September 24, 2020
As the 2020 presidential election nears, clients are asking us many questions regarding the potential tax effects of a possible change in administration. From an estate planning perspective, a Democratic win is likely to significantly impact high net worth families. While no changes would occur until 2021, it’s best to start preparing now in order to avoid potential timing issues that may arise if you wait until after the election.
In December 2017, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA), which effectively doubled the estate and gift tax exemption. Prior to the enactment of the TCJA, the exemption was $5 million per person ($10 million for married couples), adjusted annually for inflation. Today, it is $11.58 million per person, $23.16 million for married couples. The increased exemption is set to expire at the end of 2025, at which point the amount will revert to pre-TCJA values, but there is concern that such expiration could be accelerated to as early as 2021 if Joe Biden is elected president. While not all high net worth families will be in the position to use the increased exemption, those who are may have a limited opportunity to do so.
Joe Biden’s proposed tax plan includes two notable changes related to estate planning. First, Biden’s campaign proposed eliminating the increased estate and gift tax exemption established under the TCJA, which would cause each taxpayer’s exemption to drop by 50% and subject a greater part of their estate to the 40% estate tax. The loss of $11.58 million of exemption for each couple could increase overall estate taxes by $4.63 million. Second, Biden’s campaign has proposed eliminating the “step-up in basis” on inherited assets.
Currently, federal income tax rules provide for a fair market value increase in income tax basis for assets transferred at death, commonly termed a step-up in basis. Simply put, if you hold property that you purchased for $1 million, and it increased in value to $2 million at the time of your death, your heirs would avoid capital gains tax on the $1 million increase when the asset is sold. Without such increase in basis, as proposed, your heirs would pay income tax on the $1 million gain, as well as potential estate tax.
While the elimination of the basis step-up is less certain to have broad support, and there is no way to take advantage of the current rules before any new laws are passed, the loss of this benefit could be increasingly costly. To the extent some of the income tax increases proposed by the Biden campaign also pass, the current 20% capital gains tax rate on the gain described above could increase to as much as 43%.
However, even if Biden is elected president, these changes are not certain unless his party also retains control of the House of Representatives and gains control of the Senate, since all proposals must be passed by both. Moreover, even if the Democrats gain control of the Senate, current rules nonetheless require a 60-vote majority for most legislation. It is very unlikely that the Republicans would lose enough seats in the Senate to allow for such an outcome. However, there has been some talk by Biden’s campaign of changing those long-standing rules to instead require only a majority vote in the Senate. Therefore, Biden’s proposed plan could possibly pass with only a small Democratic majority in both the House and Senate. While any such changes will not be made until a new administration comes into power in early 2021, there is some concern that such rules, if imposed, could be made retroactive to the beginning of 2021.
While there is no planning that can be done in anticipation of the possible elimination of the step-up in basis, there are many ways to take advantage of the current estate and gift tax exemption before any changes are made.
Due to the anti-clawback regulations issued by the IRS in 2019, if you make taxable gifts and use the increased exemption now, such gifts will not be later subject to tax even if the increased exemption expires. Thus, for those who have the resources to make such lifetime gifts, it might be prudent to do so now in order to use some or all of the increased exemption while it is still available.
It is not necessary to make outright gifts in order to take advantage of the increased exemption. Instead, you can make gifts to irrevocable trusts created for the benefit of your loved ones, which may provide certain advantages, like the ability to limit a beneficiary’s access to trust assets and the protection of such assets from potential creditors. However, you must give up personal access to the gifted funds. Therefore, anyone considering this gifting strategy should engage in extended conversations with their financial advisors about their own lifestyle needs before determining whether to give away their assets in advance of the potential changes in law.
Other options to consider that may create less of a lifestyle burden might include gifting to an irrevocable trust that includes one spouse as a beneficiary or only using one spouse’s full exemption. That said, gifting less than one’s full exemption is not recommended, as it will not achieve any estate tax benefit. For example, if an individual gives away only $5 million now and the exemption rolls back to $5.79 million, such individual did not use any of the increased exemption and will now have only $790,000 of exemption available at death to offset against estate tax.
If you are concerned about making gifts before any changes are certain, but you’d like to have the option to do so in the event the exemption is set to expire early, talk to your estate planning attorneys about possible transactions that can allow you to make transfers today with the option to make gifts later — such as a sale of assets in exchange for a promissory note, which can later be forgiven.
If you think you might be affected by the proposed changes, do not wait until after the election to start planning because many of these transactions may take a considerable amount of time to complete. Reach out to your advisors to discuss your options and establish a strategy that works for you and your family today.
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