On December 22, 2017, the Tax Cuts and Jobs Act (TCJA) was enacted. The White House and Congress had three goals. First, they wanted to simplify the code by doubling the standard deduction. This would reduce the number of itemizers from approximately 30% of taxpayers to 10% of taxpayers. Second, they hoped to increase employment by reducing the number of corporate deductions and lowering the corporate tax rate. Third, they wanted to lower individual rates by repealing most of the itemized deductions.
The TCJA was the first comprehensive tax reform of individual, estate, alternative minimum tax and corporate taxes since 1986.
Top TCJA Tax Rates
The top income tax rate for individuals is 37%. This is lower than the 39.6% that existed previously. Most of the other brackets were modestly reduced.
Because the 3.8% Medicare tax is still applicable for passive income, the total rate for investment income could be 40.8%.
Capital gains rates were largely unchanged. The top capital gains rate is 20%, with an additional 3.8% for the Medicare tax to equal a total rate of 23.8%.
A major goal of TCJA was to reduce the corporate rate. The top corporate rate was reduced from 35% to 21%. Finally, most small and midsized businesses in America are organized as partnerships, LLCs or Subchapter S corporations. The passthrough business rate includes a 20% deduction for business income. This lowers the top personal rate from 37% to 29.6%.
Single and Married Taxpayer Rates
Tax brackets for a single individual:
|10%||$0 - $9,525|
|12%||$9,525 - $38,700|
|22%||$38,700 - $82,500|
|24%||$82,500 - $157,500|
|32%||$157,500 - $200,000|
|35%||$200,000 - $500,000|
Tax brackets for a married couple:
|12%||$19,050 - $77,400|
|22%||$77,400 - $165,000|
|24%||$165,000 - $315,000|
|32%||$315,000 - $400,000|
|35%||$400,000 - $600,000|
Long Term Capital Gains
Tax brackets for a single individual:
|0%||$0 - $38,600|
|15%||$38,600 - $200,00|
|18.8%||$200,000 - $425,800|
Tax brackets for a married couple:
|0%||$0 - $77,200|
|15%||$77,200 - $250,000|
|18.8%||$250,000 - $479,000|
The TCJA tax writers decided to use the former capital gain rates and brackets with indexed increases to 2017. The indexed increases in 2018 and later years will change from the CPI to the chained CPI. This will lead to a slower increase in the bracket amounts.
Capital Gains Simplification?
While the tax bill did attempt to simplify taxes and succeeded in some areas, capital gains remain quite complex.
There is a 0% rate for persons who are in the 10% or 12% income tax bracket. If they are in the 22% or higher bracket, the capital gains rate is 15%. However, if taxable income exceeds $200,000 as a single taxpayer or $250,000 for a married couple, they must add in the 3.8% Medicare tax.
Upper income individuals with income over $425,800 for a single taxpayer or over $479,000 for a married couple are subject to the 20% capital gain rate plus the 3.8% Medicare rate, for a total rate of 23.8%.
Finally, there are additional categories. If a person has taken straight line depreciation on a commercial property and sells that property, the depreciation recapture rate is 25%. Art and other tangible personal property are subject to a 28% rate. Short-term gain property (less than one year) is subject to ordinary income tax rates. For single taxpayers with incomes over $500,000 and married couples over $600,000, the short-term gain rate is 37%. All three of these rates could also be increased by the 3.8% Medicare tax for passive income. The short-term top rate therefore is 40.8%.
The tax writers intended to simplify filing by allowing nine out of ten taxpayers to use the "postcard return." The shortened return is possible because many taxpayers do not have above-the-line deductions. They will report their income, take the standard deduction and calculate their tax payment.
The married couple standard deduction is $24,000 and the single taxpayer deduction is $12,000. While there have been multiple Joint Committee on Taxation estimates of the number of remaining itemizers with various versions of the bill prior to final passage, it seems likely that the number of itemizers will indeed be reduced. A probable number is a reduction from the current 45 million itemizers in 2017 to about 18 million itemizers in 2018.
Charities had expressed concern that the reduction in the number of persons who itemize charitable deductions would cause a decline in annual fund gifts. Tim Delaney, President of the National Council of Nonprofits, stated TCJA would "damage charitable giving by $13 billion or more annually."
There is a two-part solution to this potential challenge. First, all nonprofits need to improve their multichannel marketing plans for annual fund gifts. Many donors already take the standard deduction and give out of pure charitable intent.
Second, there is a "universal charitable deduction" for donors over age 70 ½. This is the "IRA Charitable Rollover." Nonprofits need to conduct sustained, effective IRA rollover marketing programs and build a "new annual fund" with a strong marketing program. If charities hold current donors and build increased annual fund gifts through IRA charitable rollovers, they can overcome this potential $13 billion loss and actually increase annual fund gifts.
A primary goal of the tax writers was to repeal or reduce itemized deductions. The one exception was an expansion of the charitable deduction for gifts of cash from 50% of adjusted gross income (AGI) to 60%.
Nearly all other itemized deductions were limited or repealed. Most of the miscellaneous itemized deductions were repealed. The state and local tax deduction is reduced to $10,000. This may be allocated between property taxes and state income taxes. There also is an option to substitute state sales tax for state income tax.
The mortgage deduction remains for loans on first and second homes. New loans are limited to $750,000. Existing loans (prior to passage of TCJA) up to $1 million still are qualified.
The medical deduction floor is lowered to 7.5% for 2017 and 2018. The 10% medical deduction floor will resume in 2019.
A typical donor will start by allocating up to $10,000 of state and local tax (SALT). Qualified mortgage interest and charitable gifts may then be deducted. If a single taxpayer has deductions over $12,000 or a married couple over $24,000, he or she will use the itemized deductions rather than the standard deduction. If the donor is in a state with income tax or owns a fairly valuable home, it is quite possible that the combination of these various deductions will be greater than the standard deduction.
Gift and Estate Tax Exemption
The original House bill doubled the exemption for gift and estate taxes and repealed the estate tax after four years. However, several senators demanded that the estate tax be retained, but with the higher exemption.
The gift and estate basic exclusion amount was raised to $5 million in 2011. With indexed increases, it was scheduled to be $5.6 million in 2018. The exemption is doubled to $10 million as of 2011 plus indexed increases. The 2018 exemption is assumed to be $11.2 million. Depending upon the number of decimals in the government calculation of the 12-month average for the CPI used to determine the index factor, the government number when released could vary by plus or minus $10,000 from $11,200,000.
Charitable Deductions in 2018
Charitable deductions for cash gifts are deductible up to 60% of AGI if the recipient is a public charity. Appreciated gifts to public charities qualify up to the previous 30% of AGI limitation. Conservation gifts continue to qualify for deductions up to 50% of AGI, with a 15 year carry forward.
While the IRA rollover or qualified charitable distribution (QCD) is not a charitable deduction, it is an attractive planning strategy. Because the QCD qualifies to fulfill part or all of the required minimum distribution (RMD), a transfer from the IRA custodian directly to charity may reduce the donor's taxable income. For individuals over age 70½, the QCD is in essence a nonitemizer charitable deduction.
Income Tax Planning Single
A single taxpayer with income over $200,000 is subject to the Medicare tax of 3.8% on passive income. If the single person has taxable income over $500,000, he or she then will pay tax at the maximum 37% rate. For passive income over $500,000, the Medicare tax applies and the top rate is 40.8%. A single taxpayer with income over $425,800 who is selling a long-term capital gain asset will pay 23.8% tax.
Many single individuals with higher incomes will seek to reduce their taxable income. Because SALT deductions are limited to $10,000 and mortgage interest is usually fixed, their only flexible planning strategy will be to create charitable deductions.
Income Tax Planning Married
A married couple is subject to the 3.8% Medicare tax if their income is over $250,000. A married couple with $600,000 of taxable income pays the maximum 37% rate. They also could pay the 3.8% Medicare tax on passive income, for a top rate of 40.8%. If the married couple has capital gains and income over $479,000, they pay the 23.8% top capital gains rate.
Both single and married taxpayers may also pay substantial state income taxes. Because many individuals will use the $10,000 state and local tax deduction to cover the property tax on their home, high-income persons will frequently not be able to deduct their state income taxes. In states with substantial taxes (CA, NY, OR, MN, NJ and others), the top combined income tax brackets could approach or exceed 50%. These taxpayers have great incentive to make charitable gifts.
2018 Income Tax Planning
There are three charitable strategies for 2018 income tax planning. First, for individuals who are over age 70½, an IRA rollover gift up to $100,000 is an excellent starting point. A high-income person will not want to increase adjusted gross income and may not need the income from his or her IRA. The IRA charitable rollover is a very convenient and excellent method for tax planning.
The deductible portion of charitable gifts should maximize appreciated property gifts. With equities and most real estate at very high valuations, this is an excellent time to consider an appreciated property gift. The donor generally benefits from both the capital gain bypass and an income tax deduction for the fair market value of the gifted asset. The maximum annual deduction limit for gifts of appreciated property is 30% of AGI. Deductions in excess of that limit may be carried forward for up to five years.
Because the cash gift limit is 60% of AGI, the optimum strategy is to give to 30% of AGI with appreciated property and then 30% of AGI through cash gifts. The 30% appreciated plus 30% cash gifts will total 60% of AGI. The combination of an IRA rollover up to $100,000 per year and gifts to 60% of AGI will lead to maximum tax savings.
Tax Free Sale
With the increase in value of both stocks and real estate, many of the 10,000 Americans per day turning age 65 hold highly appreciated assets. It is very common between ages 65 and 75 to sell a growth asset and benefit from an income stream during retirement.
In many states with substantial tax, the 23.8% federal capital gains tax plus state tax can create a total bracket of 30% to 37%. Historically, when capital gain rates exceed 30%, unitrusts increase dramatically in attractiveness. It seems probable that there now is a confluence of many individuals who have appreciated property and will be reluctant to pay 30% to 37% capital gains tax. They will prefer to convert the appreciated asset into an income stream without paying a large tax.
A logical method to convert this highly appreciated property into income for one or two lives is a charitable remainder unitrust. Assume a $1 million investment property has been transferred to a 5% unitrust with payments to a couple for two lives. The property is sold tax-free and that saves $269,600. The charitable deduction saves another $158,771. Total tax savings are $428,371. The unitrust income of $50,000 may pay out $1.7 million over 30 years. Finally, after the trust matures, there is a gift to charity over $1.3 million.
Annual Gift Annuity
Some senior donors who are age 75 have substantial liquid assets and desire to reduce their taxable income. Because they frequently have traditional IRAs or other qualified plans that provide a substantial amount of ordinary income, they would like to receive a substantial tax-free amount from their investments.
An excellent plan is to fund a series of charitable gift annuities. The gift annuity produces a charitable income tax deduction that offsets the tax on the IRA withdrawals each year. In addition, over 75% of the annuity payout can be tax-free.
Assume a donor transfers $100,000 cash each year to charity. The deduction for this cash gift is now available up to 60% of AGI. Because the individual wants to maximize the tax-free payout, he or she chooses the lowest of the three applicable federal rates. This produces a larger tax-free payout. By funding a gift annuity each year for five to ten years, the donor offsets most of the tax on IRA withdrawals and builds a large (mostly) tax-free payouts.
IRAs and Other Qualified Retirement Plans
IRAs, 401(k)s, 403(b)s and other qualified plans have grown dramatically as equities values have increased. Most IRAs are still traditional IRAs with pretax contributions, pretax growth and required taxable distributions after age 70½.
A creative IRA strategy is to use the qualified charitable distribution (QCD) to fulfill part or all of the required minimum distributions (RMDs) after age 70½. Many donors find that between age 71 and graduation day they are able to make QCDs for a period of twenty or more years.
If a donor plans to benefit charity in his or her estate, the first transfer to charity should always be from an IRA, 401(k) or another qualified plan. With the $11.2 million exemption ($22.4 million for a married couple), very few estates will pay estate tax. Therefore, income tax planning is the principal goal.
IRA owners should plan to transfer "good" estate assets to children. These assets do not have any income in respect of a decedent (IRD) and include stock, homes, land and other similar property. The traditional IRA is a "bad" asset from the perspective of the children because it comes with an unwelcome note stating "you owe the IRS an income tax." Therefore, most estate transfers to charity should be by beneficiary designation of the IRA or other qualified plan.
If a donor wants to benefit both children and charity with an IRA, a "Give It Twice" trust is an excellent solution. The Give It Twice Trust is a testamentary charitable remainder unitrust. The preferred method is to craft the trust during life as an unfunded "life plus term of years" unitrust.
The beneficiary designation for the IRA then selects the trustee of the unitrust to receive the IRA or other qualified retirement plan. This is a very simple and convenient method for funding a charitable remainder trust.
In most cases, the trust pays 5% to children for a term of 20 years and then is distributed to charity. A "Give It Twice" trust passes an inheritance once through the income stream to children and then the remainder amount to charity. Fortunately, because the trust is generally tax exempt, there is no income tax ever paid on the IRA remainder that is distributed to charity.
Lead Trust Factors
Because the estate tax was not repealed in the TCJA, it is probable that the estate tax will be in existence for a significant period of time. While only the very large estates are now subject to tax, those estates are a good prospect for charitable lead trusts.
Lead trusts are attractive when the estate will be taxable, the applicable federal rate is reasonably low and there is substantial potential appreciation. With these factors, a lead trust is an excellent planning strategy. It allows parents to continue their philanthropic goals for a term of years. It encourages children to be involved in philanthropy. With the very large basic exclusion amount, the lead trust term may now be fairly brief before the transfer of the remainder to family.
Early Inheritance for Five Children
Joe and Mary Donor have a $22.4 million basic exclusion amount. This amount may be used either for lifetime gifts or in their estate. They have five children and have determined that they would like to transfer an inheritance of $25 million to their children. Joe and Mary are in their early 70s and could easily live for twenty to twenty-five years. They would like to transfer the inheritance to their children when they are in their 50s, rather than in the distant future when the children are likely to be in their 70s. An excellent solution for this strategy is to transfer $25 million into a charitable lead trust with a 5% payment. The lead trust pays 5% or $1,250,000 to charity for eight years. The total payments to charity are $10 million over that period of time. The $25 million plus any growth then pass to family members. The present value of the $10 million to charity is over $9 million. This reduces the taxable gift to under $16 million. Joe and Mary use part of their basic gift exclusions and have a total of approximately $6 million remaining that could be used in the future if needed.
This trust accomplishes several goals. Joe and Mary are accelerating the inheritance to children with zero gift or estate tax. They will use the charitable payouts for a family donor advised fund (DAF) or supporting organization (SO). The DAF or SO will enable the children to be involved in philanthropy.
Joe and Mary are able to fulfill their personal giving goals, while also providing a generous inheritance for their children and involving them in philanthropy. They are able to do all of this with no gift or estate tax. There also are favorable income tax results because the charity does not pay tax on distributions from the lead trust.
Lead Trust Unitrust
Clarence is a surviving spouse in his early 70s and has three children. Clarence decides that each child would benefit from a trust for his or her lifetime. Because his estate is fairly substantial, he thinks it is best if each child has his or her own trust. The child may then be able to have an investment and tax planning strategy that is appropriate for his or her personal situation.
Clarence plans to create a combination of a layered lead trust and a 5% unitrust for the life of each child. The unitrust will be funded with $1 million remainder amounts from the lead trusts. The charitable transfers from the lead trusts will fulfill Clarence's current philanthropic goals. After the unitrust is fully funded with $4 million, it will distribute 5% or $200,000 to the child for life.
Clarence has given thought to the right amount of inheritance. He has a number of friends who also have large estates. A small number in that group have created a "provide everything" estate plan. They want to provide ample resources so all the wants and needs of their children may be fulfilled.
However, about nine out of ten of his friends who are in a similar situation want an "added economic security" plan. These friends want their children to have an IRA or retirement plan, some savings and to be a good citizen, but the parents want to provide children with added economic security.
Clarence has thought through this question and decided that an additional $200,000 per year for the life of each child would provide food, shelter, clothing and a very good lifestyle. He thinks that any more funding than that could lead to a level of lifestyle that may not be beneficial for the child.
How the Lead Trust Unitrust Plan Functions
Clarence funds each unitrust through four lead trusts. Each child has his or her own unitrust and 1/3 of each lead trust remainder is distributed to each of the three unitrusts. The four lead trusts last for four years, six years, eight years and ten years. At the end of each term, the lead trust remainder flows into the charitable remainder unitrusts.
While the assets are highly appreciated when they are transferred to the unitrust, they may be diversified tax-free. The unitrusts pay 5% income for the life of each child. The unitrusts with growth will eventually distribute $15 to $20 million to charity.
An option that Clarence may consider is to use a Flex-FLIP Unitrust for a child. By transferring a building lot into the trust and designating sale of that lot as the FLIP trigger event, the trustee may decide whether to maintain the trust as a net income plus makeup trust or change to a standard 5% payout trust.
While the unitrust is a net income plus make-up trust, the trustee also has discretion under the trust instrument to use a partnership for the investment strategy. The partnership can invest in various equities and other securities. When a distribution is desired from the net income plus makeup trust, the partnership can make the distribution to the trust and distribute it to the individual. This strategy is somewhat sophisticated, but it allows each child to have control over the growth and the distribution. This a sophisticated form of income tax planning. Because Clarence knows that two or three of his children may be in high brackets, he plans to give them this additional flexibility for their income tax planning.
Charitable Planning with Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act will permit advisors to engage in multiple strategies that will be very beneficial to both donors and their children. These strategies may reduce current taxes by 40% to 65%, increase the donors' tax-favored or tax-free income, provide a substantial and helpful inheritance to family and leave a legacy though a favorite charity.