In my last article I wrote about the numerous reasons estate planning is important outside of estate tax planning, in light of the recent doubling of the federal estate tax exemption as part of the Tax Cuts and Jobs Act. This article is devoted to the other end of the spectrum, the new opportunities for estate tax planning under the Tax Cuts and Jobs Act.

The Tax Cuts and Jobs Act doubled the federal estate tax exemption from $5 million to $10 million, adjusted for inflation annually. This means that the use of typical estate tax planning techniques, such as sales to Intentionally Defective Grantor Trusts (“IDGT Sales”) and the creation of Spousal Lead Access Trusts, to implement transfers of wealth can be leveraged to unprecedented estate tax savings.

In an IDGT sale a person would sell an asset to an intentionally defective grantor trust, (the intentional defect makes the trust income taxable to the person establishing the trust, but removes the trust property from the person’s estate for estate tax purposes), in exchange for a promissory note. This acts as an “estate tax freeze” by locking in the value of the asset at the time of the sale and allowing the asset to continue to appreciate in the trust, outside of the person who created to trust’s estate. The standard practice in initiating an IDGT sale is for the seller to make a gift to the trust of 10% of the asset value, so that the trust has adequate initial capital to make note payments. This means that with the doubling of the estate tax exemption a married couple could transfer a business valued at $200 million by making a gift to the intentionally defective grantor trust of $20 million of stock in the company, or membership interest in the case of an LLC, and selling the remaining $180 million of stock, or membership interest, in exchange for a promissory note, which must at a minimum bear interest at the Applicable Federal Rate (AFR). Additionally, if the couple retained a business valuation expert and took a typical 30% valuation discount for lack of control and lack of marketability they could transfer a $285 million business free of gift tax. If the business appreciates by just 50% ($142.5 million) in the trust prior to both spouses death then the estate tax savings due to the freeze, including the New York state estate tax savings, would be approximately $57 million.

Additionally, at around the same time as the passing of the Tax Cuts and Jobs Act the IRS abandoned its proposed regulations under Internal Revenue Code §2704, which were designed to restrict the use of valuation discounts in interfamily transfers, such the discounts for lack of control or lack of marketability, discussed above. That coupled with the largest ever federal gift tax exemption and a low interest rate environment creates the  potential for unprecedented tax-free intergenerational transfers of wealth via IDGT sales.

The doubled estate tax exemption is set to sunset at the end of 2025 and revert back to the original $5 million per person adjusted for inflation. Therefore, couples may want to gift a significant portion of their estate prior to the end of 2025 to take advantage of the increased exemption, but the couple may not be ready to give up control of the assets. A Spousal Lead Access Trust (“SLAT”) may be the ideal solution. Both spouses would create what is called “non-reciprocal” trusts, which means the trusts are different enough to avoid the reciprocal trust doctrine under the Internal Revenue Code; such as the inclusion in one trust of the power for the spouse to receive the greater of $5,000 or 5% of the trust property, and not including that power in the other trust. Each trust is an irrevocable trust for the benefit of the other spouse (and often the benefit of the couple’s children). The trust is set up as a grantor trust, so that the creator of the trust will pay the trust income tax, which is then effectively an additional tax free gift to the trust. The couple can each transfer up to their entire remaining estate and gift tax exemption to their trust gift tax free. The trust assets will not be included in the estate of the person who created the trust. Since each trust benefits one spouse the couple has essentially not given up control of the assets, while removing the assets and the appreciation on the assets from their estate.

One aspect of the Tax Cuts and Jobs Act that provides a tax saving opportunity to individuals stems from something the act did not change. The Tax Cuts and Jobs Act did not change the basis rules at death. Meaning assets that are included in a decedent’s estate will continue to receive a step up in basis to their fair market value as of the decedent’s date of death. Lifetime gifts have a carryover basis of the basis the person making the gift had in the asset. This provides an excellent opportunity for individuals who found themselves with a potential taxable estate in years past, but who will likely not have a taxable estate with the new $10 lifetime exemption. For example, many people created Qualified Personal Residence Trusts or other types of trusts designed to remove assets from their estate. Those assets will transfer to the beneficiaries with the same basis as the person who made the transfer had in the asset. Since for most people the estate tax rate is at least double the capital gains rate this strategy made perfect sense and saved beneficiaries from a potential hefty estate tax bill. Now however, if there is no estate tax to worry about, those same people should consider exploring options to help their beneficiaries avoid  capital gains upon the sale of the estate assets. One option would be to decant the trust into a trust that will make the trust assets includable in the decedent’s estate. What that does is give the beneficiaries a stepped-up basis in the asset, which means if the asset was sold immediately there likely would be no gain and therefore no capital gain tax.

Lastly, I stated this in my previous article, but it bears repeating, New York State still imposes an estate tax of up to 16% on estates over $5,250,000. Originally, New York State was set to match the federal estate tax exemption amount in 2019 and remain in lock step with the federal estate tax exemption amount. However, with the doubling of the federal estate tax exemption under the Tax Cuts and Jobs Act that is no longer the case. New York will remain where the federal exemption would have been had the Tax Cuts and Jobs Act not doubled the estate tax exemption ($5,000,000 adjusted for inflation every year after 2011). Additionally, unlike the federal government, New York state has an “estate tax cliff” meaning if your estate exceeds the exemption amount by more than 5% your entire estate is subject to tax, not just the amount exceeding the exemption. Additionally, unlike the federal government, New York does not allow the surviving spouse to use their deceased spouse’s unused estate tax exemption, referred to as portability. Therefore, if your estate exceeds the New York state estate tax exemption amount then you will still need to do some estate planning to minimize New York estate tax.

Estate tax planning is complex. The estate planning attorneys at Twomey, Latham, Shea, Kelley, Dubin & Quartararo are available at your convenience to answer your questions, review your current estate plan to ensure it continues to meet your needs or to discuss the implementation of an estate and succession plan.

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