Wealthy clients should consider planning now for the reduction in estate and gift tax exemption

215

In 2018, Congress doubled the lifetime estate and gift tax exemption from $5 million per person (with annual cost of living increases) to $10 million per person. The exemption covers taxable gifts made during lifetime (those beyond the $15,000 per person annual exclusion) and then applies to cover your estate upon your death from estate tax.

This doubling of the exemption is set to expire or “sunset” on Dec. 31, 2025. This means that even if Congress takes no further action to change the exemption, it will be reduced by half to what it was in 2018 when both parties agreed to a $5 million exemption per person with cost of living adjustments.

Many people are wondering what will happen to the exemption if there is a Democratic president and possibly a Democratic-controlled Congress. It is very possible that the exemption could be reduced as part of tax legislation before 2026 to move it back to the $5 million exemption or even lower.

Most people do not need to be concerned if they do not have estates that come close to these figures. But for wealthier individuals and married couples, it is a real concern since the tax on anything over the exemption is at a rate of 40%. The chart below will give you an idea of the possibilities for exemption given the current cost of living adjustments.

Per personMarried couple can protect as much as:
Current estate and gift tax exemption$11,580,000$23,160,000
Possible reduction to 2018 levels$5,790,000$11,580,000
Possible reduction to a lower amount$3,500,000$7,000,000

For those individuals or couples whose net worth exceeds these amounts, they should consider acting this year to use the additional exemption that is currently available that might be eliminated as early as next year.

The Treasury Department and the Internal Revenue Service have issued final regulations to clarify that if taxpayers make taxable gifts before the exemption is reduced, they will not “clawback” the exemption or impose a gift tax on the transfer based upon the lower exemption.

People have at least a few options available.

One option is to transfer substantial assets directly to children or grandchildren or to irrevocable trusts that they establish for their children or grandchildren.

These transfers are generally considered “taxable gifts” and a gift tax return (Form 709) would be required by April 15 after the year of the transfer.

The “taxable gift” would essentially be “paid” by applying a portion of the donor’s exemption. As a result, no actual payment is made to the Internal Revenue Service. Because the direct gifts or the transfers to trusts for children or grandchildren are irrevocable, the assets transferred and all future appreciation on those assets are no longer in the parents’ estates for estate tax purposes upon the parents’ deaths.

Another option for a married couple is to set up a spousal lifetime access trust or SLAT. This is an irrevocable trust that one spouse sets up to provide income and perhaps principal subject to a set standard (e.g. for health, education and support) for the other spouse and eventually for their descendants.

These trusts are usually set up with the appropriate powers and language so that they are no longer considered part of either spouse’s estate for estate tax purposes at their deaths, but the income tax on the trust assets remains taxable to the donor spouse during his or her lifetime.

The advantage of this type of irrevocable trust is that it uses up some of the estate and gift tax exemption to offset the gift to the trust; the couple still has access to the income (and perhaps principal) during the life of the spouse who is the beneficiary of the trust; the income tax on the trust assets are paid by the donor spouse so that the trust assets can grow free of income tax for the ultimate benefit of children or their descendants; and all growth on the assets transferred to the trust avoids estate and gift tax.

The spouse who is the beneficiary can also set up his or her own SLAT for the other spouse. The terms of each SLAT in such cases should be a little different as to the distribution provisions and perhaps trustees to avoid the IRS arguing that the trust arrangement should be ignored on a “reciprocal trusts” theory.

However, a SLAT is irrevocable. If a marriage is not solid and divorce is a real possibility, a SLAT is not advisable because, upon a divorce, the spouse who created the SLAT likely will lose access to the income and principal from the donated assets.

There are certainly other variations and options for making gifts to individuals and trusts to use up the large exemptions currently available. Every person’s situation is different. However, wealthy individuals should start planning now so that the documents and transfers can be in place before any reduction in the exemption.

Facebook Comments