The big question in the estate planning world today is whether, when, and to what extent Congress will enact changes to gift, estate, and income tax laws. With many challenges facing the new Biden Administration, and the narrowly Democratic Senate, major tax legislation may not even be considered in 2021. Nevertheless, the tax proposals endorsed by the Biden Administration provide clear signals for actions clients should consider this year.
- The time to gift is 2021—change is on the horizon.
- The timing and extent of potential changes to gift and estate tax laws are unclear.
- Some potential changes include: reducing the exemption, increasing the estate tax rate, increasing the capital gains tax rate, and eliminating the basis adjustment.
- Consider “locking in” the $11.7 million exemption by gifting to irrevocable trusts and continuing to take advantage of low interest rates to shift appreciation out of your estate with techniques such as GRATs and intra-family loans.
- Retroactive changes are unlikely; expect changes to take effect January 1, 2022, at the earliest.
Potential Legislative Tax Changes With Greatest Impact on Wealth Transfer
While campaigning, President Joseph Biden proposed lowering the current $11.7 million exemption amount to $3.5 million per individual and increasing the estate tax rate from 40 percent to 45 percent on amounts exceeding the exemption. Lowering the exemption to $3.5 million is ambitious on its own, given the need for support from moderate democrats with large Republican bases. Instead, Congress may simply revert back to $5 million, adjusted for inflation, which was the exemption amount before the substantial increase enacted under the Tax Cuts and Jobs Act of 2017 (TCJA).
For what it’s worth, the exemption has never been lowered. Despite this, the doubling of the exemption under the TCJA was a dramatic departure from past policies. Thus, reducing the exemption to $5 million, adjusted for inflation, seems easier to agree on. In other words, Congress may opt to treat the last four years as a fluke and return to “normal.”
The Biden team also signaled during the campaign that it would seek repeal of the basis step-up at death and tax capital gains as ordinary income. Although the basis step-up is an income tax planning concept, it is also an important consideration in transfer tax planning. Under current law, gifts of low basis assets can be detrimental because the donee receives the donor’s basis. Taxpayers often decide to retain certain low basis assets, rather than sell them or gift them, to obtain the basis step-up at death. The family members or trusts receiving those assets then can sell those assets with little or no capital gains tax.
The Biden campaign had proposed to eliminate this basis adjustment. An alternative proposal involves treating the transfer of appreciated property at death or by gift as a taxable event causing the gain to be recognized, but commentators think this is unlikely.
The Biden campaign proposal to tax long-term capital gains and qualified dividends as ordinary income on all income over $1 million would further exacerbate the impact of a repeal of the basis step-up. It’s possible, too, that Congress could increase the current top ordinary income tax rate from 37 percent to 39.6 percent.
Planning for the Year Ahead
This year is an opportune time to make the most of your estate and gift tax exemption and the low interest rate environment.
“Locking In” the Estate and Gift Tax Exemption
Many ultra-high net worth individuals have used most, if not all, of their exemption. Under current tax laws, in 2021, individuals may gift up to $11.7 million during their lives ($23.4 million for married couples). If the exemption is decreased from $11.7 million to $3.5 million and the estate tax rate is raised from 40 percent to 45 percent, the cost of inaction is nearly $3.7 million (if an individual makes a gift of $11.7 million while the exemption is $3.5 million and gifts beyond the exemption are taxed at a rate of 45 percent, the resulting gift tax amounts to roughly $3.7 million; $7.4 million for married couples). If individuals and married couples have not used their exemption(s) and can afford to, they should give serious consideration to completing gifts equal to their remaining exemption(s) in 2021, ideally to a generation-skipping trust for the benefit of their descendants.
Depending on your and your family’s goals, circumstances, remaining exemption, and cash flow needs, gifting up to $23.4 million, or even $11.7 million, to a trust for your beneficiaries may not be feasible. A long-accepted way to address this concern is to create a trust that benefits both the Grantor’s spouse and descendants. These are commonly referred to as Spousal Lifetime Access Trusts (SLATs). A SLAT is a simple and effective way to address the possible need of the senior generation to access the property transferred—it provides direct access for the beneficiary spouse and indirect access for a Grantor spouse. Grantor Trust provisions, such as ones allowing the Grantor of the trust to swap assets or take loans from the trust, offer tax flexibility and access to funds by loan.
SLATs have become so popular that couples have created trusts for each other. This is not without risk and should only be done with different trust provisions and with creation of the trusts separated in time. Finally, it is important to remember that potential estate tax savings should never be the sole determinate of your financial planning decisions. Individuals who have stretched themselves thin to make significant gifts sometimes have profound “gifter’s remorse.” Thus, make gifts if you can, but, more importantly, make them if you’re comfortable doing so.
Freezing the Size of the Estate
Perhaps you and your spouse have already utilized your exemptions and are seeking ways to further reduce the tax burden on your estate or you are not ready to commit large transfers of your property. In either situation, an excellent alternative is to freeze the growth of your estate with strategies like Grantor Retained Annuity Trusts (GRATs) and installment sales with trusts or family loans. GRATs and installment sales have thrived in the low interest rate environment (as we previously wrote about) because assets have often grown in value at a rate above the rate of the annuity, in the case of GRATs, or the interest rate on a note. Thus, these strategies essentially “freeze” the size of one’s estate and transfer significant appreciation, which would have otherwise remained in the client’s estate, out of his or her estate.
Uncertainty Doesn’t Preclude Planning
It is absolutely within Congress’ power to enact retroactive tax legislation if it is rationally related to a legislative purpose, but on a practical level, Congress usually avoids doing it. It is almost always unpopular and adds only nominal additional revenue for budgeting purposes. Biden Administration officials already have stated they are not interested in seeking retroactive tax changes.
Given the low probability, the threat of retroactive tax law changes should not prevent clients from implementing new estate planning strategies. For those who remain worried, a number of strategies can be structured in a manner that limits potential gift tax liability in the unlikely event legislative changes are enacted retroactively. In 2021, clients should consider reviewing their existing plan to determine whether they can employ certain strategies to maximize use of their exemption and achieve their planning objectives.