There is significant momentum in Congress to reduce the amount of money an individual or married couple can shelter from the dreaded estate tax. Time to act may be limited.
Reduced Estate Tax Exemption
Under the Tax Cuts and Jobs Act of 2017, the Basic Exclusion Amount ("BEA") (i.e. the amount of assets and property an individual can pass to beneficiaries during life and after death without incurring gift and estate tax) doubled from $5 million to $10 million, adjusted for inflation. In 2021, the inflation-indexed BEA is $11.7 million per person. This enhanced BEA is scheduled to expire on December 31, 2025 and revert back to the pre-Tax Cuts and Jobs Act BEA of $5 million (likely $6.6 million after inflation adjustments for 2026). Importantly, the IRS issued regulations in 2019 stating that “individuals taking advantage of the increased gift and estate tax exclusion amounts in effect from 2018 to 2025 will not be adversely impacted after 2025 when the exclusion amount is scheduled to drop to pre-2018 levels.” Accordingly, if someone takes advantage of the increased BEA during these years, they will not be penalized if they pass away having transferred during life more than the BEA available to them at death. The increased amount is available to them today, if they are willing and able to use it, but they either “use it, or lose it” under the IRS rule.
Where we previously believed there were four (4) more years to take advantage of the enhanced exemption amounts, Congress now seeks to pass legislation to expedite the reduced estate tax thresholds. This would potentially reduce the BEA from $11.7 million per person today to $6.02 million per person on January 1, 2022 (or sooner, if Congress elects to make the change effective immediately). It would be a big change that could put your family at risk of higher taxes, depletion of wealth, and increased need for liquidity to pay the additional taxes at death. If you wish to explore using your enhanced BEA, the time to act is now.
Important Strategies Could Be Removed
What’s more, some elements being discussed within the current proposal would eliminate or curtail other popular tax planning tools. These tools currently allow you to keep more of what’s yours through the use of discounting techniques on intra-family gifts made through family limited partnerships or limited liability companies. These valuation discounts, currently ranging from 20% to 40%, may be eliminated under the new law. Other planning techniques that may be curtailed include the use of irrevocable trusts whose income taxes do not (currently) need to be separately reported. The new law may treat every irrevocable trust as a separate income tax entity and therefore require a separate tax return for each, eliminating the gift tax-free benefit of allowing the donor to pay the taxes on irrevocable trust income each year. While these tools are utilized only in a small fraction of family estate plans, the change will be significant for those high net worth families that look to rely on those strategies to reduce their taxable estates or keep concentrated holdings (like business or farm properties) whole.
It’s important to underscore that we don’t yet know the details of the reconciliation bill. If it does pass this year, however, certain aspects of the bill may be effective on the date the bill passes Congress and is signed by the President.
ISC Financial Advisors uses many other strategies outlined below to help our clients with estate tax mitigation. Please note: Your plan and situation are unique. We suggest you consult your estate planning attorney and tax advisor for a plan specific to your family, your assets, and your goals. If you do not have an estate planning attorney and tax advisor, please contact us and we'll be happy to make an introduction.
Common Tools for Reducing Taxable Estates While Preserving Overall Plan Benefits for Spouse and/or Descendants
Irrevocable Trust. An Irrevocable Trust is a trust that can accept gifts of assets, accounts and property during your lifetime and distribute them during your lifetime and after your death according to your wishes and timeline. Irrevocable Trusts are considered to be outside of your estate for estate tax purposes.
Spousal Limited Access Trust (SLAT). A SLAT is a type of Irrevocable Trust that is outside the donor's estate for estate tax purposes but permits distributions to a surviving spouse for health, education, maintenance, and support purposes without losing its estate tax exempt status. After the death of a surviving spouse, assets can be distributed to children (or any other beneficiary) without limitation based on donor's goals.
Irrevocable Life Insurance Trust (ILIT). An ILIT is a type of Irrevocable Trust designed specifically for holding life insurance policies and removing the life insurance death benefit from your taxable estate while still going to your chosen beneficiaries. Consider an ILIT if your net worth (including life insurance death benefits) is pushing up against the newly proposed estate tax exemption threshold, especially if the life insurance includes one or more term life insurance policies.
Grantor Retained Annuity Trust (GRAT). A GRAT is an irrevocable trust that allows the donor (also known as the grantor) to gift certain assets to trust to "freeze" the assets’ value, pull a defined annuity amount back to donor during the trust term, and remove the remainder from the taxable estate if the grantor outlives the duration of the trust. The freeze is a reference to the removal of any additional appreciation on the assets following gift to the GRAT, though this benefit exists with any gift to an irrevocable trust (i.e. the additional appreciation on gifted assets or property is removed from the grantor’s estate immediately, rather than being determined at death and included in the overall estate). A GRAT is ideal in today’s low-interest rate environment as the calculations are favorable for tax and asset growth purposes. This tool, however, has been specifically targeted in much of this year’s tax change legislation because it has been used to great advantage by many prominent wealthy families (e.g. the Walton family).
Qualified Personal Residence Trust (QPRT). A QPRT is an irrevocable trust that allows you to remove the value of your home (and future appreciation on your home) from your taxable estate, thereby reducing potential estate tax. Moreover, a discount against the value of the home is applied when funding the QPRT, which allows more room in your BEA for other assets. Consider this scenario: If your home value today is $1 million, the value for gift and estate tax purposes may be discounted by 20% to 30% based on the duration of the QPRT and the value of the remainder interest going to your children, thus using only $700k to $800k of your BEA upon transfer out of your estate.
Common Tools for Reducing Taxable Estates with Charitable Giving
Donor Advised Fund (DAF). A DAF is similar to a charitable investment account. The sole purpose is to support your favorite charitable organizations. We normally help clients fund DAFs with highly appreciated investments to maximize tax savings.
Charitable Remainder Trust (CRT). A CRT is an irrevocable trust that can receive a gift of property or accounts (usually highly appreciated property or stock holdings) from which one or more income beneficiaries (often the donor and/or the donor's spouse) receives regular payments for a term of years or for the remainder of the income beneficiaries' lifetimes. The payments can be in the form of a specified dollar amount or a specified percentage amount each year. The remainder upon expiration of the CRT goes to one or more charities defined by the donor, which may be changed from time to time and may include the donor's own DAF (see above). The value of the remainder (which can be no less than 10% of the value of the gift upon creation of the CRT) can be applied immediately by the donor on donor's income tax return(s). CRTs are popular because they can avoid capital gains tax on highly appreciated property or stock holdings and provide immediate income tax relief in the form of a current income tax deduction, while retaining a right to an income stream for a term defined by the donor.
Charitable Lead Trust (CLT). A CLT is essentially the inverse of the CRT in that it provides annual payments to one or more charities for the term of the CLT and the remainder upon termination goes according to donor's directions, ordinarily to a donor's descendants.
Other Tools That Can Be Used Within a Comprehensive Approach
Beneficiary Designations. If you are charitably inclined, you should consider using your pre-tax IRA for charitable giving, whether together with some of the charitable techniques listed above or alone, if your goals are simple. Another tip: It may be worthwhile to add to your estate plan specific instructions with regard to your philanthropic goals to instill this same mindset in your descendants. These may be in the form of binding gifts to specific charities or non-binding instructions, which we sometimes call "letters of instruction."
Roth Conversions. If leaving after-tax money to your heirs is important to you, consider Roth conversions. This strategy moves retirement money from pre-tax to after-tax status. While it results in income tax realization in the year the Roth conversion takes place, your estate value decreases post-conversion. Roth conversions can be used to pass money to your heirs in a tax-efficient manner and future growth on holdings is tax free.
Annual Gifting. Today, you can gift up to $15,000 per year to any person without having to file a gift tax return. A married couple can split their gifts to give up to $30,000 per year to any person (ordinarily children and grandchildren) without filing a federal gift tax return. If children are married, married persons may give up to $60,000 to a child and child's spouse without need to file a return, if done properly. It's important to note that there is a common misperception that you cannot give more than the annual exclusion amount per year; you can, the law merely requires that you report the amount in excess of the annual exclusion on a federal gift tax return. If you have a good estate planning attorney, most will assist with annual gift planning and, ordinarily, without charge if you intend to gift under your annual exclusion amount.
Wrapping It Up
As you can tell, while many specifics remain to be resolved by Congress, there are plenty of tax-savvy strategies available to help you keep more of what’s yours. The conversations in Congress are dynamic and there will likely be more changes soon. Your ISC team will stay on top of the latest developments.
Without the proverbial crystal ball, no one can say with certainty what will happen with tax laws. The best we can do is make smart decisions using the latest information we have today.
If you believe these current conversations in Congress could impact you, we suggest you connect with your estate planning attorney as soon as possible. We’re seeing tax professionals booked 45 days in advance, so time may be limited.
Please do not hesitate to contact our office if you have any questions. We remain your trusted advisors and, as always, we are here to help.