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January 2020 Newsletter
Congress passed the Secure Act in the final days of 2019, effective as of January 1, 2020. This is a transformational tax law in terms of post-death income tax on inherited IRAs.
To provide context, the Investment Company Institute estimates there is almost $6 trillion in 401(k) assets and almost $10 trillion in IRA assets, as of 2019. So it is not really a surprise that Congress would seize on an opportunity to tax these assets sooner rather than later, as the aging of the population continues and the impending generational transfer of this wealth looms large.
And that is the main thrust of the Secure Act. Seniors will enjoy somewhat greater income tax deferral, but their heirs will encounter quite a compressed time frame for recognition of the income tax on what they inherit from an IRA or 401(k).
Channeling Clint Eastwood, allow us to share The Good, Bad and the Ugly.
Previous Newsletter (March 2018)
Giveth the Tax Man
On December 22, 2017, President Trump signed the highly anticipated “Tax Cuts and Jobs Act” of 2017. Significant gift/estate tax relief is provided by the new law. Notably however, proposals to repeal the estate tax did not prevail. This appears to signal that the estate tax is here to stay.
Key provisions of the new estate/gift tax law are as follows:
- Specifically, the estate and gift tax exemption for 2018 is $11,180,000. More generally, the estate tax exemption is doubled from (a base before inflation of) $5,000,000 to $10,000,000, for an eight year period. On December 31, 2025, the new law “sunsets,” and the exemption will revert to $5,000,000 (adjusted for inflation, the exemption is estimated to be in the range of $6.5M by then). Going forward, the index for inflation is adjusted using a slightly diminished CPI measure.
- Most taxpayers will not itemize their deductions under the new law, and therefore will lose the benefit of their charitable contributions. For those taxpayers who continue to itemize, charitable contributions remain deductible, with an increased cap on cash contributions to public charities (now 60% of adjusted gross income). The former “Pease limitation,” which phased out charitable deductions above certain income thresholds, has been eliminated. The net result is that significant charitable gifts will be rewarded, while the more modest charitable giver will effectively be penalized from an income tax perspective.
- 529 Plans can now disburse up to $10,000 tax free per year for tuition at elementary and secondary schools. Previously, only college or graduate school expenses qualified for tax-free disbursements from 529 Plans.
- Traditional IRAs that have been converted to Roth IRAs can no longer be recharacterized as traditional IRAs. Under prior law, this recharacterization option provided a benefit if the IRA declined in value before the due date of the income tax return reporting the conversion.
These are some action items to consider:
- Since the higher gift/estate tax exemption will expire at the end of 2025 under current law, this may present a “use it or lose it” opportunity. High net worth clients may wish to consider using these higher exemption amounts (and the corresponding generation-skipping exemption) with gifts to trusts for children or spouses. Many creative and leveraged gifting options can be developed to fit your family’s situation. Of particular interest in a secure marriage is one spouse’s creation of a trust for the other spouse that escapes inclusion in both estates. Death before 2026 is another option for using the higher exemption (but not one we generally recommend).
- If your Will makes a “formula” gift of your estate (or generation-skipping) exempt amount, we highly recommend you consult with a Farner & Perrin attorney regarding the effects of the new tax law. In all likelihood that formula gift has just doubled, and a revision to your Will may be in order.
- Taxpayers with estates below the estate tax exemptions may need to re-evaluate the use of a bypass trust (see following article).
Finally, the substantial income tax changes to the tax law are beyond the scope of this article. We would be pleased to consult with you on the effects the new law might have on your business income, and whether a business re-structuring might be beneficial.
Back to Basics or Back to Basis?
Given the generous exemptions against the Federal estate tax, many of our clients are moving away from traditional “bypass” trust planning. We are seeing this arise not only as married couples update their planning, but we also see the issue arise after one of them has died with a bypass trust in their Will. This article discusses each of these situations and options they present. Let’s consider the case of Adam and Eve, and assume Eve survives Adam.
Traditionally, a bypass trust was seen as the best of both worlds, a veritable utopia. Upon Adam’s death, Eve managed and had access to the trust assets, but these assets were outside her taxable estate at her later death. A “cap” was placed on the bypass trust at funding, being Adam’s estate tax exempt amount as of his death. Yet, the trust assets could grow beyond that cap and pass to their progeny (Cain and Abel) upon Eve’s later death, with no estate tax. The accepted trade-off for estate tax exclusion was greater exposure to capital gains tax following the survivor’s death. If the trust were not deemed a part of the survivor’s estate, the tax relief provision granting a step up in basis at death would not be available for the trust assets upon the survivor’s death.
Fast forward to 2013 when “portability” was added as a permanent tax law feature. In very general terms, portability can be thought of as a “carry forward” of the exemption of the first to die, which is then added to the exemption of the second to die at the second death. If Adam died in 2018 with an $11M+ exemption and Eve died in 2026 with a $6M+ exemption, a full $17M+ might be able to be sheltered from estate tax in 2026, without use of a trust. As a result, the bypass trust might not be as compelling to Adam and Eve, depending on the size of their estates.
At this point in the drama, Adam and Eve are tempted…to remove any trust for their spouse in their Wills. They are lured by the idea of going back to basics: a simple outright bequest of all their estate to their spouse, mostly so that all assets can enjoy a step up in basis at the second death. They figure that if estate tax is not looming large over them, they will focus on saving their heirs exposure to capital gains tax.
However, like many couples, Adam and Eve desire an estate plan to protect Cain and Abel from the wiles of the surviving parent (who we will posit has a history of bad judgment and) who might remarry or otherwise disinherit them. In short, trust planning is still compelling for this couple, but the bypass trust turns out not to be utopia for capital gains tax reasons.
This couple may be well advised to incorporate a trust for their spouse that can achieve all their wishes. They want a trust to control the assets to better assure their own children ultimately inherit their estate. They also want to elect that the trust be treated as if in the survivor’s estate, in order to get the basis adjustment when the second spouse dies. This election is made on the Federal estate tax return of the first to die, and is referred to as a “qualified terminable interest property trust election,” or “QTIP” election. In the past, many of our clients have had both a bypass trust and a QTIP trust in their [old] estate plan, and some of them may benefit from revisiting whether this should be distilled down to one trust at the first death.
Bear in mind that this is a very fact-driven decision, depending not only on the ages of the of the couple and their net worth, but also the nature of their assets (e.g., IRAs and retirement plans are outliers for some of the above purposes). Of course, one of the biggest variables is the vicissitudes of Congress, which is all but impossible to predict. Recent tax changes have shown us that an estate plan made in 2008 for the same couple may look quite different than that recommended in 2018. Feel free to contact one of the Farner & Perrin attorneys to assess your particular situation.
The second context where we are seeing an increased emphasis on basis planning is after the first spouse’s death, when the bypass trust is dictated in the first spouse’s Will. Eve comes in to probate Adam’s Will and indicates she would prefer not to fund his bypass trust, so Cain and Abel can enjoy a further step up in basis on the trust assets when she later dies. In Eve’s case, let’s assume she is under a nefarious (and slimy, shall we say) influence, and may well cut the boys out of her Will eventually. The law protects Adam’s wishes by requiring her to fund the trust as intended (even if in actuality he intended it only due to tax reasons).
However, in harmonious family situations, we have counseled clients who wish to enter into a family settlement agreement to forego funding the bypass trust, or to dissolve one that has been funded previously. But this must be analyzed against possible gift tax consequences and even the risk of a future lawsuit. For example, Eve must consider a grandchild who, as a minor, is not able to sign the settlement agreement and may otherwise stand to share in Adam’s estate as per the bypass trust in his Will.
In sum, Adam/Eve should not be too impulsive in biting at the chance to move away from trust planning, without proper legal advice. We at Farner & Perrin encourage each client to embrace making their own decisions and understand the ramifications of their choices.
The Crude Oil Blues
The ever-talented George Strait may have crooned about Amarillo and All his Ex’s in Texas, but The Crude Oil Blues is a ballad instead made famous by rank-and-file Texans. Individuals owning oil and gas interests, as is so common in Texas, often fail to consider the requirements of transferring such mineral interests to their family members or other beneficiaries at death. Executors or beneficiaries too often encounter a daunting process to have those interests and their cash flow transferred into their names. In fact, some opt to leave these interests unresolved, due to lease inactivity or depressed market conditions. These loose ends in the administration of a decedent’s estate will ultimately cause greater entanglements for future generations, especially as the interests get fractionalized.
To ease the transfer of mineral interests at death, mineral owners may be well advised to consider placing their mineral interests in a limited liability company (LLC) during lifetime. The consolidation of Texas mineral interests into an LLC has compelling merits, with compounded benefits for individuals owning interests in multiple states. Whereas most of these interests within families constitute royalty interests, the mineral LLC offers an additional benefit for owners of working interests. That is, critical liability protection is achieved for the high-risk activities of oil and gas production. In fact, our Firm recommends that working interests and royalty interests be segregated into distinct LLCs so as not to expose the royalty interests to the risk of working interest liability within the same LLC entity.
As an example, meet George and Norma, both Texas residents. George owns, as his separate property, mineral interests in Texas, Louisiana and Oklahoma. Norma does not own any mineral interests herself, and has no experience with oil and gas interests or their management. George retires from his illustrious music career and at long last, passes away leaving his entire estate outright to Norma. Norma, as executor of George’s estate, probates his Texas Will in Atascosa County, Texas. Let’s review the steps Norma must take to transfer George’s mineral interests. Then, let’s compare the alternate results if George had formed Crude Oil Blues, LLC, during his lifetime.
Default strategy: Outright ownership of mineral interests at George’s death
- Not only must a Texas probate be undertaken for George’s estate, but in addition his out-of-state mineral interests require that Norma initiate ancillary probate proceedings in both Louisiana and Oklahoma. Once these probate processes are concluded, Norma must file a deed in each county (or parish) where George owned mineral interests in order to transfer the interests into her name. Norma must then contact each oil and gas operator with an active lease regarding the minerals and provide the necessary paperwork to have them reissue division orders in her name. The requirements for achieving revised division orders are as varied as the companies involved, and the royalty payments may be held in suspense for months while this is pending, first being a transfer from George to his Estate, then from the Estate to Norma.
- At Norma’s death, she leaves everything to their surviving children, equally and outright. The children must now go through the same onerous processes of multiple probate proceedings, filing deeds of conveyance and obtaining revised division orders, first out of Norma’s name to her Estate, then from her Estate in shares to her children. The mineral interests are fractionalized between the new owners (and further so, as each generation passes the interests down to future generations). This provides enterprising landmen with a chance to secure one party’s agreement on a lease and use such as leverage in negotiating with the others. A consolidated LLC could avoid that issue and more, as follows:
Alternate strategy: minerals owned in Crude Oil Blues, LLC, at George’s death
- Prior to George’s death, he conveys all of his mineral interests into Crude Oil Blues, LLC, and has division orders reissued to remit payments to the LLC. George is sole Member and sole Manager of the LLC. Since Norma is not versed on managing mineral interests, George includes provisions for the succession of management in the LLC Company Agreement, naming Hank, Jr., as successor Manager if George cannot serve.
- As a result, rather than owning mineral interests at his death, George instead owns 100% of the LLC membership interest. Accordingly, instead of bequeathing mineral interests to Norma, George bequeaths her all of his LLC membership interest. The membership interest passes under George’s Will via his Texas probate process, given it is personal property (rather than real property, as is a royalty interest). As a result, none of the underlying minerals require ancillary probate proceedings in Louisiana or Oklahoma. Furthermore, since the LLC already owns the minerals, there is no change in ownership of the minerals themselves (and therefore, no requirement to transfer by deed or reissue division orders). Norma now has the benefit of the royalty cash flow (through LLC distributions), but looks to Hank, Jr., to manage the interests on behalf of the LLC.
- At Norma’s death, her Will passes the LLC membership interest to the surviving children. They now each own a 50% interest in the LLC. As at George’s death, no deeds, out-of-state probate, nor revised division orders are necessary. Moreover, the mineral interests themselves (still wholly-owned by the LLC) are not further fractionalized down the family lines.
If George has the foresight to undertake the LLC plan, then once he is deceased, it’s pretty much Love without End, Amen.
F&P Folly and Prudence
- Fair is not always equal, and equal is not always fair.
- The worst thing about being a lawyer is we have to point out the worst things that can happen, and many times the worst thing does happen.
- Fly first class; your son-in-law will.
- At 40th anniversary party, husband announces, “My wife makes all the small decisions in this marriage, and I make all the big decisions….So far, there have only been small ones.”
- Graduation advice: Never trust anyone from Dallas.