This is the first of a two-part blog note briefly exploring federal transfer and some income tax considerations as we approach the end of the calendar year 2020.
“You’ve got to be careful if you don’t know where you are going, because you might not get there” Lawrence Peter (Yogi) Berra (maybe).
Although many of us may look forward to this year’s end, from a federal tax planning perspective, there are some aspects of current tax law that U.S. taxpayers may wish to take advantage of before putting 2020 in the rearview. Although it can be said that the federal tax law landscape is constantly changing, these changes (or possibilities of change) seem never more relevant or disruptive than in a presidential election year. This year is no exception. As 2020 circles the drain, it may be appropriate to explore what options remain for tax planning before we sing “Auld Lang Syne” and usher in 2021. This blog discusses the estate and gift tax exemptions applicable to certain high-net worth individuals and their families.
Estate and Gift Tax Overview
Although it only effects an estimated 0.10% of taxpayers, the United States federal estate and gift tax is often a target of changing tax policy, particularly in an election year. Sometimes referred to as the “death tax,” the U.S. federal estate tax applies to every U.S. citizen and U.S. resident at his or her death to the assets included in the taxpayer’s “taxable estate.”
Although described more technically in the Code as a credit, each taxpayer can effectively reduce his or her taxable estate by a dollar amount equal to the basic exclusion amount (informally and more widely referred to as the “estate tax exemption amount”), which is increased each year for inflation. The current estate tax exemption amount, following the enactment of the Tax Cuts and Jobs Act of 2017 (the “TCJA”), is $10,000,000, increased for inflation to $11,580,000 for decedents dying in 2020; for tax year 2021, the estate tax exemption amount is expected to increase to $11,700,000 per taxpayer under current law.
The federal gift tax works like the estate tax, meaning, taxpayers can elect to use their exemption now (with taxable gifts) which serves to reduce exemption available to the taxpayer at death, or preserve their exemption, applying it at their death to their taxable estate. For the purposes of the discussion that follows, the term “exemption” will generally refer to either the gift or estate tax exemption.
A separate and additional transfer tax, the generation skipping transfer (GST) tax, is generally applied to transfers made to (or in trust for) grandchildren and more distant generations. Like the gift and estate tax, there is an available exemption amount applicable to these transfers (currently equal to the amount of the gift and estate tax exemptions). Although very important to consider in transfer planning, an analysis of GST tax would be a separate blog topic and beyond the scope of this discussion.
Without legislative action, the current increased exemption under the TCJA will revert back to $5,000,000 (again, increased for inflation) for decedents dying on January 1, 2026, or later.
Estate Tax Policy Change Proposals
Republicans and Democrats have each, through their presidential nominees, provided us a glimpse of how they would intend to shape future tax policy if elected. In connection with the federal estate tax, their competing policies are easily distinguished: the Republicans would hope to eliminate the “sunset” provision of the TCJA with respect to the exemption amount, extending the current (and increasing) exemption amounts beyond 2026 to permanency, while the Democrats would prefer to accelerate the 2026 “sunset” back to pre-TCJA amounts (e.g., $5,000,000 per taxpayer, indexed for inflation), or possibly further reduce exemption amounts (e.g., to $3,500,00 per taxpayer) as early as 2021. Former Vice President Biden has also proposed making changes to the basis adjustment rules for inherited capital assets. Although there is little detail on his website on implementing that change, its presence there at least merits a mention here.
Potential Retroactivity of Estate Tax Law Changes
It is well-settled that Congress can retroactively apply federal tax laws. The enactment, or effective date of a law, may be applied as early as the beginning of the tax year or date of introduction (e.g., the draft bill is introduced to the House or Senate and sent to committee, desk, or calendar). The ability of Congress to retroactively apply tax laws can, obviously, create great uncertainty in tax planning. Understanding that retroactivity is a possibility is critical to understanding tax planning in an election year where tax proposals set forth significant tax law changes. The bottom line is that the possibility that policy changes proposed even later in 2021 could still become effective as of January 1, 2021, means that any taxpayers wishing to take advantage of current tax laws should seriously consider taking action to implement such planning before the end of 2020.
Tax Planning for Year-end
If we assume there will be a reduction in the current exemption amount, then making use of the available increased exemption now, prior to the end of calendar year 2020, may be an appropriate approach. This approach, however, will not apply to all taxpayers. There are, for example, practical limitations to fully using a taxpayer’s current exemption amount as well as technical considerations to be developed and critically analyzed on a case-by-case basis. For example, the current exemption of $11,580,000 is effectively two separate exemption amounts: the original “base” amount and the additional “bonus” amount (such “bonus” being the increased exemption added by the TCJA). The IRS has promulgated ordering rules which require that taxpayers use the “base” amount prior to the use of the “bonus” amount. This means a taxpayer would need to gift the entire $11,580,000 to avoid losing his or her “bonus” exemption if the exemption is later reduced. The IRS has further provided that there is, thankfully, no risk that using the “bonus” amount now will trigger a tax at the taxpayer’s death if the exemption amounts revert to pre-TCJA amounts or are further reduced (i.e., there will be no “claw back” of previously used exemption).
For many taxpayers, even with substantial wealth, gifting most or all of their exemption may deplete resources currently used to maintain the taxpayer’s standard of living and protect against unknown future health or economic issues. For such taxpayers, currently using all available exemption is not a viable option even if the tax result is less favorable to their beneficiaries. For other taxpayers, however, “locking-in” the current exemption prior to any potential reduction can be accomplished using several different transaction structures.
The next blog of this two-part series will explore planning options for taxpayers who may want to explore year-end planning, such as transfers using current exemption amounts, leveraging the use of available exemptions, and some income tax considerations taking into account the current basis adjustment rules set forth in the Code for assets acquired from a deceased taxpayer.