Planning for Estate and Gift Tax changes

September 28, 2020
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estate planning tax information 2020 jennifer wilkerson grass valleyThe upcoming November election may bring tax changes that impact your estate planning. Tax increases may be needed to raise revenue, including for the COVID-19 federal stimulus spending. Estate and Gift tax increases would surely be considered because they mostly affect wealthy taxpayers, and not those struggling due to the pandemic and its economic impacts.

The current lifetime Estate and Gift tax exemption amount is $10 million, adjusted for inflation. In 2020, the lifetime exemption is $11.58 million (with the increase for inflation.) With proper planning, married couples are able to transfer property of twice this amount, up to $23,160,000, without incurring Estate or Gift tax.

The Estate and Gift tax exemption amount will continue to increase for inflation through 2025. The exemption will then revert to $5 million (adjusted for inflation) beginning in 2026, due to the ‘sunset’ provision in the original legislation.

Could the lowered exemption happen sooner? Many have speculated that the exemption amount might be reduced before 2026, and to an amount as low as $3.5 million. It is also possible for the Estate and Gift tax rate to increase from the current 40% to 55% or even higher.

In addition, former Vice President Biden has proposed eliminating the “step-up” in basis for inherited capital assets, which means more taxes on wealth passed to heirs, and ending favorable tax rates on capital gains for anyone making over $1 million. It’s unclear whether the heirs would owe tax immediately on a gift or inheritance, or instead continue a “carry over” cost basis resulting in higher tax when they eventually sell the inherited asset.

Furthermore, current record-low interest rates (including the IRS-sanctioned Applicable Federal Rate (“AFR”) and the “Section 7520 Rate” interest rates) favor estate planning strategies which shift appreciation in value as a tax-free gift to children or other beneficiaries.

Here are some strategies to consider implementing before year end 2020:

estate planning federal guidelines jennifer wilkerson grass valleyTransfers to Use Highest-Ever
Estate Tax Exemptions

If you desire to pass assets to younger family members or other beneficiaries, it may work to create and fund Trusts now that take advantage of the historically high $11.6 million Estate and Gift tax exemption. This ‘use-it-or-lose it’ benefit works only if you are prepared to make significant gift-transfers.

Suppose a single taxpayer gives away $9 million to his children covered by this year’s high exemption (so no Gift tax), and then dies in 2026 when the personal estate tax exemption has reverted back to $6 million. Since the donor has used his entire exemption, his estate will still pay Estate tax- but only on the excess he retained above the $9 million (so he might have given away even more). And zero tax was paid on the $3 million gifted above the reduced exemption amount.

It may make sense to make such larger gifts if your remaining assets will sufficiently cover your lifestyle needs, and you are confident that those assets will further appreciate. Capital gains tax on low-basis assets must be considered, however, because the donee-children will not receive a stepped-up basis on the gifted assets, as would occur if you hold the asset until death (unless the current law is changed.)

estate planning guidelines for married couples grass valley For happily married couples, a Spousal Limited Access Trust (“ SLAT”) is an effective strategy to take advantage of today’s record-high exemption amounts while preserving access to your assets in the future. With a SLAT, one spouse (the “Donor Spouse”) makes a gift of assets to a trust for the benefit of the other spouse (the “Beneficiary Spouse”) along with other beneficiaries (usually, the children and/or grandchildren). The trust names an independent trustee (who is likely to abide by the Donor Spouse’s distribution wishes, though there should be no express or implied understanding with the trustee to do so) who has discretion to make distributions of trust assets to the trust’s beneficiaries, including the Beneficiary Spouse.

The Donor Spouse’s exemption amount is used because the transfer is not a qualified marital deduction. Similar to the example above, the entire gift (up to $11.6 million) is non-taxable. Also, all future appreciation in value of the trust’s assets will be free of future gift, estate, and possibly GST tax.

If the spouses later need to use the transferred assets, the independent trustee may distribute trust income and/or principal to the Beneficiary Spouse– which is then added back to his or her taxable estate. For this reason, the Donor Spouse should retain sufficient assets to maintain the couple’s lifestyle and only fund the SLAT with excess assets.

If the marriage dissolves or if the Beneficiary Spouse predeceases the Donor Spouse, the Donor Spouse may lose the ability for a potential return of the trust’s income and/or assets, unless a power of appointment is included.

estate planning and taxes grass valley attorney jennifer wilkersonTransfers which Benefit from Low Interest Rates
Generally, the success of the following strategies depends upon the Trust investments earning a higher rate of return than the designated interest rate for the gift. This planning is more likely to succeed in the current low-interest rate environment.

  1. With a Grantor Retained Annuity Trust (“GRAT”), the grantor transfers assets to a trust for a term of years while receiving back an annual annuity payment. At the end of the trust term, any remaining principal will be distributed to the trust beneficiaries. If the grantor dies before the end of the GRAT term, all or a portion of the value of the GRAT is included in the grantor’s estate tax base.

    The taxable gift to the GRAT is the property value, less the present value of the annuity payments to the grantor. The interest rate for calculating the retained interest is the “Section 7520 Rate” which for September 2020 was only 0.4%. All growth in value of the GRAT’s assets in excess of 0.4% per annum will pass to the GRAT’s beneficiaries free of gift or estate tax.

  2. An Installment Sale to an Intentionally Defective Grantor Trust (“IDGT”) is similar to a GRAT, but with added advantages for generation-skipping planning. With an IDGT, the grantor sells property to a Trust in return for an installment Promissory Note that bears interest at the low AFR rate, plus at least 10%-15% of the property value as “seed” money (which is a taxable gift.) All appreciation in value of the Trust assets exceeding the total Note payments to the grantor passes to the beneficiaries free of gift, estate, and possibly GST tax.

    Another advantage of both a GRAT and an IDGT is that these trusts qualify as “Grantor Trusts” for federal income tax (and some but not all state income tax) purposes. This allows the grantor to pay the federal income tax on the income earned by the trust, which is essentially an additional economic benefit to the trust not treated as a gift for gift, estate, and/or GST tax purposes.

  3. An Intra-Family Loan is the simplest of the estate planning techniques. Similar to the IDGT, the grantor loans funds to the beneficiary (which can be an individual or a trust), documented by a Promissory Note with interest no lower than the prescribed AFR interest rate. For example, at the September 2020 rates, the minimum required interest rate would be only 0.11% for a loan term of 3 years or less, 0.27% for a loan term of between 3 to 9, and 0.76% for a loan term of more than 9 years. The younger generation can use the loaned funds to pay down higher-rate debt or make investments that may yield a higher return. The excess earned above the required interest payments is a tax-free gift.
  4. For those who support charitable organizations, a Charitable Lead Annuity Trust (“CLAT”) also works well when interest rates are low. A CLAT provides for an annual annuity payment to charitable beneficiaries for a period of time, regardless of the income generated by the CLAT. The trust may be established for a term of up to 20 years or can be based on the lifetime of a designated person. or lives of individuals living at the time of the creation of the trust. Your charitable deduction at the creation of the CLAT is the present value of the annuity, using the Section 7520 Rate. The taxable gift is the value of the assets gifted to the CLAT less the present value of the annuity payments. In a low interest rate environment, there is a greater chance that the rate of return will exceed the Section 7520 Rate, which increases the value of the assets passing to the remainder beneficiaries (e.g. family) free of gift or estate tax at the end of the annuity term.

Some Easy-to-Implement Strategies
estate planning grass valley jennifer wilkersonIf an existing grantor trust owns assets with a low tax basis relative to current fair market value, you may consider an Exchange of Low Basis Assets for a Higher Tax Basis in cash or other assets. This type of exchange between an individual and grantor trust is not treated as a “sale” for income tax purposes, and consequently will not trigger capital gains tax. Upon death, under present law, the low basis assets in the decedent’s trust receive a “step-up” in basis equal to their current fair market value. When later sold, the beneficiaries will pay capital gains tax on the sales proceeds only if they exceed the new “stepped-up” basis.

In 2020, individuals may make Annual Gifts of up to $15,000 per recipient without triggering the gift tax. Married couples eligible to split gifts may make gifts of up to $30,000 per recipient. Additional amounts may be gifted for education and medical care, within specific IRS restrictions. Gifting is an easy way to reduce your taxable estate.

Gifts to 529 education savings plans have a further advantage because earnings may grow free of federal income tax when used for education. Qualified education expenses were expanded in recent years to include laptops, computers and related technology. A special exclusion allows you to elect to treat gifts up to $75,000 in one year as if made ratably over the future five-year period.

act now 2020 estate planning laws jennifer wilkerson grass valley

Given the time needed to analyze options and decide on a particular strategy, we should begin discussions immediately to prepare for year end. Additional time may be needed to transfer securities or property, and obtain tax identification numbers for new trusts. Waiting until close to year-end may be too late to implement a recommended plan. Please contact us soon to explore which planning techniques will work best for you.

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