The Tax Cuts and Jobs Act signed into law in December 2017 could have a big impact, not only on estate tax planning but also on income taxes derived from unrealized estate tax consequences.
If you haven’t reexamined your estate plan in light of these changes, now is the time.
Estate tax exemption raised
One of the most frequently discussed changes implemented by the tax law was a doubling of the federal estate tax exemption from $5.49 million per person in 2017 to $11.18 million per person in 2018 (or $22.36 million per couple) in 2018.
For 2019, the federal estate tax exemption is $11.4 million per person (or $22.8 million per couple).
Avoid unintended consequences
Take a close look at any wills or trusts that were drafted before the legislation passed. If the trusts use formulas that are tied to the federal estate tax exemption, there could be unintended consequences due to the new larger exemption amount.
For example, suppose your trust was created in 2001 when the estate tax exemption was just $675,000.
Your trust may have stipulated that your children receive the amount of your assets that could be passed free from federal estate tax, while the remainder — which exceeded the federal estate tax exemption — would go to your spouse (thus eliminating any federal estate tax).
If your trust hasn’t been updated since then, your children could be in line to receive up to $11.4 million and you could inadvertently disinherit your spouse.
In addition, pay particular attention to trusts drafted prior to 2011, when portability was introduced (as discussed in the following section).
Portability and step-up of basis
Two other important factors to consider are portability and step-up of cost basis. In the past, many married couples established bypass or credit shelter trusts that pay income to the surviving spouse and ultimately pass the trust assets on to children upon the surviving spouse’s death. By using this type of trust, the first deceased spouse’s estate exemption could be fully used.
However, new legislation passed in 2011 allows for “portability” of the deceased spouse’s unused estate exemption. In other words, the surviving spouse’s estate can now use any exemption amount that wasn’t used by the first deceased spouse’s estate.
Another important part of the Tax Cuts and Jobs Act that was left unchanged was a step-up of basis. But the unintended effects of this “non-event” are potentially more significant now.
Upon a decedent’s death, the heir’s cost basis of many assets becomes the value of the asset on the date of the decedent’s death. Therefore, highly appreciated assets that avoided income taxes to the decedent could also avoid or minimize income taxes to the heirs.
Maintaining the ability for assets to receive a step-up of basis is a more important part of estate planning now, given the larger federal estate tax exemption.
Beneficiaries who inherit assets from a bypass or credit shelter trust upon the surviving spouse’s death, however, do not benefit from a “second” step-up of basis.
In this circumstance, the basis of the heir’s inheritance would be the original basis on the first spouse’s death.
Therefore, bypass trusts are much less valuable than in the past and could have negative income tax consequences for the heirs.
This is especially true if the assets in the bypass trust appreciated significantly after the first spouse’s death or if there was a relatively long amount of time between spouses’ deaths.
Restructure trust funding
If your current trust establishes a bypass trust upon death, you might want to consult with your estate attorney about restructuring how the bypass trust is funded to allow for the larger federal estate tax exemption.
While bypass trusts are not necessarily wrong or bad now, they generally no longer fit many estate plans as originally intended.
It normally doesn’t require a significant amount of work to amend the trust and it could be as simple as amending the way a bypass trust might be funded in order to provide more flexibility for an estate exemption decrease — or in case you win the lottery.
Since fewer estates are subject to federal estate tax and there is more focus on income tax planning, maximizing the benefit of the step-up of basis for income taxes while providing flexibility in the event of future estate tax law changes is becoming more important.
If you haven’t reviewed your estate planning documents with an estate attorney recently, make it a goal for 2019.
Mark Howe is a Certified Financial Planner and member of the Financial Planning Association of Greater Kansas City. He is a senior financial planner at Frontier Wealth Management.