2016 Year-End Estate Planning

As 2016 comes to a close, Steptoe’s private client practice would like to take this opportunity to highlight some of this year’s important legal developments affecting estate planning, as well as certain year-end planning opportunities that may be of interest.

The end of 2016 brings far greater uncertainty than has been the case in the last few years due to the new administration.  One of President-elect Donald Trump’s campaign promises was the elimination of the estate and gift tax.  If Congress does repeal the federal transfer tax, it is likely that, with certain limited exceptions, the basis step-up at death will also be eliminated.  If these changes occur, personal planning may shift from estate tax considerations to capital gains tax considerations. 

The following is a summary of the proposed transfer and income tax changes:

Proposed Tax Changes

Trump’s Plan

House Republican Plan

Transfer tax repeal

Eliminates estate tax but unclear on fate of the gift and generation-skipping transfer taxes.

Eliminates both the estate and generation-skipping transfer taxes but does not address the gift tax.

Tax on Unrealized Gains at Death

Capital gains held until death and valued over $10 million will be subject to tax but it is unclear whether this tax will be imposed at death or when beneficiaries sell appreciated assets.

Despite proposed elimination of the estate, does not eliminate basis step-up at death.

Reduction in Itemized Deductions

Limits itemized deductions for individuals to $100,000 annually (or $200,000 for joint returns).

Eliminates all itemized deductions other than deductions for home mortgage interest and charitable gifts.

Income Tax Rates

Decreases top individual income tax rate to 33% (20% in the case of long-term capital gains and qualified dividends); eliminates alternative minimum tax (AMT) and 3.8% Medicare surtax on investment income.

Decreases top individual income tax rate to 33%; lowers effective top tax rate on capital gains, interest and dividends to 16.5%; lowers top rate applicable to business income to 25%; eliminates AMT.

Whether we will continue to have an estate tax or move towards no tax on death until the sale of assets or a capital gains tax on death (similar to the Canadian system) is unclear but a possibility, given Republican control of Congress and Donald Trump’s election.  In as much as it is impossible to plan for the unknown, we recommend continuing to plan under the current tax laws, building in flexibility to account for future changes in the law. 

The following summarizes some of the planning techniques currently available and highlights proposed legislative changes affecting such techniques.

Current Considerations

  • Historically high federal estate, gift, and generation-skipping transfer (GST) tax applicable exclusion amounts may be used to make gifts during your lifetime or at death.  The amount is currently capped at $5.45 million but increases due to inflation to $5.49 million in 2017.  We do not recommend making gifts beyond this amount and incurring gift tax.
  • Gifts made during your lifetime remove both the value of the gifted property as well as any appreciation on that property from your taxable estate, thus minimizing what may be taxed at your death. 
  • For taxpayers looking to make gifts of significant family-owned and controlled businesses, either to reduce the value of their estate for estate tax purposes or simply to implement a tax-efficient plan for business succession, valuation discounts have enabled the transfer of these high value assets with significantly reduced gift and estate tax consequences.  The IRS recently released long-awaited proposed regulations under Section 2704 of the Internal Revenue Code aimed at curbing the availability of planning with discounts for transfers of family-owned entities.  Many practitioners believe that certain portions of the proposed regulations exceed the IRS’s authority and would require legislative changes and that other portions ignore the economic realities of minority interest ownership in actual operating businesses.  If adopted as proposed, the regulations would be effective prospectively upon adoption.  Although the proposed regulations were subject to public hearing, commentary, and potential revision, given the change in Washington administration we believe that the proposed regulations will not be made final before year end – if at all.  Regardless of tax issues, business succession issues should be examined to insure the continuation of operations and proper allocation of assets among family members, particularly in situations where certain family members are active in the business and others are not.
  • Lifetime gifts may be further leveraged by the use of dynasty trusts to which the GST tax exemption is allocated.  These transfers allow property to pass in trust for the benefit of multiple generations free of estate, gift, and GST tax.  Dynasty trusts are also an extremely valuable tool to protect assets from creditors, including spouses in the event of a divorce, to make sure younger generations are protected from having too much wealth in their own hands, and, in some cases, to preserve unity of ownership.
  • Annual gifts up to $14,000 per person may be made to an unlimited number of individuals without consuming any of your lifetime exclusion amount or incurring a gift tax.  The annual exclusion gifting amount remains at $14,000 per donee for 2017.  A married couple together will be able to gift $28,000 to each donee.  The limitation on annual gifts made to noncitizen spouses will increase from $148,000 to $149,000 in 2017.

Income Tax Considerations

  • State transfer tax laws must also be taken into consideration.  For example, although New York has raised its estate tax exemption to match the federal exemption, the increase is phased in over several years and will not fully match the federal exemption until 2019.  In addition, the New York exemption is eliminated entirely for those estates that exceed the exemption amount by more than five percent.  New York also includes certain lifetime gifts made between April 1, 2014 and January 1, 2019 and within three years of death in the decedent’s New York taxable estate.
  • Under the current income and estate tax rules, property included in your taxable estate receives a step-up in basis.  Assets gifted during your lifetime will not receive a step-up in basis at death.  Therefore, income tax considerations must be taken into account when deciding whether to make lifetime gifts.  Higher income tax rates mean that maximizing the basis step-up allowable at death may be as important as minimizing transfer taxes, since the maximum income tax and transfer tax rates are now almost the same.  However, if the estate tax is eliminated and replaced with a capital gains tax at death or a system of carry-over basis as proposed, our focus may shift to an analysis of where and when it would be best to realize capital gains.
  • The 3.8% Medicare surtax on investment income and 0.9% Medicare surtax on earned income also remain in 2017.  Unlike individuals, trusts hit the base income threshold for this tax almost immediately.  Therefore, some or all of the Medicare surtax may be avoided by distributing trust income to beneficiaries who are below the individual net investment income threshold amount for the Medicare surtax.  As noted above, President-elect Trump has proposed eliminating this tax entirely through repeal of the Affordable Care Act.

Consider Grantor Retained Annuity Trusts (GRATs) and Sales to Defective Grantor Trusts to Remove Appreciation From Your Taxable Estate

Low interest rates continue to make GRATs and sales to defective grantor trusts attractive and effective planning tools.  Interest rates are expected to rise but when is unclear.

  • Sales to Intentionally Defective Grantor Trusts (IDGTs)
  • Sales to IDGTs using loans are especially useful in this time of uncertainty, as notes can be forgiven if the gift tax is eliminated.  If the gift tax is not eliminated, planning remains in place using a minimum amount (if any) of your lifetime exemption.
  • How sales to IDGTs work:
    • The grantor of an IDGT is treated as the owner of the trust assets for income, but not estate tax, purposes.  Thus, a grantor may sell assets that are likely to appreciate to an IDGT in exchange for a reasonable down-payment and a promissory note bearing a minimum required interest rate for the balance.  No taxable gain is recognized on the sale and no interest income is recognized by the grantor because the trust is a grantor trust for income tax purposes.  So long as the trust assets appreciate by more than the applicable interest rate charged on the note (a different rate than that used for GRATs, which currently is 0.74% for short term loans or 2.26% for long term loans entered into in December 2016), the appreciation over the applicable interest rate on the purchased assets will pass free of estate and gift tax. 
    • The grantor pays the income tax liability on the IDGT assets, which allows the principal to grow undiminished by the payment of income taxes.  Because the grantor is the owner of the assets for income tax purposes, the grantor’s payment of the IDGT’s income taxes is not treated as a gift to the trust beneficiaries even though it results in an increased amount of trust assets available for distribution.
    • Proposed regulations under Section 2704 of the Internal Revenue Code limit the utility of sales of discounted family business interests to IDGTs.  However, as discussed above, it is unclear whether these proposed regulations will ever be finalized.
  • GRATs
    • A GRAT requires that the grantor retain a fixed annual annuity from the trust for a term of years.  The annuity retained may be equal to 100% of the amount used to fund the GRAT, plus the IRS assumed rate of return applicable to GRATs.  As long as the GRAT assets outperform the IRS assumed rate of return (currently 1.8% for December 2016), at the end of the annuity term the grantor will be able to achieve a transfer tax-free gift of the spread between the actual growth of the assets and the IRS assumed rate of return.  Under current law you can structure a GRAT so that no taxable gift is made.  Although the grantor will retain the full value of the GRAT assets, if the grantor survives the annuity term, the appreciation on those assets could pass outside of the grantor’s estate without using any applicable exclusion amount and/or incurring any gift tax. 

Consider Making Year-End Charitable Gifts

  • If you have not reached the limits of your charitable contribution percentage limitations, direct contributions to charity before year end may be appropriate.  Particularly in this time of higher income tax rates, charitable income tax deductions are more valuable so now is the time to give. In addition, President-elect Trump’s proposals would reduce income tax deductions and tax rates making charitable contributions less valuable from an income tax perspective.

International Considerations

  • In May of this year, the US Department of the Treasury announced proposed regulations to increase the reporting and record maintenance requirements of US disregarded entities owned by foreign persons.  If these proposed regulations are finalized, such disregarded entities would also be required to obtain an employer identification number (EIN) by filing an IRS Form SS-4 and disclosing significant information to the IRS about their ownership.  Concurrent with the release of the proposed regulations, Treasury announced final Financial Crimes Enforcement Network (FinCEN) regulations increasing customer due diligence requirements for financial institutions and proposed legislation that would require a company to know and report beneficial ownership information to Treasury at the time of the company’s creation.
  • A Report of Foreign Bank and Financial Accounts (FBAR) must be filed by those who have a financial interest in or signature authority over a foreign financial account.  Those required to file FBARs should note that for taxable years beginning December 31, 2015, FBARs are now due April 15 rather than June 30.  A six-month extension will now be allowed, whereas no extension was permitted previously. 
  • Citizens of European Union member states, US citizens with assets located in EU member states, and individuals with a habitual residence in an EU member state should be aware of the European succession regulation that became effective August 17, 2015.  The regulation provides for the application of one uniform law governing succession across all EU member states and was adopted by 25 countries in the EU.  It provides individuals the ability to choose the law of nationality to govern their estate, thus affording the opportunity to bypass potentially undesirable laws of EU member states where property is located, such as community property and forced heirship rules.
  • The Foreign Account Tax Compliance Act (FATCA) requires US persons (including those living outside the US) to annually report certain information regarding foreign financial accounts and assets to the IRS with their income tax returns (in addition to the FBAR reporting mentioned above).  FATCA also generally requires foreign financial institutions to identify US account holders and report the accounts to the IRS or, under certain FATCA Intergovernmental Agreements (IGAs), to the local foreign government, which will then provide such information to the IRS.  A total of 113 jurisdictions have signed IGAs with the United States.
  • In response to a request by the G20, the Organization for Economic Cooperation and Development (OECD) developed a “Common Reporting Standard” (CRS) under which jurisdictions will require financial institutions to report certain information about nonresident account holders and then automatically exchange that information with other jurisdictions.  The information that is required to be reported includes account balances and gross amounts of interest, dividends, capital gains, and other income and, where an account is held by an entity, the entity’s controlling persons.  The goal is to provide home country tax authorities with information about their residents’ offshore accounts.  Over 90 jurisdictions have committed to implementing the CRS.  The US has not committed to implementation.  The CRS reporting standards are broader than FATCA’s and may require providing information regarding different aspects of trusts such as beneficiaries and grantors.
  • Proposed regulations issued in 2015 providing guidance with respect to gifts from covered expatriates to US persons remain unfinalized.

Planning and Year-End ‘Housekeeping’ to Remember and Consider

  • Now is a good time to review your current estate plan, particularly if you have had major life events such as a marriage, divorce, or birth of a child or grandchild.
    • Review will and trust provisions for formulas that may no longer accurately reflect your dispositive wishes.
    • Consider whether existing trusts need to be decanted to adjust the way property is distributed to certain beneficiaries by changing the trust provisions.
    • Review all beneficiary designations to ensure that they do not conflict with your overall testamentary plan.
    • Confirm that all necessary “Crummey Notices” have been sent to the appropriate parties to ensure that corresponding gifts made in trust qualify for the annual exclusion (particularly applicable to insurance trusts).
    • Consider refinancing high rate intra-family loans.
    • Maximize annual IRA contributions.