A Second Look at the Proposed Tax Code Reform

Take-Away: Since a week has passed, commentators have now had an opportunity to study the sketchy Tax Reform Proposal that was released last week. There are still many unanswered questions, and thus considerable speculation about what a new Tax Code might look like, but it is possible to begin to identify some estate planning strategies to response to the proposed repeal of the ‘dreaded death’ and the generation skipping transfer (GST) taxes and the elimination of several income tax deductions.

Estate Tax: Due to the partisan acrimony in Congress, there is a very good chance that any tax reform will be subject to Congress’ reconciliation process, which means that the tax reform provisions will have a shelf-life of no more than 10 years. Consequently, if we are looking at an estate tax/GST tax repeal that may only last 10 years, the change may only benefit those clients who face short life expectancies, i.e. those who will probably die during the 10 year tax hiatus. With younger clients, they should probably continue to plan their estates as they have in the past based upon the assumption that the estate tax/GST tax will spring back in 10 years and they will still have to plan for that tax and accumulate the needed liquidity to pay these transfer taxes.

Liquidity: Liquidity may still be important, even with the repeal of the estate tax/GST tax. Recall that Mr. Trump’s campaign platform called for replacing the repeal of the federal estate tax with a ‘deemed disposition on death’ tax, following Canada’s capital gain on death approach to revenue raising. Mr. Trump proposed a limited step-up in income tax basis on the death of an individual, but it was capped at $10 million. If there is a capital gain tax on death tax used to replace the loss in estate tax revenues, families will still need liquidity to pay that deemed capital gain tax. If there is a capital gain on death, states that do not have any estate or inheritance tax, like Michigan, might receive an income tax windfall if estates are treated as having liquidated assets on the owner’s death.

Dynasty Trusts: If the estate tax disappears, but could return after 10 years, more clients might be inclined to establish and fund multiple generation dynasty trusts, especially if they are grandfathered from a GST tax that could re-appear after 10 years. The current use of dynasty trusts to permit multiple generations to avoid having to pay estate and GST taxes might become even more popular if there is no GST exemption limitation on how many assets a donor can ‘stuff’ inside a dynasty trust during the next 10 years.

GRATs: Longer term grantor retained annuity trusts (GRATs) may become more popular. If the grantor dies within the 9 years, there will be a step-up in the GRAT’s assets. If the grantor survives the 9 years, all the growth in the GRAT assets (above the presumed IRS interest rate used when the GRAT was initially funded) will pass to the remainder beneficiaries of the GRAT gift-tax-free. So we may move away from 2 year ‘cascading’ GRATs to a period of one long term GRAT as a means of shifting wealth to the next generation gift-tax-free.

Elimination of Tax Deductions: The tax reform proposal would increase the standard deduction for taxpayers, and would eliminate the number of income tax deductions for itemizers to two: the home mortgage interest deduction and charitable gift deductions. All other income tax deductions would disappear. Some possible planning steps to respond to the disappearing income tax deductions include:

Accelerate Inherited IRA Income Now: IRC 691(c) is the income tax deduction that a taxpayer could claim if he/she inherited an IRA on which the IRA owner’s estate had to pay an estate tax. This deduction was intended to avoid ‘double taxation’ on the IRA dollars. If there is no estate tax, there is no need for the IRC 691(c) deduction. What happens if a taxpayer inherited a large IRA 4 or 5 years ago, on which estate taxes were assessed. That taxpayer is now ‘stretching’ their IRA distributions over their life expectancy, and each year the taxpayer is claiming an IRC 691(c) deduction to off-set some of the taxable income reported for the inherited IRA distribution. This taxpayer might completely lose the IRC 691 deduction if all deductions, but for home mortgage interest and charitable gifts, are eliminated. Some taxpayers in this situation might decide to take a 100% distribution from their inherited IRA before the end of 2017, just so that they can use their remaining 691(c) deduction before it disappears.
Accelerate State and Local Income Taxes Now:
(i) If the federal income tax deduction for state income taxes is eliminated, more taxpayers might take a second look at establishing non-grantor trusts in states that do not tax trust income, called SINGs, DINGs and NINGs- acronyms for irrevocable trusts established in the handful of states that do not impose a state income tax on accumulated trust income if there is little nexus between the trust asset that generates the income or the trust beneficiary and the state where the trust has its situs. Expect heavy marketing to establish these irrevocable trusts from the handful of states that have intentionally adopted favorable trust taxation statutes, e.g. Delaware, South Dakota, Nevada, in order to attract even more trust business. Michigan is one of a few states that base the residence of a trust for taxation purposes exclusively on the domicile of the trust settlor.
(ii) Additionally, if the income tax deduction for state and local taxes disappears at the end of this year, it might be wise to accelerate payment of those taxes in 2017 if possible, although this acceleration might expose the taxpayer to the AMT tax (in its last year of existence.)
Accelerate Trust/Estate Administrative Expenses Now: The administrator of a decedent’s estate can choose to deduct some administrative expenses, e.g. legal, appraisal, personal representative, accounting, on either the federal estate tax return or the estate’s income tax return. All of these expenses as income tax deductions would disappear, meaning no more choice after 2017.
Accelerate Investment Income Now: : Generally a taxpayer cannot deduct more in investment interest than what the taxpayer earned in investment income. Any excess investment interest expense can be carried forward to future years and applied against investment income in those future years. If this deduction ends in 2017, it may make sense to accelerate the recognition of investment income in 2017 to use against this carried tax deduction, before the deduction disappears unused.
Contribute to Donor Advised Funds: While the charitable income tax deduction is supposed to remain, the tax implications of losing many other income tax deductions may prompt a taxpayer to open and heavily fund a donor advised fund in 2017, so those excess contributions can be carried over for 5 more calendar years as charitable contributions. Also, this charitable deduction would be used this year when the marginal income tax rate is at its highest, 39.6%, thus off-setting more income taxes in 2017.

Respond to the Elimination of the Alternative Minimum Tax (AMT): Some taxpayers have AMT credit carry-forwards. An example would be a taxpayer who exercised an Incentive Stock Option in prior years who has an AMT credit carry-forward that is used when the taxpayer later sells the stock. If that credit disappears, the sale of the stock by the taxpayer that triggers a gain recognition may no longer have that AMT credit to absorb some of the recognized capital gain tax. If a taxpayer is in this situation, it might make sense, if not still in a ‘blackout sales period,’ to sell the stock so the AMT credit can be used before the end of this calendar year.

Possible Retirement Plan Changes?: I will not repeat my often stated concern about that prospect of the repeal of the ‘stretch IRA’ and its replacement with a mandatory 5 year payout rule. You’ve heard enough about that proposal from me already. But this past summer a couple of brave souls stressed the need to pay-as-you-go for the proposed rate reduction and tax simplification with the ‘Rothification’ of traditional retirement plan accounts. This would be the compulsory conversion of some or all qualified plans to Roth-like plans. It is designed, like the elimination of the ‘stretch’ IRA, to accelerate the recognition of retirement plan income, possibly exposing that taxable income to marginally higher income tax rates than would otherwise be the case, since all that untaxed income would be ‘bunched’ into a single calendar year when the Roth-like conversion occurs.

529 Higher Education Plans to Disappear?: There is some concern that the income tax ‘shelter’ that is provided by an IRC 529 higher education expense account might disappear as part of tax reform which promises the end of all tax ‘loopholes.’ If that is the case, some taxpayers should be prepared to maximally prefund 529 accounts before the end of 2017. Nor is it clear if previously funded 529 accounts that defer/eliminate income recognition, will be grandfathered under a new simplified Tax Code.

Other Implications to Estate Planning:

Decedent’s Estate Fiscal Year?: If a taxpayer died earlier in 2017, then the estate fiduciaries must decide when the tax-year will end to report income for the estate, i.e. the estate’s fiscal year. It might make sense to select November 30, 2017 as the fiscal year end for the decedent’s estate. This would enable some estate expenses incurred after December 1, 2017 to be deducted in the next fiscal year.
Encouraged Split Dollar Plans?: A general rule-of-thumb in life insurance planning is to maximize leverage by purchasing life insurance at the lowest income tax bracket. Split-dollar plans between an employer and an employee, which are used to purchase a large amount of life insurance on the employee, can remove equity from the business while minimizing the current income tax consequences to the employee-insured. If there is a reduction in the top corporate income tax rate (down to 20%), that lower corporate tax rate may make split-dollar plans more attractive to employees who want, or foresee the need for, more liquidity for their estates.

As noted at the beginning, there is a lot of speculation surrounding the proposed tax reform and its simplification. As such, many of the thoughts and suggestions mentioned above need to be carefully considered before adopting any of them. Nonetheless, it pays to plan ahead and be prepared to move quickly if we find ourselves with a new Tax Code come January 1, 2018.