Many of the major tax law changes introduced by the Tax Cuts and Jobs Act (TCJA) of 2017 will expire (or phase out) in 2025 and return to the rules that were in place before the Act was signed into law. But here lies a planning problem: no one can know what the political landscape will be like then, whether the TCJA will actually come to an end, or whether entirely different legislation might be enacted. As a financial advisor, where do you start when developing a planning strategy?
An essential starting point is a detailed understanding of the key tax regulations that are about to expire. These include:
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Exemption from inheritance and gift tax
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Tax Rate Changes
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Qualified business interest deduction
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Alternative Minimum Tax Rates
Exemption from inheritance and gift tax
Perhaps the only change that could attract the most attention is the reversal of the inheritance and gift tax exemption.
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Today the liberation is at the highest level: $12.92 million per person.
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It is scheduled to return to pre-TCJA levels on January 1, 2026: 5 million dollars, adjusted for inflation.
For clients (both individuals and families) with estates of significant value, you may want to explore options for donating assets from the estate while the tax exemption is still at these unprecedented levels.
Sunset Strategies
Give away wealth now. The IRS has stated that there will be no clawback rule for direct gifts made before the TCJA expires. In other words, as long as the gifts are made before sunset and were not taxable at the time of the donation, then the client is never taxed for him, even if the allowance is lower at his death.
This means that an individual (or a married couple) can avoid taxing gift assets in excess of a future reduced allowance while still allowing the assets to grow from there outside of the estate.
Here is an example to illustrate this point:
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Let’s say a person gives a gift $10.46 million Today.
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Then the inheritance tax exemption expires, resulting in a new exemption amount of $6.46 million (the estimated inflation-adjusted amount) in 2026.
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With the no-clawback rule, the 4 million dollars beyond the new tax exemption (and subsequent increase) would escape inheritance tax.
Now, before applying this strategy, there are some caveats to consider. Firstly, it only applies to clients with significant assets. A $5 million gift today would provide no additional estate tax relief than the same gift in 2026 after Sunset. Why? This $5 million gift is less than the assumed future allowance. The customer would still have $1.46 million left to gift after sundown, so there would be no additional benefit to them by gifting the money now or later. But donations above the future allowance (but below the current one)? You are in the sweet spot for individuals to see real value.
Second, while there are no clawbacks, your clients shouldn’t rush to make large gifts to family members or irrevocable trusts—otherwise they could get burned. Gifts that go beyond the annual gift tax exemption place the donor under significant control, And These assets are no longer entitled to an increase in the basis. This could result in a significant capital gains tax liability for the beneficiaries. And if the inheritance tax exemption never again reached a level that made the donor’s estate taxable on his death, the gift would have created a tax liability for the donor without accruing any appreciable benefit.
Conduct a critical document review. When evaluating options for effective planning for the TCJA process, being able to see the complete financial picture of your client can be invaluable. Conducting a critical document review (e.g. trusts, powers of attorney, wills) is a proven strategy to spot potential problems before they become actual problems. For many consultants, having the right partner can make all the difference.
Commonwealth’s Advanced Planning team consists of experienced estate planners and priors attorneys who are in a unique position to provide an objective analysis and summary of these important documents. With their insights, advisors can enter planning meetings with clients and their attorneys with confidence. Hear what consultant Vance Barse has to say about this value-added service:
Tax Rate Changes
In addition to the exemption from inheritance and gift tax, individual tax rates are also available to return to pre-TCJA levels. As a result, individuals and married couples pay higher taxes and lower income limits. Therefore, it might make sense for some customers to charge taxes at today’s lower rates.
Sunset Strategies
Complete a Roth IRA conversion. A Roth IRA conversion transfers money from a traditional IRA or 401(k) to a new or existing Roth IRA. Clients are likely to have to pay normal income tax on all pre-tax dollars and converted investment gains. The trade-off is taking on less tax debt now and earning tax-free income later in retirement. And three years until sundown has individuals and couples to complete multiple annual Roth remodels — potentially saving thousands in future taxes.
But there is more! The benefit of a Roth conversion is further enhanced by the change in the payout period for heirs of retirement accounts. Most beneficiaries now have 10 years to use up the account and having a short time frame for withdrawing the funds is far more beneficial tax free from an inherited Roth IRA than from a tax-deferred inherited traditional IRA.
Make monetary donations to charity. Under the TCJA, the deduction for cash donations to charities was increased from 50 percent of Adjusted Gross Income (AGI) to 60 percent for taxpayers who file an individual tax return. At sunset, the threshold will fall back to 50 percent of the AGI.
Clients could potentially limit the tax implications of a Roth conversion by making a large cash donation to a charity (or donor-recommended fund) in the same year.
Qualified business interest deduction
The TCJA has introduced a brand new tax deduction known as the QBI (Qualified Business Interest) deduction. It allows certain pass-through companies (e.g. S Corporations, LLCs) to deduct up to 20 percent of their business income, although it is subject to certain limits and income thresholds. And it too will perish at the end of 2025.
Sunset strategy
change entity type. While the QBI deduction will not be available, the corporate tax rate reduced under the TCJA will apply will not sunset and stayed at 21 percent. You may want to help your business owner clients explore the prospect of changing their corporate structure from a transit company to a C corporation.
First, you want to determine the benefit the business owner received from the QBI deduction. Will the loss of this deduction coupled with higher individual tax rates support a change?
Be aware that C-Corps are subject to double taxation (at the corporate level and then at the individual level if a distribution is made). In addition, changing the corporate structure is quite a drastic maneuver that can be costly and complex. It needs to be analyzed extensively in careful consultation with other professionals (e.g. accountants and lawyers) to ensure it is a prudent path and the change is formalized in accordance with the law.
Alternative Minimum Tax Rates
When filing a tax return, two calculations take place behind the scenes: the traditional income tax liability and the alternative minimum tax liability (AMT). The amounts are compared and the taxpayer pays the higher amount.
Although the AMT tax rate can be lower than the individual tax rate (it’s a flat 26 percent or 28 percent), it’s calculated by removing many of the typical income tax deductions (such as state, local, and property taxes) on which Individuals rely This can result in a higher tax liability.
The TCJA significantly reduced the number of taxpayers subject to AMT by increasing the AMT exemption amount (ie, the threshold above which a taxpayer is subject to AMT). However, this allowance will return to pre-TCJA levels in the event of sunset. This would mean that a large number of taxpayers who previously paid their income tax liability under the traditional tax structure will now pay at the AMT rates.
Sunset strategy
Practice ISOs. Generally, an individual can exercise incentive stock options (ISOs) but does not have to pay tax on the stocks received until they sell them. However, the AMT calculation takes this into account as the taxpayer’s income in the vesting year.
Accordingly, if the AMT exemption is reduced as a result of the expiration of the TCJA, those exercising ISOs will pay the AMT at a higher rate than those who exercised prior to expiration and remained under the exemption.
So what if your customer wants to avoid a higher tax burden? after Sunset? It’s worth checking if they have ISOs available to exercise before 2026. However, this is a complex decision with many factors (e.g. the development of the share price). In order to determine the most sensible training strategy, a comprehensive analysis is important.
Don’t let the sun go down . .
As you and your clients plan for the changes ahead, it is imperative to discuss the unpredictability of Congress and the election. The rules may be as likely to expire as stay the same – or that entirely different tax rules will be enacted instead.
So before the sun goes down on TCJA and a strategy is set, explore all the options available to help your clients navigate the path to a successful financial plan.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax advisor regarding your individual situation.
