As the 2020 election looms near, estate planning practitioners are holding their collective breath in anticipation of what may be radical tax reform if the Democrats sweep the election. In either case, Republican or Democrat, practitioners are considering potential changes to tax policies as revenue-generating proposals to address pandemic-fueled fiscal policies. Such reforms, if enacted, may upend traditional "rules of the road" for wealth planning, and are cause for clients to proactively reconsider their current plans.
This alert outlines key proposals concerning tax law that estate planning practitioners and clients alike should be aware of and describes flexible estate planning techniques that may better position clients for the uncertainty of the future of tax policy. If the 2020 election results in Democratic control of the presidency and Congress, new tax reform passed in 2021 could be retroactively effective to January 1, 2021.
The current basics of estate planning include an exemption from federal estate and gift taxes equal to $11,580,000 in 2020 for each individual. Assets included in an individual's estate that exceed the individual's remaining exemption available at death are taxed at a federal rate of 40% (with some states like New York adding an additional 10-16% state estate tax). However, each asset receives a step-up in income tax basis at the individual's death, so that the decedent's heirs inherit the asset with a basis equal to its fair market value on the date of the decedent's death. In other words, upon a subsequent sale of the asset, the decedent's heirs will incur capital gains only to the extent the asset has appreciated since the decedent's death. Furthermore, any capital gains that are considered "long-term," i.e., gains from assets that the seller has owned for more than one year, are taxed at preferential rates. There are also ways to avoid gain recognition on real estate through like-kind exchanges that reinvest the sale proceeds into a replacement property within a certain period of time.
The following tax proposals, if enacted, would greatly affect wealth planning strategies going forward:
1. Decrease in estate and gift tax exemption.
Even without any legislation, the current estate and gift tax exemption of $11,580,000 ($10 million indexed for inflation) is scheduled to decrease on January 1, 2026 to $5,000,000 (indexed for inflation). However, the exemption could decrease as soon as 2021 if made part of Democratic tax reform. The generation-skipping transfer (GST) tax is a separate tax that is levied when transfers are made to or for the benefit of someone two or more generations younger than the transferor, and such transfers are taxed at a rate of 40%. The current law provides for a separate GST tax exemption of $11,580,000, and such a GST tax exemption level historically mirrors that of the estate and gift tax exemption. Presidential candidate Joe Biden has suggested that the exemption for the estate and generation-skipping transfer (GST) tax could be made as low as $3,500,000 per individual, while the exemption amount for gifts could be as low as $1,000,000.
2. Increase in estate tax rate.
The current estate tax rate of 40% has been in place only since 2013. The estates of taxpayers who died in 2011 and 2012 enjoyed a top estate tax rate of 35%; however, this top rate has historically been much higher—as high as 77% in the 1940s and more recently in the 45% to 55% range under the 2001 Tax Act. In addition to the decrease of the estate and gift tax exemption, it is conceivable that sweeping Democratic tax reform could include an increase in the estate and gift tax rates, as several Democratic presidential candidates discussed increasing rates to "historical norms."
3. Elimination of the step-up in basis at death or death as a realization event.
The concept of the step-up in basis of assets included in an individual's estate has been a guiding principle in structuring estate plans since 1980 (when the carryover basis rule was repealed retroactive to 1976).[1] The basic planning advice is to gift high-basis assets during the donor's lifetime, as the donee receives the donor's basis in the gifted asset (called "carryover basis"), and to retain low-basis assets so that the donor's heirs receive those assets at death with a new stepped-up basis, equal to the fair market value of the asset as of the donor's date of death. The donor's heirs can turn around and sell the assets post-death without incurring any capital gains tax for the difference between the donor's original basis and the fair market value of the assets at death. The Biden tax plan calls for the repeal of the stepped-up basis concept.
Stepped-up basis has historically been a counterbalance to the levy of estate tax. Upon an individual's death, the fair market value of the decedent's assets is determined, and if the value exceeds the estate tax exemption available at the decedent's death, then estate tax is due on the excess amount. However, no capital gains tax is due as a result of death, and the heirs inherit the assets with a stepped-up basis.
There are two possible scenarios should the stepped-up basis at death rule be eliminated. Under one scenario, the beneficiary inherits the asset with a carryover basis (as previously described). As an alternative to a carryover basis regime, one radical change that has been suggested in the Biden tax plan for tax reform is the realization of capital gains upon death. This could mean that upon an individual's death, both estate tax and capital gains tax will be levied on the same assets. The heirs should then receive the assets with the "stepped-up" basis, but that would be a result of the triggering of the capital gains at death.
By way of illustration of the three scenarios, let's take an example of an individual purchasing an asset (real estate, stock, or art, for example) for $1 million in 2000 and dying in 2021 when the asset had a fair market value of $5 million, and the individual's heirs selling the asset in 2022 for $7 million.
- Current Tax law:
- Estate Tax: Asset is included in estate and is potentially subject to 40% federal (and additional state) estate tax if the total value of the estate assets is over the exemption amount (which is scheduled to be lower in 2026). Asset receives a step-up in basis to date of death value.
- Capital Gains Tax: Asset is not subject to capital gains tax at the individual's death, and the individual's heirs will only owe capital gains tax on the $2 million of appreciation between date of death and date of sale in 2022.
- Proposal for No Step-Up of Basis for Assets at Death:
- Estate Tax: Asset is included in estate and is potentially subject to 40% or higher proposed rates for federal (and additional state) estate tax if the total value of the estate assets is over the exemption amount (which may be lowered effective Jan. 1, 2021). Asset does not receive a step-up and retains the donor's original basis of $1 million.
- Capital Gains Tax: No capital gains tax at death. At sale, the heirs would owe capital gains tax on the $6 million of appreciation between the donor's original basis of $1 million from acquisition date and the value at the later date of the sale ($7 million).
- Proposal for Realization of Capital Gains Tax on Assets at Death:
- Estate Tax: Asset is included in estate and is potentially subject to 40% or higher proposed rates for federal (and additional state) estate tax if the total value of the estate assets is over the exemption amount (which may be lowered effective Jan. 1, 2021), just as above.
- Capital Gains Tax: At death, (i) the individual's estate will owe capital gains tax on the $4 million of appreciation that has accrued between date of purchase and date of death, and (ii) the heirs will owe capital gains tax on the $2 million of appreciation between date of death and date of sale.
4. Increase in tax rate on capital gains for high income earners.
Currently long-term capital gains are taxed at preferential rates of 0% for single filers with less than $40,000 of annual income, 15% for single filers with less than $441,450 of annual income, and 20% for single filers with $441,450 or more of annual income. Short-term capital gains are generally taxed as ordinary income. The Biden tax plan calls for imposing a 39.6% rate on long-term capital gains for individuals with more than $1 million of annual income. This proposal also reflects an overall increase in the graduated income tax rates to restore the rates to their pre-2018 levels. Although estates and trusts with high income levels have not been specifically addressed, it is likely that these ordinary rates for long-term capital gains will apply to estates and trusts with $1 million of annual income and may even affect estates and trusts at a lower income threshold, as estates and trusts reach the highest marginal rate of income taxes at a much lower threshold of income than individual taxpayers under current law.
5. Elimination of like-kind exchanges.
Like-kind exchanges allow taxpayers to avoid paying capital gains taxes upon the sale of real property if the taxpayer invests the sales proceeds into a replacement property that is valued the same as or higher than the original property within 180 days of the original sale. Prior to the enactment of the Tax Cuts and Jobs Act in 2017 (TCJA), these like-kind exchanges applied to the exchange of other classes of assets in addition to real estate; the art market in particular was impacted severely by the removal of like-kind exchanges for art. The Biden tax plan identifies the like-kind exchange rules as a provision that could be repealed in order to raise revenue to fund child care and elderly care initiatives.
6. Additional changes to valuation discounts and to GRATS.
Clients and practitioners currently enjoy the use of valuation discounts when transferring interests in closely held business in the form of a lack of control discount and a lack of marketability discount. During the Obama administration, the Treasury released proposed regulations that would sharply restrict the use of these valuation discounts, and such proposed regulations were later withdrawn under the Trump administration in October 2017. Senator Sanders introduced legislation in 2019 that would have a limiting effect on the application of these discounts as well, and we could see similar restrictions on discounts as part of future tax law changes.
Furthermore, grantor retained annuity trusts, or GRATs, are useful estate planning vehicles in low-interest-rate environments. The transferor, or "grantor," retains an annuity for the term of the trust, and any assets remaining at the end of the trust term pass to other beneficiaries. For gift tax purposes, the grantor makes a gift equal to the remainder value of the trust, which is determined by the annuity amount and a factor published monthly by the IRS. Under current law, many practitioners draft GRATs to generate a gift of $0 (or nearly $0) and provide for a trust term as short as 2 years. This means that the grantor uses no gift tax exemption in the transaction and receives his or her money back in only two years. In other words, there is little downside to creating a GRAT, and the upside is the potential for a large tax-free gift to the remainder beneficiaries of the GRAT if the assets appreciate (which is easier to achieve in economic environments where the assets are depressed in value because of current market conditions). Over the past few years, several Democratic lawmakers have introduced legislation that would heavily limit the appeal of GRATs, including requiring a minimum GRAT term of 10 years and a retained interest that would produce a gift equal to the greater of 25% of the trust assets or $500,000. Such legislation could be included in future Democratic tax reform.
Stay Tuned Next Week for Six Strategies You Might Use to Prepare for These Possible Changes
If you have any questions about the possible tax policy changes or wish to begin discussing what, if any, planning you should be considering before year end, please contact our Venable Tax and Wealth Planning and Regulatory attorneys.
*A special thank you to Peter Nielsen for his contribution to this article.
Footnote
[1] This change was enacted under the Crude Oil Windfall Profits Tax Act of 1980, P.L. 96-223, 96th Cong., 2d Sess. (1980).