The election is in the rear-view mirror leaving the U.S. with anticipated divided control of the executive and legislative branches. With the outcome of the Georgia Senate races yet to be finally determined, the possibility of no party controlling the Senate exists. President-elect Joe Biden campaigned on sweeping tax policy changes that he will have to negotiate with a Republican controlled Senate but that a Senate with the Vice-President of the U.S. casting the tie vote ought to pass. This means at this moment we cannot completely rule out the possibility of a decrease in the estate and gift tax exclusion amounts, potentially even retroactive to January 1, 2021. While post-election this seems a more difficult path for the new President, especially with a predicted Republican controlled Senate, if you remain concerned about an immediate reduction in the estate and gift tax exclusion amounts, this memorandum reviews a number of estate planning opportunities worth consideration and implementation before the end of 2020.
Estate and Gift Tax Exclusion Amount
In 2020, each individual is entitled to a tax credit against federal estate and gift taxes which enables $11,580,000 to pass tax-free (the “exclusion amount”). The exclusion amount is indexed for inflation. However, in 2026 the exclusion amount is scheduled to revert back to the 2017 level ($5,000,000), adjusted for inflation, which may be approximately $6,000,000. The estate and gift tax rate is 40%.
The exclusion amount is “portable” between spouses. Generally, portability allows a surviving spouse to elect to inherit the unused portion of the exclusion amount of the predeceased spouse, thus providing a surviving spouse with a larger exclusion amount (special limits apply to decedents with multiple predeceased spouses).
During his campaign, Joe Biden proposed turning back the clock on the estate tax to 2009, when the top tax rate was 45 percent (compared to 40 percent today), and the exclusion amount was $3.5 million (as opposed to $11.58 million today). In addition, proposals have been made for new tax revenues which will not necessarily be limited to lowering the exclusion amount and increasing the estate and gift tax rate. Other targets include imposing capital gains tax on appreciated assets when a person dies and increasing ordinary income rates. Restricting estate planning strategies, such as grantor retained annuity trusts (GRATs), family limited partnerships (FLPs), and family limited liability companies (FLLCs) are also proposed.
What Can Be Done?
High net worth families should consider using their currently high exclusion amount now as well as engaging in other tax savings arrangements, such as GRATs.
Gift of Exclusion Amount
The easiest and most direct way for an individual to preserve the advantage of the current exclusion amount and favorable gift tax rates is to make gifts before the end of 2020. For example, if an individual transfers $11,580,000 in 2020 and in 2021 the exclusion amount is reduced to $3,500,000, then there would be an estate tax savings of $3,232,000 ($11,580,000 – $3,500,000 = $8,080,000 x 40%).
The 2020 gift also removes all income and appreciation generated by the gifted property from the donor’s taxable estate. If you have concerns over losing control of assets given away and losing the economic benefit from them, there are several attractive alternatives to outright gifts.
Spousal Limited Access Trust
A married individual can create an irrevocable trust for the benefit of the spouse and transfer assets equal to his or her exclusion amount to the trust. This arrangement is called a Spousal Limited Access Trust (“SLAT”). The donor’s spouse can be the trustee, and the trust can provide that the donor’s spouse can receive distributions of income and principal for health, education, maintenance and support. The trust can also provide for distributions to descendants for health, education, maintenance and support. By creating a SLAT for a spouse, a donor can continue to indirectly benefit from the property through the spouse without concern of estate tax inclusion.
The SLAT can give the donor’s spouse, at death, the power to direct the remaining trust assets be held in further trust for the health, education, maintenance and support of the donor. If the donor’s spouse has a limited power of appointment, the donor’s spouse could exercise it in favor of a trust for the donor. Unless the IRS (or a creditor) could show an understanding that the donor’s spouse would exercise this power in such a manner, there should be no inclusion in the taxable estate of the donor’s spouse.
The planning is more complicated if each spouse creates a SLAT for the other and cannot safely be accomplished before the end of 2020 for the following reasons. SLATs created too close in time raise the risk of the IRS applying the so-called “reciprocal trust” doctrine. When successfully raised, each beneficiary spouse is treated as creating the trust for himself or herself instead of for the other, potentially causing the assets of each trust being subject to estate tax (and claims of creditors). The parameters of how different the trusts for the spouses must be, or differences in amounts involved, to avoid the doctrine have not been determined. Although one case held the doctrine did not apply when one spouse gave a lifetime power of appointment to the other and no power of appointment was granted by the other, it is generally recommended that the trusts be created at different times, with different trustees, with different assets and under the laws of different jurisdictions, among other differences. Therefore, we do not recommend that a “reciprocal SLAT” be established by each spouse for the other in 2020. We are comfortable creating one SLAT before the end of 2020.
The Wait and See QTIP
A married individual can create an irrevocable trust called a Qualified Terminable Interest Property (“QTIP Trust”) for the benefit of a spouse and transfer assets equal to his or her exclusion amount to the trust. The trust provides that all income must be paid to the donor’s spouse and can
be used only for the spouse’s benefit during the spouse’s lifetime. The donor can file a gift tax return as late as October 15, 2021, to treat the QTIP Trust as one or a combination of the following:
- A non-taxable gift to the spouse in trust eligible for the marital deduction. The trust would be a pure 100% marital deduction trust, in which event the donor spouse has not used any of his or her $11,580,000 exclusion amount, and the trustee of the QTIP trust may elect to pay all of the assets to the donor’s spouse. The assets will be included in the donor spouse’s taxable estate.
- A gift to the spouse in trust designed to use some or all of the exclusion amount. The donor can elect to have some or all of the trust assets treated as having been gifted to the spouse, using the donor’s exclusion amount. The trust will not be subject to estate tax in the estate of the donor’s spouse. Upon the death of the donor’s spouse, he or she can have the power to direct that the assets be held in trust for the health, education, maintenance and support of the donor.
When an individual makes a gift to a QTIP trust, the donor, if the spouse is a U.S. citizen, retains the power to decide whether the gift will be taxable or not for the period between the date of the gift and the date the donor’s gift tax return is due. When the gift tax return is filed, the donor can make an election to treat the gift as eligible for the marital deduction. If, for example, a gift is made in 2020, the donor can wait until October 15, 2021, to decide whether or not the gift will be a taxable gift. If, with the value of hindsight, the donor concludes that the gift should be treated as a nontaxable gift because, for example, the value of the gifted property has declined significantly or it became apparent that the exclusion amount was not likely to be reduced, the donor can make a QTIP election and not use any of his or her exclusion amount.
The disadvantage of this approach compared to a SLAT, from the standpoint of tax efficiency, is that trust income will be required to be paid to the donor’s spouse for life even if the gift is treated as a taxable gift. The income will increase the value of the donor’s spouse’s estate, causing more estate tax than if the gift had been made without the income requirement. The disadvantage can be mitigated by investing the trust assets for growth instead of income.
Wait and See Disclaimers
An individual could make a gift of his or her exclusion amount to a trust which contains a provision that (i) gives one of the beneficiaries the power to disclaim his or her interest in the trust; and (ii) provides that if the beneficiary makes a disclaimer within nine months of the gift, the trust property would be returned to the donor. If a disclaimer is made within nine months of a gift, and the property is returned to the donor as a result of the disclaimer, then gift is treated as if it had not occurred. If, during the nine-month period, the value of the gifted property declined or it became apparent that the exclusion amount was not likely to be reduced, the beneficiary might see the tax benefit of a disclaimer and might exercise his or her right to disclaim. Of course, this approach requires that the donor rely on the person with the power to disclaim to exercise the power. If the person dies before exercising the power, the tool fails.
Life Insurance Trust
If a reduction in the exclusion amount will result in your estate incurring estate taxes, you could purchase life insurance to pay the expected potential estate taxes. Arguably, you can use life insurance to pay estate taxes at a fraction of the estate tax cost (premiums paid compared to estate taxes paid). With life insurance you can pay your estate taxes with discounted dollars.
Further, there are a lot of uncertainties on how the COVID pandemic may affect the ability to get life insurance and the cost of insurance. By acquiring life insurance now, you mitigate the risk of not being eligible for life insurance after a COVID positive diagnosis.
Any life insurance should be held in an irrevocable life insurance trust to prevent the death proceeds from being subject to estate tax. A life insurance trust is a common technique used to prevent the value of life insurance proceeds from being subject to estate tax. This trust is irrevocable; that is, it may not be revoked, amended or modified by you during your life. The proceeds are not included in your estate for federal estate tax purposes.
You will make all premium payments to the Trustee of the trust, who will in turn pay the premiums to the insurance company. Until you pass away, no other activity will take place in the trust, except for the payment of premiums. Upon your death, the insurance proceeds can be held in trust for the benefit of your beneficiaries under the terms you choose.
Grantor Retained Annuity Trust
For individuals not interested in gifting large amounts of net worth, a trust freezing the growth of assets is attractive. Today’s low interest rates provide a great opportunity to transfer wealth with no gift or estate taxes through the use of an irrevocable trust known as a Grantor Retained Annuity Trust (“GRAT”). To create a GRAT, you would transfer assets that you expect will appreciate to an irrevocable trust. You can be the trustee and choose the term of years which the GRAT will last. During the selected term of years, the GRAT will repay you an amount equal to the assets initially transferred into the GRAT, plus an IRS mandated annual rate of return (currently .4% for November, 2020). In essence this is like a loan of the property to the GRAT, with you, the “lender,” getting the principal back over the selected trust term plus the amount of IRS mandated “interest.” The objective is for the assets to appreciate during the selected term of the GRAT at a higher rate than the IRS required rate of return. Since the IRS mandated rate of return for GRATs established in November, 2020 is only .4%, it is not hard to envision a portfolio of marketable securities exceeding this rate of return. All the “excess” appreciation over the .4% is a tax-free gift to your children, the beneficiaries of the GRAT.
The benefits of a GRAT are best illustrated by example. Assume you transfer $10,000,000 to a GRAT with a five-year term, the GRAT assets increase at a rate of 10% per year during the term, and the IRS mandated annual rate of return .4%. The GRAT provides that you will receive approximately $2,024,000 from the GRAT each year during the five-year term for a total of approximately $10,120,000. Because the GRAT annuity payments received by you have a present value equal to the value of the property transferred, there is no gift when you create the GRAT. Based on the stated assumptions, the assets remaining in the GRAT at the end of the five-year term
will be approximately $3,750,000 and pass to your children free of gift and estate tax. Assuming a 40% estate tax rate, this results in a tax savings of approximately $1,500,000.
The exclusion amount is the largest is has been since 1916. It is set to expire at the end of 2025 unless Congress accelerates a change with legislative action. There are many attractive planning opportunities available for use now, before the end of 2020, if you are inclined, that use the exclusion amount and save estate taxes. Some of the tools allow for maximum flexibility by extending the time you have to make a decision to use your exclusion or not. If you like a technique you have read about, please call immediately to schedule a more detailed discussion and analysis. Time is running short.