On December 20, Congress passed the Tax Cut and Jobs Act, the most sweeping tax reform since 1986. I am writing to mention a few highlights of the Act.

The estate, gift and generation-skipping transfer tax exemption will increase from $5,490,000 in 2017 to $11.2 million per person in 2018. The exemption will be adjusted each year until 2026 based upon inflation.  In 2026, the exemption will be divided in half (i.e., it will be approximately $6 million, depending upon inflation between now and 2026).  In order to benefit from this temporary increase in the exemption, you must either die during the eight-year period (2018 through 2025) or make large taxable gifts during that time period.  Who dreams up these crazy laws!

The income tax rates for individuals, estates and trusts have been lowered, including the top bracket of 39.6% being reduced to 37%. The top income tax rate for C corporations will be reduced from 35% to 21%.

Individuals, trusts, and estates will receive a 20% income tax deduction for qualified business income from pass-thru entities such as LLCs, S Corporations, Partnerships, and REITs. There are significant limitations that apply to income from certain pass-thru entities that are personal service businesses.

The deduction for qualified business income and the changes in the income tax rates for individuals, C corporations, and trusts and estates will apply for an eight-year period starting in 2018.

The changes made by the Act have enormous planning implications, especially for owners of closely-held businesses. Between now and year end, you should consider accelerating certain deductions and deferring income when possible.  If you want to accelerate future charitable gifts to 2017, you can temporarily fund a donor advised fund or private foundation.

On April 14, 2014, the Tennessee Legislature approved a new type of trust known as a Tenants by the Entirety Trust (“TBET”).

A TBET is a joint trust for a married couple that provides the same protection from the claims of the separate creditors of the husband and wife as would exist if the husband and wife owned the trust assets directly as tenants by the entirety. 

Being able to transfer tenants by the entirety property to a TBET without sacrificing creditor protection will make it more feasible for couples to use revocable trusts for their various benefits, including incapacity management, probate avoidance, and privacy.

A TBET only provides creditor protection for property that was held by the spouses as tenants by the entirety property prior to the conveyance of the property to the trust.  The additional requirements of a TBET include: (1) the husband and wife must remain married; (2) the property must continue to be held in trust by the trustee(s) or their successors in trust; (3) while both the husband and wife are living, the trust must be revocable by either spouse or by both of them acting together; (4) both spouses must be beneficiaries of the trust; and (5) the trust instrument, deed, or other instrument of conveyance must specify that the provisions of the new statute apply to the property. 

Traditional tenants by the entirety property automatically passes to the survivor upon the death of the first spouse.  A TBET is more flexible.  For example, the TBET could convert to an irrevocable trust for the benefit of the survivor, with the remainder to pass to children after the survivor’s death.  This structure would provide better asset protection for the survivor as well as better protection to the children if the survivor remarries.

After the death of the first spouse to die, the property will continue to be exempt from the claims of the decedent’s separate creditors.  To the extent the survivor may withdraw the trust assets, the property will be subject to the claims of the survivor’s separate creditors.

Creditor protection may be waived as to any specific creditor or any specifically described trust property, but only if expressly permitted by the trust instrument, deed, or other instrument of conveyance or if the husband and wife both give their written consent.  This provision allows a house subject to a mortgage to be transferred to a TBET.

TBETs may be created on or after July 1, 2014. 

 

On January 1, 2013, Congress passed the American Taxpayer Relief Act of 2012The headlines have mostly focused on the income tax provisions; however, there are some very welcome provisions in the estate, gift, and generation skipping transfer tax areas. 

 

First, I will review the significant income tax changes.  The tax brackets that applied during 2012 will continue indefinitely, except that individuals earning more than $400,000 or couples making more than $450,000 will have income over this threshold taxed at 39.6% rather than 35%.  The $400,000 and $450,000 thresholds will be indexed for inflation beginning after this year.  There will be a phase out of personal exemptions and itemized deductions for individuals with more than $300,000 of adjusted gross income.

 

In the estate, gift, and generation skipping tax areas, the exemption equals $5 million indexed for inflation.  The inflation-adjusted exemption for 2013 will be $5,250,000.  This means that those people who thought they used all of their gift tax exemption in 2012 actually have more gift exemption in 2013.  It also means that the fire drill at the end of December was unnecessary.  Portability, which was introduced for the first time in 2010, is now made “permanent.”  The combination of the higher exemption and portability has significant ramifications that we will be writing about in future articles.

 

Congress chose not to close any of the transfer tax “loopholes” that President Obama wants to eliminate.  However, these could still appear as revenue raisers during the deficit reduction debate that will occur in the new Congress.

 

The capital gains and dividend rates will remain at 15%, except that individuals making above $400,000 or couples making more than $450,000 will be taxed at 20% on income above the threshold amount.

 

Finally, the Act restores the ability of individuals who are older than 70½ years of age to make a transfer directly from their IRA to charity.  You will be able to give $200,000 this year; however, you must give $100,000 before the end of January.  The other $100,000 may be given any time before December 31, 2013.  Since there is a phase out of itemized deductions for certain high-income individuals, it will be a material decrease in taxes to give money directly from your IRA to charity rather than withdrawing funds and then making a charitable contribution.  If you took your required minimum distribution during the month of December of 2012, you can treat it as a distribution directly from the IRA to charity (i.e., you do not have to take it into income in 2012), if you transferred cash to charity in December (after the withdrawal) or transfer cash to a qualified charity prior to February 1, 2013.  If you characterize any charitable cash gifts made in December or January as coming from your IRA, this will count towards the $100,000 that you can give before January 31, 2013.

In a surprising move, the Tennessee legislature has repealed Tennessee gift taxes, effective for gifts made on or after January 1, 2012. This is welcome news for a lot of our clients who plan to make a $5.12 million gift later this year. Our clients have been considering various ways to make their gifts without paying Tennessee gift tax. They will no longer have to worry about the gift tax.

Some of our clients knew that a change in the gift tax might occur later this year and have made large loans to their children. These clients will now consider forgiving the loans or giving other assets to their children.

Tennessee’s repeal of its gift tax leaves Connecticut as the only state that charges gift taxes.

The fiscal note for this bill estimated that it will cost the state approximately $15 million per year in revenue. I am sure that the revenue loss for 2012 will be a significantly higher amount due to the window of opportunity for making tax-free gifts at the federal level.

The Tennessee legislature repealed Tennessee’s inheritance tax, effective as of January 1, 2016. This means that if you can survive until 2016, you will not owe any Tennessee inheritance taxes. If you die before that date, you will owe taxes if your taxable estate exceeds the following exemption levels:

 

2012

$1,000,000

2013

$1,250,000

2014

$2,000,000

2015

$5,000,000

Since the tax still applies until 2016, Wills of married persons should still establish Tennessee QTIP Trusts. This will avoid tax at the first death. As long as the surviving spouse survives at least until 2016, the Tennessee inheritance tax will be permanently eliminated.

There are a lot of existing Tennessee QTIP Trusts (sometimes referred to as Tennessee Gap Trusts) for married individuals who died over the last few years or chose to make a gift to such a trust. These trusts are irrevocable and cannot be modified to add the children as beneficiaries or to change the income payout requirements for the spouse. Depending on the terms of the trust, it may be possible to distribute corpus of the trust to the spouse. Unfortunately, due to the instability of the federal estate tax laws, it would be imprudent to distribute assets from a TN QTIP trust to the spouse. As of January 1, 2013, the federal estate tax exemption is scheduled to be only $1 million. Distributing assets from the Tennessee QTIP Trust might increase federal estate taxes payable by the spouse’s estate.

The elimination of the Tennessee inheritance tax will eventually simplify estate planning for our clients. However, for the next four years, we must pay attention to this tax.

Over the last several years, several of our clients have changed their residences to Florida to avoid certain Tennessee taxes, including our inheritance taxes. Migration to avoid state inheritance taxes has also been occurring in other states.

Last week, the Wall Street Journal published an article about various states, including Tennessee, that are considering a repeal of their death taxes. The article states that “the main obstacle to reform in Nashville is GOP Governor Bill Haslam…”

Governor Haslam responded to the Wall Street Journal by writing a letter to the editor. In his letter, the governor points out that he has recommended repealing the taxes in the next three years and that he has worked with House Finance Committee Chairman Charles Sargent to completely repeal the taxes in four years. Indeed, the House Finance Subcommittee has recommended an amendment to House Bill No. 3760 that would increase the inheritance tax exemption to $1,250,000 in the year 2013, $2 million in the year 2014, $5 million in the year 2015, and would totally repeal Tennessee inheritance taxes beginning in the year 2016. I find it interesting that our state legislature has taken some lessons from recent federal tax cuts. If we can’t afford a tax cut now, phase it in so that the impact will be postponed to future years when revenue collections will hopefully be better. The danger with a phase-in approach is that it is easier for future legislatures to “change their mind.”

Normally, I would be skeptical that a bill with a large tax cut would survive the final budget cut. However, the governor’s unusual public support for the cut gives me reason to hope that this change will be made.

A group known as Tennesseans Against Death Taxes is lobbying the Tennessee government to repeal Tennessee gift and inheritance taxes. Tennessee is one of only two states that charge gift taxes. Our state gift tax roadblocks a lot of good estate planning that could otherwise be done, with the result that families pay significantly more federal estate taxes. A number of our clients have moved to Florida to avoid these taxes and the Tennessee Hall income tax.

If you would like the Tennessee gift and inheritance taxes to be repealed, you should consider contacting your representatives in the near future. Enclosed are a sample letter in Word and PDF, a list of Senate and House contacts, and an economic study prepared by Art Laffer, a former economic advisor to President Reagan.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 authorized portability of the federal estate and gift tax exemption for married couples. This means that if one spouse dies without having used his or her entire exemption, the survivor may use it.

Portability has been widely hailed as a great estate planning benefit. The benefit is that the first spouse to die can leave everything to the survivor rather than having to create a credit shelter trust. 

Our view is that the benefit of portability is overrated; furthermore, it creates a trap for the unwary. We are not advising any of our married clients to plan on using portability.

The foremost reason that we do not favor portability is because the statute that created it also required the law to expire on December 31, 2012. President Obama and many members of Congress have indicated that they would like to extend portability beyond this sunset date; however, we have learned that it is foolhardy to plan on the assumption that future tax laws will be consistent with sensible statements made by politicians. 

Even if portability is made “permanent” by future legislation, there are many pitfalls to using portability. First, there is no inflation adjustment. For example, assume a married man dies this year and leaves his entire $5 million estate to his wife. When the wife dies, she will be able to use her husband’s unused exemption, but without any adjustment for inflation. If the husband had placed the $5 million in a credit shelter trust instead of transferring it to his wife, appreciation of the value of the trust during his wife’s remaining lifetime would have also escaped estate taxes.

The Tennessee inheritance tax exemption is not portable. If you fail to use the exemption in the estate of the first spouse to die, it will be lost forever. This will result in higher Tennessee inheritance taxes for the survivor’s estate.

Those who plan to establish trusts that last for the lifetimes of their children and beyond, are concerned about generation-skipping transfer tax exemption. The GST exemption is not portable. However, if the first to die establishes a trust and allocates GST exemption to the trust, the trust will be exempt from generation-skipping taxes for up to 360 years.

In order to claim portability, the estate of the first spouse to die must file a timely federal estate tax return. I predict that a lot of surviving spouses who are not otherwise required to file an estate tax return will fail to file timely returns in order to claim portability. 

There are numerous portability issues associated with the remarriage of the surviving spouse. It will likely take years for regulations and court cases to fully flesh out these issues. All things considered, we recommend that you disregard portability as a planning tool, at least until the law is made permanent.

This is the seventh article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first six articles, see:

Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents
Part 3 – Temporary $5 Million Estate Tax Exemption
Part 4 – Temporary $5 Million Gift Tax Exemption: Use it or Lose It
Part 5 – Gifting Without Making Yourself a Pauper
Part 6 – Making Gifts Without Paying Tennessee Gift Taxes

Part 5 discussed methods for maintaining access to cash flow from gifted assets. Part 6 discussed methods for avoiding Tennessee gift taxes. This article will discuss a method for combining the concepts discussed in Parts 5 and 6.

A Tennessee QTIP Trust allows you to make a completed taxable gift for federal gift tax purposes without paying Tennessee gift taxes. The reason you do not pay Tennessee gift taxes is because the trust qualifies for the Tennessee gift tax marital deduction. This is not a new technique. We have been using it for 12 years. There has always been a difference between the federal gift tax exemption and the Tennessee gift tax exemption. However, due to the higher federal gift tax exemption, we plan to establish more Tennessee QTIP Trusts in 2011 and 2012 than all prior years combined.

Another appealing feature of a Tennessee QTIP Trust is the spouse’s access to cash flow from the trust. A lot of our clients would make no gift at all or would make a much smaller gift if they could not obtain access to cash flow.

Tennessee QTIP Trusts do not provide cash flow for your children.  If one of your objectives is to increase cash flow for your children, you should consdier other techniques, perhaps in conjunction with a Tennessee QTIP Trust.

In summary, if you would like to take advantage of the temporary $5 million federal gift tax exemption but are unwilling to pay Tennessee gift taxes or need to maintain indirect access to cash flow, you should consider establishing a Tennessee QTIP Trust.
 

I previously wrote about Edith Windsor, who was required to pay $350,000 of estate taxes because her deceased spouse was a woman rather than a man. This tax was caused by the Defense of Marriage Act (“DOMA”), which classifies same sex married couples as unmarried for purposes of federal taxation and various benefits.

President Obama has decided that certain portions of DOMA are unconstitutional and has directed the Justice Department to stop defending the law in court, including the pending appeal in the Windsor case.

There are many people who agree with the President’s assessment of the constitutionality of DOMA. Nevertheless, it is not the President’s job to determine the constitutionality of laws that have been enacted. Laws may be changed by Congress or ruled to be unconstitutional by the judicial branch of the government. It would create chaos if the President is allowed to prohibit enforcement of laws that he does not like.

If DOMA is overturned by Congress or the U.S. Supreme Court, this will be a watershed event for same sex married couples. There are numerous tax and non-tax benefits provided to couples who are treated as married by the federal government.