A common misconception is that estate planning, and in particular the creation of trusts, is only something that applies to wealthy individuals and families. This myth has been exacerbated by the increase in the estate tax exemption (i.e. the amount of wealth that can be transferred to the next generation before incurring an estate tax) over the past several years. When I started practicing law in 2001, the Federal estate tax exemption was $675,000 and the Federal estate tax rate topped out at 55%. Since that time, the exemption has increased several times and currently sits at $11.18 million per person or $22.36 million per couple (although the current law is set to expire in 2026 at which time the exemption will be cut in half) and the Federal estate tax rate is 40%.
While it may be accurate that the need for estate tax planning and tax shelter trusts are only necessary for eight figure estates (although this is debatable given the frequency at which the tax laws change), the benefits of using trusts for non-tax reasons are greater than ever. Some of the most important non-tax reasons to use trusts are: (i) maintain control over a younger or irresponsible beneficiary; (ii) protect assets from a beneficiary’s creditors (including divorce and lawsuit); (iii) assure that assets remain in the family; (iv) provide for business succession and governance of shared family assets; (v) incentivize beneficiaries to work hard; (vi) care for a beneficiary who is receiving governmental benefits without risking those benefits and (vii) probate avoidance.
For example, with divorce rates being so high today, many of my clients want to make sure that assets that they leave behind are ultimately only for the benefit of their children and grandchildren, and not at risk of being lost to a child’s spouse in the event of a divorce. Other clients fear that with children seeming to mature at later ages in today’s society, a child may squander his or her inheritance or decide not to graduate from college or seek out a job if they were handed a sum of money at too young an age.
Whatever the reason for wanting to create a trust, it is extremely important that the trust be drafted properly in order to accomplish its objectives. Most trusts require the trustee to make distributions to a beneficiary upon the beneficiary’s attainment of certain goals (graduating from college, buying a house, attaining a specified age, etc.). However, requiring distributions can have unintended consequences, including loss of creditor protection (even in divorce proceedings). In addition, the lack of flexibility in these trusts does not allow the trustee to adapt to changing circumstances. Instead of creating trusts with mandatory distributions it may be wise to use a purely discretionary trust.
Unlike trusts with mandatory distribution requirements, discretionary trusts authorize (but do not require) the trustee to make distributions to a beneficiary at certain times or for certain purposes, or simply provide that the trustee can make a distribution for any reason the trustee deems to be in the beneficiary’s best interest. Discretionary trusts generally offer enhanced creditor protection and flexibility to adapt to future circumstances. Many clients worry that a trustee will not be able to capture their intent without providing specific requirements in the trust document. This is why I recommend that my clients write a letter of direction to their trustee. In many cases, using a discretionary trust with a letter of direction gives a client the best of both worlds – strong protection and flexibility along with a clear statement of their thoughts and goals. Of course, the letter is non-binding on the trustee. As such, it is important that the client feel that he or she can rely on the trustee to carry out his or her wishes as best as possible in a changing environment. My experience with clients is that they generally have a friend, family member or trusted advisor who they can rely on.
Please feel free to reach out to me if you would like to learn more about this or have any questions. Finally, if you know anyone who needs help putting together their estate planning documents we are always looking to help new clients.
One of the questions that keeps popping up from my business owner clients is… Should I change my entity to be a C-Corporation? This question has been brought on by the recent passing of the 2017 Tax Act (i.e. the Tax Cuts and Jobs Act of 2017). One of the provisions of the 2017 Tax Act reduced the tax rate on C-Corporations from a top rate of 35% to a flat rate of 21%. Income from pass through entities such as S-Corporations, partnerships and limited liability companies continue to flow through to the tax return of the owner or owners where they will be taxed at the individual’s tax rate. The top individual rate is 37% (down from 39.6%). In addition, C-Corporations can fully deduct state and local taxes whereas an individual’s deduction is limited to a maximum of $10,000.
The short answer to this question is… maybe. While a tax rate of 21% is substantially lower than a tax rate of 37%, it is important to note that C-Corporations are subject to two levels of taxation, one at the corporate level on earnings (this is what the new 21% rate applies to) and one at the shareholder level, for example, on dividends. Qualified dividends are generally taxed at the rate of 15% to 20%, although there is usually no preferential tax rate at the state and local level. Dividends also may be subject to the 3.8% net investment income tax. If C-Corporation profits are distributed, the net effect of the double taxation can cause the total tax rate to exceed 37%. If a business does not make distributions to its owners (for example, the owners generally take only salary and profits are reinvested in the company), then a C-Corporation structure may result in income tax savings. On the other hand, if the business distributes all of its profit out to its owners annually, then the double tax resulting from a C-Corporation structure will most likely be disadvantageous.
Tax rates are not the only thing to consider when deciding on what type of entity is best. Income from pass-through entities may now be eligible for a 20% deduction on qualified business income. The rules around the qualified business income deduction are complex and there are several limits and exceptions which could reduce or eliminate this deduction.
Several non-tax factors also come into play in determining whether to change to a C-Corporation. For example, C-Corporations can be more complex to operate than pass-through entities and require considerably more legal compliance and paperwork. In addition, tax laws can change again in the future. It is important to know the implications of converting back to a pass through entity. If you are planning to sell the business in the near future you need to consider the implications of being a C-Corporation at the time of a sale.
While the above discussion highlights several important factors to consider in determining what type of entity to choose, it is by no means an exhaustive list. Each situation is different and it is extremely important that you review your own personal situation with your tax advisor before making any decisions.
Earlier this year, we discussed the broad highlights of President Trump’s plan to reform the tax system. As discussed back then the plan was very skeletal in nature. Earlier this month, House Ways and Means Committee Chairman, Kevin Brady (R-TX), introduced a 429-page “Tax Cuts and Job Act” that would make major changes to the taxation of businesses and individuals. Most of the changes would be made effective beginning after 2017. Below is a summary of a few of the proposed changes…
Corporate Tax Rate – The top rate of 35% would be eliminated and corporate income would generally be taxed at 20%. There would also be a 25% rate for certain personal service businesses (law, architecture, accounting, engineering health, actuarial services, performing arts and consulting where services are substantially performed by employee-owners).
Alternative Minimum Tax – The alternative minimum tax would be repealed.
Full Expensing of Certain Property – The entire cost of certain depreciable assets acquired between September 27, 2017 and January 1, 2023 would become immediately deductible in full.
Interest Expense Limitation – Net business interest will be limited to 30 percent of the business’s adjusted taxable income.
Net Operating Losses – A net operating loss deduction would be limited to 90 percent of taxable income. In addition, taxpayers will no longer be able to carry back net operating losses (currently net operating losses can be carried back two years), however taxpayers will be able to carry them forward indefinitely (currently net operating losses can be carried forward twenty years).
Like-Kind Exchanges – The gain deferral rules on like-kind exchanges would only apply to exchanges of real property.
Tax Rates – The number of tax brackets would be reduced from seven to four. The brackets would be as follows: (i) 12% ($0 to $45,000 for single taxpayers and $0 to $90,000 for married filing jointly); (ii) 25% ($45,001 to $200,000 for single taxpayers and $90,001 to $260,000 for married filing jointly); (iii) 35% ($200,001 to $500,000 for single taxpayers and $260,001 to $1,000,000 for married filing jointly); and (iv) 39.6% (over $500,000 for single taxpayers and over $1,000,000 for married filing jointly)
Standard Deduction – The standard deduction would be increased to $24,400 for joint filers; $12,200 for individual filers and $18,300 for single filers with at least one qualifying child. Personal exemptions would be repealed.
Mortgage Interest – Interest would only be deductible if the mortgage is acquired in connection with the purchase of a primary residence (not for a second home) and only for amounts up to $500,000 (for married filing jointly).
State and Local Income and Sales and Property Tax – There would no longer be allowed a deduction for state and local income taxes. There would no longer be allowed a deduction for sales tax itemized deductions for non-corporate taxpayers (unless related to carrying on a trade or business in connection with the production of income). Additionally, the state property tax deduction would be limited to $10,000 (for married filing jointly).
Exclusion of Gain on Principal Residence – The capital gain exclusion of $500,000 (for married filing jointly) on the sale of a principal residence would be limited to taxpayers who own and use a home for five out of the eight previous years (it is currently two out of the previous five year). The exclusion could only be used once every five years (instead of once every two years).
Estate, Gift and Generation Skipping Taxes – The current tax rate of 40% would be maintained through the year 2023, however the exemption amount for each of these taxes would double to $10,000,000 (not including inflation adjustments). After 2023 the estate and generation skipping taxes would be repealed and the gift tax would remain in effect with a 35% rate. The current annual exclusion gifting rules and “step-up” in basis at death rules would remain in effect.
Retirement Plans and Life Insurance – The tax advantages currently associated with retirement plans and life insurance would remain as is.