With the 2020 Presidential and Congressional elections underway, and the potential tax reform that could ensue if the Democratic Party occupies both the White House and a majority in the House and Senate, it is important for individuals and married couples to consult with estate planning practitioners and other advisors to consider how these changes may impact their overall estate plan. The current federal lifetime exemptions, which are historically high, coupled with the economic malaise precipitated by the COVID-19 pandemic, are not likely to last forever. Accordingly, certain estate planning techniques that would utilize an individual’s lifetime exemption or hold in check the size of an individual’s federal taxable estate should be implemented sooner rather than later. This article will explore selected gift and estate planning techniques that are likely to gain traction in the coming months, including those that are most beneficial in a low-interest rate environment.
Reduction of Lifetime Exemption Amounts & Other Potential Tax Reform
The current federal estate, gift and generation-skipping transfer (“GST”) tax exemption amounts are $11,580,000 per taxpayer (or $23,160,000 for married couples) and will continue to be adjusted annually for inflation under current law. Accordingly, each person may transfer up to that amount before being subject to the federal estate or gift tax, which is currently imposed at a flat rate of 40%. However, the current exemption amounts, which were essentially doubled as a result of the 2017 Tax Cuts and Jobs Act (the “Act”), are scheduled to “sunset” or revert back to the pre-Act amounts on January 1, 2026, unless Congress acts to extend that provision.
Depending on the final outcome of the 2020 Presidential and Congressional elections, reduction of the current exemption amounts may occur much sooner than the sunset date. Specifically, former Vice President Biden has proposed decreasing the current exemption amounts to “historical norms.” While it is unclear what the specific exemption amount would be if Mr. Biden were elected, it is anticipated to return to the pre-Act amount of $5,000,000 (adjusted for inflation) at the very least, although a reduction to $3,500,000 is also possible.
In addition to a reduction in the federal estate, gift and GST tax exemption amounts, Mr. Biden has also proposed eliminating the basis adjustment of property transferred upon a taxpayer’s death. Currently, the cost basis of such property is adjusted to its fair market value upon death, which minimizes a beneficiary’s capital gains tax liability on appreciation in the property’s value that may have occurred during the decedent’s lifetime. Therefore, elimination of stepped-up basis will result in increased income tax on capital gains for those that inherit appreciated assets and choose to sell the same.
Estate Planning Techniques to Implement Before Year-End
In light of the possible tax reform that the 2020 elections may usher in, and the current economic conditions caused by COVID-19, high net worth individuals and married couples should consider implementing certain estate planning techniques now that can ultimately reduce their taxable estates in the future. Of course, the applicability of certain estate planning techniques will vary depending on an individual’s financial situation and overall goals, but perhaps the most immediate and advantageous planning option would be to utilize the historically high federal estate, gift and GST exemptions before they are reduced. Examples of how such exemptions may be used include, but are not limited to, gifting to descendants either outright or via dynasty trusts, forgiving existing intrafamily loans, Spousal Lifetime Access Trusts, and Qualified Personal Residence Trusts.
A Spousal Lifetime Access Trust (“SLAT”) is an irrevocable trust that allows a married person to gift assets to his or her spouse and descendants while the grantor-spouse is still alive. The beneficiary-spouse could receive distributions of income and principal from those assets, in the trustee’s discretion. Implementing a SLAT is advantageous because it removes the assets from the grantor’s estate, but still allows access to the gifted assets through the beneficiary-spouse as long as the parties are married and the beneficiary-spouse is living. Thus, this potential access offers an incentive to spouses wishing to utilize the current exemption amount before year-end but who may be slightly uncomfortable with making a large gift that depletes assets that might (however unlikely) be needed in the future for the care of the grantor and his or her spouse.
Similarly, a Qualified Personal Residence Trust (“QPRT”) is another estate planning technique that can help individuals or married couples utilize the current exemption amount and reduce the size of their overall taxable estates. With a QPRT, the grantor transfers his or her primary or vacation residence into a trust while retaining the right to live in the home for a term of years; at the end of the term, the home passes to the remainder beneficiaries (often the grantor’s descendants) free from gift and estate tax liability. It is important to note, QPRTs lose some of their tax advantages in low interest rate environments such as we have now since the present value of the beneficiaries’ remainder interest is determined by the rate prescribed by Section 7520 of the Internal Revenue Code (the “Section 7520 rate”).
High net worth clients with large estates may also want to consider implementing estate planning techniques before year-end that are especially effective in a low interest rate environment like that which has resulted from the current pandemic. Unlike QPRTs, intrafamily loans, gifts or sales of interests in a family limited partnership or other family business to defective grantor trusts, Grantor Retained Annuity Trusts and Charitable Lead Trusts are more attractive options at this time.
A Grantor Retained Annuity Trust (“GRAT”) is an estate planning technique that allows a grantor to “freeze” the value of appreciating assets and transfer future appreciation on those assets to children and more remote descendants. Essentially, with a GRAT, a grantor contributes assets to an irrevocable trust but retains a right to receive an annuity for a specified term, while earning a rate of return as specified by the Section 7520 rate. Thus, if the contributed property appreciates or produces income that outperforms the Section 7520 rate, which is more likely when interest rates are low, and the grantor survives the GRAT term, then the remaining assets are distributed to the trust’s beneficiaries with little to no estate and gift tax liability upon expiration of the GRAT term. In the event the contributed assets do not appreciate as anticipated, then the annuity payments to the grantor will exhaust the GRAT assets and nothing will pass to the remainder beneficiaries; however, there are generally no adverse effects to a grantor’s taxable estate in this scenario as minimal gift or use of the grantor’s lifetime exemption is made.
Finally, for those individuals who are philanthropically inclined, creating a Charitable Lead Trust (“CLT”) may be beneficial. A CLT is an irrevocable trust that pays an annuity to a specified charitable organization for a set term during the grantor’s lifetime, and upon expiration of that term, the balance of the trust is available to the trust’s beneficiaries. CLTs work best in a low-interest rate environment because a lower interest rate reduces the taxable portion of the grantor’s gift to the remainder beneficiaries, and the assets in the CLT may appreciate at a higher rate.
Although the outcome of the 2020 Presidential and Congressional elections is uncertain, the estate planning techniques available now to take advantage of the current exemption amounts and low interest rates are clear. Further, any reduction in the current exemption amounts that could occur as a result of the elections, even if passed during the latter part of 2021, could be made effective as of January 1, 2021. Therefore, individuals should plan accordingly and consider implementing one or more of the above-mentioned strategies before year-end, even if the trusts are not fully funded at that time. This “wait and see” approach will be particularly helpful to individuals after the election because if it becomes necessary to make significant gifts, then the vehicle to do so is already in place and transfers may be properly completed before year-end.
This article was published in the Fall 2020 edition of Philadelphia Estate Planning Council. The article was written by William C. Hussey, II and Franca Tavella.