September 28, 2021
The Tax Cuts and Jobs Act (TCJA) of 2017 effectively doubled the amount that a taxpayer can transfer without gift, estate or generation-skipping transfer (GST) taxes. For 2021, the limit is up to $11.7 million per individual or $23.4 million per couple. The tax rate on transfers above that amount remains at 40%.
Over the past year, there have been numerous proposals from President Joe Biden and members of Congress to repeal and replace the TCJA. Even without any changes to the tax law, the current provisions expire at the end of 2025, and the exemption amount will revert to $5 million per person, adjusted for inflation.
The changes implemented under the TCJA may influence taxpayers of all sizes, but the interplay of this legislation with pre-existing tax laws in these areas complicates a taxpayer’s options:
You should review your estate plan to determine if changes are needed regardless of the size of your estate. If your estate is under $11.7 million, you may be able to make changes to reduce complexity and save income taxes after you pass away. If your estate is between $11.7 million and $23.4 million, you may want to make taxable gifts to take advantage of the increased exemption, but you must balance the benefits of lifetime gifting with your own future personal spending needs and the loss of the step-up in basis on those gifted assets. If your estate is more significant, you will likely benefit from taking steps to fully use the increased exemption, although several different options exist.
You should meet with your financial advisor and estate planning attorney to discuss:
1. Your existing estate plans
If your estate is not likely to be subject to estate tax — meaning your net estate is likely to be below your remaining exemption at death — and you previously transferred assets into irrevocable trusts for your heirs, you should consider whether to make any adjustments to that strategy. For example, if the trusts are grantor trusts, you might consider exchanging trust assets with a low-income tax basis with higher-basis assets you hold personally. This would allow those low-basis assets to receive a step-up to fair market value basis at your death, thereby reducing the income taxes on those assets when you pass away. Separately, you might decide to turn off the grantor trust nature of those trusts so that you no longer pay the income taxes of the trust. Additionally, you might decide to discontinue any annual gifting plan to the trusts. Again, you will want to discuss these options with your advisors since some of them may not be appropriate, especially if your estate would still be taxable when the estate tax exemption increase expires.
2. Continuing estate tax planning
If you expect to have a taxable estate when the current estate tax exemption expires (meaning a single person with a net worth more than $6 million or a couple with more than $12 million), it’s important to continue estate tax planning, regardless of current and proposed tax laws. While the increased estate tax exemption might keep you free from estate tax today, the only way you can fully utilize it before your death is by giving away all of your assets before the increase expires.
For example, if you are single and your net worth is $9 million, you have no estate tax today. But if the exemption reverts to $6 million after 2025 (factoring in inflation), you would still have $1.2 million in estate tax at death (40% of $3 million). Given your own financial needs, you likely are not able to use the increased exemption (which applies during life and at death) by gifting away $9 million. Even if you were comfortable giving away $6 million in assets today, after 2025 your estate would still be $3 million, and you would have used up your $6 million exemption with the taxable gift. As a result, your estate tax at death after 2025 would still be $1.2 million. But, because you would have gifted the $6 million out of your estate during your life, your heirs would lose the step-up in basis at death to fair market value on the assets and ultimately be in a worse tax situation.
Instead, if you continued to use estate tax techniques to transfer $3 million of your estate to your heirs without using the gift-tax exemption, your remaining estate would pass estate tax-free under your exemption at death, and all $6 million in assets would receive a full step-up in basis.
3. Removing an automatic bypass trust
The automatic bypass trust was universally added to living trusts before 2012, but it now adds unwanted complexity after the first spouse dies and could cause heirs to incur significant and unnecessary income taxes after both spouses pass. For married couples, unless the net value of your estate is over $20 million, you likely should not have an automatic bypass trust.
In many cases, the assets of the first spouse to pass away should instead be distributed to a marital trust for the benefit of the surviving spouse. This will allow full use of both spouses’ GST tax exemption since that exemption is not portable. To add flexibility in case of future tax law changes, the surviving spouse could be given the discretion at the first death to “disclaim” assets (i.e., give up the right to have the assets pass to the marital trust) and instead have the assets go into a bypass trust if needed. Some exceptions exist where such a plan is not appropriate, but those can be discussed with your advisors.
4. Gifting the increased exemption to grantor trusts
For very large estates, where the taxpayer has the financial ability to gift away the increased exemption amount during life, we would recommend the taxpayer go ahead and give it away if it appears the exemption will revert to $5 million per person. However, as those gifted assets will not receive a step-up in basis at the taxpayer’s death, ideally only non-appreciated assets would be gifted. We typically would recommend that those assets be gifted to new or existing grantor trusts so that any future income tax associated with those assets remains with the taxpayer. This serves as a way for the taxpayer to make annual tax-free gifts of the income tax imposed on those assets. Gifting to grantor trusts might also allow the grantor to exchange low-basis trust assets for higher-basis personal assets in the future, as mentioned above. The best plan would be to leverage the increased exemption by combining these gifts with other estate tax strategies to more substantially reduce the estate.
5. Spousal access trusts
For married couples who would be uncomfortable giving away complete access to over $23 million in assets, another option would be to have one spouse set up an irrevocable trust that benefits the other spouse and make gifts into that trust.
For example, Spouse A would set up an irrevocable trust for the lifetime benefit of Spouse B that passes to their children at Spouse B’s death. Spouse A would gift $11.7 million into the trust, fully utilizing Spouse A’s current increased exemption. If Spouse B did not need those funds during their life, the assets could grow and pass estate tax-free at Spouse B’s death. Spouse B would retain their own exemption (which may have gone down to $6 million at this point) to offset some of the estate tax due at his death. While this allows the couple to make tax-free transfers of as much as $17.7 million and for Spouse B to retain access during life, Spouse A cannot be a beneficiary of this irrevocable trust and, therefore, loses access to the funds if they outlive Spouse B. Additionally, this strategy only uses one spouse’s increased exemption.
To fully utilize both exemptions, Spouse B could also set up a non-identical trust that provides access to Spouse A, although this would not solve the access issue since the couple would lose access to one of the trusts at the first death. While this strategy may not be appropriate for all clients and does add complexity, it is an option to consider with your advisors.
6. Timing your gifting
If you have decided to make lifetime gifts to use up the increased exemption, there is no push to make those gifts until there is a clear indication that the estate tax exemption is set to decrease. Because the gifted assets will no longer receive a step-up in basis upon the taxpayer’s death, it might actually be detrimental to do lifetime gifting if the taxpayer were to pass away while the increased exemption is still in place.
However, while the increased exemption is set to revert in 2026, Congress could change these tax laws before then. At such time, the tax laws could possibly be revised with the exemption reduced to even less than $6 million. Thus, if you will have a taxable estate even with the increased exemption, and you plan to use the increase as part of some leveraged estate tax strategy, there is no reason to wait.
While the doubling of the estate tax exemption is generally beneficial, you should revisit your estate plans with your advisors. There are still many considerations that should be reviewed by taxpayers at all levels of net worth to maximize the benefits of the current tax law.
Editor’s note: This article has been updated since its original April 12, 2018, publication.
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