Top 10 Income Tax Considerations for Estate Planning in 2019

Income tax planning should go hand-in-hand with efforts to preserve and compound your estate. John O. McManus today discussed with clients key opportunities to maximize income tax savings.

Listen to the discussion and review important points below:

  1. Review Your Plan: Given the significant tax law changes on the State and Federal level over the past several years, it is important to review existing Wills and Trusts to ensure that income tax efficiency is maximized.
  • Evaluate cost basis of assets gifted to irrevocable trusts, which will not receive a step-up in basis.
  • Determine whether irrevocable trusts have swapping or decanting powers.
  • Re-visit the use and implementation of Testamentary Credit Shelter Trusts (see below).
  1. Basis and Testamentary Credit Shelter Trusts: It is important to preserve the flexibility to benefit from a step-up in basis upon the surviving spouse’s death.
  • Credit Shelter Trusts, which utilize State and Federal estate tax exemptions, typically do not allow for assets to receive a step-up in basis upon the surviving spouse’s death.
  • Since the estate tax exemptions have dramatically increased in the past decade, fewer families are impacted by estate tax.
  • This means that a Credit Shelter can do more harm than good because:

o   the children would not have been subject to estate tax even without a Credit Shelter Trust.

o   the children will have to pay capital gains on the assets of the Credit Shelter Trust when they sell them.

  • If it becomes evident that estate tax is not a concern, a power can be included in the Credit Shelter Trust to cause the assets to be included in the surviving spouse’s estate upon his or her death to achieve the step-up in basis.
  1. Paying Retirement Accounts Forward: If you inherit a qualified retirement account, you should consider disclaiming it to the next generation in order to extend the tax-deferred appreciation of the investments.
  • If you do not require the use of the retirement account investments inherited from a parent, a disclaimer within 9 months of the date of death can provide a significant tax benefit.
  • The required minimum distributions of the IRA will be based on your children’s ages, meaning the required minimum distributions will be significantly less and allowing for more assets to remain in the account to appreciate in value income tax-free.
  1. Using Assets as Leverage for Gifting: Using appreciated assets as leverage can provide for a wealth transfer opportunities to minimize estate tax without sacrificing a step-up in basis upon death.
  • It is common to gift significant assets as part of a wealth transfer plan to minimize future estate tax.
  • However, in doing so, the assets do not receive a step-up in basis upon the donor’s death.
  • If the family sells the assets soon after, the estate tax benefits are muted because the capital gains tax must be paid.
  • As an alternative, explore financing for the asset and gifting the cash to a protected, multi-generational irrevocable Trust.
  • The cash will then be invested, with any growth taking place outside of the estate and realizing the desired estate tax benefit.
  • The asset will remain in the estate to gain the step-up in basis and only the value of the equity in the property would be subject to estate tax.
  1. NINGs and DINGs: There may be significant tax-savings opportunities to eliminate the imposition of State income tax on capital gains by establishing a Trust in Delaware or Nevada.
  • If you anticipate having the opportunity to sell a closely-held business or appreciated stock holding, you will have a significant State income tax (and on your Federal return, you will no longer be able to deduct that tax paid).
  • By forming a specially-designed Trust in Delaware or Nevada and hiring a trust company located there to administer it, you can then fund the Trust with the asset that will be liquidated.
  • Since the asset is intangible and is considered to be custodied outside the state of your residence, the State cannot impose income tax on the gain.
  • The Trust can also be structured so that it will not be subject to State or Federal Estate tax after your death.
  1. Upstream Gifting: The sale of an appreciated asset to a specially-designed Trust for the benefit of a parent can provide post-liquidation tax benefits.
  • If there is high capital gains tax exposure for an investment that will be sold at some point during your lifetime, you might consider selling the investment to a Trust for the benefit of a parent.
  • By selling the investment, you do not use any of your estate tax exemption and you would hold a promissory note, the payment of which could be made by income generated by the investment.
  • The parent would be granted a power that would cause the Trust to be taxed as part of his or her estate.
  • Therefore, upon the parent’s death the investment would receive a step-up in basis, and it can subsequently be sold with minimum capital gains tax.
  1. 199A Qualified Small Business Deduction: The creation of non-grantor trusts for the benefit of separate beneficiaries can be used to expand the amount of Qualified Business Income that is deductible when income limits are exceeded.
  • Following the enactment of the tax law in 2018, taxpayers are entitled to a 20% deduction on qualified business income (QBI) from partnerships, LLCs, and S-Corporations.
  • If a single person’s taxable income exceeds $157,500 or a married couple’s taxable income exceeds $315,000, the deduction for QBI is then limited to 50% of the W-2 wages paid by the business or 25% of W-2 wages plus 2.5% basis of depreciable property.
  • A possible strategy is to establish non-grantor trusts (i.e. trusts specially designed so the creator is not considered to be the income tax owner) and transferring interest in the entity to the trusts.
  • Since each Trust is a separate taxpayer, all QBI in connection with the trusts’ share of the income would benefit from the full deduction presuming that each Trust’s taxable income does not exceed the $157,500 threshold.
  1. Qualified Small Business Stock: The creation of non-grantor trusts can be used to increase the exclusion on capital gains when Qualified Small Business Stock (QSBS) is sold.
  • QSBS is a shares in C-Corporation holding less than $50MM in assets and which have been held more than 5 years.
  • The tax code currently provides an exclusion on capital gains of $10MM or 10 times the cost basis, whichever is greater, when QSBS is sold.
  • For the sale of QSBS in which capital gains exceeds the thresholds, the transfer of the shares to non-grantor trusts will provide a separate capital gains exclusion for each trust (once again, because each trust is considered to be a separate taxpayer).
  1. Property Tax Deduction: The creation of non-grantor trusts can increase the Federal income tax deduction for property taxes paid.
  • The Federal income tax deduction for state and local taxes paid (including property tax) is currently capped at $10,000.
  • As a possible solution, a residence can be transferred to a LLC and then the membership interest in the LLC can be gifted to a separate Trust for the benefit of each child.
  • Each Trust would have the ability to deduct up to $10,000 in property taxes for Federal income tax purposes.

o   This means that if you establish one Trust for each child and retain an equal percentage ownership in the LLC, you would keep your personal $10,000 property tax deduction and get an additional $10,000 property tax deduction for each Trust created.

o   This concept could be extended to other beneficiaries, including grandchildren and other family members to further increase the amount of property taxes which would be deductible.

  • An important consideration is that each Trust should hold investment assets which generate sufficient income for which the property taxes could be used to offset the gain, interest, dividends, etc.
  1. Income Tax Opportunities in Real Estate: Cost segregation and Opportunity-Zone Funds are tools that are becoming more prominent and all real estate investors should develop a familiarity with them.
  • Cost segregation allows accelerated depreciation for certain components of a property, meaning that taxable income can be offset to a much greater degree.
  • While the regulations for Opportunity Zone Funds are not completely finalized, these may be a viable investment vehicles to defer capital gains of all types.

o   In order to qualify for the deferral of income tax, the amount of capital gains must be invested in a Fund within 180 days of a sale.

o   Remaining invested in the Fund for 5-7 years can eliminate up 15% of the original capital gain.

  • In order to be eligible for the 5 or 7 year basis readjustments, investments in a Fund must be made by the end of 2021 or the end of 2019, respectively.

o   Remaining invested for 10 years eliminates capital gains on all of the appreciation after the investment in the Fund.

o   The original capital gains that was deferred must ultimately be realized by December 31, 2026 and the tax will then be due.