Monday, November 02, 2020
WINDOW ON USE OF CURRENT FEDERAL TRANSFER TAX EXEMPTION MAY SOON BE CLOSING
By: Sidney Levine, Joel Goldblatt & Patrick Coonan of Williams, Bax & Saltzman, P.C.
November 2, 2020
When the Tax Cuts and Jobs Act became effective January 1, 2018, the gift, estate and generation-skipping tax exemption increased from $5,490,000 to $11,180,000 per person. The exemption is adjusted annually for inflation and has now grown to $11,580,000 per person ($23,160,000 for a married couple). Unless extended, the new exemption is scheduled to expire on January 1, 2026, at which time the exemption reverts to $5,000,000, adjusted for inflation.
Election results, however, may accelerate the reduction. If Republicans lose the presidency but retain control of the Senate, it would be difficult to change the current estate tax structure without crossover votes. But if Democrats win both the presidency and the Senate, major reductions in tax benefits are probable. Such changes could include a reduction in the exemption amount to $5,000,000 or even $3,500,000 per person, an increase in the estate, gift and generation-skipping transfer tax rate from the current 40% to perhaps 55% or more, and the full or partial elimination of the rule permitting step-up in basis at death which permits heirs to sell property without recognizing gains on pre-death appreciation.
If both the presidency and Senate flip from Republican to Democrat, Congress may be too busy dealing with Covid-19 issues and the general economy to immediately address estate tax matters. However, if they do adopt tax changes, the new tax laws can look backward, made retroactive to the date that the laws were proposed or even to the beginning of the year.
Because of this—presuming you are in the position of paying an estate tax liability if the exemption is reduced—you may want to consider taking advantage of the $11,580,000 exemption now. If the exemption is reduced next year, the IRS has indicated in proposed regulations that it will not impose taxes on gifts made in prior years sheltered by the large exemption then in effect.
To take advantage of the increased exemption while it is still available (provided you still retain sufficient assets to remain financially secure), you could make taxable gifts sufficient to absorb the exemption, to the extent you have not already used the exemption on prior gifts.
These gifts can be effected in several ways:
1. You can make gifts by forgiving loans to family members. Or you may forgive loans you made to an irrevocable insurance trust to help fund a split-dollar insurance policy.
2. You can gift cash or income producing property to a trust to permit it to pay life insurance premiums, thereby preserving your annual gift tax exclusions and allowing larger and more costly insurance policies to be acquired and kept apart from your taxable real estate.
3. You can gift cash or other property outright to or in irrevocable trusts for your descendants or other family members. If to trusts, these trusts can be designed as generation-skipping trusts, so that the trusts will pass estate tax-free to or in further trust for your grandchildren upon the deaths of your children.
4. If you are married and are worried that you and your spouse may need some of the gifted assets in the future, you can make gifts of cash or property to spousal lifetime access trusts ("SLATS"), a variation on a irrevocable trust.
If you are gifting hard-to-value assets and do not intend to use the full exemption, the excess exemption available in 2020 serves as insurance to protect against gift tax liability in the event the IRS claims that the gifted assets are undervalued. This protection may not be available in 2021.
Bear in mind that this may be an opportune time for gifting for other reasons. Because of uncertain economic conditions caused by the coronavirus pandemic, many properties are now being valued at a substantial discount. These discounted properties include hotels and commercial and residential real estate. Additionally, certain corporations and publicly traded stocks are now undervalued. And, if closely-held business interests are gifted, you may be entitled to reduce the gift tax value by taking minority interest discounts and discounts for lack of marketability.
Moreover, if certain swap provisions are included in the agreements creating the trusts, you may be able to recover the property that you gifted to the trusts by substituting property of equivalent value. This adds substantial flexibility to the trusts.
If you choose the SLAT planning alternative, the trust beneficiaries could be your spouse solely, your spouse and children, or your spouse, children and other descendants. Your spouse could be the trustee or you could name others, including children or independent trustees. The beneficiaries would be entitled to income and principal as determined by the trustee for their health, education, maintenance and support or as any independent trustee determines for their best interests. Your spouse can be given a limited power of appointment under the SLAT, thereby enabling your spouse to redirect the trust assets to or in trust among one or more of your descendants or others of a group of potential takers selected by you.
If the SLAT is drafted as a “grantor” trust for income tax purposes, you would recognize all the trust income on your individual income tax return. By you remaining responsible for and paying the taxes that would otherwise be a liability of the trust, you have in essence made an additional tax-free gift to the trust. Additionally, a SLAT permits you to the swap assets described above and transfer leveraged property to the trust or sell property to the trust without triggering gain. This may afford protection in the event of an IRS gift tax audit. To mitigate the risk of an IRS claim that hard to value assets are undervalued, thereby causing the gift to exceed the exemption and a gift tax to be paid, a simple agreement can be drawn up between you and the trust providing that the amount, if any, that the gift tax value as determined by the IRS exceeds the exemption will be purchased from you by the trust for a note.
If you and your spouse each create SLATs for one another, care must be taken in drafting to ensure that the trusts are sufficiently different in their terms. Otherwise, the IRS can apply a doctrine known as the reciprocal trust doctrine and unwind the transactions, in effect treating each of you as having created a trust for yourself and not for your spouse.
If you choose to use your exemption before year end, time is of the essence. You will need to not only create any trust agreements as soon as possible, but also cause the properties to be transferred before December 31st. This takes time. Often you also need an appraisal to establish value for gifting purposes, which will be the case unless you are gifting cash or publicly traded securities or forgiving loans. This takes additional time, and many appraisers are currently inundated with work. So, acting swiftly is imperative if you do not wish to lose one or more of these excellent planning opportunities.
Keep in mind that if you wait until early next year, the current exemption may no longer be available. This is something that no one can predict.
Please contact our estate planning attorneys, Sidney Levine (firstname.lastname@example.org), Joel N. Goldblatt (email@example.com), Andy Arons (Arons@wbs-law.com), Howard Cohen (firstname.lastname@example.org) or Patrick Coonan (email@example.com) if you would like to know more about this topic.