While most people know that the Tax Cuts and Jobs Act (TCJA), P.L.115-97 made significant changes to divorce planning with the elimination of deductible alimony payments, the TCJA also make other changes that also will affect divorce planning. Also, many states, including Illinois, have made changes to its laws on alimony to address the changes made by the TCJA. An overview of Illinois’ new law can be found here.
Updates to the Estate Tax for 2018
For 2018, the estate and gift tax exemption is $5.6 million per individual, up from $5.49 million in 2017. That means an individual can leave $5.6 million to heirs and pay no federal estate or gift tax. A married couple will be able to shield north of $11 million ($11.2 million) from federal estate and gift taxes. And the annual gift exclusion amount is $15,000 for 2018—up from $14,000 where it’s been since 2013.
Note that the Federal Estate tax exemption is portable, meaning that couples can pass the unused exemption to a spouse. Spouses used to have to establish a by-pass trust to get this result. Examples under the new law are as follows:
Example 1: Client is a U.S. citizen who died in 2018 with a $3 million estate. The federal estate tax exemption is $5.6M, so client can leave the entire $3 million to the client’s adult children without any federal estate tax. The executor of client’s estate can then elect to pass along the unused $2.6 million exemption to the spouse who has a $8.2 million estate. If spouse also died in 2018, the spouse can leave the entire $8.2 million estate to the children without any federal estate taxes.
Example 2: Same facts as in example 1, except this time clients leaves entire $3 million estate to spouse without any federal estate tax (using the unlimited marital deduction). The executor of client’s estate then elects to pass along client’s unused $5.6 million exemption to spouse. If spouse dies in 2018, spouse’s estate will have a $11.2 million exemption.
Note that IRS form 706 (United States Estate and Generation-Skipping Transfer Tax Return), needs to be filed even if no tax is due to pass along the unused exemption to the spouse. Also note that tax rate on estates above the exemption amount starts at 40%.
For the state of Illinois, which decoupled its estate tax from the Federal, the exemption is $4 million and is not portable between spouses. The top rate in Illinois is 16%, that would be for a taxable estate of $10.04 million and up (after exemption). So by-pass trusts for Illinois estate taxes might still be an option for married couples whose estates are larger than $4 million.
While many clients may not now worry about paying estate taxes, proper trust planning could still protect assets in divorce. For example, should clients still rely on marital bequest? Due to the increase in the estate exemption, some clients may decide that a qualified terminable interest trust (QTIP) or other marital bequest is preferable to a credit shelter trust because assets receive a second basis step-up on the surviving spouse’s death. This is especially true if the stepped-up basis of the assets and aggregating all the assets in the surviving spouse’s estate still results in an estate lower than the new exemption amount. The problem is that while this planning may make sense for estate planning, it may not make sense if a divorce happens. This is because many credit shelter trusts include the children of the marriage as beneficiaries whereas a QTIP cannot. If a QTIP is used and one spouse dies and the survivor remarries, there will be less or even no flexibility to get distributions to the children of that prior marriage if the assets are held in a QTIP.
Alimony (Spousal Support) Changes
The primary divorce change of the TCJA is that spousal support payments will not be deductible by the payer spouse but will also not be included in income of the payee ex-spouse beginning in 2019. This change is permanent and will not sunset as many other personal income tax changes in the TCJA do. This new rule applies to any divorce or separation instrument (as defined in Sec. 71(b)(2)) executed after Dec. 31, 2018, or for any divorce or separation instrument executed on or before Dec. 31, 2018, and modified after that date, if the modification expressly provides that the TCJA amendments apply.
Under the pre-TCJA law an alimony trust could have been used in a divorce to minimize the interactions of the former spouses. If a family business was involved, the alimony trust could have been used to hold interests in the business to protect the business interest while securing the interests of the payee spouse. The TCJA now prevents the prospective use of alimony trusts in divorces after 2018 by repealing Sec. 682. Now the spouse who creates the trust will be taxed on the income under the Sec. 672(e) grantor trust rules.
Many marital and post-decree settlement agreements included negotiated provisions specifying which parent could claim which children as exemptions and in which years. The TCJA has suspended personal exemptions and instead has increased the standard deductions as a substitute for the lost personal exemptions. The elimination of personal exemption sunsets after Dec. 31, 2025. This means that for divorcing couples with young children, the dependency exemption should still be considered when drafting and negotiating marital settlement agreements. But for clients who had given up other items of value to claim exemptions under a marital settlement agreement in the past may have lost the benefit altogether depending on the age of the children.
If you have any questions about how the changes to the tax laws could affect your divorce or planning for divorce, please contact the Attorneys at Allison & Mosby-Scott at 309-662-5084.