Oklahoma Bar Journal
Tax Considerations for Trusts and Estates
By Ryan J. Duffy
Recent times have given rise to a painful reminder for clients that two things are certain in this world: death and taxes. The uptick many attorneys have seen in attention to estate planning needs has been substantial. As an attorney, the job is not done once an estate plan is created for a number of reasons, not the least of which is tax planning. Tax ramifications for estate planning clients range from the simple need to monitor income being taxed within a trust (once irrevocable) to much more complex aspects of estate and gift taxes.
The estate and gift tax attributes are often a heavy consideration for individuals with taxable estates. The Tax Cuts and Jobs Act (TCJA) of 2017 doubled the estate and gift tax exemptions, and the exemptions have since ballooned to $11.7 million per person for 2021. The TCJA is scheduled to expire in 2026, with the exemptions indexed for inflation between now and the expiration. The exemptions are at a historically high level. Considering the political climate and rumblings surrounding certain provisions of the TCJA (especially the exemptions) being modified, clients may want to take advantage of the historically high exemptions in light of the potential rollback of the exemptions’ levels.
How can clients take advantage? If a couple has not utilized any of their lifetime gift tax exemption, the couple could gift up to $23.4 million in 2021 without incurring any gift tax. However, clients must use extra caution in determining the amount and the composition of any gifts. The basis of the proposed gift property should be heavily considered in determining whether a gift should be made during the grantor's lifetime or bequeathed upon death. Basis is a tax/accounting term that is utilized in determining the benchmark for a taxpayer’s capital gain calculation utilizing purchase price and adjustments. By way of example, if a client purchased an asset for $100,000 and took $10,000 in depreciation, the taxpayer’s basis would be $90,000. A sale of such asset for $110,000 would result in a $20,000 capital gain ($110,000 sale price less $90,000 basis). A detailed comparison of estate tax versus future capital gains should be considered in such determination. The basis rules under IRC Sec. 1014 must be paid close attention.
Under current rules, a beneficiary would receive "carryover basis" in a gift from the donor. In other words, the beneficiary would have the same basis in the property as the donor had immediately prior to transfer, with a few adjustments if gift tax is paid, etc.
If a beneficiary receives property as a result of the death of the decedent, the beneficiary generally receives a "step-up" in basis to the fair market value of the property. This means, regardless of the decedent's basis, the beneficiary's basis in the property is fair market value at the date of death or an alternate valuation date. As such, the estate planning attorney should get a full disclosure of the client’s asset composition as well as basis for such assets.
Notably, under IRC Sec. 1014, property left to a surviving spouse receives a step-up in basis at the first spouse’s death and a second step-up at the second spouse’s death. As one can imagine, transferring property without careful consideration of basis may have severe, adverse consequences. A simple mistake, such as the transfer of property with significant appreciation during the donor’s lifetime, could result in the beneficiary paying quite unnecessary capital gain taxes. Notwithstanding, capital gains are typically at a lower rate than estate or gift taxes, hence the necessity to evaluate the overall economic effect of both aspects. In almost all situations, the donor (and donee) would be better off gifting an asset without a substantial appreciation above the asset’s basis, all other things considered equal. Lifetime gifting of property, even considering the basis rules, may make great sense as a tool to “freeze” the estate value and effectively push any subsequent estate appreciation to the donee’s estate.
Considering the foregoing, estate tax planners should also keep a close eye on legislative developments. Capitol Hill has been fairly active in pushing for changes, including the elimination of the step-up in basis on an individual’s death. If that were to go into effect, the onus against gifting appreciated assets would be greatly diminished if not eliminated.
Another set of estate tax-saving tools that is under fire of late is discounts for lack of marketability and lack of control in family entities. Contributing the client’s assets to a family entity, frequently a family LLC, is another invaluable tax savings tool. The individual simply puts assets into the family LLC and subsequently gifts interest in the family LLC over time to the desired beneficiaries. The family LLC would be under a transfer restriction, thus the discount for lack of marketability. Provided the client has reached a level of ownership interest that would be below the controlling vote threshold, the estate would also be entitled to a discount for lack of control. While these combined discounts can vary widely based on specific facts, they certainly can reach a substantial percentage and corresponding tax savings. However, as mentioned before, these discounts have been under some scrutiny by Congress.
An additional consideration from an estate tax perspective is whether or not to utilize some or all of the first-to-die spouse’s exemption when dealing with husband and wife clients. Under current IRC rules (and since 2010), if a spouse passes without using their entire estate tax exemption, the surviving spouse may make an election to have such deceased spouse’s unused exemption (commonly called "DSUE") added to the surviving spouse’s exemption. DSUE and the increased exemptions’ amount have done away with some traditional estate planning techniques, such as the traditional A-B trust arrangement, where a trust is set aside equal to the remaining estate tax credit of the first spouse to die (to ensure the estate tax credit of the first spouse to die is exhausted), leaving the surviving spouse limited access to such “A” trust. Setting aside an amount unrelated to a decedent’s remaining estate tax credit to care for children or other beneficiaries is still often desirable. This allows a client to shield a legacy for their preferred beneficiaries without concern of remarriage by a surviving spouse, creditors of a surviving spouse invading the funds and a number of other factors. Setting aside a specific dollar amount (not tied to the remaining estate tax credit of the first spouse to die as in the traditional A-B trusts of years past) to be held in trust away from a surviving spouse and creditors is likely to be more commonplace now. The amount can be a flat amount to be divided among beneficiaries, an amount per child or beneficiary or any other number of ways to figure a set amount.
In evaluating whether to utilize the estate tax exemption of the first spouse to die, an attorney must be mindful of the potential of remarriage of the surviving spouse. If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion that is available for use by such surviving spouse may only utilize the most recent spouse to die. In short, if a surviving spouse remarries and such remarried spouse predeceases their new spouse, the first spouse’s DSUE is extinguished.
As we approach the end of 2021, clients have an opportunity to capitalize on the most favorable estate tax regime in United States history. It would seem likely that 2022 would carry a similar estate tax framework, but there certainly is no guarantee based on the velocity of legislation movement of late. With midterm elections soon, there is even greater uncertainty as to what the estate tax climate will look like in the near future. Perhaps more favorable? Sure. Perhaps less favorable? Definitely a possibility. In short, examining your estate planning client’s desire and ability to capitalize on these favorable conditions is a worthwhile task. Attorneys must make sure to execute any such tax-saving plan with great caution to fully maximize the client’s tax saving benefit as well as protect the client’s donee from unwanted tax consequences.
ABOUT THE AUTHOR
Ryan Duffy received his BBA from OSU and his J.D. from the OU College of Law. His practice has focused on estate planning and administration, taxation, corporate organization, transactional law, oil and gas, real estate and nonprofit organization, with a specific concentration on tax controversies and business development.
Originally published in the Oklahoma Bar Journal – OBJ 92 Vol 9 (November 2021)