Estate Planning in the Trump Era: A Peek Around the Corner

As the tumultuous opening weeks of the new Donald Trump Presidency unfold, the pre-election histrionics have not abated, and everyone cautiously watches to see what’s next. Regardless of your politics, there is no denying that these are interesting times.

Meanwhile, in the GSRNH Estate Planning group, we’ve been following the trade winds to understand what the political sea change might have in store for estate and financial planning. The President made broad promises during his campaign which, if implemented, will have a great impact on our corner of the office.

No legislation has been proposed or passed yet, but here’s our early thoughts on what might be coming down the road, and what it means for our estate planning clients, and our professional partners:

Estate Tax Repeal! Maybe . . .

Candidate Trump supported the repeal of the federal estate tax. Will President Trump push it through? Many financial commentators guardedly believe that repeal will be a reality; however, one clear lesson emerged from the last election cycle – the predictions of the cognoscenti are simply not reliable. But let’s assume they’ve got this right.

Republicans have long wanted to repeal the estate tax. In fact, polling shows the majority of Americans have viewed this tax levy as an unfair double tax – the income tax whittles away a person’s lifetime earnings that accumulate into his or her “estate” – only to be followed by the estate tax whack at death.

In fact, the estate tax affects precious few taxpayers; the Congressional Budget Office estimates that only 2 of every 1,000 citizens have exposure to the estate tax. This levy brings in an amount of revenue that could almost be considered a “rounding error.” The CBO forecasts that the estate tax will generate less than 1 percent of federal revenue over 2017-2026 under current law.

Most observers understand that the estate tax is not a revenue raiser. As a tool to accomplish the social objective of limiting the concentration of wealth, the estate tax has not been horribly successful either; the disparity of wealth between the rich and poor in the U.S. continues to grow, and is thought to be wider than any other major developed nation.

So all signs appear to point to repeal. But is this cause for exhilaration?

Much ink has been spilled discussing revenue ideas that could replace the estate tax. For example, it has been suggested that the tax laws should treat inheritances as income for income tax purposes. The argument from an economic perspective is stated simply: if lottery winnings are treated as income, is it unreasonable to treat an inheritance similarly?

Expect a more likely development: Candidate Trump proposed a return of carryover basis, coupled with the imposition of a capital gains tax at death. Right now, appreciation on assets that have not been sold before someone passes away (the built-in capital gains) escapes income tax in the hands of the beneficiaries. The President would change this and require that the built-in capital gain be taxed as though sold on the date of death. He proposes to exempt capital gains below $10 million, and exempt family businesses and farms from the tax. This is essentially the current Canadian death tax model.

But there are no shortage of unanswered questions and complications with this approach. Here’s just a few:

• If taxing capital gains tax at death is instituted as part of the repeal of the estate tax, will transfers prior to death – say, to an irrevocable trust – avoid that capital gains tax on death? How about such transfers that were made years ago?

• How will taxpayers find tax basis data to determine the tax? Many clients complained about this in 2010 when a carryover basis regime existed for one short year. For many assets, such information is readily available (brokerage accounts); for some assets it will be a challenge (the lake house that’s been in the family for generations). If implemented, everyone will need to be sensitive to the recordkeeping involved to identify income tax basis information for this purpose.

• Will the focus of future estate planning efforts switch to analyzing the built-in capital gains of various assets so that beneficiaries are treating equitably “after tax”? Consider: Dad wants to treat his two children equally and directs that one receive $1.0 million in cash and the other a home worth $1.0 million. If the home has untaxed appreciation of $500,000, the children have clearly not been treated equally.

Gift Tax Repeal

Most of us think of the estate tax and the gift tax as two sides of the same “transfer tax” coin. While this is largely true, there are some different policy drivers for each that suggest estate tax repeal might not include gift tax repeal in lock-step.

Recognize that the gift tax is not just a backstop for the estate tax – i.e., preventing the transfer of assets during life that would have been subject to estate tax at death. It also ensures the integrity of the income tax. If the gift tax were repealed, a parent could shift income without tax cost to a child who is in a lower tax bracket. The parent could simply gift the asset to be sold to the child to sell, who then would pay a lower income tax than the parent, and then could gift the net proceeds back to the parent.

That said, with the current gift tax exemption at $5.49 million, the gift tax does not really deter this type of income-shifting behavior. And for the small population of Americans for whom this discussion has relevance at all, it is likely that all family members are in the highest tax brackets anyway and no effective income-shifting is possible.

Some commentators have suggested that gift tax repeal might result in an uptick in asset protection planning. Transferring assets into irrevocable trusts to protect them from creditors is often befuddled by the need to avoid a gift tax. Repealing the gift tax would allow asset protection planning free from gift tax complications.

Generation Skipping Tax Repeal

While there are policies that support the continued existence of a gift tax even if the estate tax is repealed, the same does not hold true for the generation-skipping transfer tax (“GST tax”). The existence of the GST tax is directly tied to the prevention of deemed abuse of multi-generational estate tax avoidance strategies. If the estate tax is repealed, look for the GST tax to disappear as well.

Illinois Keeps a Foot in the Door

Currently over 20 states have separate estate or inheritance taxes. Many state estate taxes will disappear if the federal estate tax is repealed since they are based on the federal estate tax system. However, Illinois has a stand-alone estate tax system which is not tied to the federal system. There is little doubt that federal repeal will cause no change to the Illinois estate tax, and planning for it will therefore continue to remain important.

Considerations if Repeal Really Happens

What should estate planning clients and their advisors be thinking about now?

Should estate tax repeal occur, we believe that existing wills and revocable trusts that employ “tax planning” should be reviewed. This may be important for a number of reasons:

• A common approach taken in wills and revocable trusts is to incorporate a “credit shelter” trust and a marital disposition (either outright or in trust). The purpose of the credit shelter trust was generally to make assets available to a surviving spouse, but to avoid them being included in the surviving spouse’s estate for estate tax purposes at his or her later death. To achieve that goal, various restrictions on access to funds must be included in the governing documents which – but for the need to dodge the estate tax – would not have been included. If repeal occurs, what continuing utility will credit shelter trusts have?

• Another common approach in wills and trusts has been to direct that these credit shelter trusts be funded with the maximum amount that will not create a federal or state estate tax. If there is no federal (or state) estate tax, no assets will be directed to the credit shelter trust, and the entire estate will go to the surviving spouse or a trust for his or her benefit. In many circumstances (second marriages, for example) this might be contrary to the client’s intent.

• What happens to the requirement to pay income out at least annually from a marital trust? While that payment obligation was required to qualify the trust for the marital deduction, that provision may or may not remain desirable if estate tax repeal occurs.

• Life insurance is often acquired to fund the payment of estate tax, and is sometimes owned in an insurance trust. Prudence suggests not terminating such coverage (where premium cost is a neutral consideration) since our mercurial Congress could reenact the estate tax before the client dies. In addition, there may well be some type of “replacement” tax – for example, a capital gains tax at death as suggested above – for which insurance may provide some or all of the funding for paying that tax. Note that in many cases, the life insurance trust also provides desirable asset protection benefits which should not be lightly disregarded or discarded without careful thought.

• The IRS permits “portability” of the federal estate tax exemption; this allows a surviving spouse to “inherit” any unused portion of a deceased spouse’s exemption from estate tax. If a client died recently, should the surviving spouse even bother filing a federal estate tax return to elect portability?

• Some clients have implemented a planning strategy known as the “grantor retained annuity trust” and its residential counterpart, the “qualified personal residence trust.” These are clever methods of transferring appreciation in asset value from one generation to another at reduced transfer tax cost. Should clients look to dismantle these structures?

• In a wider sense, if repeal in fact occurs, how will the provisions of wills, revocable trusts, and irrevocable trusts be interpreted in a no-tax environment that was never contemplated at the time of drafting?

• But: trusts will continue to have vitality as a planning tool. While some clients may opt for simplistic outright bequests if there is no tax planning required, the benefits of trust planning for non-tax reasons need to be underscored:
  • Asset Protection. Trusts can still provide valuable divorce and asset protection benefits. In the absence of any transfer taxes, this may become the primary goal for many trust-based estate plans. With increased longevity, the likelihood of remarriage following the death of a prior spouse will increase. The need for trusts on the first death to protect assets is more important than many clients appreciate.
  • Income Tax Planning. Trusts can provide income tax planning opportunities by sprinkling income to whichever beneficiary is in the lowest income tax bracket. Even if the beneficiaries are all in the maximum income tax bracket, there still might be significant state income tax differences, or the ability to offset a trust income tax gain by a beneficiary income tax loss.
  • Incapacity. In addition, the lay press has noted that financial abuse of the elderly is growing; state legislatures have passed laws to help curb it. Trusts can provide control as a client ages, or as a client’s health wanes. Using a revocable trust could mitigate the dissipation of wealth as a client’s cognitive abilities wane.

Restructuring Trusts

As suggested above, under the Trump Administration, clients may face issues in a couple areas: revising existing estate plans to best take advantage of the contours of an estate-tax-free landscape, and determining whether – and how – to deal with existing irrevocable structures that may no longer serve their original functions (life insurance trusts, for example).

With repeal, we expect a ramp up in client desire to dismantle irrevocable trusts that were solely driven by estate tax avoidance. There’s no single, or right, approach to approach changes to existing irrevocable trusts. Some answers may lie within a trust document itself – such as a trustee’s discretionary right to terminate or distribute all assets. Perhaps there is a “trust protector” provision in the controlling document to be considered. Relief may be available from the Courts which can order the judicial termination of existing trusts.

Illinois law also offers an “escape hatch” of sorts – the opportunity to use the new trust decanting statute to effect certain changes. This recent change in the law is beyond the scope of this article, but it was lightly touched upon in an earlier GSRNH newsletter, and more information about it can be found by clicking here.

Conclusion

We will continue to watch Washington as all this unfolds, and will share further thoughts when there are developments of interest to our clients and professional partners. While much uncertainty remains, reading the tea leaves suggests that estate tax repeal may be in our future, and business-as-usual estate planning may dramatically change. Stay tuned!