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Wealth Transfer Planning After the Tax Cuts and Jobs Act

Discuss key points with clients and start taking action now.

The Internal Revenue Code Section 7520 rate and its sibling, the applicable federal rate, are on the rise. In and of itself, this uptick in key wealth transfer hurdle rates might be regarded by some as just another data point on the ebb and flow of economic indicators. But the astute planner should recognize this blip as much more, because it’s a call to action to take advantage of the wider planning bandwidth attributable to what the Tax Cuts and Jobs Act gave, and, just as important, to what it didn’t take away.

Prominent in the “gave” column is, of course, the doubling of the estate, gift and generation-skipping transfer exemptions to approximately $11.2 million. But, for many clients, especially those with large estates, the tally in the “left alone” column may be more meaningful, as it includes stepped-up basis, unfettered flexibility with grantor retained annuity trusts and sales to intentionally defective trusts and the availability of valuation discounts that can add just enough body English to the economics to make that GRAT or sale work in the first place.

Still, the role of the IRC Section 7520 and other rates shouldn’t be downplayed. Every basis point of uptick in the applicable hurdle rate of an interest-sensitive planning technique is a basis point of appreciation required of the transferred asset to make the technique successful in the first place. Just by way of example, a five-year GRAT funded this month when the Section 7520 rate is 2.8 percent would call for a level annuity of 21.71 percent a year to reduce the remainder gift to virtually zero. That same GRAT done next month, when the Section 7520 rate will be 3 percent, will call for a 21.84 percent annuity. All things and asset performance being equal, just that 20 basis point difference in the Section 7520 rates will result in a difference in wealth transfer that will do a lot more than buy lunch. The point is that, with daily prognostications for rising interest rates, it’s time for clients to take what the new tax law gives them and what it left alone. 

Two Key Discussion Points

Here’s a suggested agenda for a discussion about getting started with wealth transfer planning in this environment:

  1. Develop an approach to planning that puts first things first. Suffice it to say, clients should focus first on putting out any fires in the basement before working on the design of the new gables atop the third-floor addition. One such fire, which has actually been burning since well before TCJA, is the formulaic estate plan that could fund a bypass trust with approximately $11.2 million, potentially defunding the financial flexibility and independence of the surviving spouse. In many circumstances, notably those involving the very wealthy, that kind of incremental funding of the bypass trust is of little or no concern to the survivor. In other circumstances, that kind of planning will sacrifice the surviving spouse’s financial flexibility on the altar of potential estate tax savings for the children. That could be an interesting topic of conversation between the spouse’s old estate planner and tax advisor and his new attorney and tax advisor.
  2. Using the increased exemptions to fix or ameliorate any problematic current planning. The existence and nature of any problems in the current plan will obviously vary among individuals, as will the degree of difficulty and stress any such problems present. However, a common thread that runs through these situations is that the objective isn’t incremental wealth transfer. Rather, it’s to staunch the tax and/or economic bleeding from prior planning that either over-promised but under-delivered or was under-designed in the first place.

So, a non-exclusive list of situations that need attention might include:

  • Forgiving debts from the children, with a good example being that big loan that the parents made to the kids to buy that big house. Some might refer to that kind of loan as “acquisitive indebtedness.” In any case, forgiveness of the loan would be a gift, perhaps now covered by the increased exemption.
  • Shoring-up underperforming or under-capitalized IDGTs, with good examples being adding to the IDGT’s capital base to alleviate concerns about IRC Section 2036 or enabling the IDGT to release the guarantees that the children provided in lieu of seed money for the trust.
  • Shoring up underfunded irrevocable life insurance trusts and split-dollar plans, with examples too numerous to mention, largely due to the fact that most interest-sensitive life insurance products or planning structures are showing how truly exquisite that sensitivity is to prolonged low rates that are, in turn, calling for prolonged and/or higher premiums.
  • Using some of the newfound GST tax exemption for late allocations.

Incremental Planning

To the extent that there’s still both need and interest in incremental planning, what’s a sensible approach to determining what to do? One way to fashion a response to this question is to consider incremental planning from two perspectives, income tax and estate tax, and to do so contemporaneously. That’s because the client’s family won’t necessarily be better off on a net basis by transferring an asset during lifetime to remove appreciation from the taxable estate than by retaining it in the estate. Yes, the 40 percent estate tax rate is a lot higher than the 23.8 percent top federal capital gains rate. But that’s not where the comparison stops. Consider, for example, that if an individual gifts a low basis, highly appreciated asset to a child, the child will take the parent’s basis in the asset, that is, a carry-over basis. If the child sells the asset, that 23.8 percent rate will be applied to all of the appreciation above the parent’s basis. If the individual holds the asset until death, it will pass to the child with a stepped-up basis, thereby eliminating or at least reducing the gain when the child sells it. The point is that the asset would have to appreciate substantially after the gift for the estate tax savings on the removed appreciation to offset the loss of the basis step-up. Well, a prompt and reasonable counter would be, “What if the child doesn’t sell the asset? Maybe it’s a beach house that will stay in the family for generations!” Clearly, the resolution of such planning issues will be situationally dependent.

Planning from an income tax perspective might involve individuals making adjustments so that significant assets that won’t now get a stepped-up basis at death will do so. Some of those adjustments would be to:

  • Make gifts to parents who have non-taxable estates to obtain step-up in basis on those assets at the parents’ deaths
  • Exercise swap powers in an IDGT to bring low-basis assets back into the estate
  • Review the income tax basis trade-offs between bypass trusts and portability
  • Add powers of appointment to trusts that will cause estate inclusion and get a stepped-up basis for the included property

Planning from an estate tax (savings) perspective could involve:

  • Continuing or starting to make annual exclusion gifts as well as payments of tuition directly to the school as an additional tax-free gift
  • Intra-family loans to IDGTs, especially if the parent/lender can lend to an IDGT at an AFR that the trust can easily outperform with its investments
  • Spousal lifetime access trusts for those who want to retain some measure of control after the gift
  • GRATs, especially because they can transfer appreciation with virtually no use of exemption
  • Sales to IDGTs, a technique that can be designed in nuanced fashion to serve well more than one planning objective
  • Charitable lead annuity trusts, which can offer income tax benefits as well as wealth transfer benefits

Needless to say, each of these wealth transfer techniques involves its own set of features, benefits and risks. Therefore, practitioners should make sure a given technique fits with the client’s goals. That’s especially true if the technique involves that inconvenient term “irrevocable.”

Life Insurance Planning

Because of the increased exemptions, the indexing of those exemptions and the scheduled sunsetting after 2025, the role of life insurance in the estate plan after TCJA will require a more nuanced and multidisciplinary analysis than before. Just consider the impact of those variables on such important inquiries as how much life insurance a client needs for liquidity and for how long he’ll need it, whether to keep paying the premiums on a policy no longer needed for liquidity, whether an ILIT is needed for a new policy and, if it is, how best to design a tax-efficient approach to funding the ILIT. There’s a lot of expertise needed here on both the tax side and the life insurance side, especially if the life insurance program is to be well-coordinated with the rest of the planning.

There really is a lot to talk about, and now would be a good time to start the conversation.


Charles Ratner is a Senior Director at RSM US LLP.

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