Affluent taxpayers are likely to see some of the best tax-planning opportunities in years under the balanced budget accord that was reached by White House and Congressional negotiators this month.
In some cases the deal will take us back to the future by reviving estate and income tax strategies that have been in the deep freeze since the late 1980s. While details of the tax law changes are still uncertain, events are likely to develop rapidly during the next several months.
Enough information already is available to allow for intelligent, if preliminary, planning. The lifetime “unified credit” exemption amount for gift and estate taxes is expected to rise in stages from the current $600,000 to as much as $1.2 million. This would be the first boost in the unified credit since 1986. Properly used, it will allow married couples to transfer at least $2.4 million, and potentially much more, to heirs without paying any tax.
Capital gains taxes are expected to be cut, as well. Most likely, taxpayers will be allowed to exclude from taxable income up to half the gain on assets held for at least one year. Absent other changes, this would effectively reduce the tax on those assets to 14%. More realistically we can expect the current 28% rate cap on long-term gains to be eliminated if the exclusion is enacted, so the maximum rate on long-term gains would be 19.8% for taxpayers in the top federal bracket and 18% for those in the second-highest bracket.
Basis Step-Up Survives
Equally important is a change that has not been announced in the budget agreement. The rule providing a step-up in tax basis at death apparently will be preserved, though it has been the target of Treasury attack throughout the Clinton administration. Despite the capital gains cut, therefore, it will in many cases make sense to hold highly appreciated assets until death rather than sell them.
It is possible, however, that tax-writers will limit or kill the “short-against-the-box” strategy that allows taxpayers to lock in a capital gain while deferring the tax until a subsequent year. This technique has also been attacked by the Clinton Treasury, and its elimination could well become one of the revenue raisers that are used to offset part of the remaining tax cuts.
A $10,000 annual deduction for higher education costs, and a $1,500-per-student credit for each of up to two years of college study, also are expected to make it into the tax package, despite widespread criticism from economists who believe that much of the economic benefit will go not to students, but to institutions that will be under less pressure to hold the line on tuition costs. Upper-income taxpayers may not benefit at all from these provisions if lawmakers include an income qualification.
Preparing For Law Changes
The big question, of course, is what steps you should take — or avoid taking — in anticipation of the expected new laws and their effective dates. Here is a quick rundown:
Gift Taxes: Have you fully used the existing unified credit? If you have not, but you and your spouse can afford to give away $600,000 each to your heirs, no time is better than the present. This is true regardless of whether the estate tax laws are changed this year. The sooner you get assets out of your estate, the better you can avoid tax on future appreciation of those assets.
If you have already used the unified credit, a boost in the credit amount will give your favorite planning strategy a new lease on life. Expect to see the credit rise by about $100,000 to $150,000 per year over the next four or five years. In each of those years, you and your spouse can transfer $200,000 to $300,000 to heirs tax-free. Most taxpayers will want to avoid making gifts in excess of the unified credit if the gifts could be deferred for a year and then sheltered under the next round of increases in the credit amount.
This may be a perfect opportunity to use techniques that “leverage” the unified credit by allowing you to claim a discount on the amount transferred to heirs. Such techniques include family limited partnerships, charitable lead and remainder trusts, and qualified personal residence trusts, as well as certain life insurance policies.
A big caveat: Treasury has been aggressively challenging the valuation discounts typically claimed in intra-family business transfers, such as with family limited partnerships. Most of those challenges are bounced out of court when taxpayers have done their homework with well-drawn agreements and solid appraisals. The administration may see the coming tax package as a good vehicle to try to limit the availability of these discounts in family transfers. Watch the legislation carefully, and consider letting your own representatives know how you feel about paying transfer taxes on “value” that does not actually exist in the marketplace.
Estate taxes: A phased-in hike in the unified credit means your estate plan has to hit a moving target. If, for example, your will provides that your children receive today’s maximum credit amount of $600,000 while everything else goes to your spouse, your family may pay unnecessary tax if you die after the maximum credit jumps to $750,000. This is a good time to review existing wills and trusts. Documents should be as flexible as possible to accommodate frequent law changes. I do not like to see documents that are “hard-wired” with today’s tax provisions, since they can change on short notice.
Generation-skipping taxes: If the unified credit rises, will Congress also boost the $1 million per donor exemption from the 55% tax on “generation-skipping” transfers to grandchildren and others? Either way, your estate plan may need adjustments. Without a hike in the GST exemption it will often make more sense to route additional dollars through your children’s hands. This is another good reason to review your estate plan later this year when the legislation is in final form.
Income taxes: Unless you have a compelling reason to hold on to an underwater position, sell depreciated long-term assets now. A dollar of long-term loss today can offset a dollar of higher-taxed short-term gains. But if Congress enacts a 50% long-term gains exclusion, it is quite likely to revive the old rule that it takes $2 of long-term loss to offset $1 of short-term gain. Triggering the long-term loss now might get you grandfathered ahead of the effective date of such a change.
If you are holding highly appreciated long-term property, try to wait before selling it, since a lower tax is likely to be available. But you should never let the tax tail wag the investment dog. If you need to diversify or if the price really is right today, consider a strategy to sell on a tax-sheltered basis. This can include a short sale against the box, an equity swap, or a charitable remainder trust.
Finally, if you want to use the short-against-the-box or equity swap techniques, get into those deals now, but make sure you have an escape clause that lets you out in case of an adverse tax law change. When choosing a shield against the tax man, it is best not to get stuck behind one that has a big bull’s-eye drawn on it.