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Act Now, While the Giving Is Good

New York Law Journal
September 12, 2019
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The Tax Cuts and Jobs Act of 2017 did not abolish the federal estate tax, but it greatly eased taxpayers’ exposure until 2026. The estate tax exemption was $5.49 million per decedent in 2017, but the TCJA has increased that number to $11.4 million in 2019. With scant planning, a married couple can use both exemptions and leave up to $22.8 million to heirs this year, free of federal estate tax.

However, the estate tax exemption is scheduled to drop by about 50% in 2026, exposing more taxpayers to the current 40% tax rate on assets over the lower threshold. That exposure could come even sooner, if political shifts in the interim generate another new tax law that lowers the estate tax exemption. Swift action that anticipates a pullback on estate tax relief could wind up saving millions of dollars for certain taxpayers.

Winning the Numbers Game

In 2026, the federal estate tax exemption is scheduled to drop to $5 million, plus cost-of-living adjustments: probably around $6 million per individual. Thus, a married couple with a projected estate of, say, $15 million, could owe substantial tax if today’s 40% tax rate remains in effect on assets over the combined exemption amount of $12 million.

Savvy planning can help such taxpayers and one possible place to start is via astute use of family gifts.

The annual gift tax exclusion in 2019 is $15,000 per recipient. For example, suppose a hypothetical John and Mary Smith have two children, both married, and a total of four grandchildren. These grandparents could each give up to $15,000 to their eight relatives this year, or $120,000 apiece, for a total of $240,000 in asset reduction, with no tax consequences.

In addition, the senior Smiths could directly pay education and medical bills for all of these younger people. By using such gifts each year, they could be reducing future estate tax significantly by giving away some wealth, as well as any future appreciation of those transferred assets.

This strategy can be done every year.

Larger Gifts

Above the annual exclusion amount and the medical and education expenses, larger gifts can produce larger tax savings. Fortunately, an IRS notice has reduced the “clawback” risk that had some observers worried.

For example, suppose John and Mary Smith have made a total of $20 million of taxable gifts ($10 million apiece) to their children and grandchildren. Under current law, those gifts reduced their estate tax exemptions by that $20 million but did not generate an obligation to pay gift tax. (The current gift and estate tax exemption also applies to the generation-skipping transfer tax, so certain gifts to grandchildren can be made without tax consequences.)

Now suppose that a tax law passed in 2021 reduces the estate tax exemption to $6 million apiece, so the Smiths could make no more than $12 million of taxable gifts without owing gift tax. They would be $8 million over the new limit, potentially subject to $3.2 million in gift tax, at an assumed 40% rate.

That possible issue was addressed by the IRS on Nov. 23, 2018, with a notice of proposed regulations. As the notice said, “The proposed regulations ensure that a decedent’s estate is not inappropriately taxed with respect to gifts made during the increased BEA [basic exemption amount] period.” Thus, gifts that were exempt under the contemporary law in effect, would remain exempt from gift tax, regardless of any adverse changes in the future.

Consequently, taxpayers who will be subject to estate tax, under the current exemption amount or a possible lower one, might consider making family gifts in excess of the annual exclusion amount and any medical and educational expense payments. People who already have made gifts up to the pre-TCJA ceiling can make additional gifts, up to the 2019 limits of $11.4 million per donor. Other taxpayers, who may have made few or no taxable gifts in the past, should consider giving assets to loved ones in order to reduce estate tax obligations. All of these gifts should be made before the exemption amount is rolled back. Once the law changes, this planning opportunity is lost.

Additionally, some states do not have a gift tax, so making gifts now may reduce state estate tax. In any event, the state tax implications of making any gifts needs to be taken into account.

Trust Worthy

Family gifts needn’t be outright transfers. In fact, giving large amounts to individuals opens up the possibility that the recipients will mishandle their funds. Transferring money to a trust not only can in many cases reduce estate tax, but also preserve assets for use by family members, over a long term.

Transfers to trusts work best when the trust beneficiaries are well-informed and well-advised. For example, a wealthy individual might establish a “disclaimer” trust.

Suppose that Joe Brown dies in 2022 and leaves all of his assets to his wife Jill. No estate tax would be due because the bequest goes to a surviving spouse. Further suppose that the estate tax exemption has been reduced by then and Jill’s estate would owe tax at her death, when her assets pass to their children.

If the Browns’ estate plan allows Jill to disclaim certain assets and pass them to a trust, she would personally die with fewer assets and possibly avoid saddling her heirs with an estate tax bill. Here, a successful plan might call for including a disclaimer provision in Joe’s will, and for Jill to recognize the advantage of disclaiming certain assets, which would go into the trust.

Special Cases

Many specific types of trust can be used now, for tax-efficient estate planning while the estate tax exemption tops $11 million. For instance, assets could be placed into a grantor retained annuity trust (GRAT). The grantor would get an annuity from the GRAT during the trust term, usually a few years. After the trust terminates, the GRAT beneficiary—perhaps the grantor’s child—will receive any assets still held in trust. As long as the asset growth in the interim outpaces the relevant IRS §7520 interest rate, assets may be transferred with little or no gift tax exposure.

Thus, GRATs may work very well in a low-interest-rate environment, especially if the assets involved have lost value before going into the trust. The §7520 for July 2019 transfers is 2.6%. For the GRAT to be successful, the assets held in trust must grow greater than this rate. So if the assets in the GRAT appreciate at a rate of 5%, the additional 2.4% of appreciation escapes estate taxation in the grantor’s estate.

Another type of specialized trust to consider is an irrevocable life insurance trust (ILIT). As the name indicates, the creator of this type of trust may use money transferred into the trust to obtain an insurance policy on his or her life and pay the premiums. The younger and healthier the creator is, the more likely a policy can be obtained with reasonable premiums.

When the insured individual dies, the policy benefit (which can be considerable) will go to the ILIT. As long as all the formalities have been followed carefully, the proceeds from the life insurance policy will be outside of the insured individual’s estate, exempt from estate and income tax. Conversely, a life insurance policy owned by the insured individual will generate funds that are included in that individual’s estate, so 40% of the payout could be lost to estate tax.

A properly-drafted ILIT can lend money to or buy assets from the decedent’s estate, providing cash for estate tax obligations and other expenses. Going forward, assets held within the ILIT can be protected from taxes, creditors, and imprudent spending.

Another popular trust is a spousal lifetime access trust, commonly known as a SLAT. A married couple can both create non-reciprocal SLATs to use their exemptions through gifts but preserve their access to the funds in the trusts. The provisions of a SLAT authorize the trustee to make distributions to your spouse and even your children. All future appreciation on the assets in the SLAT is shielded from estate tax.

Charitable Thoughts

Clients with significant philanthropic intentions have other ways to reduce possible estate tax burdens, including charitable remainder trusts and charitable lead trusts. Funding a remainder trust, for example, not only removes the donated assets from the donor’s taxable estate but may also provide a tax-efficient way to turn appreciated assets into lifelong cash flow.

Beyond funding charitable trusts, tax-efficient planning in this area may call for deferring sizable donations until after age 70½. Then qualified charitable distributions may be made, directly from an IRA to a charity or charities, potentially reducing the income tax cost of required minimum distributions (RMDs). Such donations may be up to $100,000 per person per year. While the distribution is not taxable, there is no charitable contribution deduction. However, there is no need to make sure that the charitable contribution deduction limitation based on a taxpayer’s adjusted gross income doesn’t apply.

In addition, estate planning can call for specified charities (even a charitable remainder trust) to be the beneficiary of a client’s IRA or employer-sponsored retirement plan. This will avoid passing on a deferred income tax bill to individual beneficiaries; the charitable organization won’t pay income tax, so the deferred income tax obligation from retirement funding will vanish.

If a client’s philanthropic intentions are satisfied in this way, other assets, including appreciated property, can pass to family members. Under current law, heirs receive a basis step-up in appreciated property. With a higher basis, beneficiaries can sell those assets immediately and avoid capital gains tax, so all appreciation during the decedent’s lifetime also can avoid income tax altogether.

Such sophisticated estate planning can use gifts, trusts and other tactics to hold down taxes for high net worth clients, even if future legislation reduces the current estate and gift tax exemption.


Reprinted with permission from the “September 6, 2019” edition of the “New York Law Journal”© 2019 ALM Media Properties, LLC. All rights reserved.

Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 - reprints@alm.com.