Current federal estate, gift, and  income tax laws offer significant estate planning opportunities for all clients, but especially married couples.

Federal income tax planning has become a major objective, to avoid having trust or estate income  taxed at very unfavorable rates.

This article will discuss these new planning opportunities for 2017 and beyond.

CARRYOVER BASIS TO REPLACE THE ESTATE TAX?   The change in administrations as of January 2017 may result in significant changes in the wealth transfer tax system.  One possibility is that the federal estate tax (but not the gift tax) will be repealed, and replaced with an income tax imposed on inherited assets using carryover basis rules.


■ Highlights of Changes in Tax Law

■ Estates and Trusts Treated as “High Income” Taxpayers

■ Planning Ideas Emerging from Federal Law


■ Highlights of Changes under New Federal Tax Law

2017 Federal Estate and Gift Tax Exemption Amount Is $5.49 Million

This amount will be adjusted upwards each year based on inflation.

The exemption is a unified amount that applies both to lifetime taxable gifts and death-time transfers. To the extent the exemption is used during one’s lifetime, it will not be available at death.

2017 Federal Gift Tax Annual Exclusion Amount Remains At $14,000

Taxpayers can make gifts up to an annual exclusion amount each year to any number of donees, without using up any of their $5.49 million unified exemption. The annual exclusion amount is subject to increases from year to year based on inflation. For 2017 the annual exclusion amount remains set at $14,000 per donee.  Spouses can make joint gifts of up to $28,000 per donee without using either spouse’s exemption.

Permanent Estate and Gift Tax Rate Set at 40%

The federal estate and gift tax rate is set at 40%, which will apply to any amount transferred in excess of the $5.49 million exclusion amount.

Portability Will Allow a Deceased Spouse’s Unused Exclusion Amount to Carry Over to the Surviving Spouse

The concept of “portability,” by which any exclusion amount not used by the deceased spouse’s estate can be carried over (or “ported”) to the surviving spouse, has been made permanent.  With portability spouses will have a relatively simple way to fully utilize their combined exclusion amounts, without having to keep their assets in separate names during their lifetimes, or to create a credit shelter (also known as a “bypass”) trust in their respective wills to hold the exclusion amount for the surviving spouse’s lifetime.

How Does Portability Work?  

The surviving spouse during his or her lifetime, and the personal representative of the surviving spouse’s estate, will now have two exclusion amounts that can be used to eliminate — or at least reduce — that spouse’s federal gift and estate tax. The first exclusion amount will be any unused portion of the deceased spouse’s exclusion amount, and as necessary, the surviving spouse’s own exclusion amount.

EXAMPLE:  John and his wife, Mary, together own property valued at $8 million, which includes their life insurance and retirement accounts.  All of their assets are titled in joint names, and they have named each other as the primary beneficiary of their respective life insurance policies and retirement accounts. Assuming that John would die first and in the year 2017, none of his $5.49 million exclusion amount would be needed by his estate, because the marital deduction would have already reduced his taxable estate to zero. Since Mary would then own the entire $8 million outright in her sole name, without portability she and her estate could only shelter $5.49 million (not taking into account the cumulative increase in the exemption amount from 2017 to the year of her death), leaving an excess of $2,510,000 that would be result in a tax of $1,004,000 (40% of $2.51 million).

With portability in effect, and assuming that an election was made after John’s death (discussed below), Mary’s estate could use both John’s full unused exemption amount and as much of her own exclusion amount – $2.51 million — as would be necessary to offset the entire $8 million estate, thus saving the family $1.004 million.  

Portability Not Applicable to GST Tax

Portability is not available for any generation skipping transfer tax exemption that is not used at the first spouse’s death.

No Inflation Adjustment for Deceased Spouse’s Carried Over Exclusion.

While the surviving spouse’s exclusion amount will be determined as of the year in which a taxable gift is made or the year of his or her death, and reflect the inflation-based adjustments allowed by federal law at that time, the deceased spouse’s exclusion will remain fixed at its amount determined in the year of his or her death.

Portability Not Automatic!

A major hurdle to the surviving spouse being able to carry over the deceased spouse’s unused exclusion amount is that the executor of the deceased spouse’s estate must have made a portability election on a timely filed Federal Estate Tax Return (normally due nine months following death), even if such a return was not otherwise required. Planning for portability for the benefit of the surviving spouse thus must be done within nine month’s following the first spouse’s death.

Remarriage May Negate Use of Portability. If the surviving spouse later remarries and also survives the second spouse, he or she will no longer be able to use the exclusion amount of the first deceased spouse.

Note on Pennsylvania Inheritance Tax

These changes in federal gift and estate tax law will not affect the Pennsylvania inheritance tax, which will continue to be imposed on the transfer of taxable property at death (other than to the surviving spouse), and lifetime gifts in excess of $3,000 per donee made within one year of death, at rates that are based on the relationship between the beneficiaries and the decedent. There is no exemption amount applicable to the Pennsylvania inheritance tax.

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Estates and Trusts Treated as “High Income” Taxpayers 

Federal law now recognizes a category of taxpayers called “high income” taxpayers, who will be required to pay taxes at the highest rate allowed by law.  For 2017 the “high income” threshold amount for married couples filing jointly is $470,701, for single filers it is $418,401, and for head of household files it is $444,551.

Estates and trusts, however, will be treated as “high income” taxpayers if they have taxable income of only $12,500 (in 2017)!

Rates on High Income Taxpayers

The new marginal rate for high income taxpayers is 39.6% on ordinary taxable income and short-term capital gains. Long-term capital gains and qualified dividends will be taxed at a 20% rate, as compared to a 0% or 15% for other taxpayers.

Medicare Surtax

These income tax rate increases are coupled with the Medicare surtax that has taken effect under the Patient Protection and Affordable Care Act.  A surtax of 3.8% is imposed on net investment income at an adjusted gross income threshold of the same $12,400 for trusts and estates, $250,000 for married couples filing jointly and $200,000 for individuals, plus a .9% Medicare tax on earned income.  Net investment income includes interest, dividends, capital gains, annuities, rent and passive income. These thresholds are not indexed for inflation.

Combined Rates

High income taxpayers, including estates and trusts with only $12,500 of taxable income (in 2017), will have a combined effective rate of 43.4% on ordinary income and 23.8% on qualified dividends and long-term capital gains.

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Planning Ideas for 2017

Planning for Married Couples

Spouses normally prefer to hold their assets in joint names, and there are many advantages to joint ownership. However, when engaged in estate planning spouses were often advised to divide up their assets into separate “his” and “hers” shares, so that they could utilize both spouses’ federal estate tax exclusion amounts regardless of the order of their deaths. Likewise, tax considerations would dictate that spouses could not simply leave all their property outright to the other, but had to create a trust to hold at least a portion of the property for the spouse’s benefit, with strict limits placed on the surviving spouse’s access to trust principal. The recent changes in federal law have eliminated the need for such tax-motivated complexities.  The surviving spouse can now take advantage of the first spouse’s unused exclusion amount, even if their assets were owned jointly and if no credit shelter trust was created at the first spouse’s death. Thus couples can opt for a simple estate plan in which the surviving spouse will receive the entire estate of the first spouse outright, whether by will, right of survivorship, or beneficiary designation, and still achieve full utilization of their combined exclusion amounts, producing maximum tax savings.

■ When Should a Trust Still Be Used for the Surviving Spouse? 

Tax savings, of course, is not the only reason why a trust should be created for a person.

■ Diminished Capacity or Vulnerability of Spouse

For example, the spouse may be showing signs of dementia or have some other condition indicating that he or she may be unable to properly handle their financial affairs or will be vulnerable to being exploited by some “designing person.” A trust for such spouses would be a good solution to ensure that the property will be protected and properly invested for their benefit.

■ Asset Protection for High-Risk Spouse

Other spouses may be engaged in a high-risk profession or business activities where the threat of litigation and possible judgment creditors is a serious concern.  A trust with strict distribution standards for this type of spouse can ensure that the property will escape the reach of creditors.

■ Protecting Children of Prior Marriages

In the case of second marriages, a spouse may prefer that the assets be placed in a trust at his or her death, to ensure that the assets will pass to his or her children from a prior marriage after the current spouse’s death.

■ Passing Appreciation in Value of Assets Tax Free

Finally, a credit shelter trust would be in order to ensure that all appreciation in the value of the assets will escape estate taxation at the surviving spouse’s death. Outright bequests to the surviving spouse will result in the appreciation being taxed at his or her death.

Bottom Line 

Portability will not eliminate the need for thoughtful planning for married couples, in light of both tax and non-tax considerations applicable to their situation then and projected for the future.

■ Need to Review Existing Estate Plans

In light of the portability provisions discussed above, current estate planning documents should be reviewed with the guidance of legal counsel to determine if the documents should be revised.

■ Need to Review Existing Asset Ownership and Beneficiary Designations

In addition to possibly updating documents, an estate planning review should also look at how the couple’s assets are currently titled, and the identity of current beneficiaries designated on retirement accounts and life insurance policies.

■ Minimizing the Tax on Income Received by a Trust or Estate

Concern With Increased Income Tax Rate on Trusts and Estates. Apart from portability, the increased income tax rates for trusts and estates discussed above means that trustees and executors will have to carefully monitor the amount of taxable income building up inside a trust or estate during the year, and decide from time to time whether, and how much, income should be timely distributed to the income beneficiaries (assuming such distributions are permitted by the trust document or will) to reduce the tax burden on such income if it would be retained in the trust or estate.

EXAMPLE:  Sam and Alice, who are both in their 20’s, are the beneficiaries of a trust established by their deceased Uncle Bill, which was funded with a $1,000,000 life insurance policy that he had owned through work. The trust is due to last until both Sam and Alice have attained age 40.  The trust document gives the trustee broad discretion in deciding how much if any of the trust’s income or principal may be distributed to Sam and Alice at any one time. As 2017 comes to a close the trustee calculates that during that year the trust has received net taxable income of $60,000 from its investments. No distributions have been made to Sam or Alice during the year. If the trustee does not make any distributions to Sam and Alice by December 31, 2017, the trust will have to pay $26,040  in federal income tax ($60,000 x 43.4 % = $26,040). By contrast, if the trustee would distribute $60,000 of assets to Sam and Alice in equal shares in 2017, and assuming that Sam is in a 25% income tax bracket and Alice in a 15% bracket, their combined taxes on the same $60,000 would be only $12,000 ($30,000 x 25% = $7,500; $30,000 x 15% = $4,500). Thus, the tax burden is more than double when the trust income is accumulated inside the trust and not distributed to the beneficiaries.

Capital Gains Tax Planning.  Likewise, a trust’s potential capital gains on a sale of assets should be reviewed to determine if the distribution of the underlying asset in kind to certain beneficiaries might lower taxes.

EXAMPLE: The trustee of an education trust needs to come up with the cash required to cover the costs of the beneficiary’s upcoming semester at State U.  The trustee has decided to liquidate some securities that have been held in the trust more than one year in order to meet this cash need.  If the trust would sell the securities, which have a current value of $40,000 and a cost basis of $15,000, the $25,000 long-term gain would be taxed to the trust at its combined capital gains rate of 23.8%, resulting in a tax of $5,950. On the other hand, assuming the beneficiary was in a 15% marginal income tax bracket, so in a 0% capital gains tax bracket, if the trustee would transfer the stock in-kind to an account owned by the beneficiary and the stock was then sold from that account, the tax would be $0! 

■ Need for Revisions to Wills and Trust Documents

Some commentators are predicting that fiduciary income taxes will become the “new estate tax” in light of the much  higher rates to be imposed on both the ordinary income and capital gains accumulated by trusts and estates, as compared to the lower rates payable by most of their beneficiaries. As a result, trust provisions in wills and trust documents should be reviewed and revised if possible to ensure that taxable income can be distributed to the beneficiaries, if consistent with the trust’s underlying purposes, to avoid the higher income tax rates. For trusts where a beneficiary, due to age, incapacity, or other good reason, should not be receiving any income outright, drafting solutions are available whereby the beneficiary would be treated as the taxpayer for income reporting and payment purposes, but the income could be held by another person or entity as a fiduciary for the beneficiary.

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