Gazing into the Sunset: Preparing for Big Tax Changes after 2025

In addition to lowering the top marginal tax rate for individuals from 39.5% to 37%, TCJA also:

• doubled the estate tax exemption (currently $12.92 million or $25.84 million for married couples), greatly reducing the number of estates liable for taxation on transfers of wealth from one generation to the next;
• nearly doubled the standard deduction (currently $13,850 or $27,700 for married couples);
• instituted a 20% pass-through tax deduction for qualified business income (QBI) applicable to sole proprietorships, LLCs, partnerships, and S corporations;
• greatly increased the threshold at which the alternative minimum tax (AMT) applies to taxpayers;
• and a number of other major changes.

But, of course, TCJA wasn’t only about providing new benefits to taxpayers. The act also eliminated or steeply reduced the availability of certain longstanding deductions, including:

• eliminating the personal exemption;
• limiting deductions for state and local taxes (SALT) to a total of $10,000;
• reducing the mortgage interest deduction to the first $750,000 of mortgage debt.

All that said, most analysts have concluded that TCJA lightened the overall tax burden on most American taxpayers. But the provision of the act that is coming into closer focus as time goes on is the so-called “sunset provision,” which calls for most or all of the TCJA’s provisions to revert back to their prior conditions at midnight on December 31, 2025. Unless Congress passes new legislation and the president (whoever that is at the time) signs it into law, the provisions of the Tax Cuts and Jobs Act of 2017 will no longer be governing law, beginning in 2026.

One might think, since we’ve known about the sunset provision since 2017, that there would have been more than adequate time to prepare for the change in the law. But remember the phrase above: “Unless Congress passes new legislation and the president signs it.” In other words, efforts to plan around the 2025 sunset of TCJA are greatly complicated by our inability to predict what the political and legislative landscape will look like two or three years from now. On the other hand, taxpayers who wait until the picture is “clear” (if that ever happens) may find themselves at a disadvantage when the sun rises on the year 2026. With that in mind, let’s take a look at four major implications of the TCJA sunset provision and consider some planning alternatives taxpayers may want to think about as we move toward the coming changes.

Estate tax exemption

One of the most heralded changes wrought by TCJA was the dramatic rise in the exemption from estate taxes. By some estimates, the number of estates subject to tax fell by more than half, from some 5,500 in 2017 to around 2,000 in 2018. By basically doubling the size of estates subject to the wealth transfer tax, the TCJA created a flurry of activity for estate planners, grantors, and others.

Gifting

The sunset provision appears likely to stimulate another flurry, perhaps in the opposite direction. In preparation for the drastic reduction in the exemption indicated for 2026, it may be advisable for estates near or above the prior threshold ($5 million, adjusted annually for inflation) to give increased attention to their annual gifting plans, since the IRS has indicated that claw-back provisions for conforming gifts made prior to the sunsetting provisions are unlikely. In 2023, you can gift up to $17,000 per individual to as many persons as you like (couples can gift up to $34,000), with a lifetime exemption equal to the estate tax exemption, $12.92 million ($25.84 million for couples). Gifting is a relatively simple way to reduce the size of the taxable estate without creating an additional tax burden for the recipients. Be sure to consult with your tax advisor in connection with any planned changes in your gifting strategy.

Trusts

Prior to TCJA, credit shelter trusts (CSTs) were a popular way to maximize the available deductions for the estate of a married couple. This strategy may be important to revisit in light of the sunsetting provision. Irrevocable trusts are another legal structure that may become more useful, including the use of life insurance to fund potential future estate tax liability (allowing beneficiaries to avoid the necessity of disposing of illiquid assets). For high-net-worth individuals, now is probably the time to schedule a meeting with estate planning professionals and investment advisors to review planning documents in light of the impending changes.

Increased marginal rates and capital gains

Absent new legislation, the top marginal rate will go from 37% back to 39.5% for tax year 2026. Additionally, the tax rate for capital gains, which was decoupled from marginal rates by TCJA (based upon income), will be “rejoined” to tax brackets unless new legislation is passed. In other words, for taxpayers in the highest marginal bracket, capital gains will be taxed at 20%.

Roth conversion

If you believe your tax bracket will rise in 2026, you may be well advised to convert traditional IRAs, 401(k)s, and 403(b)s to Roth plans. While you will have to pay taxes on the converted amounts, you’ll be doing so at potentially lower rates now than after the sunset. And converting to a Roth account means that when you begin withdrawing funds in retirement, there will be no tax due.

Capital gains “harvesting”

If you believe you may be in a higher bracket for capital gains in the future, it could make sense to sell appreciated assets and recognize the gain now, while rates are lower. Further, since the wash sale rule only applies to harvested losses, you can immediately re-purchase the asset to establish a higher cost basis, in anticipation of continued, future gains in value.

Small businesses and QBI

Unless new legislation passes, the 20% tax deduction for qualified business income (for proprietorships, partnerships, LLCs, LLPs, and S corporations) will go away after 2025. For certain businesses, the loss of the deduction and potentially higher personal taxation may make it worthwhile to explore reorganizing as a C corporation. While C corporations will retain the current 21% tax rate, they will remain subject to “double taxation,” paying as a corporation, and again at the individual level when income is distributed from the company. It may also be advisable for pass-through entities like those mentioned above to recognize as much income as possible until the sunset provision takes effect. Here again, potentially affected business owners should consult with their tax and legal experts about the advantages and disadvantages of these strategies.

Alternative Minimum Tax

Passage of TCJA radically altered the thresholds at which taxpayers became subject to the alternative minimum tax (AMT). As a result, according to the Tax Policy Center at the Brookings Institution, the number filers subject to the AMT went from more than 5 million in 2017 to some 200,000 in 2018. Unless the law changes prior to the 2025 sunset, many more taxpayers can expect to pay AMT.

Incentive Stock Options

One event that often creates AMT liability for taxpayers is the exercise of stock options. Because the AMT considers the receipt of stock as income to the taxpayer when the option is exercised (not when the stock is sold), it may be advantageous for persons holding options on highly appreciated stock to exercise their options prior to the sunset. This is a complex decision, however, as it involves considerations about the likely future trajectory of the stock price, future tax bracket projections, and other factors. People considering this strategy should consult with their investment and tax advisors before exercising their options.

At Modera Wealth Management, keeping our clients well informed is a core value. As you consider the implications of the TCJA sunset provision and other impending changes, you may have questions pertaining to your estate plan, your investment strategy, or other important aspects of your overall financial plan. We want to help you find the answers you need. To learn more, visit our website to read our article, “2023 Tax Planning Strategies.”

Buen Camino!