3.29.21 | BERDON VISION
President Biden’s estate tax proposal includes a reduction of the estate exemption, increased estate tax rates, and the removal of asset step-up in basis at death. The combination of these estate tax proposals with the COVID-19 impact on decreasing asset values in certain businesses, as well as historically low interest rates, kick-started an influx of estate planning activity in the 2020 tax year, which has carried over to 2021. This is an opportune time to review all estate planning documents, including designated beneficiary forms.
Current Estate, Gift, and GST Tax Law
Today’s record-high gift, estate and GST exemption allows an individual to gift or bequeath up to $11,700,000 (effectively $23,400,000 for married couples) without incurring tax. The current exemption is scheduled to expire on January 1, 2026, when it will return to $5,000,000 ($10,000,000 for married couples), indexed for inflation. Gifts made today are protected by the “anti-clawback” regulations, which allow individuals to use the current exemption without fear of future penalty or “clawback” at the taxpayer’s death.
Any portion of the exemption not used during an individual’s lifetime is applied against estate and GST tax at death. In the case of a married couple, the unused estate exemption, but not the GST exemption, is portable to the surviving spouse (if an election is made on a timely filed estate tax return). Gifts or estates in excess of the exemption are taxed at a flat federal rate of 40%. Beneficiaries of estate assets receive a step-up in basis equal to the fair market value on the date of death.
President Biden’s Estate, Gift, and GST Tax Proposals
Reduction in Exemption Amounts
The estate, gift, and GST exemption could potentially be reduced to $3,500,000 ($7,000,000 for married couples) and the federal gift exemption further reduced to $1,000,000 per individual ($2,000,000 for married couples) with no index for inflation, as early as this year. While there is authority for allowing such legislation to be retroactive to January 1, 2021, the likelihood is generally considered low. To mitigate the impact of a reduced exemption, individuals should be working with their advisors currently to establish a plan for using their remaining exemption early in the 2021 tax year.
Planning Opportunity: A gift transfer is permanent once fully executed. For clients that are concerned about permanently giving away assets to younger generations, they may consider creating a Spousal Lifetime Access Trust (SLAT) to preserve distributions to spouses, thereby maintaining access to the trust.
Caution: Individuals who live in Connecticut or have real property located in Connecticut that they are considering gifting are also subject to the Connecticut gift tax. The Connecticut gift exemption is currently $7,100,000, far less than the federal exemption, with a top tax rate of 12%.
Increased Estate Tax Rates
The estate, gift and GST tax rates could potentially increase up to 45%. This means, aside from reductions in exemption amounts, that an additional 5% of estate assets may be turned over to the IRS. An essential part of an estate plan is making sure there is enough liquidity to pay the estate tax. Individuals and business owners often use life insurance policies to make-up for any potential shortfall. In addition, existing provisions of law allow for the deferral of estate taxes on estates with closely held business interests and/or in hardship situations. With the potential increase in estate tax rates, individuals should be reviewing their estate plans to ensure that there is sufficient liquidity to timely pay the estate taxes.
Planning Opportunity: The recent dramatic decline in asset values, including many businesses, combined with historically low interest rates makes this an advantageous time to gift or sell assets to a GST-exempt intentionally defective grantor trust (IDGT). The gift or sale of a minority interest in a business asset may also reflect certain valuation discounts. These types of transfers can be structured as a partial gift/partial sale whereby the grantor uses a portion of the estate and GST exemption for the gift and takes back a note for the sales price. By using a GST exempt IDGT, the grantor will still pay the income taxes on the income generated by the trust, including capital gains tax, during her lifetime. This allows the property sold and/or gifted to grow outside of the grantor’s estate for the benefit of the beneficiaries and future generations, unencumbered by income taxes during the grantor’s life. The trust can use the cash flow generated from its business interest to pay off the note.
Caution: When planning to gift and/or sell low basis assets to an inter-vivos trust, the age and health of the individual making the transfer should be carefully considered. A gift retains the same tax basis as in the hands of the transferor, whereas assets included in an estate will receive a step-up in basis if current law holds. Advisors often recommend retaining low basis assets within an individual’s estate, so that the unrealized appreciation at death passes to the beneficiaries’ income tax free. However, Biden’s tax proposal includes the removal of step-up in basis at death.
Removal of Step-up in Basis at Death
President Biden’s tax proposal falls silent on how the removal of step-up in basis would be structured. There is a question of whether there will be an income tax on unrealized appreciation at death or a carryover of the decedent’s basis to estate beneficiaries. There is also skepticism that a credit or deduction would be available against either the estate or income tax to mitigate the effect of the double income and estate taxation, as well as uncertainty as to how such credit or deduction would be calculated. This condition exists in current law with assets such as qualified retirement plans. The income tax is not imposed at death, but when the asset is realized in cash, by allowing an income tax deduction for the estate tax attributable to the asset.
An income tax at death combined with the estate tax may have a devastating impact on the after-tax assets available to pass to estate beneficiaries. For business owners, including real estate professionals, their estates often include assets that have been held for decades, with little, none or even “negative” tax basis. For example, the combination of an estate tax and income tax at death, on a zero-basis asset, could be as high as 98.4% (55% estate tax, 43.4% income tax), or more than 100% if an asset has negative tax basis. This is before the impact of additional state estate and income taxes. This could lead to the forced sale of estate assets to satisfy the income and estate taxes, preventing these assets from continuing to pass within a family.
A carryover in basis to estate beneficiaries would defer the income tax until the time when the beneficiary decides to sell the asset (if ever). Assets that have been held by families for multiple generations can continue to pass down the line without the trigger of an income tax. Although still not ideal, the carryover basis concept provides more time to plan for retaining these low basis assets within successive generations or understanding the after-tax impact of a sale.
Berdon Observation: Planning for a potential repeal of step-up in basis at death is context specific, and strategies should be assessed on a case-by-case basis. A conversation with your tax adviser is the best place to start.
Other Popular Wealth Transfer Techniques May be at Risk
There are many planning techniques and strategies that in recent years have been targeted for potential limitation or elimination. These include valuation discounts in family control contexts, grantor retained annuity trusts (GRATs) with certain characteristics, and sales to IDGTs. These are all popular techniques currently in use for family wealth transmission that are on many reform-minded tax writers’ radar.
If you have any questions about how to structure your gifting and overall estate plan in light of Biden’s estate tax proposals, contact Veronique Horne at 212.331.7631 | firstname.lastname@example.org or Scott T. Ditman at 212.331.7464 | email@example.com or reach out to your Berdon tax advisor. We are just a phone call (or Zoom call) or e-mail away.
Berdon LLP New York Accountants