TAX CUTS AND JOBS ACT (THE “ACT”) – “CLAWBACK”

Prior to the passage of the Act, effective January 1, 2018, the individual exclusion from Federal estate, and gift tax was approximately $5,600,000.00.  Under the Act, the exclusion is doubled to approximately $11,200,000.00, per individual.  That increased exclusion, however, “sunsets” on January 1, 2026, when it will revert to the exemption of $5,600,000.00 in effect prior to January 1, 2018.  This Article will discuss the possibility of a “clawback” of the doubling of the exclusion, when the sunset takes place and the exclusion reverts to the pre-existing $5,600,000.00, i.e. will any gifts made between 2018 and the sunset date be “clawed back” to the taxable estate of the donor who passes away after the sunset date.

Discussion

As a result of the increase in the gift and estate tax exclusions individuals have the opportunity to make gifts utilizing the increased exclusion up to approximately $11,200,000.00 per person, without subjecting those gifts to either life time gift tax, or being included in the individual’s taxable estate upon his death.

Of course, where assets are gifted, those gifts would not be entitled to a step up in income tax basis of those assets upon the death of the donor.  Thus, the advisability of such gifts will continue to require an analysis of the potential income tax cost of the loss of that step up in tax basis in case of a sale of any such assets following the death of the donor.

However, utilizing the increased gift tax exclusion during life time, does raise a question as to whether the death of the donor after the “sunset” of the increased exemption, when the exemption reverts to the pre January 1, 2018 amount, will result in some form of “clawback” or recapture of the benefit of the increased exclusion.  Thus, will the IRS in determining the taxable estate of the donor who dies after the sunset date, apply the exclusion at the time of the gift, i.e. when the Act doubling of the exclusion was still in effect, or will it apply the amount of exemption at the time of death, when the exclusion has been “sunset” back to $5,600,000.00, thus, “clawing back” the benefit of the pre sunset exclusion.

To deal with this question, the Act contains a separate provision, which together with a clarifying Conference Committee Report, directs that the Secretary of the Treasury adopt regulations necessary or appropriate to deal with the difference “between the exclusion amount applicable at the time of a decedent’s death”, and that applicable “at the time of any gifts by the decedent.”

What is not clear is whether that provision directs the adoption of regulations requiring the inclusion in the taxable estate of an individual who passes away after the sunset, of the full amount of the gifts made during life, but only allowing the lower exclusion amount in effect following the sunset, in determining the estate tax due i.e. the “clawback” approach.  That approach could result in an additional estate tax in excess of $2,000,000.00, depending on the amount of gifts made during the pre-sunset period.

On the other hand, the non “clawback” approach would only include in the taxable estate of a donor who dies after the sunset dates, pre sunset gifts in excess of the exclusion in effect at the date of gift, i.e. $11,200,000.00.

A related issue is what, if any, regulations will be adopted to deal with the situation where the donor during the pre-sunset period may not have utilized the then full amount of the gift and estate tax exclusion.  It is possible that, in those circumstances, the donor may still have the unused exclusion amount available for gift tax purposes, even after the sunset indeed even after sunset, the unused portion of the pre-sunset lifetime gift tax might be used in calculating the exclusion amount for estate tax purposes.

Clearly, uncertainly exists as to how the Treasury Department will exercise its statutory authority to issue regulations dealing with the sunset and the change of the exclusion amounts.  The IRS has published a so-called 2017-2018 Priority Guidance Plan, in which it indicates that a near term priority in issuing guidance with respect to the Act is “Guidance on computation of estate and gift taxes to reflect changes in the basic exclusion amount”.  Although no specific date with respect to such guidance has been reported, it is expected sometime in 2018.

Obviously, planning now to take advantage of the current increase in the lifetime exemption to $11,200,000.00, leaves uncertainty as what the effect may be following sunset, and how the Treasury would approach its mandate to deal with the different exclusions existing at the date of the gift and following sunset.

In general where the donor is in a position to take advantage of the increased gift tax and estate tax exclusion, it may still be beneficial to do so.  Even if the IRS were to issue regulations clawingback the amount of the pre sunset exclusion in excess of the post sunset exclusion amount, into the taxable estate, in case of death following sunset, which many do not believe will happen, it would likely be subject to challenge as exceeding its statutory authority. In any event, this will all depend on the structure of the donor’s estate plan, and at a minimum, those individuals in a position to take advantage of the increased exclusion should reexamine their current estate plan.

Pass Through Deduction Under Tax Cuts and Jobs Act (the “Act”)

General

A.  Under the Act a new deduction is introduced effective for tax years beginning after December 31, 2017, available to individuals, trusts, and estates. The deduction is equal to 20% of “qualified business income” from income earned directly by the taxpayer, and income from so-called pass through entities.  Pass through entities are essentially defined as partnerships (including limited liability companies or other entities treated as partnerships for tax purposes) and S corporations, where the taxable income or loss of the entity is generally reported by its partners or shareholders.  Qualified business income also includes certain dividends from real estate investment trusts and other defined entities (including certain cooperatives and publicly traded partnerships).  Unless it is extended by Congress, the deduction expires for tax years beginning after December 31, 2026.

B.  In general, the pass through deduction is limited to 20% of the taxpayer’s taxable income with certain adjustments. Thus, where a taxpayer has reduced taxable income through other adjustments, the benefit of the pass through deduction may be limited.

C.  The benefit of the 20% “flow through” deduction obviously depends upon the taxpayer’s tax bracket. For example, for a taxpayer in a 35% bracket the 20% deduction in effect reduces the tax rate on the taxpayer’s qualified business income, from 35% to 28%.

Qualified Business Income – Exclusion for Services

A.  As indicated, the 20% deduction relates to qualified business income. Generally, qualified business income means income from any trade or business, but it excludes certain service trades or businesses.  Disqualified service trades or businesses include any trade or business in accounting, health, law, consulting, athletics, financial services and brokerage services.  Service trades or businesses also include any business, if the principal asset of the business is the “reputation or skill of one or more of its employees”.

B.  The exclusion for services income is phased in based upon the taxpayer’s taxable income. Taxpayers with income below a certain level are not subject to the exclusion – for a single taxpayer the limitation on services income does not apply unless the taxable income of the individual is in excess of $157,500, and in the case of a joint return, the limitation does not apply, unless the taxable income on the joint return is in excess of $315,000.  For taxpayers with taxable income in excess of those amounts, the exclusion for services income is phased in, so that the deduction is eliminated entirely for single taxpayers with taxable income in excess of $207,500, and married taxpayers with taxable joint return income in excess of $415,000.

Calculation of the Deduction

A.  As noted, for each qualified trade or business, the deduction is equal to 20% of the qualified business income from that trade or business. However, except for taxpayers with taxable income below certain levels, as discussed below, the deduction is limited under two methods.  The first method, defines qualified business income as 50% of W2 wages paid with respect to the business.  The second method provides that qualified business income is equal to 25% of the W2 wages paid with respect to the business, and a portion of the tax basis of the business, in depreciable property owned by the business.  Thus, for capital intensive businesses, the second method would typically produce better results.

B.  The limitations on the pass through deduction based on W2 wages, or W2 wages and tax basis in depreciable property as discussed above, are phased in, in the same manner as the exclusion of service trades or businesses, depending on the level of the taxpayer’s taxable income. Thus, if a single taxpayer has taxable income not in excess of $157,500, or a married taxpayer has joint return income not in excess of $315,000, the pass through deduction is 20% of qualified business income, without any limitation based on W2 wages or tax basis in depreciable assets.

C.  In determining the 20% deduction, qualified business income does not include investment income, such as capital gains, dividends and interest.

Open Questions and Planning Possibilities

A.  A number of questions with respect of the application of the pass through deduction will need to be clarified. Indeed, the Treasury Department recently advised that guidance with respect to rules for determining whether a pass through entity generates income qualifying for the pass through deduction, is a high priority area.  One area which is likely to receive attention, relates to the exclusion of certain specified service businesses from the benefits of the deduction.  In particular, the treatment as service businesses, if the principal asset of the trade or business is the “reputation or skill of one or more of its owners or employees”, will need to be clarified.

B.  Depending on the nature of the business, to the extent the limitations on the pass through deduction, based upon W-2 wages, or based upon W-2 wages and capital investment, may apply, planning may be available to maximize the deduction. For example, it may be appropriate to increase the amount of W-2 wages paid, by converting independent contractor relationships to employee relationships.

C.  There has been some discussion as to the benefits of operating a business as a C Corp rather than as a pass through S corporation, to take advantage of the new low corporate tax rate – 21% – under the Act, which may be lower than the S corporation shareholders, individual tax rate. However, in many cases the benefit of the lower corporate tax rate may be offset by the pass through deduction available to S corporations shareholders (which is not available to C Corps or their shareholders) and of course, by the additional tax, which may apply, when a C Corp makes distributions to its shareholders.

D.  Obviously, the particular circumstances would need to be examined to determine if operating as a C Corp rather than an S corporation, may be beneficial.