In contrast to a revocable trust, an irrevocable trust is one in which the terms of the trust cannot be amended or revised until the terms or purposes of the trust have been completed. Although in rare cases, a court may change the terms of the trust due to unexpected changes in circumstances that make the trust uneconomical or unwieldy to administer, under normal circumstances an irrevocable trust may not be changed by the trustee or the beneficiaries of the trust.
An irrevocable trust is a common estate planning tool because it provides an estate tax exemption and the taxable assets are removed from the estate. However, the new federal tax reform legislation adopted at the close of 2017 more than doubles the estate tax exemption in 2018 – a significant increase that prompts a second look at existing irrevocable trusts and estate plans in general.
Irrevocable Trust Basics
With an irrevocable trust, the grantor transfers assets into the trust, and removes all rights of ownership to both the assets and the trust. An irrevocable trust cannot be modified or terminated without the permission of the trust beneficiary. The financial benefit of an irrevocable trust as part of an overall estate plan is that it removes the assets from the grantor’s taxable estate, and alleviates the tax liability of the income’s assets on the grantor. Irrevocable trusts may include assets such as investments, a business, life insurance policies, cash, and other assets.
New federal tax law effecting irrevocable trusts 2018
The new federal tax law passed by Congress in December of 2017 increases the exemption amount for estate, gift, and generation-skipping taxes, creating a tremendous opportunity to reap tax savings. The previous estate exemption amount was $5.49 million per person, established in 2011; under the new tax law, that threshold for tax exemption jumped to $11.18 million (indexed for inflation), good for tax years 2018 through 2025.
This more than doubles the amount that individuals can transfer without paying any tax. So, unless the gross value of an estate exceeds $11.18 million in the year of the individual’s death, no estate taxes are due. If the amount does exceed this threshold, only the amount over the exemption level is taxable. For example, an estate that is valued at $11,180,050 will be required to pay federal estate tax on $50, the amount that exceeds the limit.
In October, Trump’s Treasury withdrew proposed Obama-era regulations cracking down on certain of these aggressive techniques, which, when done right, have been upheld by the courts.
Adding to planners’ interest, the new tax law, with its complexity, hasty drafting and last-minute giveaways, creates new opportunities to use trusts and gifting to reduce income taxes, too.
Affluent folks should have old trust plans reviewed for booby traps as soon as possible, because they may need to be modified or replaced. Same goes for those living in 15 states that impose estate and/or inheritance taxes at much lower levels of wealth than the feds.
A Common Estate Tax Exemption Trap
One common estate tax exemption trap is a will that establishes a trust linked to an outdated federal and/or state exemption amount. For example, a New Yorker has assets in his own name of $11 million. His current will, the one he had drawn up in 2011, when the federal estate-tax exemption was raised to $5 million, leaves the “exemption amount” in a trust for his kids from his first marriage and the rest to his current wife. But if he dies, the kids’ trust would get everything and his wife zip. Since New York exempts only $5.25 million from its own estate tax, accidentally leaving the full $11 million to the kids will incur a $1,226,800 state estate-tax bill.
Unintended Consequences can be fixed
The good news is unintended consequences can be fixed. The fix can be as simple as amending your will. Because of the “portability” of exemptions between spouses introduced in 2011, in some cases, the best fix will be to get rid of the trusts altogether.
Trust Asset Portability
In the past, wills of affluent couples typically created what’s known as a “credit shelter” or “bypass” trust. When the first spouse died, an amount equal to his estate-tax exemption went into a trust for the spouse and kids. The living spouse would have access to trust income and, if need be, principal. But his exemption wouldn’t go to waste. When the spouse later died, the trust assets wouldn’t be part of the estate. Now, with portability, any unused portion of the deceased exemption passes to the living spouse, so long as the executor of the husband’s estate files a tax return electing portability.
How to avoid capital gains tax
When someone dies, the assets in his or her estate (including real estate, collectibles and stocks/ mutual funds that aren’t in a retirement account) get a step-up in basis to their current value, meaning heirs can sell immediately without owing capital gains tax. For example, if the husband’s assets are left directly to his wife, they get one step-up at his death and another at hers. In contrast, assets in a traditional credit shelter trust won’t get that second step-up at her death.
With a large $11 million exemption to play with, lawyers are coming up with new techniques that avoid capital gains tax that require trusts. Consider the “mother-in-law trust” where you give your mother-in-law or other older relative a general power of appointment over an irrevocable trust for your spouse and descendants and fund that trust with low-basis assets. When your mother-in-law dies, the assets in the trust get a step-up. The trust is now includable in your mother-in-law’s estate, but since she wasn’t wealthy enough to use her whole $11 million exemption, you’ve expropriated the excess for a good cause, avoiding capital gains tax.
How to exploit the law’s new tax break for “qualified business income”
Trust lawyers are now busy figuring out ways to exploit the law’s new tax break for “qualified business income” (QBI). While there are various restrictions on claiming the break at higher income levels, the provision allows singles with total income of less than $157,500 (and couples below $315,000) to avoid income taxes on 20% of their profits from a sole proprietorship from farming, or from a passthrough, such as a partnership or S corporation. At the last minute, tax writers gave the 20% exclusion to trusts with income of less than $157,500 too.
For example, if a marketing business earns about $1.6 million a year from it, you can set up eight separate non-grantor trusts for three kids and five grandkids, then give each trust 10% of the new business. After the entrepreneur takes a reasonable salary, each trust should be left with about $150,000 a year in passthrough profit. Each of the eight trusts can shield 20% of that–or $30,000–from federal income tax, avoiding tax on a total of $240,000. Expected federal income tax savings from this example would net about $89,000 a year.
Using trusts to avoid the deduction cap
Another example of the use of trusts to get around the new law’s $10,000 cap on deductions for state and local taxes (which, like the doubled estate exemption, technically expires at the end of 2025), would be putting your $1.8 million home into an LLC, and then placing the LLC shares plus an additional $130,000 of marketable securities into four non-grantor Alaska trusts, which then may effectively yield a full deduction for $40,000 in annual property taxes on the home.
Evaluate existing estate tax plans and make modifications
It is always in your best interests to review your existing estate tax plan whenever you experience any major life changes, such as marriage, divorce, or the birth of children. It is equally as important to periodically review your estate plan with an experienced estate planner to ensure that the strategies that were implemented are still an effective means to achieve your financial goals under existing federal and state tax laws. Changes in tax laws present opportunities to utilize different tax-saving strategies and may require modifications to existing trusts and other financial tools to do so.
Leading Maryland estate planning lawyers ensure your estate plan is maximizing financial opportunities
Estate planning can be challenging, particularly in light of recent changes to federal tax laws that necessitate revisiting your overall long-term financial strategy. At Altman & Associates, estate planning is all we do. Our skilled estate planning specialists have spent more than 40 years designing estate plans for individuals and families, helping them to achieve their financial goals. Contact a member of our team today to discuss your estate planning needs. We serve the Maryland, Washington, D.C. and Northern Virginia area, with convenient office locations in Columbia and Rockville. Schedule your consultation today by calling 301-468-3220 or online.