Proposals to repeal the federal estate and gift tax came about during the Presidential campaign and continued into 2017. The enacted Tax Cuts and Jobs Act changes, but does not fully revoke, estate and gift taxes. The tax reform increased the 2018 exemption amount per person from $5.6M to $11.2M, doubling what can pass on to the next generation without federal taxation. For married couples using portability, this means the combined exemption is $22.4M for the household. Inheritors will continue to receive the benefit of a step up in basis equal to the date of death value on assets included in the decedent’s estate. While not a full repeal, this is otherwise good news for high net worth families who could face a 40% rate on a taxable estate.
Three Important Caveats
Before placing estate planning in the rear-view, one should be reminded of three important caveats with potentially large consequences – and just a few reasons why estate planning is still relevant.
First, many provisions in the Tax Cuts and Jobs Act are intentionally not permanent as enacted in law– the new exemption only applies to estates of decedents dying after December 31, 2017, and before January 1, 2026. After that, the exemption would revert back to the previous level, adjusted only for inflation.
Second, the temporary increase in the exemption means fewer estate tax filings. The number of estates subject to federal estate tax has fallen in the last 15 years and is estimated to be under 5,000 estates per year. This may make it easier for the IRS to audit every estate that is subject to tax, and scrutinize those returns as large estates are targeted for any omissions or abuses.
Third, states may still apply an estate tax of their own. In some cases, the exemptions at the state level are much lower (for example $1M). State estate tax rates are generally not as high as the federal rate, but with the low exemption, it often does not take a sizeable estate for a tax to apply. When a large estate does exist, the state tax can be material. A $2M estate in Massachusetts would incur a state death tax of approximately $100,000. A $5M estate would owe close to $400,000 and a $10M estate over $1,000,000 in tax.
What does this mean for effective wealth transfer plans?
Estate plans may need to be flexible to encompass changing laws. If estate documents or beneficiary designations were designed over the past few years with specific dollar amounts in mind, those plans may need to be revisited to see if the higher exemption could change the intended outcome. Documents should consider not only the temporary nature of the federal law, but also the changing environment of state estate taxes. Several states have phased out estate taxes in recent years, and it is possible more could do so to stay economically competitive to attract and retain business owners and high income residents.
Gifting assets before death can be a means to lessen the impact of estate taxes and should be examined for those who might have a future state or federal estate tax. In some cases, one can remove future growth from a taxable estate, effectively “freezing” a value in time so that additional appreciation is not taxed upon the death of the original owner. This can be a strategy for growing family businesses or appreciating real estate, for example.
Following the Tax Cuts and Jobs Act, federal estate taxes will apply to fewer households. However, this does not eliminate estate planning as a critical aspect of personal finance. One should keep in mind that the changes are temporary, estates that are subject to a tax may be met with greater scrutiny, and states can still impose a tax burden that could come as a surprise to a family that had only read news that (federal) estate taxes were a thing of the past.