August 2020
The Ballooning Deficit. The Congressional Budget Office estimated a $3.6 trillion addition to the national debt for 2020. And that was in April 2020. The pandemic will add trillions more to the deficit. Regardless of what happens in November’s election, people are going to start talking again about “the elephant in the room.”
Low Hanging Fruit. One source for additional revenues is estate tax reform. The amount of assets that a married couple can shelter from federal estate or gift taxes through what is referred to as the “applicable exclusion amount” or “AEA” is currently $11,580,000 (indexed for inflation) per person or $23,160,000 for a married couple.[1] The AEA had doubled pursuant to the Tax Cut and Jobs Act of 2017 and, importantly, will revert to its original amount even without any legislative action on January 1, 2026.
Even at half the current AEA, the AEA would still be high compared to historic norms. Lowering the AEA even further than half may therefore be considered “low hanging fruit” in addressing the deficit. For instance, many pundits believe that the AEA could be reduced to $3,500,000 per spouse. The estate tax rate of 40% for assets beyond the AEA could also increase. Other potential changes include (1) a partial or full repeal of the income tax step-up-in basis that typically occurs on death, (2) a change in the laws governing certain methods used to reduce taxable estates, (3) taxing unrealized appreciation at death, (4) restricting the use of some valuation discount techniques and (5) restricting the use of some grantor trusts, such as intentionally defective grantor trusts, as a planning tool.
When is the Earliest that any Change Can Occur? It is possible that changes will be made as part of a sweeping array of new legislation in the Spring of 2021. There is also precedence for the changes to be made retroactive to January 1, 2021. It has been done in the past in a process affirmed by the U.S. Supreme Court.[2]
What Should Taxpayers Consider? As a result of the potential for significant changes, people with combined assets of more than $7,000,000 may want to consider estate tax reduction strategies. Although a complete discussion of the techniques is beyond the scope of this Client Alert, a few techniques to consider include: (1) the sale[3] or gifting of appreciating assets to family members, including through the use of a family LLC or an intentionally defective grantor trust (“IDGT”), (2) using an irrevocable life insurance trust (referred to as an “ILIT”) to shelter insurance proceeds from estate tax inclusion and taxation and (3) employing a grantor retained annuity trust (“GRAT”) which is an irrevocable trust into which the grantor makes a gift and retains a stream of annuity payments. If the grantor survives the term of years, all GRAT assets should be excluded from the grantor’s estate.
How Soon Should Taxpayers Consider Taking Action? Taxpayers should consider taking action by the end of the year, particularly if the Democrats sweep in November. As discussed above, tax legislation passed in 2021 can be made retroactive to January 1, 2021. While we never advise that clients act rashly, an important consideration is the impact of what is referred to as the “clawback rules”.
In November 2018, the Treasury revised Reg. §20.2010-1 to protect taxpayers from being whipsawed if the AEA is reduced in half. For example, and without considering any increase in the AEA due to inflation, assume that Fred makes taxable gifts of $9 million before the AEA is reduced in half, all of which were sheltered from gift tax by his available AEA. If Fred dies after 2025, when the AEA is scheduled to revert to $5 million (under existing tax laws as discussed above), Fred would still have the benefit of the $9 million AEA. IRS can’t “clawback” the $4 million portion of the AEA that Fred previously used which exceeds the new AEA of $5 million.
The difference is even starker if the Democrats sweep and the AEA is reduced even lower, e.g., to $3,500,000. Thanks to the clawback rules, if a taxpayer used his or her entire $11,580,000 AEA by gifting assets in 2020 and the law changed reducing the AEA to $3,500,000, the difference of $8,080,000 would essentially amount to a windfall. The unique planning opportunity is staggering, particularly when you consider that interest rates are historically low[4] and the valuation of certain assets has been reduced as a result of the pandemic.
A More Cautious Approach. Many taxpayers will, not surprisingly, balk at taking significant action in 2020 without knowing the outcome of the election. In addition, people are often hesitant to take more aggressive planning for fear of losing control over the transferred assets.
To be sure, there are techniques available to benefit from assets sold or gifted and to minimize the loss of control. For instance, a donor’s spouse could be a beneficiary of a type of IDGT referred to as a Spousal Lifetime Access Trust (“SLAT”). Trust protector provisions can be utilized for even greater rights to gifted assets, including potentially revising the SLAT at some point after formation to include the donor as a beneficiary. Another strategy applicable to certain assets is creating non-voting interests to gift while retaining control over the voting interests.
We suggest that clients, at a minimum, begin to familiarize themselves with the potential need for more aggressive estate tax reduction strategies. The strategies are complicated and take time to understand and implement. Appraisals are often recommended, depending upon the type of asset. The November election will be quickly followed by the holiday season, and there may not a lot of time to react before 2021 without taking some pre-planning steps prior to the elections.
Summary. In summary, we recommend that taxpayers at a very minimum consider the impact of a changing tax landscape on their wealth transfer plans. While a wait and see strategy is often prudent, you should at least talk to your estate, tax and financial planning advisors to prepare in case it becomes necessary to act quickly.
We hope that this Client Alert provides some guidance, although please understand that the Client Alert does not represent a full discussion of the issues. Please contact our firm if you have any questions and we wish that you and the members of your family and business stay safe and healthy.
This Client Alert is intended as an introduction only to the topics addressed – it is not a full discussion of the issues presented. Let us know if you want to discuss the issues in this Client Alert in greater detail or if you have other questions.
DISCLAIMER. This Client Alert does not provide legal advice. We are providing it for general informational purposes only.
[1] The AEA can also be used to shelter taxable gifts from gift taxes. Estate and gift taxes are part of a “unified” system with any AEA applied during lifetime to shelter taxable gifts reducing the amount available upon death.
[2] In Welch v. Henry, the Supreme Court said: “Taxation is neither a penalty imposed on the taxpayer nor a liability which he assumes by contract. It is but a way of apportioning the cost of government among those who in some measure are privileged to enjoy its benefits and must bear its burdens. Since no citizen enjoys immunity from that burden, its retroactive imposition does not necessarily infringe due process, and to challenge the present tax it is not enough to point out that the taxable event, the receipt of income, antedated the statute.” Welch v. Henry, 308 U.S. 134, 146-147 (1938) (emphasis added).
[3] Sales price can at least partially be paid through a promissory note, even including a note that self-cancels upon the seller’s death (aptly referred to as a self-cancelling installment note or “SCIN”).
[4] Interest rates are important for determining the impact of certain tax transactions.