With the Democrats in control of both the executive and legislative branches of the federal government, there has been a plethora of new proposals that could have sweeping effects within the estate planning industry. Some of the most notable proposals include increasing the capital gains tax rate to 39.6 percent, ending stepped-up basis, and making sweeping modifications to the estate, gift, and generation-skipping transfer (GST) tax exemptions.
Although it is unlikely to pass in a fifty-fifty Senate, Senator Bernie Sanders’s For the 99.5 Percent Act (the Act) would primarily affect transfers occurring after December 31, 2021. Some of the Act’s most notable changes include
- reducing the current exemption amount from $11.7 million per individual in 2021 to $3.5 million per individual and $7 million for married couples, adjusted for inflation;
- reducing the gift tax exemption to $1 million per individual, not adjusted for inflation;
- making the estate and gift tax rates progressive, ranging from 45 percent of the value of estates between $3.5 million and $10 million to 65 percent of the value of estates over $1 billion;
- eliminating valuation discounts for nonbusiness assets;
- treating grantor trusts created or funded by a grantor as owned by the grantor for both income and estate tax purposes; and
- imposing a minimum term of ten years and minimum gift amounts on the funding of new grantor-retained annuity trusts (GRATs).
At the 2021 Heckerling Institute on Estate Planning, presenter Steve Akers, JD, mentioned that, although he thinks retroactive changes to tax laws are unlikely to pass, some cautious clients will continue to be interested in strategies to mitigate the impact of such changes. Should you have such a client, below are six possible strategies.
1. Formula allocation gift. With this approach, a donor makes a current gift transfer that is structured as a formula allocation type of gift, splitting the transferred assets into shares equal to (a) the donor’s available gift tax exemption amount (whatever that may be) as of the date of the transfer, and (b) the “excess” amount. Although the actual amount of the gift tax exemption may be unknown at the time of the transfer, once the law has been settled and the amount of the available exemption is clear, that amount can be allocated (along with a pro rata share of any posttransfer appreciation) to a trust for the donor’s beneficiaries, which would absorb their available gift tax exemption (the exemption share). The amount remaining (the excess share) can be allocated so that it avoids a gift tax, such as to a marital deduction trust general power of attorney under section 2523(e), a GRAT, an incomplete gift trust, or a charitable organization.
We do not prefer a qualified terminable interest property (QTIP) trust here because making a protective QTIP election with respect to an inter vivos QTIP trust is not allowed. If the bonus exemption amount is retroactively reduced, the recipient can make a QTIP (or a partial QTIP) election on the gift tax return, thereby allowing the gift in the amount of the assumed bonus exemption to qualify for the lifetime marital deduction under I.R.C. § 2523. No taxable gift would occur, and the marital trust will qualify as a QTIP trust to the extent desired and then be included in the spouse’s gross estate under I.R.C. § 2044 upon the spouse’s death.
2. Gift into a QTIP-eligible trust. Making a gift equal to the assumed bonus exemption into a marital trust for the lifetime benefit of the taxpayer’s spouse, for which a QTIP election can be made (or not), is another option. If the bonus exemption remains intact, no QTIP election should be made in the gift tax return because the result equals a taxable gift. Though the marital trust can be held for the lifetime benefit of the taxpayer’s spouse, the assets will not be subject to estate taxation upon the spouse’s death because no QTIP election has been made. A benefit to this approach is that the donor has until October 15 of the following year to decide whether to undo the taxable gift aspect of this strategy.
Another advantage is that this kind of trust operates like a spousal lifetime access trust (SLAT) because the donor’s spouse is a beneficiary. The disadvantage is that this type of planning is more complex, and the donor’s spouse is the only permissible beneficiary. Also note that the election must be made on a timely filed gift tax return.
3. Qualified disclaimer by the spouse. A client can make a gift equal to the assumed bonus exemption into a marital trust for the lifetime benefit of the taxpayer’s spouse. If the bonus exemption remains intact, the spouse/beneficiary can make a qualified disclaimer of their interest in the marital trust under I.R.C. § 2518. The assets in the trust will then pass into a trust for the benefit of the grantor’s descendants, causing the grantor’s transfer to be a taxable gift into the trust, which would absorb the assumed bonus exemption amount. If, however, the bonus exemption amount is retroactively reduced, the spouse would not disclaim or partially disclaim the interest in the marital trust. The portion of the gift not subject to the disclaimer would thus qualify for the gift tax marital deduction.
If you use this strategy, you must carefully consider the type of marital trust being employed. For example, if the marital trust is designed to qualify as a QTIP trust, there are some special timing considerations. A QTIP trust requires that all income be distributed to the spouse beneficiary annually; however—and this is critical—to preserve the ability to make a qualified disclaimer of an interest in the trust under I.R.C. § 2518, the beneficiary—in this case, the spouse—must have received no distribution. To preserve the ability to make a QTIP election, the spouse must execute a qualified disclaimer within nine months of the transfer to the trust. It is not clear whether the spouse could disclaim and have assets go into a trust of which they are a discretionary beneficiary as an inter vivos transfer (although this could be done for a testamentary transfer).
4. Trust with a disclaimer. A trust with a disclaimer is similar to the strategy discussed above, but the disclaimed interest reverts back to the donor if a beneficiary or trustee disclaims. The ability to disclaim must be included in the trust agreement. A disclaimer will undo the taxable portion of the transfer. A disadvantage here is that the donor is not in control. Rather, the trustee or the beneficiary must take action.
5. Sale for a note with the potential for a subsequent cash gift. This strategy involves a sale of assets, ideally to a grantor trust, for fair market value equal to the taxpayer’s assumed bonus exemption amount, should it remain unchanged. The taxpayer should make the sale in exchange for a promissory note with interest imposed at the applicable federal rate. If the higher exemption amount remains in place, the taxpayer can make gifts of cash or other assets to the trust to absorb the exemption. If the bonus exemption is reduced retroactively, there will be no taxable gift, because the sale was made for full and adequate consideration.
Practitioners can use defined value or price adjustment to mitigate the risk that the Internal Revenue Service will deem the consideration to be inadequate. Further, to avoid a loan being recharacterized as a gift, you must ensure that the promissory note is valid and that formalities are observed .
6. Rescission. Planners can rely on a theory of rescission based on a mistake of fact or law. The problem with this strategy is that federal law determines the tax effect of the rescission. In other words, rescission may be available in state court under state court trust principles, but that does not mean that the federal government will recognize it for tax purposes.
In addition to legislation that would affect gift tax exemption amounts, on April 28, 2021, the Biden administration proposed The American Families Plan that would eliminate stepped-up basis on gains for many taxpayers when stocks, real estate, and other capital assets are passed down to heirs. Stay abreast of these potential changes by subscribing to the WealthCounsel Blog.