usually skittish about the idea of the death tax, it is an easier source of revenue that falls exclusively on the very wealthy. So it's not hard to envision political power shifting in Washington in the next few years or lawmakers compromising to raise more estate tax revenue to pay for something else.
David Stewart: What are estate planners telling their clients?
Jonathan Curry: A big part of what I've seen is that there's been a shift in focus. Before the TCJA, it was all about planning ways to avoid the estate tax, so the focus was on things like moving assets out of your taxable estate before you die. Now, estate planners also have to balance the importance of basis and income tax planning. And this is a big shift for a profession in which income tax planning has been something of an afterthought for many years. The reality for estate planners is that in most cases you just don't really know when your client is going to die. So the idea is that rather than focusing all your planning on mitigating the estate tax itself, which is tied to when your client dies and is something which an estate planner doesn't have any control over . . .
David Stewart: I should hope not.
Jonathan Curry: Yeah, that'd be terrible . . . you focus on what you can control, which is taking advantage of the higher exemptions to make gifts now. But while doing that now gives you the benefit of avoiding the estate tax on future appreciation of those assets, making gifts now forgoes a step-up in basis, which only takes place at death.
David Stewart: Okay, let's take a step back and explain basis.
Jonathan Curry: Yeah, this one's really important. Basis refers to an asset’s cost basis, which is usually the amount that you paid for it. So let's say you own stock and you paid $20 for a share. If a few years go by and you sell that share for $50, you made a $30 gain. But then you have to pay capital gains taxes on that gain. A basis step-up essentially lets you bump up the asset’s starting value, its basis, from $20 to $50 without having to owe any taxes on the capital gain that just took place there. So, to use the previous example, rather than starting at $20, you get to step-up the starting value of the share to $50. And then you can either sell it immediately and not owe any capital gains taxes, or you can hold on to it, and that way, any future capital gains will be based on that higher $50 value as the starting point. So, to put this in the context of the estate tax, when you die, your heirs automatically get a step-up in basis on assets that they inherit from you, and that is a huge benefit. If they immediately sell those assets, they can avoid paying capital gains on those assets altogether.
David Stewart: What happens if they continue to hold those assets?
Jonathan Curry: In that case, they still get that benefit of saving on future capital gains taxes whenever that share of stock is eventually sold. And this kind of thing applies to all different kinds of assets, like real estate, so there is a potential for a lot of savings here. I mean, let's say your parents bought a house for $200,000 many years ago, but now it's worth $800,000. With the basis step-up, you can avoid paying capital gains taxes on that $600,000 difference. But remember, you only get that basis-step up at death. If it's just a run-of-the-mill lifetime gift, your kids are stuck with what's called carry-over basis, meaning they get the same starting basis you have. So the point is, estate planners have to weigh a bunch of different factors, like is it better to keep assets in the estate until death to get a basis-step up, and thus reduce capital gains taxes? Or should they take advantage of the temporary higher exemption levels to gift assets out of the estate now to avoid the estate tax later? And the answer is, well, it just kind of depends.
David Stewart: You mentioned earlier that estate planners are balancing basis and income tax considerations, so what's happening there?
Jonathan Curry: So, this is really oversimplifying it, but it might look like setting up trusts that distribute assets to your heirs, and then making gifts to those trusts now before the exemption goes away. That way, you still get to burn through your extra unneeded gift exemption, while still ensuring that when your assets eventually do get passed to your kids when you die, they're also going to get that basis step-up.
Another example of this could be that when spouses set up a trust for each other and gift a bunch of assets to it, when one of them dies, the other spouse then gets the assets with a basis step-up. And if the higher exemptions are still in effect when one spouse dies, then the living spouse can distribute those assets to their other kids — only now, they have a stepped-up basis.
It is important to remember that the estate tax and gift tax exemptions are linked, though. So the goal for many people will be to make more gifts now while the higher exemptions are in effect in case the exemptions snap back later.
David Stewart: What happens if you diligently give away all of your assets while you’re still breathing only for the exemption limits to fall before your time is up?
Jonathan Curry: Yes, so this brings up the dreaded issue of clawback. The worry with clawback is that if someone makes a bunch of gifts now and uses up their extra gift tax exemption in doing so, if the exemption amount reverts back to the 2017 levels before the tax law, do they then effectively lose the exemption protection over gifts made during this period of temporarily higher exemptions? Now when Congress passed the Tax Cuts and Jobs Act, they did include a little section there that directs the Treasury Department to come up with regulations to address the difference between the exemption amount at the time of the gift and the amount in effect at the time of death.
David Stewart: So, problem solved?
Jonathan Curry: Yeah, you would think so, and most practitioners I've talk to seem to think that that should settle it. That at some point in the next few years maybe Treasury and IRS will come up with something that puts people's minds at ease. But until they do so, and they do have a lot on their plate right now implementing the rest of the tax law, there is still going to be some lingering concern that the anticlawback regulations that they come up with might not be satisfactory.
David Stewart: How so?
Jonathan Curry: Well, for example, one way this could get complicated is whether Treasury decides that gifts made now during the higher exemption period should be treated as using up the extra exemption first, or the pre-2018 amount. In other words, are you counting from the top, or are you counting from the bottom when you're calculating gift tax exemption used up over the next few years?
David Stewart: Interesting. Are there any other ways that the temporary exemption amounts may complicate things?
Jonathan Curry: Well, how much time do you have? Because there's a whole lot here. The fact that these new exemption levels are temporary has really thrown a lot of estate planning out of whack. Another way we've seen this at work is with life insurance. For years, estate tax planners have used life insurance payouts to provide their clients' heirs with an immediate source of cash with which to pay estate taxes after their client dies. This can be really important because the estate tax is due nine months after death. And if you have to suddenly pay hundreds of thousands or millions of dollars even in taxes, you gotta pay in cash.
David Stewart: You mean the IRS won't accept my prized Beanie baby collection?
Jonathan Curry: Yeah, that's just not going to work. So, what you do is you get a life insurance policy to avoid leaving your heirs in a situation where they have to sell off a bunch of assets or properties, maybe at even way below market value, just to quickly get a source of cash. So then, what do you do if you've got a life insurance policy for that reason, but now it looks like you won't owe estate taxes anymore? Well, if you're happy and healthy, and unlikely to die in the next eight years, maybe you hold on to it, in case Congress lets the new exemption levels drop back down.
David Stewart: What if you know you don't have very long to live?
Jonathan Curry: So that complicates things. Maybe it just means that you simply rethink the purpose of life insurance in your estate plan. I mean, you can use life insurance payouts for other reasons like to pay other fees associated with estates, or you can even just use it as a savings and investment vehicle. But you also might decide that it's just not ideal to keep a life insurance policy under these circumstances. So then you'd have to look at unwinding the life insurance policy or selling your policy on a secondary market. Now, in the midst of all this uncertainty, there's a lot of creative tax planning going on as well through things like upstream planning.
David Stewart: What is upstream planning?
Jonathan Curry: Well, downstream planning is when you plan for your client's assets to pass downstream, which would be to their kids and grandkids and so forth. Upstream planning reverses that flow, so that instead of making gifts directly to your kids, you're first transferring highly appreciated assets to your elderly parents, who have more estate tax exemption amount than they know what to do with, and they in turn pass those assets to your kids when they die.
David Stewart: But doesn't giving all that stuff to your parents use up your gift tax exemption?
Jonathan Curry: It does, but this way when the kids receive those assets, they also get a step-up in basis on those assets that they wouldn't have gotten if you had just gifted it to them yourself, and you get to use up your parents’ unused generation-skipping transfer tax exemption.
I mean, in theory, you could actually do this with anyone that has plenty of exemption to spare who might be nearing death. It could be an aunt, or even a stranger. One upstream planning technique I heard about involves creating a trust and then assigning a general power of appointment to someone, which effectively moves the assets in that trust into that person's estate. And if you want to make sure that that person, maybe it's your elderly Uncle Owen, with whom you never totally got along with growing up, doesn't actually exercise their general power and do something else with your assets, you can set up the trust in a way so that he can't do anything with it unless he has the consent of an adverse party. And you can even designate your best friend or your lawyer to be that adverse party, and in fact, you might not even have to tell Uncle Owen he even has this general power. So if you do that, you can help keep those assets safe.
Now, looking at it, it is a little bit sneaky and it's a little bit risky too, because there are some odd rules that apply here. One example: The person you're giving a general power to can't die within a year or you lose the basis benefit here, but it is an interesting technique nonetheless.
David Stewart: So bottom line, it's all very complex, but as in all areas of tax, complexity can be the source of planning opportunities.
Jonathan Curry: That's absolutely right.
David Stewart: Jonathan, where can listeners find you online?
Jonathan Curry: You can follow me on Twitter. It's @jtcurry005.
David Stewart: Thank you for being here.
Jonathan Curry: My pleasure.
David Stewart: And now, Coming Attractions. Each week we preview the commentary that will be appearing in the next issue of the Tax Notes magazines. We're joined by executive editor for commentary, Jasper Smith. Jasper, what do you have for us?
Jasper Smith: In State Tax Notes, Leah Robinson and Amy Nogid argue that constitutional challenges to the corporate tax code could produce undesirable results for those pursuing them. Additionally, the authors offer ways to anticipate how a court may rule on those challenges.
Also, we're launching a new quarterly column from Bowles Rice titled, “Inside West Virginia Taxes.” In the inaugural article, Robert Kiss discusses West Virginia's failure to enact widespread tax reform in the 2018 legislative session. He also touches on lesser changes that were enacted, and recent tax cases from the state's courts.
In Tax Notes, David Schneider of Skadden writes about the new advance payment statute in the Tax Cuts and Jobs Act and highlights some questions that should be addressed in coming guidance.
In Tax Notes International, Thomas Zollo, Mike Moore, Anjit Bajwa, and Tom Chamberlin — all of KPMG — discuss how certain provisions of the TCJA may affect U.S.-based multinational service companies and provide a few key practical considerations.
David Stewart: You can read all that and a lot more in the April 30th editions of Tax Notes, State Tax Notes, and Tax Notes International. That's it for this week. You can follow me on Twitter @TaxStew, that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcasts@taxanalysts.org.
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