Lots of legal changes are coming for Californians. These changes may have profound impact on our tax liability, as well as in estate, business, and asset protection planning. This article explores some of the more pertinent changes that may be coming with Federal tax reform, and discusses a few strategies to consider today.

  1. Tax Reform

Current tax proposals on the table include: (1) elimination of all income tax deductions except for mortgage interest and charitable deductions (this would include the very important deduction for state income and property taxes); (2) Limiting charitable and mortgage deductions according to a taxpayer’s gross income or loan principal balance; (3) repeal of the estate, gift, and generation-skipping transfer tax and possible replacement with a carry-over basis regime; (4) changes to the way retirement plans are taxed at death; (5) repeal of the Alternative Minimum Tax; (6) lowering taxes on corporations and small businesses; (7) and fewer marginal tax brackets and some reduction in tax rates. We do not address all of the changes in this article, but have included some discussion on (1), (2), and (4).

With respect to estate, gift, and generation-skipping transfer tax planning, we know that it is extremely unlikely that Congress will be able to pass tax reform as a long term deficit-increasing measure, since Republicans do not have the required votes in the Senate. Instead, pursuant to the so-called Byrd Rule, made part of the Congressional Budget Act, a majority of 60 in the Senate is required to pass any deficit increasing measure that does not contain a sunset provision. A sunset provision would require the measure to expire after a five or ten year period. Accordingly, similar to estate tax repeal in 2001, estate tax repeal in 2017 will likely be accompanied by a 10-year sunset provision, requiring Congress to act at the end of such time. As we know, however, there are no guarantees when it comes to living and dying. 90-year old’s might live another 10 years. 50-year old’s might not. As such, an estate tax repeal that phases out in 10 years is not something that should be relied upon when making major tax planning decisions. This makes planning ahead very frustrating!

Yet, if estate, gift, and generation-skipping transfer taxes are repealed, they will likely be replaced with carry-over basis. That is because repeal in 2001 was accompanied by a replacement with carry-over basis, effective in calendar year 2010 only (the year of “sunset” before estate taxes came back in 2011). Carry-over basis means that the cost basis of a deceased person’s asset will “carry over” to their heirs. As such, upon the death of the deceased, capital gains tax must be paid upon sale of assets, if the sale price is greater than the cost basis in the hands of the decedent. This contrasts with today’s law, whereby all assets owned by a deceased person are 100% “stepped up” to their value as of the deceased person’s date of death. It’s for that reason that we sometimes joke that step up in basis is the greatest tax benefit that you’ll never get to enjoy (since you have to be deceased for your heirs to enjoy it).

To take an example, say that your grandfather bought his house in 1920 for $5,000 and now it’s worth $5 Million. In places like Palo Alto, that’s totally conceivable. Now assume that he dies in 2017. His heirs sell the home for its fair market value. Under today’s laws, the heirs will pay ZERO capital gains tax. Under a carry-over basis regime, the heirs will have to pay between 15% and 20% capital gains tax (ignoring changes to capital gains tax rates) on the gain, plus ordinary income tax in California. That equals at least $749,250 in capital gains tax, before California taxes are even imposed!

To illustrate how extreme a change this would be versus current law, consider that today, since there is a $5.49 Million exemption from estate taxes, the heirs in our example don’t have to pay any estate tax if the home is grandfather’s primary/sole asset. As one might have easily deduced, repealing the estate tax and replacing it with a capital gains tax will severely punish the beneficiaries of moderately sized estates (i.e., less than $11 Million) with low-basis assets. There are many estates in California that could be described as such, due to the substantial long term appreciation of real estate.

  1. Some Strategies to Consider Today

Given the wide range of potential changes coming, some might argue that it is impossible to plan effectively until the changes occur. However, to take no action may prove short-sighted if tax-saving strategies need to be implemented before the changes will take effect, likely on January 1, 2018. Depending on the direction of tax reform, clients may need to act very quickly to lock in current tax benefits. Over the long term, clients may need to adjust their estate, business succession, and tax strategies once we have a clearer idea where the law is going.

Regarding the phase-out of the charitable deduction, high income tax payers may have been considering making a gift to a donor advised fund or foundation. They may be thinking that they have time to make those gifts before the year’s end if the charitable deduction becomes subject to a phase-out in 2018. However, establishing a donor advised fund can take significant lead time with financial institutions, at least a few weeks. Establishing a foundation can take even longer. For that reason, it might be a good idea for clients with charitable intent to start thinking about getting the paperwork started in order to establish their donor advised fund or foundation, if this has been on their radar. Otherwise, they may not have time to get their charitable gifts made under the 2017 rules. Waiting until December may not be a realistic option.

With respect to the elimination of gift, estate, and generation skipping transfer tax, in some cases it might be better to act now under today’s laws, considering that such taxes will likely come back in about 10 years. For instance, gifts made into GST-exemption trust which survive the sunset period may be well-positioned in the event that the estate & GST tax comes back with a vengeance. In such a case, the lucky creator of such a trust would get the benefit of an “estate freeze” based upon today’s asset values. During the interim period, it may not be possible to file a 709 with a GST allocation.  And, perhaps the traditional obstacle to GST exempt trusts (that such trust are not subject to a cost basis “step-up” at the death of the donor), will become less important if there is a carry-over basis. Such trusts, similar to other planning techniques, require lead time to draft. Based upon the direction of tax reform, they can be funded if need be.

A new carry-over basis regime will profoundly impact decisions to sell or retain properties at someone’s death. Unfortunately, this one is harder to plan for. If capital gains tax are triggered upon sales at death, it is much more likely for heirs to divvy up an estate while holding onto low basis assets like real estate, etc. That might create practical difficulties in that siblings may be co-owning and managing a lot of rental properties. To plan for this, individuals might consider structuring their estates to avoid holding low basis assets, by for instance, actively trading their investment portfolios. Or, they might consider being more strategic in whom they chose to manage the property, since such relationships might endure after their deaths. If siblings will be expected to either recognize significant capital gains taxes or co-own property, then well-drafted LLC operating agreement, and effective property management arrangements, will become paramount. Seeking expertise in partnership taxation will be a must. Finally, there will be a need to properly structure tax deferred exchanges to continue delaying tax after one’s death.

  1. Long Term Planning : What Happens if Tax Deferral of Inherited Retirement Plans Is Lost?

Under today’s tax laws, qualified retirement plans (except for Roth Plans) are funded with pre-tax contributions. Once an employee reaches age 70 ½, required minimum distributions must begin. All such distributions are treated as ordinary income. In the case of inherited qualified plans, required minimum distributions must begin immediately, according to a somewhat less favorable time schedule than for the original employee-owner. Stretch-out over the beneficiary’s lifetime for the balance left in the plan yields significant benefits, by spreading out the income tax burden over a lifetime. Meanwhile, the assets in the plan continue to grow tax-free.

Yet, several times over the last year, Senator Orin Hatch has floated the idea of replacing lifetime tax deferral of inherited retirement plans (such as 401(k)s and IRAs) with the 5-year rule. Separately, GOP tax proposals have indicated that they will preserve incentives for employees to save for their retirement. The resulting tax reform might be that tax deductions for contributions to retirement plans will continue, but that stretch-out at death with be phased out.

Elimination of stretch-out of retirement plans would have significant implications in estate planning. If beneficiaries have to pay tax at significantly higher levels on retirement plans without the prospect of tax deferred growth, then such accounts will have much less long-term value for beneficiaries. Already, a beneficiary who receives a retirement plan vs. one who receives an outright distribution of cash has a much different kind of asset, even if the value of each asset is equal on day 1. That is because the beneficiary of a retirement plan has to pay income tax on all withdrawals from the plan (excluding Roth accounts). If those withdrawals must now be accelerated over a 5 year period, the difference in potential value between retirement accounts and non-tax deferred assets becomes more pronounced.

One potential solution to a loss of lifetime stretch-out may be to name a charitable remainder trust as the beneficiary of a retirement plan. A charitable remainder trust pays an income interest to a beneficiary over their lifetime. The remainder at the death of the beneficiary goes to charity. Charitable remainder trusts do not eliminate income tax, since the beneficiary has to pay such tax on distributions they receive from the trust. However, they do allow for an exclusion from income tax for most transactions that occur within the trust, such as sales of investments titled to the trust. Moreover, they can stretch out the benefits of retirement plans over an entire lifetime. Even if a client doesn’t have charitable intent, the math on charitable remainder trusts may make sense if tax deferral on inherited retirement plans goes away.

  1. Conclusion: Stay Tuned

As always, everyone’s life circumstances are unique. The law also may not go the direction we predict in this article. That’s why it’s always important to consult with an attorney before acting on the contents of this article. If you take anything from this article, let it be that death and taxes aren’t going away, even with tax reform. In fact, both might be harder to plan for given the pace of changes in law and society. To help anticipate these and the other changes that are sure to come down the road, consult with a certified specialist in estate planning, trust, and probate law, as well as competent financial and tax advisors.