Tax Law Provides Opportunities

You may be aware that the Tax Cuts & Jobs Act was enacted at the end of last year, and that it provided certain income tax cuts to individuals and corporations. It also raised the federal estate tax exemption to more than $11 million per person. What you may not know is that this new law provides huge income tax planning opportunities that you can build into your estate plan, allowing for significant savings during your lifetime.

In order to understand the theory, you need to first understand what the federal estate tax is and how the transfer of assets into partnerships and trusts opens up opportunities for capital gains and income tax savings.

The federal estate tax is a transfer tax on the value of your assets at the time of your death. It is, essentially, a tax on your balance sheet. Your estate tax exemption however, is not just something that is available to your estate after your death. The estate tax exemption is also part of a gift tax exemption.

You can make $15,000 annual tax-free gifts to anyone that you choose. To the extent that you make gifts to anyone in excess of that amount, you must file a Federal Gift Tax Return Form 709 reporting the excess. You don’t actually remit tax to the IRS until you have consumed your $11+ million exemption. The exemption that you have remaining at the time of your death is what you can apply to your estate. If the value of your estate at the time of your death does not exceed the unused exemption amount, then there is no federal estate tax due.

So how does this provide you current income and capital gains tax planning opportunities? Stay with me here.

Because everyone has a large federal estate and gift tax exemption, this opens doors to creating trusts that sprinkle income among beneficiaries, even the grantor himself, without fear of actually having to pay any transfer tax. Suppose, for example, you have a family business and you wish to distribute some of its income to children or grandchildren.  You can create a trust that sprinkles the income among those beneficiaries who then pay the income tax at their lower marginal rates. The increase in the transfer tax exemption provides you the means to create trusts that accomplish just that, especially if the value of your estate is below the current federal threshold of $11 million.

Capital gains taxes are yet another consideration under the new law. Generally speaking, when I die, my estate achieves what is known as a “step-up” in tax cost basis equal to the date of death value of assets at the time of my death. The theory behind this is because there is an estate tax on that value then the capital gains should be eliminated.  The step-up doesn’t hold true for qualified retirement accounts, such as IRA, 401(k) and 403(b) accounts.

Because the federal gift/estate tax exemption is so high, taking maximum advantage of this step-up to eliminate capital gains is of paramount importance for our loved ones, especially in estate plans for married couples. Under the federal estate tax law of several years ago, dividing assets and using each spouse’s separate exemption was of primary importance. Now, for many married couples, it might be better to have inclusion of the assets in each spouse’s estate as he or she passes. This way, the family achieves a “double” step-up. As always, individuals should check with a qualified estate planning attorney to determine if their estate plans should be amended to take advantage of the new law.

Partnership tax law can also be used to minimize capital gains. Here, you might create trusts that benefit younger family members and gift low basis assets (those that have not appreciated greatly) to that trust. That trust then contributes those low basis assets to a LLC or to a partnership. You also form another type of trust funded with high basis assets (those that haven’t appreciated much). That trust then contributes those high basis assets into another LLC or partnership. A new general partnership is formed (call it the Parent Partnership) and both of the existing partnerships contribute their underlying assets into the Parent Partnership.

After the tax law’s requisite holding period, the Parent Partnership is dissolved and the assets are distributed to the various trust/partners and ultimately to the beneficiaries, except the low basis assets are distributed in the liquidation to the older generation. When the older generation dies the step-up in tax cost basis is achieved eliminating the capital gains on those assets. This is known as a “swap technique”. The new tax law opens the door to this and similar planning strategies.

These strategies are not without significant risks if improperly established. Failure to comply with the complicated partnership and income tax laws could result in a deemed sale, accelerating the very taxes that one is trying to minimize.

The swap technique is beneficial not only for wealthy retirees, but also for wealthy middle-aged individuals who have a living, cooperative parent. Assuming that parent doesn’t have a taxable estate (one that exceeds $11 million) then one could use that parent’s exemption and subsequent step-up at death advantageously, minimizing capital gains exposure during the lifetime of the middle-aged child.

The Tax Cuts & Jobs Act is scheduled to sunset on January 1, 2026. It may also be likely that Congress passes a Technical Corrections Act of some kind closing loopholes. Consequently, the application of any strategy should be carefully considered with your legal and tax advisors before jumping in.

The Sheppard Law Firm is located in Fort Myers and Naples by appointment.

© 2018 Craig R. Hersch. Originally published in the Sanibel Island Sun.

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Craig R. Hersch

  • Senior Partner,
    • Sheppard Law Firm
  • Florida Bar Board Certified Estate Planning Attorney / CPA
  • Editorial Advisory Board Member,
    • Trusts & Estates Magazine
  • Founder & Board Member,
    • State Chartered Trust Company