There’s a real problem with this estate tax thing. It isn’t so much that the tax exists, or the exemption amount, or the tax rate (although you may justifiably have an issue with any of those). Rather, the problem it presents is that clients are compelled to make major planning decisions today relying on current estate tax law, while they (hopefully) won’t be passing away for a long time into the future. In the interim, of course, we can likely expect there to be many more changes to the law. It wouldn’t be so bad if changes were infrequent, gradual, or otherwise predictable in some way, but the trend seems to point in the direction of increasingly frequent, and perhaps more dramatic shifts in the law. Thus, clients are in the position to look at today’s law as well as proposed changes and seek to use their best judgment as to whether now is the time to act.
Our current estate tax law, enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA), set a historically high estate tax exemption (now approximately $11.7 million or $23.4 million for a married couple). The exemption can currently be used during lifetime (the ‘gift tax exemption’) or at death, with lifetime gifts counting against the amount available at death. This provides a tremendous opportunity to efficiently transfer wealth to future generations. To no one’s surprise, following the 2020 elections, several proposals have been made to reform the estate tax system. Keep in mind that legislative proposals often do not become law, but below are some of the most noteworthy proposals:
- Election Promises:During the 2020 campaign, then-candidate Biden proposed reducing the estate tax exemption amount from approximately $11.7 million to $3.5 million for an individual or from $23.4 million to $7 million for a married couple. Although not explicitly stated, it was also assumed that the lifetime gift tax exemption would be reduced from $11.7 million to $1 million. These proposals were recently reaffirmed by Treasury Secretary Yellen in congressional testimony. President Biden also proposed increasing the estate tax rate to 45% from the current 40% and eliminating the step-up in basis at death (discussed below). For a married couple with $25 million of assets, their potential estate tax liability would rise from roughly $640,000 under the current system to approximately $7.65 million under President Biden’s proposal. This proposal, of course, set off a wave of planning discussions in 2020, with clients wanting to use their exemption before potentially losing it.
- Proposed Legislation: Senator Bernie Sanders has proposed fairly comprehensive legislation reforming the estate and gift tax system. While some of Senator Sanders’ legislative proposals could be considered to be constitutionally dubious, far-fetched, or otherwise having a low probability of passage (such as an annual wealth tax), some of his ideas have been proposed by others, including Senator Elizabeth Warren, several times in the past and may ultimately be used as new legislation is crafted. Some of the more ‘mainstream’ proposals include limiting and simplifying annual exclusion gifts (the current law allows for annual $15k gifts to everyone and anyone a person desires without the use of lifetime exemption), putting limits on how long a trust can be exempt from the generation-skipping transfer tax (basically 50 years), the inclusion of ‘grantor trusts’ (trusts where the grantor pays the income tax for the trust) in the estate of the grantor and treating distributions from grantor trusts as gifts from the grantor (for trusts created after enactment). Additional proposals include restrictions on Grantor Retained Annuity Trusts (GRATs) that would make GRATs significantly less efficient for transferring wealth, eliminating discounts for lack of marketability and lack of control for family entities like FLPs and family LLCs, and a graduated estate tax system that would raise rates more aggressively than President Biden’s proposal for the ultra-wealthy.
- Basis Proposals: Both President Biden and other Democrats have proposed elimination of the ‘step-up in basis of assets at death, and some (including President Biden at least at one point) have gone further to propose a ‘realization event’ at death. This is a subject that deserves a bit of attention, as the step-up in basis is probably a bit of an under-appreciated aspect of the transfer tax system. First, what is the “step-up in basis”? It is the elimination of gain (and associated capital gains tax) in assets as of the moment of death. So, if a person owns a share of stock trading at $11 on the day of his or her death, but that share was originally purchased at $1, the $10 of gain is forgiven, so that if the client’s son or daughter sells the share the next day for $11, there is no associated capital gains tax. The step-up in basis is often viewed as a trade-off for the estate tax system. Yes, you may have to pay estate tax if your estate is large enough, but at least your heirs get the benefit of a new fair market value basis, so they are not as burdened by capital gains taxes going forward. To an extent, this takes away from the traditional argument that the estate tax represents double taxation. Less appreciated, perhaps, is the role of the step-up in basis in the administrative area. In other words, the step-up in basis prevents you (and the government) from having to keep track of the basis of every knife, fork, and spoon that you own throughout your lifetime because that issue will be ‘cleaned up’ by receiving a new basis as of the date of death. The US has tried eliminating the step-up in basis before, most recently in 2010 when we had a one-year pause on the estate tax. In that year, as well as in the late 1970s when legislation eliminating the step-up in basis was passed (but ultimately repealed), complaints about the complexity and administrative burden of the ‘carryover basis’ system ultimately resulted in the reinstatement of the step-up in basis.
By now you may be making the observation that none of these proposed changes seem very good for a wealthy individual, and we are unable to present an argument to that point. So where is the dilemma? Why not act now to use the $11.7 million exemption before it potentially gets reduced? Clients (particularly those in a certain wealth range roughly between $7 million and about $30 million) face a trio of challenges:
- I Don’t Want to Give it Away Yet: In order to take advantage of today’s exemptions and rates, you have to actually give away the assets. If you have $20 million in assets today, you certainly don’t want to give away the full $20 million to your children, or to trusts for them, because that could leave you destitute. Additionally, your children may not be ready to inherit significant wealth just yet. On these points, at least for married couples, there are planning techniques that should be discussed. One popular strategy is a Spousal Lifetime Access Trust (SLAT) that allows a spouse to be the beneficiary of a trust holding the assets that have been given away.
- Retroactivity: What if you make a gift today using some of your exemption and then Congress passes a change to the exemption amount retroactive to January 1, 2021? This possibility certainly drove a lot of clients to their estate planning attorneys at the end of 2020. However, the possibility of a retroactive change to the estate and gift tax system, particularly as we get further and further from January 1, 2021, is generally considered by most commentators to be remote. The Biden administration has not yet expressed an interest in making changes retroactive, and there are strategies that can be developed to lessen the risk of planning this year.
- Basis Issues Again: The downside of making gifts during a person’s lifetime is, and has always been, that you do not get the advantage of the step-up in basis at death (because you don’t own the assets anymore). The step-up in basis does not apply to gifts, so whatever basis you have gets carried over to the recipient of the gift. Therefore, when making a large gift, an often challenging comparison is made between the potential estate tax savings versus the potential loss of the step-up in basis. Why is this analysis so difficult? There are a lot of moving or unknowable factors:
- What is the basis of the assets being gifted?
- How much will they grow in the future?
- How long will you live?
- When will your heirs sell the assets?
- Will Congress and the President eliminate the step-up in basis anyway?
- What will the income and estate tax laws be for your heirs when they pass or sell the asset?
Needless to say (but of course I will anyway), wealthy clients need a team of sophisticated financial, legal, and accounting advisors to help navigate through these issues. The good news is that it is still a historically good time to plan. We certainly welcome the opportunity to assist.