Succession Planning Trends
Recent changes to tax laws related to succession planning include the Tax Cut and Jobs Acts of 2017, the SECURE act, New York’s property transfer laws, and Connecticut’s new legislation. The following information presents an overview of each law and some insights into how they affect (or may affect) estates and succession planning.
Tax Cuts and Jobs Act of 2017
- Signed into law on December 20, 2017, the Tax Cuts and Jobs Act (TCJA 2017) changed the estate tax exemptions to $10 million, adjusted for inflation (11.18 million in 2018 or $22.36 million for a married couple). This provision will last until January 1, 2026, when the exemption amount will revert to $5 million (adjusted for inflation). The tax rate for estate, gift, and generation-skipping transfer tax remain at 40%.
- Some lawyers fear that the Act is decreasing the demand for estate planning. Notwithstanding, the American Bar Association believes that the need for state planning is not necessarily affected by the tax cut, as conflicts between family members are by far a more prevalent concern. The association estimates that 85% of the crises faced by family businesses are related to the issue of succession, not taxes.
- The TCJA 2017 does grant new possibilities for business succession planning. For clients who have trusts that own business interests, considering whether to restructure the trust to ensure an income tax basis step-up upon the death of a beneficiary is a valid approach.
- Another important consideration relates to the political landscape, as some analysts predict that the Act is likely to be amended or repealed if President Trump is not reelected and the Democratic Party gains control of the House and Senate.
- The Act attempts to provide greater parity between the tax treatment of pass-through entities and corporations. Nevertheless, guardrails were introduced hoping to prevent pass-through owners from “recharacterizing wage income as more lightly taxed business income.”
- Estates and trust taxpayers may deduct 20% of the domestic qualified business income (QBI) regarding the qualified trade or business from a partnership, S corporation, or sole proprietorship. The deduction is subjected to limitations based on W-2 wages and capitals.
- They may also deduct 20% of aggregate qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income.
Tax Status of the Business Entity After the TCJA 2017
- When considering business succession plans, taxation is important and likely the reason a business owner chose a particular entity structure, as reported by Deloitte. The choice of an entity structure has the potential to affect the succession process in multiple ways.
- For instance, if the owner wants the heirs to own and run the business, a pass-through entity like an S corporation may make it easier to “move money from entity to shareholder and transfer full or partial ownership interests with less tax and regulatory difficulty."
- The 2017 Act reduced the top federal income tax rate for corporate payers from 35% to 21%. It also introduced a 20% deduction for the QBI. The corporate rate does not “sunset” in 2026 and prompted some business owners to consider whether they should change the tax status of their entity from Subchapter S corporation to Subchapter C corporation.
- An S corporation is a separate legal entity, much like a C corporation. However, instead of paying corporate income taxes, it functions as a pass-through, meaning it divides income or losses among its shareholders, who then pay taxes on any gains as part of their personal income. To meet the standards to convert to S corporation, an organization must be an individual or certified trust with no more than 100 shareholders.
- Approximately 92% of private businesses in the U.S. are structured as pass-through entities.
- This type of conversion typically contributes to succession plans, as the “pass-through” allows tax advantages in ownership plans. As Deloitte observes, to preserve these advantages, S corporation shareholders used to lock in their status “with agreements and policies that keep the corporate structure from being terminated without their consent.”
- A C corporation, on the other hand, is a legal entity separated from its owners. It is commonly chosen for large publicly owned companies. The decision to “go corporate” often relates to liability. Since a C corporation is a separate legal and taxable entity, it helps owners to obtain a firewall against legal and financial exposure, something that partnerships or sole proprietorship may not grant.
- The TCJA 2017 changes the tax treatment of business. Prior to the law, a C corporation shareholder marginal rates would be around 35% for corporate rate plus a 20% dividend plus a 3.8% NII rate. For an S corporation shareholder, it would be an individual rate of 39.6% plus 3.8% NII rate.
- The Act reduced the 35% corporate tax to 21%, while the tax imposed on dividend distributed remains at the same 20%. Therefore, under the new Act, a C corporation would incur a 21% corporate rate plus a 20% dividend plus a 3.8 NII rate. For an S corporation with no QBI, it would be an individual 37% rate plus the 3.8% NII rate. However, for an S corporation with QBI, it would be a 37% rate less the 20% Sec. 199A deduction.
2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act.
- Effective as of January 1, 2020, the rules applying to the distribution of assets remaining in Individual Retirement Accounts (IRAs) and Qualified Retirement Plans after the death of the participant (owner/employee) changed.
- Historically, a non-spouse beneficiary of a retirement account could choose to either take distributions over their life expectancy or to liquidate the account and pay taxes within the next five years (the five-year rule). Under the SECURE Act, non-spouse beneficiaries are required to withdraw the account balance within ten years of the owner’s death.
- Exceptions to this rule are beneficiaries who are a minor child, a disabled individual, a chronically ill individual, or an individual who is not more than ten years younger than the account owner.
- Prior to the SECURE Act, trusts would include a “conduit” provision, where the trustee would only distribute required minimum distributions (RMD) to the trust beneficiaries, allowing the continued distribution based upon age and life expectancy. Under the SECURE Act, a conduit trust structure is no longer effective, as the RMD taken by the trustee will no longer protect the account, since the entire amount of it will be in the beneficiary’s control within ten years.
How The SECURE Act Affects Employer-Sponsored Plans
- For tax years beginning after December 31, 2019, the SECURE Act enables businesses to treat qualified retirement plans adopted before the due “date of the tax return for the tax year as having been adopted as of the last day of the tax year.”
- Multiple Employer-Defined Contribution Plans (MEPs) were also affected, as the “one bad apple rule” was softened by the Department of Labor. In the past, the disqualifying actions of one employer would disqualify the entire plan. Under the SECURE Act, plans beginning after December 31, 2020, the portion of the plan covering the disqualified employer will be carved out, but the rest of the MEP will continue as a qualified plan.
- The Act also included provisions to help employers encourage employees to increase contributions to retirement plans. Before the Act, employers could set the default contribution to 10%. The default percentage was increased to 15% after the first full plan year for plans beginning after December 31, 2019. 18
- The 401(k) Safe Harbor has been simplified for plans beginning after December 31, 2019, as the Act eliminates the notices that were required to be given to employees who make safe harbor qualified contributions. However, employers who make safe harbor matching contributions still need to provide notice. 18
- The SECURE Act offers a safe harbor for fiduciaries for selecting a lifetime annuity provider, pending verification and requirements. “The SECURE Act also provides for a new distribution event applicable only to annuities in the plan. If the plan no longer allows for an annuity to be an investment option, then the plan may distribute the annuity in kind beginning 90 days after the annuity is no longer a plan investment option. Thus, the annuity is portable.”
- For tax years beginning after December 31, 2019, the SECURE Act creates a new tax credit of up to $500 per year to employers who adopt an “eligible automatic enrollment arrangement” as defined by IRC Section 414(w)(3). The credit is in addition to the plan start-up credit described above. The credit is available for the year in which the automatic enrollment is adopted and for the next two years, assuming the auto-enrollment feature is still in place.
- Prior to the SECURE Act, it was common for employers to exclude employees who worked less than 1,000 hours in the plan year from participation in the employer-sponsored 401(k) Plan. In an effort to increase retirement savings for longtime part-time employees, the SECURE ACT now requires employers who have a 401(k) plan to include employees who have three consecutive years of service in which the employee completes more than 500 hours of service each year. This excludes collectively bargained plans.
- Employers and plan fiduciaries must be extra cautious to ensure that all required notices and filings are done in a proper and timely manner. The SECURE Act has significantly increased penalties for failure to comply with these requirements.
New York State Laws
- New York has set a $5.25 million estate tax exemption. If the estate exceeds that amount, it is required to file a New York estate tax return within nine months of the death. The highest tax rate possible is 16%.
- Effective July 1, 2019, residential and nonresidential property transfers are now subject to an increase in the transfer tax and supplemental mansion tax. The state's real estate transfer tax law has been amended from a 0.4% transfer tax to 0.65% of the purchase price. This affects property transfers with a purchase price of $3 million or higher, and nonresidential properties with a $2 million purchase price (or greater).
- Under the current law, the mansion tax is equal to 1% of the consideration if the consideration is $1 million or more. As of July 1, 2019, the mansion tax will apply to transfers of New York City residential property if the consideration is $2 million or more. The tax rate will begin at 1% but can reach 3.9%.
- The 16% rate only applies to estates over $10 million. New York also implemented a rule precluding certain estates from taking advantage of the exclusion, known as the "cliff." If the amount of taxable estate is more than 5% over the exclusion amount, one cannot take advantage of New York's exclusion rule, therefore, "falling off the cliff" if the taxable estate is too high.
- For instance, the tax exclusion amount was $5,740,000 as of 2018. If an individual died with a taxable estate of $6,100,000, then his entire estate would be subjected to the state's tax, since it is more than 5% higher than the exclusion amount. This would result in an estate tax rate of over 100% on the amount by which the estate exceeds the exclusion amount.
- For those dying on or after January 1, 2020, the estate exemption will be $5,850,000. If the taxable estate is greater than 105% of the value of the exemption at the time of the death, the exemption is completely phased out, and all assets are taxed.
Connecticut's Budget Law
- Signed by Governor Malloy on October 31, 2017, the new Connecticut state budget law increased the individual exemption over the next three years. The Connecticut estate tax exemption will be $5,100,000 in 2020, $7,100,000 in 2021, $9,100,000 in 2022, and it will match the federal exemption amount on January 1, 2023. The tax rate on estates or gifts above the Connecticut exemption ranges from 7.8% to 12%.
- The new law also lowered the cap on the maximum estate and gift tax payable, from $20 million to $15 million since 2019.
- It modified the marginal rate schedule for estates and gifts over $5.1 million, by raising the initial rate to 10%, with graduated increases of 10.4%, 10.8%, 11.2% and 11.6% for each million dollar increase, until reaching the top rate of 12% for a taxable estate or gift over $10,100,000.
- Another aspect of the bill is the increase based on fair market value. For instance, if someone buys a property for $100,000, but at the time of their death, it is worth $1 million, the basis of the property will be the $1 million value. “By raising the exemption while retaining the step-up in basis, most people with highly appreciated assets will never pay any tax on the appreciation.”
- In addition to the increased estate tax exemption, the annual exclusion amount for gifts is $15,000 in 2018.
Connecticut's New Trust Legislation
- Connecticut’s new trust legislation consists of four parts: Connecticut Uniform Trust Code, Connecticut Uniform Directed Trust Act, Connecticut Qualified Dispositions in Trust Act, and Connecticut Uniform Rule Against Perpetuities Act. The legislation provides changes to the state trust law by “modernizing trust management and administration, outlining fiduciary duties.” The law provides for the formation of Dynasty Trusts, Directed Trusts, and Asset Protection Trusts in the state.
- Dynasty Trust: It is a trust that continues for multiple generations. The previous law provided that non-charitable trusts could not exist in perpetuity, lasting for a maximum of 90 years, or 21 years after the death of an individual alive at the time the interest was created. The new Act extends the maximum period to 800 years.
- Directed Trusts: Prior to the Act, trustees retained full responsibility over how trust assets were managed, distributed and invested. The new law allows for the responsibility to be distributed among individuals more qualified to carry the trust objectives, along with the trustee. In practical terms, a grantor can appoint a trust director, a non-trustee with authority to manage the trust.
- Asset Protection Trusts: The Act allows the creation of “Self-Settled Asset Protection Trusts”, a trust created by an individual for the “benefit of himself or herself, which in certain limited circumstances may shield assets from the claims of creditors.”
- Income Tax Reimbursement: Prior to the enactment of the new law, if a trustee permitted the reimbursement of income taxes to the grantor of the trust, the principal would be subject to creditor claims. The new legislation stipulates that the reimbursement does not subject the trust to the creditor’s claims.
- Notice of Beneficiaries: Trust beneficiaries must be adequately informed about the trust’s administration. The law imposes a set of requirements on the trustee on how to notify the beneficiaries.