As a result of the election, and with a new Congress and administration, many clients are wondering about potential changes to the estate and gift tax, as well as the changes that may occur to the income tax. Clients who used up their exemptions in 2020 may want to “top off” their gifts in 2021 to reflect the indexed increases of $120,000, and those who did not fully use their exemptions in 2020 may be interested in doing so now. This alert discusses the potential changes to the estate, gift and generation-skipping transfer (“GST”) taxes, and notes some potential income tax changes.
Increased Exemptions at Risk. Tax legislation in 2017 doubled the estate, gift and GST tax exemptions temporarily, resulting in exemptions of $11.58 million ($23.16 million for a married couple) in 2020, increasing with inflation to $11.7 million ($23.4 million for a married couple) in 2021. The exemptions will continue to increase with inflation through the end of 2025, but will then be cut approximately in half beginning in 2026, even if no action is taken by Congress and the President.
The potential planning that could be done (and which would probably be deferred until 2025, when the scheduled January 1, 2026 gift/estate tax exemption “sunset” is much closer) would include doing lifetime gifting of assets using the currently high gift tax exemption amounts to an irrevocable trust for a spouse and/or in trust or outright to descendants or others.
As discussed previously in our alerts, President Biden has expressed an intention to decrease an individual’s federal estate tax exemption amount either to $5 million per individual ($10 million for a married couple), possibly indexed for inflation, or to the pre-Tax Cuts and Jobs Act amount of $3.5 million per individual ($7 million for a married couple). This decrease in lifetime exemption could be coupled with an increase of the estate and gift tax rate from 40 to 45 percent.
A reduction of the estate and gift tax exemption could also affect taxpayers wishing to leave substantial amounts to grandchildren or to trusts that will eventually pass to grandchildren or lower generation beneficiaries. A federal GST tax can apply to these transfers in addition to the estate and gift tax. The amount of the exemption from the federal GST tax is equal to and tied to the amount of the estate and gift tax exemption. Any reduction in the estate and gift tax exemption, therefore, will reduce the GST tax exemption by the same amount.
In addition, previous tax proposals included limitations on certain estate planning techniques that currently allow a taxpayer to leverage the use of estate and gift tax exemption to transfer wealth to lower generations, such as grantor retained annuity trusts, sales of assets to grantor trusts, and valuation discounts on transfers of partial interests in family-controlled business entities. While it is unclear whether these limitations will be part of future tax proposals, taxpayers should recognize both that these wealth transfer tools might be limited in the future, and that they are particularly useful today for certain wealthy taxpayers due to currently low interest rates, as we discussed recently (see here ).
Additionally, the Biden plan might repeal stepped-up basis on death and might tax unrealized capital gains at death at the proposed increased capital gains tax rates. Although transfer tax rates have gone up and down, transfer tax exemption amounts have never decreased before and prior attempts to repeal stepped-up basis on death have not been successful. Treasury Secretary Yellen has also recently signaled that Congressional action related to the pandemic and economic stimulus should take priority over tax law changes, and other administration figures have signaled that retroactive tax increases are not preferred.
Why Make a Gift? As we noted in a recent alert (see Time to Plan for Year-End Gift) there are compelling reasons to consider accelerating your estate plan through 2021 lifetime gifts. None of Idaho, Oregon or Washington imposes a gift tax at the state level, and making gifts during lifetime will avoid the Washington or Oregon estate tax at death. (Note that the Washington and Oregon estate tax applies to individuals who own property in the state as well as to domiciliaries.) We also addressed elsewhere other benefits of making gifts to use the current high gift exemption before any possible change in law (see Is Now the Time to Use Your Lifetime Exemption?). One traditional disadvantage of lifetime gifts—the loss of step up in basis at death—would be a nonissue if the step up in basis at death is repealed by new legislation.
Effective Date of Tax Law Changes. Typically, tax legislation is prospective, and might not be effective until January 1, 2022 or later (depending upon how long the process takes). In some cases, however, tax legislation is retroactive, in which case it would either be effective as of its date of introduction (perhaps in March) or possibly even effective as of January 1, 2021.
There is some precedent in previous court cases that suggests such a retroactive law lowering exemption amounts would be constitutional, but it should be noted that this precise issue has not been litigated before and its outcome would be uncertain. Still, much case law points to the fact that a retroactive change would be approved by courts, except in a situation where the taxpayer had no reason to think that the tax treatment would later change. Given the amount this topic has been discussed, an argument that the taxpayer could not have foreseen the change may not be persuasive.
Although many high-net-worth individuals are contemplating additional planning in 2021 to use more or all of their remaining estate, gift and GST tax exemptions before a potential reduction in those exemption amounts (currently $11.7 million and $23.4 million for a married couple), one reason to proceed with some amount of caution is the possibility that any change to these tax regimes may be retroactive to January 1, 2021. In other words, a retroactive reduction in exemption amounts to, for example $3.5 million or $5 million, could cause otherwise gift-tax-free transfers retroactively to be subject to a large amount of gift tax.
Ability to Adapt if Changes Are Retroactive. If reductions to the gift, estate and GST tax exemption amounts are made retroactive to January 1, 2021, what can clients do if they made gifts in 2021, prior to the enactment of these changes in law? Clients contemplating such gifts should speak with a professional advisor to discuss possible unwinding of estate planning in order to avoid an unintended gift or GST tax. For example, the client could consider disclaimer planning, including allowing the trustee, or one beneficiary of a trust, to disclaim on behalf of all trust beneficiaries. This plan should provide the designated beneficiary with nine additional months to disclaim the gift and, if the designated beneficiary does so, the result should be that the gifted assets are returned to the client without using any of the client’s gift and/or GST tax exemption.
Clients could also consider planning with qualified terminable interest property (“QTIP”) elections. A married client could make a gift to a trust, such as a Spousal Limited Access Trust (“SLAT”), as discussed in a recent alert. The SLAT would be for the benefit of a U.S. citizen spouse and qualify for the marital deduction if a QTIP election is made or, if no election is made, would instead pass to a non-qualifying trust for the spouse that would use up the donor spouse’s lifetime exemption. This plan provides the donor spouse with flexibility about making the QTIP election when the related gift tax return is due in 2022, depending on whether any reduction of the gift and/or GST tax exemption amount is made retroactive to January 1, 2021.
Summary. Regardless of whether Congress changes the estate and gift tax exemption or GST tax exemption in 2021, current law already states that those exemptions will be halved in 2026, as noted above. Gifts of this magnitude should only be made with professional assistance and considering the client’s objectives for the client’s family and investments, not merely with tax planning in mind. Lifetime gifts can provide substantial tax and nontax benefits, whether exemptions decrease now or not. Accordingly, it makes sense to consider your options for making gifts in 2021. There are many good estate planning opportunities in times of low interest rates and market volatility, as we discussed recently (see here ). Married couples who are reluctant to part with all control or who may have future needs to use gifted assets may wish to consider a SLAT, as discussed in a recent alert. There is also a need now, as always, to review estate plans, to make sure your tax and personal objectives are being met.