Part 2: Six Strategies You Might Use Today to Prepare for Potential Tax Law Changes

8 min

On January 1, 2013, the estate and gift tax exemption was scheduled to decrease from $5,120,000 to $1,000,000. Estate planning practitioners and their clients scrambled in the last months of 2012 to take advantage of the high exemption level before it "sunset" on New Year's Eve. In January 2013, Congress enacted legislation to retain the $5,000,000 estate and gift tax exemption amount, indexed for inflation, and such exemption was retroactive to January 1, 2013. This is to say that there is no guarantee that the $10,000,000 (indexed) exemption level available to individuals this year will be available at all in 2021, even if tax reform passes later in the 2021 calendar year. However, practitioners are cognizant of the concept of "donor's remorse" that some taxpayers experienced in 2013 after hastily making transfers in December 2012 to ensure their exemptions were fully used. In approaching this 2020 election season, which may yield wildly different tax policies in 2021 and beyond based on November's results, tax practitioners should be mindful that creating flexibility in their clients' estate plans is key.

Below are six estate planning ideas that may be worth considering in the remaining months of 2020 in light of the uncertainty of 2021.

1.  Completing gifts this year

As the TCJA has a reduction of the estate and gift tax exemption already scheduled for January 1, 2026, many high-net-worth taxpayers have already been contemplating how best to utilize this exemption before the 2026 sunset. For those clients who have had their extra $5,000,000 exemption on their mind, 2020 may be an excellent time to proceed with making completed gifts. Treasury regulations finalized in 2019 ensure that transfers covered under a taxpayer's exemption in the year of transfer cannot be "clawed back" later at the taxpayer's death if the exemption level has decreased. Furthermore, Treasury guidance makes clear that the $10 million exemption (indexed) is a use-it-or-lose-it proposition. If a taxpayer gifts $5 million and the exemption later decreases to $5 million, the taxpayer has no remaining exemption and the additional exemption afforded under the TCJA is lost.

2.  Sales to trusts and other estate freezes

If a client is uncertain about transferring assets out of his or her estate by completing gifts this year, an estate freeze may be a better option. In a freeze transaction, the transferor retains the present value of an asset in his or her estate for estate tax purposes and transfers away the future growth of the asset. Because the transferor is retaining the fair market value of the asset on the date of the transfer, the transaction is not a gift and does not use any exemption.1

Many estate freeze transactions are structured so that the transferor sells appreciating assets (a minority interest in a closely held business or real estate, for example) to a trust for the benefit of his or her intended heirs, in exchange for cash or a promissory note equal to the fair market value of the sold assets. Because the trust purchasing the asset is typically a "grantor trust," which treats the transferor and the trust as the same taxpayer for income tax purposes, the sale is ignored for income tax purposes. An estate freeze transaction before any tax law changes (potentially Jan. 1, 2021) involving a grantor trust would do nothing more than remove an appreciating asset from the client's taxable estate – no gain is triggered and no exemption is used.2 Additionally, if Democratic tax reform looks more likely after the November elections, estate freezes are more effective, as clients would have the option to forgive any promissory note that was received as part of an estate freeze transaction, and the amount of the note forgiven would be a gift and would utilize the client's exemption.

As discussed above, GRATs can be used as an estate freezing tool, as the grantor retains a set annuity amount, and any assets remaining at the end of the trust term can currently pass tax-free to the trust remainder beneficiaries. Because of tax law changes that may significantly impact the effectiveness of short-term GRATs, coupled with today's low-interest-rate environment, clients may also consider setting up a GRAT this year.

3.  SLATs

Spousal limited access trusts, or SLATs, were very useful in 2012 for clients who wished to use their exemptions, but still retain the ability to receive the gifted assets back if needed at a later time. The typical SLAT is an irrevocable trust for the benefit of the transferor's descendants, but the trust terms also allow for distributions to be made to the transferor's spouse. Because the transfer to the SLAT uses the transferor's gift tax exemption (and generally the transferor's GST tax exemption as well), the strategy is to refrain from making distributions to the spouse, which has the effect of pulling the distributed asset back into the combined estates of the transferor and the spouse, so that the trust assets will be preserved for the younger generations. However, the SLAT's safety valve is that the spouse is an eligible beneficiary, so that the assets may be distributed back to the spouse if there is a financial hardship in the future.

This structure is a useful tool for estate planning in uncertain times. Often married clients each create a SLAT for the other spouse, to ensure that both spouses' exemptions are fully utilized, and both trusts should be respected as long as they contain nonreciprocal terms. Sometimes one trust is created for the spouse and future descendants, and a second trust is set up only for the children and future descendants. When planning with SLATs, practitioners and clients should consider how to best address a future divorce of the couple, as well as the premature death of the spouse-beneficiary, which terminates the transferor's access to the trust assets.

4.  Toggle off grantor trust status and triggering gains

Triggering capital gains in 2020 for low-basis assets may save a client a tremendous amount of taxes if the Biden capital gains proposal is enacted. Note that, in the alternative, President Trump has indicated that he would like to see a greater reduction in capital gains rates. Given these two polarizing policies, clients may be hesitant to undertake any transaction prior to the November elections that involves the recognition of capital gains.

Tax practitioners should be talking with their clients now to see if there are low-basis assets that can be poised for sale in the last few weeks of the year if the client wishes to incur the gains this year based on the election results. For grantor trusts that were created at an earlier time, one consideration is whether toggling off grantor trust status would be desirable at the end of the year. Toggling off, or converting a grantor trust to a non-grantor trust, causes the trust to be treated as a separate taxpayer after the conversion. The result is that the transferor is treated as having sold the trust assets to the trust on the date of the "toggle off" so that capital gains are triggered at that time. One consideration of toggling off is that the trust must begin paying its own income taxes going forward and will lose the "gift" of its income tax liability being paid by the transferor each year; however, toggling off prior to capital gains rates increasing may be an efficient way to engage in tax planning in the last few weeks of the year.

5.  Insurance

Given the possibility of a lower estate tax exemption, higher estate tax rates, and capital gains that may now be realized at death, clients should consider whether their estate will contain sufficient liquidity to cover taxes at death. If the client's cash sources are greatly outweighed by illiquid assets, it may be time to consider obtaining or increasing life insurance coverage. The life insurance industry is confronting new issues arising from both COVID-19 and low interest rates. However, in order to continue to attract new business, a number of insurance carriers have made concessions to capture this new business, resulting in a faster process with pricing identical to pre-pandemic rates. Ultimately, life insurance is a useful tool for financing taxes at death and can be excluded from the assets subject to estate tax at death if owned in a qualifying life insurance trust.

6.  IRA Conversions

Traditional IRAs are funded with pre-tax dollars which continue to be invested and grow tax-free until the account holder is required to begin withdrawing funds from the account in retirement. Withdrawals from traditional IRAs will be included in the taxpayer's income for the year of withdrawal. Given that Democratic tax reform, if enacted, could return income tax rates to pre-TCJA levels, clients may consider a Roth IRA conversion of some or all of his or her traditional IRA this year. The amount converted will be added to the account holder's taxable income in the year of the conversion, but the converted assets in the Roth account and any appreciation thereon will be tax-free in the future. Unlike traditional IRAs, Roth IRAs do not require distributions at any age, and the conversion of a traditional IRA to a Roth IRA is not subject to the income limits that prohibit high earners from contributing directly to a Roth IRA account. A conversion does require a 5-year holding period on withdrawals, and the client will incur early withdrawal penalties if he or she is younger than age 59½ and uses the IRA account to pay the tax due on the conversion.

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If you have any questions about the possible tax policy changes or wish to begin discussing what, if any, planning you should be considering this fall, please contact our Venable Tax and Wealth Planning and Regulatory attorneys.

Read Part 1 here.

[1] In most situations, the best practice is still to report the estate freeze on a timely filed gift tax return.

[2] If the sale involves the transfer of closely held business assets, the transaction would take into account available lack of control and lack of marketability discounts, as may be applicable, which may not be available under a Democratic tax reform, if enacted.