EVERYTHING OLD IS NEW AGAIN:
PLANNING FOR ESTATE TAX INCREASES
Clients need timely counsel regarding their wealth management, and we should endeavor to keep them informed regarding potential tax changes on the horizon. While we do not know what the future holds, we do have some indications as to potential future tax laws as a result of the recent elections.
Much of what we know about the potential tax landscape under the new majority has been pieced together from reviewing campaign speeches and debates, interviews with candidates, and drafted legislation waiting to be introduced into the new Congress. Importantly, many of the changes discussed below could be implemented with bipartisan support as the nation grapples with economic pressures stemming from the ongoing coronavirus pandemic.
POSSIBLE LEGISLATIVE CHANGES
Currently, the estate and gift tax exemption is $11.7 million with any wealth over that amount taxed at a 40 percent rate as it passes to heirs. This exemption amount is scheduled to be lowered to $5 million (adjusted for inflation) on December 31, 2025, unless new legislation is passed before then. Furthermore, President Biden has suggested that he would support legislation to reduce both the estate and GST tax exemptions to $3.5 million per individual and would lower the lifetime gift tax exemption to $1 million.
In addition to reduced transfer tax exemption amounts, some tax reform proposals include returning estate tax rates to historic norms. In the 1940s, the top estate tax rate was 77 percent, and under a 2001 federal tax law, it was as high as 55 percent. Therefore, in addition to reduced exemption amounts, we could see an upward adjustment in the transfer tax rates!
CAPITAL GAINS TAXES
Presently, taxes on capital gains are treated as regular income if those gains are realized on property held for less than one year. For long-term capital gains (gains on property held for one year or longer), there is a graduated tax rate (maximum rate of 20 percent) depending upon the tax filer’s income level. For individuals and couples who earn more than $200,000 and $250,000 per year, respectively, in net investment income, there is an additional 3.8 percent surtax added to their capital gains tax rate.
Additionally, the current law allows for a step-up in basis to the date-of-death value on appreciated property transferred after the owner dies. This allows for selling or liquidating inherited property shortly after the death of an individual with little to no capital gains taxes assessed on the sale of the property.
President Biden has proposed changes that would either limit the step-up basis rule for inherited property and impose a carryover basis rule for inherited property or impose recognition of gain on property at the owner’s death. Additionally, there are proposals imposing a 39.6 percent long-term capital gains tax rate on individuals earning more than $1 million per year. If the law leaves the 3.8 percent surtax on net investment income in place, the effective top federal tax rate on long-term capital gains could reach over 43 percent!
If these changes are implemented along with the changes to the estate tax exemptions and rates, many estates could see significant tax bills at date of death. There are, however, a number of possible estate planning strategies one can implement now to mitigate the deleterious effects of these potential tax law changes. Three strategies that we suggest clients consider are: (1) GRATs, (2) SLATs, and (3) ILITs.
GRANTOR RETAINED ANNUITY TRUST
A properly structured grantor retained annuity trust (GRAT) allows a client to transfer more property to beneficiaries at a lower gift tax value than if the client were to make gifts outright to those same beneficiaries. GRATs are excellent estate planning techniques that are still available today. After the donor transfers property to the GRAT and until the expiration of the initial term, the trustee of the GRAT (often the donor for the initial term) will pay the donor an annual annuity amount. The annuity amount is calculated using the applicable federal rate as a specified percentage of the initial fair market value of the property transferred to the GRAT. The donor’s retained interest terminates after the initial term, and any appreciation on the assets in excess of the annuity amounts passes to the beneficiaries. In other words, if the transferred assets appreciate at a rate greater than the historically low applicable federal rate (currently 0.6%), the GRAT will have succeeded in transferring wealth. Ideal clients for GRATs would be those who want to pass assets to their descendants but need some income from those same assets during life.
SPOUSAL LIFETIME ACCESS TRUST
The spousal lifetime access trust (SLAT) strategy requires that a client make a gift of property into an irrevocable trust for the benefit of the client’s spouse (as a beneficiary of the trust) and other beneficiaries (children or grandchildren). The trust names a trustee who has discretion to make distributions among the various beneficiaries. The transfer to the trust is intentionally designed not to qualify for the unlimited marital deduction, thereby using the gifting spouse’s estate exemption and shielding the appreciation on the transferred property from future gift and estate tax. Furthermore, a SLAT can be drafted as a grantor trust for income tax purposes, so the trust will not pay income taxes thereby allowing trust property to grow estate tax free during the donor’s lifetime.
This strategy is designed to take advantage of the current high exemption amounts. Ideal clients for a SLAT strategy are happily married couples who own property that is expected to significantly appreciate and who can transfer such property irrevocably without jeopardizing their current standard of living. There are, however, carryover basis considerations associated with this strategy that should be carefully considered before implementation.
IRREVOCABLE LIFE INSURANCE TRUST
Although the irrevocable life insurance trust (ILIT) strategy has not been utilized as much recently, it is still a highly effective one — especially in an environment where the estate and gift tax exemption amounts may be reduced significantly in the near future in which clients are forced into a use-it-or-lose-it scenario. This technique calls for a client to transfer cash to an irrevocable trust. This cash can then be used by the trustee to purchase life insurance on the client, and when the policy pays out at the client’s death, the proceeds are paid to the trust free of income tax and may then further be distributed to the trust beneficiaries outside of the client’s estate and free of estate taxes.
Even if clients are not prepared to execute any of the above strategies, we should, nevertheless, discuss one or more of these strategies with them, so that when clients decide to engage in planning, they will be much more prepared to move quickly. Educating clients about these and other valuable wealth preservation strategies has the potential to solidly embed us as essential and trusted advisors to multiple generations of clients. By working together, we can help our clients navigate whatever changes these uncertain times may bring. Thoughtful estate planning can provide clients with peace of mind while they are living and ensure that their wealth is passed on to their loved ones in a tax efficient manner. Don’t hesitate to contact us to discuss how we can assist your clients with these and other estate planning strategies.
*The information contained in this article should be used for informational purposes only. It is not legal advice and should not be relied upon by the reader as legal advice.