We hope this Gift and Estate Tax Planning Alert finds you and your family doing well. Due to the recent presidential election and potential estate tax legislation supported by what will become the Biden Presidency in 2021, we write this alert to apprise you of some possible changes in 2021 to the federal gift and estate tax laws that could affect estate planning in December of 2020 and in 2021. The concern is that Congress could act in 2021, possibly retroactively to January 1, 2021, to lower the per person gift and estate tax exemption amounts and action may be considered now to take advantage of the current exemption amounts. Any adverse change by Congress would likely affect only single persons whose net worth is in excess of $6M or married persons whose net worth is in excess of $12M. Idaho does not have its own, state-specific gift, estate, or inheritance tax, although some other states do which could affect you if you reside there or own assets there.
Under current federal law, a person may generally gift up to $15,000 per year (in cash or property) to as many non-spouse persons as he or she wants to without incurring any duty to report such gifts to the IRS and without incurring any gift tax liability associated with such gifts. Such gifts are called “annual exclusion” gifts and were limited to $10,000 for many years. Married persons can combine their $15,000 per person, per year annual exclusion amounts and gift up to a combined $30,000 per year to someone. An outright gift to a fellow American spouse can be an unlimited amount and is tax free, so the annual exclusion limits do not apply; however, a gift to a spouse in care of an irrevocable trust for the spouse is generally a taxable gift and subject to the gift tax exemption amount discussed immediately below.
If a person makes a gift in excess of the annual exclusion amount, then for the year the gift was made the person must report the excess gift amount to the IRS on a gift tax return (IRS Form 709). Such excess gifts are called “taxable gifts.” The IRS tracks a person’s lifetime taxable gifts. Under current federal law, a person may, during his or her lifetime, make taxable gifts of up to $11.58M without incurring any gift tax liability, but he or she must still report the taxable gifts to the IRS even though no gift tax is due. The $11.58M lifetime gifting amount is typically referred to as the lifetime gift tax exemption amount. If a person makes lifetime gifts in excess of this exemption amount, which is rare, he or she will pay gift tax at a rate of 40% of the excess amount so gifted.
Under federal law, at death, each person’s assets are subject to a federal estate tax. The estate tax applies to all assets the decedent owns at death and also includes the amount of the death benefit of life insurance that is paid out due to the decedent’s death. There are two main ways to avoid paying the federal estate tax at death (other tools can be utilized during a person’s life to reduce his or her estate tax exposure). First, assets of a decedent passing to his or her surviving spouse, either outright or through a specially designed trust for the lifetime benefit of the surviving spouse (often called a marital “QTIP” trust), are, after an IRS election as to a marital trust is made, excluded from the deceased spouse’s taxable estate. This exclusion is called the unlimited marital estate tax deduction. Second, each person has an estate tax exemption amount which exempts, up to the applicable exemption amount, all other assets not passing to a spouse (such as transfers to children or a significant other) from federal estate tax. Under current law the estate tax exemption amount is $11.58M, the same as the lifetime gifting exemption amount discussed above. Please note that a decedent’s estate tax exemption amount is reduced, dollar for dollar, by the amount of lifetime taxable gifts the person made. With the gift tax returns filed by the decedent for any lifetime taxable gifts he or she made (see gift tax return discussion above), the IRS has the data to calculate how much estate tax exemption amount the person has left to use at death. Because the gift and estate tax exemption amounts are tied together, they are sometimes referred to as the unified credit or exemption amount. So, even though you can make lifetime taxable gifts without paying gift tax, the IRS settles up with you at death by reducing your available estate tax exemption amount. The estate tax rate on assets valued in excess of the decedent’s applicable exemption amount is 40%.
It should be noted that in addition to the federal gift and estate taxes, there is a third wealth transfer tax known as the generation skipping transfer tax (“GST tax”), which, in general terms, taxes assets a person may gift during their life or transfer at death to a person more than one generation removed from them (called a “skip person”), such as a gift from a grandparent to a grandchild. Under current federal law a person may make transfers to skip persons during life or at death in amounts up to $11.58M in total without incurring GST tax. The GST tax is not discussed further in this alert.
As indicated above, it is important to note that assets of the decedent passing to a surviving spouse at death (either outright or though a qualified marital QTIP trust) generally do not affect or rely upon the decedent’s estate tax exemption amount due to the unlimited marital deduction. In that setting, part or all of the decedent’s estate tax exemption amount may be “unused” at death if there is a surviving spouse. To avoid having the first spouse to die’s estate tax exemption amount be wasted, federal law allows a surviving spouse to make an election with the IRS, filed within nine months of the first spouse’s death, to port, or carry over, to the survivor the deceased spouse’s unused estate tax exemption amount. This carry over option is referred to as “portability” and by so carrying over the unused exemption amount, at the surviving spouse’s later death he or she will have their own estate tax exemption amount plus the deceased spouse’s carried over unused exemption amount to use to reduce the estate tax on the survivor’s assets.
Another common method that is used to avoid losing the first spouse’s to die’s estate tax exemption amount is to place so much of the deceased spouse’s assets, up to the decedent’s available estate tax exemption amount, in an irrevocable trust for the lifetime benefit of the survivor with the trust being designed so that it will not qualify for the unlimited marital deduction (i.e., it will not be a marital QTIP trust) and thereby it will be subject to estate tax. Because the value of the assets placed into the trust are equal to or less than the deceased spouse’s available estate tax exemption amount, the estate tax is zeroed out and the exemption is effectively used up. The trust assets and any appreciation to their value during the surviving spouse’s lifetime will be exempt from estate tax when the survivor later dies because he or she does not own them and the assets (and any appreciation in their value) will pass to the couple’s descendants or to others estate tax free. This type of trust is commonly called a credit shelter trust, a bypass trust, a B trust, or an exemption trust. A credit shelter trust plan has some potential income tax drawbacks for heirs after the trust ends, but such issues are outside of the scope of this alert.
All other at-death transfers of a decedent’s assets, such as by a single or widowed person to children or to others, are subject to estate tax and the decedent’s estate tax exemption amount (along with any exemption amount ported over from a prior deceased spouse) is relevant to reducing or eliminating estate tax on such assets. As an aside, at-death transfers to charities generally create a deduction to the estate tax liability.
Due to the currently high estate tax exemption amounts, the federal estate tax affects very few people. Persons who have a current net worth significantly less than $11.58M (current exemption amount) and who have made little or no taxable gifts during their life that would reduce their estate tax exemption amount at death to at or below their current net worth, do not need to worry about the estate tax (but see the discussion below in this letter for potential issues if the estate tax exemption amount should drop). For those who have a high net worth, the 40% tax rate on assets in excess of applicable estate tax exemption amounts can be impactful.
Please note: under current federal law that was passed in 2016, the per person gift and estate tax exemption amounts, which are each $11.58M in 2020, will drop, effective January 1, 2026, to $5M each, indexed for inflation, which should be about $6M person or potentially up to $12M combined for married couples who do estate planning (down from the current potential, with planning, of $23.16M combined for married couples). This is a major tax change.
The preceding gift and estate tax principles can be illustrated by the following examples:
Ex. 1. A and B have assets totaling $11M (or less). They have not made any significant taxable gifts. Under current 2020 law they have no estate tax planning issues because their personal estate tax exemption amounts are each $11.58M.
If one or both spouses die after the gift/estate tax exemption drops to $6M per person (currently scheduled for 1-1-2026), and their net worth is still $11M, they will need to plan to use both spouse’s exemption amounts (such as through a portability election or a credit shelter trust at the first death) so as to utilize their then combined $12M estate tax exemption amount to avoid estate taxes at the surviving spouse’s death.
If after the gift/estate tax exemption drops to $6M per person (currently scheduled for 1-1-2026) A and B have a total assets of less than $6M and they have not made any significant taxable gifts, they would have no then current estate tax planning issues.
A and B represent 99% of American married couples.
Ex. 2. X is single and has no unused estate tax exemption carry over from a prior, deceased spouse. She has assets totaling $11M (or less). She has not made any significant taxable gifts. Under current 2020 law she has no current estate tax planning issues because her personal estate tax exemption amount is $11.58M.
If after the gift/estate tax exemption drops to $6M per person (currently scheduled for 1-1-2026) and X still has total assets that are greater than $6M, she will have estate tax planning issues because any of her assets in excess of her $6M exemption amount will be taxed at a 40% rate at her death. X may benefit from making lifetime gifts of assets while the gift tax exemption amount is high.
If after the gift/estate tax exemption drops to $6M per person (currently scheduled for 1-1-2026) and X, still unmarried, has total assets of less than $6M and she has not made any significant taxable gifts, she would not have an estate tax planning issue.
Ex. 3. C and D are married and have assets totaling $15M, or $7.5M each assuming all assets are community property. During their lives, C and D each gifted $1M to their daughter using part of their respective lifetime gift tax exemption amounts. C dies in 2020 when the estate tax exemption amount is $11.58M. C’s estate plan says to leave everything to spouse D. C’s estate has no estate tax liability due to its size/value and the application of the unlimited marital estate tax deduction. C’s estate has an unused estate tax exemption amount of $10.58M ($11.58M less the $1M lifetime taxable gift C already made to daughter). D makes a timely portability election and carries over C’s unused estate tax exemption amount so that D now has an estate tax exemption amount in 2020 of $21.16M [D’s own $10.58M exemption amount (she had $11.58M but also made a taxable gift of $1M to daughter) plus C’s carried over unused exemption amount of $10.58M]. D also dies in 2020. D’s taxable estate, representing all assets, is $15M. D’s estate tax exemption amount of $21.16M completely exempts all assets from estate tax and all $15M passes estate tax free to daughter.
Ex. 4. Assume the same facts in example 3 above except that D does not make a portability election to capture C’s unused estate tax exemption amount and no other means are employed to capture C’s unused estate tax exemption amount (such as by employing a credit shelter trust at the first death). At D’s later death, also in 2020, D’s taxable estate would still be $15M, but D’s available estate tax exemption amount would only be D’s personal $10.58M (C’s unused exemption amount was lost), and, once applied, there would be an excess above the exemption amount of $4.42M ($15M estate less $10.58M exemption amount) and an estate tax (40% rate) would be owed of about $1.77M. Daughter would inherit $13.23M ($15M estate less estate tax of $1.77M).
Ex. 5. E and F are married and have assets totaling $15M, or $7.5M each assuming all assets are community property. During their lives, E and F each gifted $1M to their daughter using part of their respective lifetime gift tax exemption amounts. E dies in 2020 when the estate tax exemption amount is $11.58M. E’s estate plan says to leave everything to spouse F. E’s estate has no estate tax liability due to its size/value and the application of the unlimited marital estate tax deduction. E’s estate has an unused estate tax exemption amount of $10.58M ($11.58M less the $1M lifetime prior taxable gift E made to daughter). F makes a timely portability election and carries over E’s unused estate tax exemption amount. F later dies in 2026 when the per person estate tax exemption has dropped to $6M. F’s taxable estate, representing all assets, is $15M. F’s estate tax exemption amount is: $10.58M carried over from E, plus F’s personal exemption amount of $5M ($6M amount for 2026 less $1M prior gift she made) for a total of $15.58M. The $15.58M exemption amount exempts all assets from estate tax and all $15M passes estate tax free to daughter.
Ex. 6. Assume the same facts in example 5 above except that F does not make a portability election to capture E’s unused estate tax exemption amount and no other means are employed to capture E’s unused estate tax exemption amount (such as by employing a credit shelter trust at the first death). At F’s later death, F’s taxable estate would still be $15M, but F’s available estate tax exemption amount would only be F’s personal $5M (E’s unused exemption amount was lost), and, once applied, there would be an excess above the exemption amount of $10M ($15M taxable estate less $5M exemption amount) and an estate tax (40% rate) would be owed of $4M. Daughter would inherit $11M ($15M estate less estate tax of $4M).
Please note that the above discussion and examples deal mainly with at-death estate tax issues based upon assets that are still owned by taxpayers as of their deaths. There are many effective tools people can use during their lives to reduce the amount and value of assets remaining at their deaths to lower their estate tax exposure and which are beyond the scope of this alert.
POTENTIAL 2021 LEGISLATION
President-elect Biden has stated that he wants to accelerate the decrease in the gift and estate tax exemption amount from the current 2026 timeframe, possibly in 2021. There has been some discussion that new legislation could lower the gift/estate tax exemption amount even lower than the scheduled $6M to $3.5M per person. To get such a change done, Biden will need both houses of Congress to pass, by simple majority in certain circumstances, the legislation necessary to make it happen. Currently the Democratic Party controls the House of Representatives and the Republican Party, who historically dislikes the estate tax, controls the Senate and would, presumably, block such a change. However, if two Senate seat run-off elections in Georgia go to Democrats (the run-offs are on January 5, 2021), the Republican control of the Senate may be in jeopardy. If legislation is passed in 2021, taxpayers who will then have increased estate tax exposure may have limited time to act to take advantage of the currently high gift/estate tax exemption amounts before the effective date of the new law. It is also possible that Congress may make such 2021 legislation retroactive to January 1, 2021 making any needed planning impossible to do unless it is done in December of 2020.
The potential planning that could be done (and which would normally be deferred until 2025 when the scheduled January 1, 2026 gift/estate tax exemption drop was much closer) would include doing lifetime gifting of assets using the currently high gift tax exemption amounts to an irrevocable trust for a spouse and/or in trust or outright to descendants or others.
When making lifetime gifts using the currently high gift/estate tax unified exemption, and assuming it will drop in 2021, it is a “use it or lose it” proposition. For example, currently a person can gift up to $11.58M of his or her assets to a trust for a spouse or child and forever remove those assets from being part of the person’s and his or her spouse’s later taxable estates, but in 2026, or possibly sooner if the gift/estate tax exemption law changes, the maximum per person gifting amount will only be $6M (or possibly $3.5M depending upon passed legislation). If a gift is not made before the law changes, the ability to remove the additional $5.58M in assets (the difference between $11.58M and $6M in this example) from the taxable estates will be lost.
Also, it is important to clarify that you can’t currently gift just the excess amount that will be going away with a law change, $5.58M in this example (the difference between the current exemption amount and the projected reduced exemption amount), and still have a full $6M (assuming that will be the new exemption amount) to use for gifting after a new, lower gift/estate exemption law goes into effect; the IRS rules will not allow that. For example, if you gifted away $5.58M in 2020 and the exemption dropped in 2021 to $6M, you will have only $420,000 of lifetime gifting exemption left ($6M less $5.58M). These facts show that unless a person is currently willing to gift more than $6M, there may be little upside to acting now (because you could still gift that amount even if the exemption dropped to $6M). Please consider the following examples:
Ex. 7. A and B are married. They are concerned about a potential gift/estate tax exemption drop to $6M per person in 2021. In 2020 they each gift $6M to an irrevocable trust for their spouse, $12M total. If the exemption does drop to $6M in 2021, they each have $420,000 of lifetime gifting exemption left.
Ex. 8. Same as example 7 above, but in 2020 A alone elects to use his full exemption of $11.58M and make a gift of that full amount to a trust for his spouse. B does not make a similar gift. If the exemption does drop to $6M in 2021, A has no remaining lifetime gifting exemption left (he has gifted more than $6M already), but B still has $6M which she could use during her life to make gifts or not. At B’s death, her remaining $6M exemption (less any lifetime taxable gifts she made) could be carried over to A if he survives her, or if not, it will be used by her estate to reduce her personal estate tax liability.
It is noted here that the IRS has ruled that if you currently make lifetime gifts that are greater than what the estate tax exemption ultimately is when you later die (i.e., you gift $11.58M this year and the exemption is only $6M at your death), you are not penalized and you are credited with the higher at-death exemption amount as to the 2020 gifts.
So, what should be done? Please consider the following:
- If you are single and your current net worth, inclusive of the death benefit of life insurance owned by you is less than $3.5M – $6M (depending upon what the new per person exemption amount could be, likely $6M), and you have made no prior, significant lifetime taxable gifts, don’t panic, you likely don’t need to act.
- If you are married and your combined current net worth, inclusive of the death benefit of life insurance owned by you is less than $7M – $12M [depending upon what the new per person exemption amount ($3.5M or $6M) could be, likely $6M], and you have made no prior lifetime taxable gifts, don’t panic, you likely don’t need to act.
- If you are single and your net worth is in excess of $6M (or possibly $3.5M) or you are married and your combined net worth is in excess of $12M (or possibly $7M), you could consider: (a) do nothing and see what, if anything, happens with Congress in 2021 assuming there will be time to act in that year before any new legislation takes effect – it is entirely possible that Congress will do nothing, or (b) make lifetime taxable gifts in December of 2020 to a trust for your spouse and/or outright, or in a trust, to descendants or others. Please keep in mind that unless you are irrevocably willing to gift away more than what will become the new gift/estate exemption amount (likely $6M per person), then making the gifts now will be a waste because you could make those lower value gifts just as easily after the exemption drops. Doing lifetime gifting now will only benefit those who are willing, alone or with a spouse, to irrevocably part with significantly more than $6M in gifting transfers.
- If you want to move forward with lifetime gifting, the most commonly used tools are an irrevocable trust for your spouse (called a spousal limited access trust or “SLAT”) and outright, or in-trust, irrevocable gifts to descendants or others. With a SLAT, you can contribute assets in trust for your spouse for his or her lifetime benefit. Because you are married, you should indirectly benefit from the assets put in the trust through your spouse’s receipt of trust income and principal over time. The trust can be designed so that trust income is taxable to you just as the income from the trust assets would have been if the trust had never been created. Your spouse can also make a somewhat similar trust for you (there are IRS rules that prohibit the trusts from being identical or substantially the same). By utilizing SLATs, a married couple can each gift up to $11.58M each, or up to $23.16M combined, and remove such assets and any later post-transfer appreciation of the assets from their taxable estates. The possible downsides to a SLAT include changed circumstances, such as buyer’s remorse for setting up the trusts, especially if the tax laws don’t change, or a divorce, whereupon the assets in the trust will typically pass to your children (outright or in trust) once your spouse becomes your ex-spouse, whereby you will lose the back-door benefit of the assets while still remaining liable to pay income tax on the income derived from the assets in the trust.
When making a large taxable gift, please note that the value of whatever is gifted must be supportable and reported on the required IRS gift tax return. Cash and publicly traded stock that is readily valued are easy to substantiate. Gifts of real estate and ownership interests in private business entities typically require a third-party appraisal to support value as well as any discounts to value taken for minority or non-controlling ownership interests.
There is no perfect solution to the gift/estate tax issues the Presidential election has presented, but you do have some options to consider which are possibly time-sensitive. If you have a high net worth estate and are interested in discussing these matters further, please contact the Hawley Troxell estate planning team: Jason Melville and John McGown at (208) 344-6000.