The Tax Cuts and Jobs Act of 2017 (“TCJA”), signed into law at the end of 2017, was based on tax reform advocated by Congressional Republicans and the Trump administration and resulted in the highest federal gift and estate tax exemption ever available under the current transfer tax system, currently $11.58MM per person. A couple can leave just over $23MM to their beneficiaries before incurring a 40% tax on the excess. This high exemption is scheduled to return to pre-TCJA levels, or $5MM per person indexed for inflation back to 2010, in 2026. If Joe Biden is elected President in the November election, and the Democrats regain control of the Senate and keep control of the House, a government looking to raise revenue for stimulus spending and to address wealth inequality could seek to implement tax changes that could negatively impact estate planning. Changes anticipated include reducing exemption amounts before 2026 and possibly to amounts lower than pre-TCJA levels, raising the gift and estate tax rate above 40%, and curtailing effective estate planning techniques such as valuation discounts. Any such changes could be effective as soon as January 1, 2021 if Congress passes legislation having retroactive effect.
Bottom line: If you were considering implementing estate planning strategies before 2026 to take advantage of the high TCJA exemptions, you may want to do that now. Recall that in 2012 there was much anticipation that the exemption could drop from $5MM to $1MM. As a result, there was a flurry of activity at the end of 2012, and many who rushed to make large gifts to lock in the higher exemption were later unhappy with the plans they made when the exemption did not, in fact, go way down. The lessons to be learned from 2012 are (1) plan ahead: go ahead and contact your advisory team to run projections, discuss strategies, get appraisals and have documents prepared, and (2) whatever you decide to do, make sure you will be comfortable with your decision even if the laws do not change after the election.
It is important to keep in mind that the exemption is used from the bottom up, meaning that if you want to use the “bonus” part of the current exemption that is scheduled to sunset in 2026 (or next year, worst case), you have to make a gift in excess of what the exemption will be in the future when it is reduced. Example: You make a gift of $6MM today and the exemption is $10MM. If the exemption is reduced to $5MM on January 1, 2021, on that date you will have $0 exemption left and $4MM of the $5MM “bonus” exemption you had in 2020 will have been wasted.
What strategies might you implement to take advantage of the record high exemptions before tax mitigation techniques are curtailed, exemptions are reduced, and taxes are increased? It depends, of course. If you are wealthy enough to use your full exemption without having to access any assets you give away, you could simply make a gift outright or in trust for your beneficiaries up to the amount of the current exemption. Many wealthy people, however, do have not sufficient assets to use all of their exemptions and not be able to access those assets should they need to.
If you are in that category, a spousal lifetime access trust (or “SLAT”) is a strategy that can take advantage of high exemption amounts without eliminating access to your assets in the future. With a SLAT, one spouse makes a gift in trust for the benefit of the other spouse (and others if desired). This uses the donor spouse’s exemption, and if the spouses later need funds, the trustee can make distributions from the trust to the beneficiary spouse. If you have sufficient assets, it is possible for each spouse to set up a SLAT for the other spouse and use all $23MM of their combined exemptions. If you don’t have sufficient assets, one spouse should set up a SLAT using as much of his or her bonus exemption as possible, preserving the full base exemption of the other spouse for future planning.
There are obvious complexities to designing and implementing a SLAT. For example, what assets should fund the trust, who should serve as trustee, and how you may be able to protect against the possibility of divorce or the beneficiary spouse predeceasing. Consultation with your advisory team is critical to the viability and success of the strategy.
In addition to record high exemptions, wealthy individuals should also take advantage of the economic impact of COVID-19, namely pandemic-depressed asset values and record low interest rates. One such strategy is a Grantor Retained Annuity Trust (or “GRAT”). With a GRAT, you can transfer assets to a trust and retain an annuity interest in the trust for a term of years. At the end of your retained term, any amount remaining in the trust passes to your beneficiaries. A gift is made equal to the value of the property contributed to the trust less the present value of your retained interest. (Note that if the annuity is sizeable enough, the gift can be virtually zero, which is a way to implement additional planning to take advantage of low rates even if you have already used your exemption.) If the assets in the trust appreciate in excess of a government rate called the Section 7520 rate, that appreciation will pass to the remainder beneficiary without making any additional gift. The Section 7520 rate for October 2020 is 0.4%, so it is quite likely that a GRAT could pass significant value to the trust’s remainder beneficiaries without a gift tax cost, especially if assets contributed to the GRAT are currently at depressed values and are expected to appreciate post-pandemic.
An intra-family loan is a simple and low cost technique that works best in low interest rate environments. If the interest rate on a loan to a beneficiary is at the applicable federal rate (“AFR”), which for long-term loans made in October 2020 is 1.12%, the loan will not be treated as a gift. Assuming the beneficiary can use the loan proceeds to pay down higher rate debt or make investments that will yield more than the AFR, assets are passing to the beneficiary without any gift or estate tax.
There is a window of opportunity to take advantage of these and several other estate planning strategies before the impact of the November election hits and the economy recovers from the pandemic. Anyone with net worth in excess of the reduced exemption levels that may be in effect as early as January 2021 should engage their advisory team to explore these planning opportunities while there is still time.