The Transitory Nature of the Estate Tax Exemption Amount

With $11.18 million of cover under the unified credit under the 2017 tax act, more estates than ever are exempt from federal estate tax. This is especially so for married individuals, who have double this amount and the benefits of portability to help make effective use of both spouse’s exemption amounts.

Clients need to be reminded that this exemption amount is NOT permanent. Come 2026, the exemption will return to pre-2017 tax act levels, adjusted for inflation. So the exemption will be cut in half (approximately). But it is not just the built-in changes that need attention – it is the political reality that if there is a change in power in Washington, there is a substantial likelihood that the Democrats would seek to lower exemptions even farther (and/or increase estate tax rates).

This was brought home recently via proposed legislation of Elizabeth Warren, a possible 2020 presidential candidate. A recent article notes:

Warren’s office says her bill would lower the exemption to what it was at the end of President George W. Bush’s administration in 2009 — $3.5 million for individuals or $7 million for couples — and tax the value above that threshold beginning at a rate of 55 percent. Warren’s bill also includes progressive, marginal estate tax rates with higher thresholds: 60 percent on anything over $10 million for an individual or $20 million for a couple and then 65 percent on anything over $50 million for an individual or $100 million for a couple. For estates worth more than $1 billion, all of those rates would be increased 10 percent across the board to 65 percent, 70 percent, and 75 percent, respectively.

Even if Congress and President Trump can make the 2017 tax act provisions “permanent,” there really is no such thing as permanent. A willing Congress and President can pass whatever changes they want in the future.

Planners and taxpayers alike ignore the of possibility of a reduced exemption at their own peril. At a minimum, consideration should be given in marital planning to what would be the best disposition plan at the death of the first spouse based both under current exemption amounts and what would be best if exemption amounts are materially lowered. Consideration should also be given to using the higher exemption amounts before they are rescinded (for those that can afford to do so).

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Avoiding Drafting Errors in Estate Planning Documents

As a member of a law firm with a substantial practice in estate and trust litigation, I have the opportunity to see numerous cases of poor drafting that end up in dispute or litigation. In the best of circumstances, it can be difficult to draft a 20-30 page trust or other instrument 100% free of all drafting errors. But there are many circumstances that are more likely to create, or not catch, drafting errors.

A recent article by L. Paul Hood, Jr. addresses many of these circumstances, and provides suggestions to minimize errors. I highly recommend it. Below is a list of several of these circumstances and/or suggestions, as paraphrased and commented on by me, but you should read the whole article:

a. Do your best to avoid the need to rush. Easier said than done when under client pressure or senior attorney pressure, but one source of time pressure is within your control: procrastination. Also, resist pressure to draft to immediately implement a settlement solution or with a client waiting in your office for a revision to sign. I tell our litigators when they are drafting a complex settlement agreement at the end of a day and night of mediation that what they are trying to do in a few hours would probably take several days of drafting, review, and rewriting  to properly prepare and that the risk of drafting (or analysis) errors is obviously higher in those circumstances.

b. Take good notes at your client meetings, and review drafts with the client. For clients with little interest in reading your legalese, a diagram illustrating key dispositive provisions goes a long way to make sure everyone is on the same page. Doing the diagram will also reveal to you, the draftsperson, contingencies, circumstances and planning alternatives you may not have considered. Of course, this can increase your time investment in the project and thus your or client costs, but it sure beats a malpractice action.

c. Confirm that procedures included in the document can be reasonably implemented in the real world, such as how to prove a trustee has become disabled or incapacitated.

d. Be especially vigilant when cutting and pasting provisions from one document to another.

e. Review the execution version for blanks, and make sure the printed version is the latest draft on your computer.

f. Review other documents that will affect the drafted document or will be affected by it, to assure they are consistent with each other.

My favorite is to set aside a document and come back to it for final review the next day with fresh eyes. I can’t tell you how many times I see things on such a fresh read through that were not obvious when drafting.

Hood, Jr., L. Paul, How to Avoid Common Sources of Drafting Errors, Estate Planning Journal (WG&L), August 2018

Multiple Trusts and the Section 199A 20% Deduction

Section 199A Background

The Tax Cuts and Jobs Act of 2017 created a 20% deduction for noncorporate taxpayers against their qualified business income. For taxpayers in the highest bracket, this would reduce their tax on such income from 37% to 29.6%.

There are limits on the use of the deduction for higher income taxpayers. One set of limits is the exclusion of service income (subject to some exceptions) from the deduction, and another requires significant wages or depreciable business property to benefit from the deduction. Therefore, higher income taxpayers are incentivized to reduce their taxable income to avoid these limitations.

The deduction is available to trusts and estates and their beneficiaries.

Using Trusts to Reduce Income

Since trusts can take the deduction, it has been suggested that income from qualified businesses be split among numerous nongrantor trusts. By splitting the income among numerous trusts, the trust can stay below the limitation thresholds and take full advantage of the deduction.

Code §643(f) provides that under regulations, the Service can treat two or more trusts as 1 trust if (1) the trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and (2) a principal purpose of such trusts is the avoidance of federal income tax. If applicable, it would defeat the above planning by combining multiple trusts into one trust – thus, the income would be combined and would then likely push the income of that trust up above the Code §199A income thresholds.

Proposed Regulations Weigh In

Treasury seeks to implement the authority under Code §643(f) and has issued Proposed Regulation §1.643(f)-1. The proposed regulation starts by parroting the above language of Code §643(f). It then indicates a “principal purpose” of avoidance will be presumed as to the establishment or funding of multiple trusts if it results in a significant income tax benefit unless there is a significant non-tax (or non-income tax) purpose that could not have been achieved without the creation of the separate trusts. It gives an example (Example 1) of a “principal purpose” problem where interests of a business are split among nongrantor trusts for the purpose of qualifying for the Code §199A deduction when an owner reads about the idea in an article. Spouses are treated as one person (as to being a grantor or beneficiary).

As to the question of substantially same beneficiaries, that Example 1 holds that the following trusts with substantially the same terms and established by the same grantor will be aggregated as one trust:

Trust 1 – Beneficiaries B, C, D

Trust 2 – Beneficiaries E, C, D

Trust 3 – Beneficiary E.

Example 2 has one grantor and these beneficiaries:

Trust 1 – G as to mandatory income, with H as remainder beneficiary

Trust 2 – H is discretionary income beneficiary for health, support and maintenance, and G is discretionary income beneficiary for medical expenses. He is the remainder beneficiary upon G’s death.

The example concludes that the trusts will not be aggregated due to the significant non-tax differences between the terms of the two trusts.

Conclusions

One conclusion is that multiple nongrantor trusts are viable for Code §199A planning purposes, if there is sufficient differentiation as to beneficiaries and trust terms. It is not viable without that differentiation.

Another conclusion is that the examples do not provide a clear demarcation or explanation of when trusts will be aggregated when there is some level of overlap in beneficiaries and terms. So taxpayers using trusts with some level of overlap will need to proceed at their own risk.

The preamble to the regulations notes that the proposed regulations are not limited to Code §199A avoidance.

The new rules are proposed to apply to taxable years ending after August 16, 2018. The preamble indicates they will apply to trusts entered into or modified after that date, but trusts existing or modified prior to that date will be governed under Code §643(f) on the bases of the statute and legislative history guidance.