For financial and tax advisors, and millions of Americans, 2020 has felt like the equivalent of being hit by Mike Tyson’s signature combo. The COVID-19 pandemic was an explosive right hook, and the November election is the impending right uppercut that we all wish we could avoid.
For small businesses and professionals, handling the COVID-19 pandemic, the PPP program, EIDL loans, medical provider programs, and delayed tax filing deadlines have been extraordinarily complicated and challenging. Just as CPAs and other tax return preparers have finished corporate returns by October 15th, PPP borrowers must struggle with income tax planning as they realize that the expenses that they made sure to pay to obtain forgiveness for their loans will not be tax-deductible, which is essentially the same as if the PPP loan forgiveness was taxable!
In addition, a great many wealthy individuals and families are ardently working to organize their trust and estate planning situations in order to be ready for a possible reduction in the estate tax exemption amount that could occur before they have a chance to make use of the exemption.
If the Democrats take control of the House, Senate, and presidency in the upcoming election, those making medical decisions for wealthy individuals in intensive care in late December, out of fear of potential changes to the tax code, might be influenced to take advantage of the current $11,580,000 estate tax exclusion and the certainty of receiving a new fair market value income tax basis for Great Grandpa’s assets.
During past critical moments in the history of estate and gift taxes, such as in 2010 and 2012, a number of articles were written with the tongue-in-cheek query asking whether it was time to unplug grandma or grandpa before the estate tax law changed drastically.
While the vast majority of families will not have a senior family member in intensive care in the last week of 2020, whose premature death may save significant taxes, affluent families should now be seriously planning how each individual member can best use his or her $11,580,000 exclusion if and when the time comes that they must “use it or lose it.”
With the year quickly coming to an end, this article reviews a number of key estate planning opportunities that can be considered and implemented for 2020 planning before it is too late.
In 2000, the lifetime exclusion for estate and gift tax purposes was only $675,000, which was barely enough to cover the value of a home and a relatively modest retirement account. Additionally, there was even a separate excise tax that was imposed at death on “excess accumulations” in certain retirement accounts.
Following the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the estate tax exclusion amount rose from $1 million in 2002 to $3.5 million by 2009. This legislation also increased the gift tax exclusion amount to $1 million, where it has since remained static. Not only did the exclusion amounts increase, but the maximum rate imposed on estates and gifts fell as well. No longer were decedent’s estates and lifetime gifts subject to rates as high as 55 percent or higher for the largest estates.
Additional changes occurred beginning in 2010. In that year, the estate tax was supposed to have been repealed, but it was instead reinstated with an applicable exclusion amount of $5 million (although the rate for 2010 was zero, to the delight of wealthy families). The gift tax exclusion remained $1 million with a maximum rate of 35 percent. In 2011 and 2012, the estate and gift tax lifetime exclusions were once again paired at $5 million, adjusted for inflation and the concept of “portability” was added to Internal Revenue Code. The so-called “fiscal cliff” negotiations at the end of 2012 brought further changes for 2013 and later, including a rise in the maximum estate and gift tax rate to 40 percent. More recently, the 2017 Tax Cuts and Jobs Act, doubled the estate and gift tax exclusion amount to $10 million, adjusted for inflation, so that for decedents dying and gifts made in 2020 the amount is currently, $11.58 million.
Given the above, one could easily conclude that change has been good for those facing possible estate and gift taxes. However, the future holds great peril based on the unfortunate circumstances we now find ourselves in. While the overall economy has been strong over the last decade, 2020 has proven to be a very unpredictable and downright scary year. Unemployment has spiked to historic numbers and the financial markets have swung wildly over the last few months. Over 200,000 people have died from COVID-19 related illnesses and the end is not in sight. A vaccine is months, if not a year or more away, and to top it all off, a volatile Presidential election is upon us.
Although the changes made by the 2017 Tax Cuts and Jobs Act have a sunset date, which is the end of 2025, there is no guarantee that they will remain in place until then. With the election just on the horizon, a major turnover in Washington D.C. with Democrats controlling both houses of Congress and the White House is a very possible scenario that we may see come to fruition. If that occurs, what is to prevent a reversal of the trend toward more favorable estate and gift tax rules?
In recent years, many Democratic tax policy proposals have called for new revenues that will not necessarily be limited to lowering the estate tax exclusion amount and raising the applicable transfer tax rates. Other targets in these proposals include imposing capital gains to be paid on appreciated assets when a person dies, and higher ordinary income rates to apply when IRAs, annuity investments, and other items that are considered as income in respect of a decedent (IRD) are distributed. Additionally, restrictions on more esoteric estate planning strategies, such as grantor retained annuity trusts (GRATs), family limited partnerships (FLPs), and family limited liability companies (FLLCs), have also been proposed.
Many families with significant wealth have yet to address the issue of planning how each individual member can best use his or her $11,580,000 exclusion if and when the time comes that they must “use it or lose it.” Many of these families have also not done the type of planning with FLPs, FLLCs, sales to trusts in exchange for notes bearing interest at low rates, or other arrangements that might not be available in the future.
Although this comment may seem harsh to some, reality dictates that the “Survival of the Fittest” results from the fact that smart and responsible people and their families will survive economically, while not so smart, unresponsive, or ill-advised wealthy families may become much less wealthy because of failure to take the right steps, including the Biden 2-Step. You can learn more about the Biden 2-Step by watching Jerome B. Hesch, Martin B. Shenkman and I deliver a complementary LISI webinar on this topic by clicking HERE.
The significant tax law increases we may see under a Democratic-run government include the elimination of a new fair market value income tax basis that occurs for most assets when someone dies (i.e., “stepped-up basis”), higher income tax rates, and even possibly a capital gains tax to be imposed at death, as if a person who died sold all of their assets. The latter would be similar to the tax law system that has prevailed in Canada for many years.
A few tools for the sophisticated advisor to consider include the following:
1. Having Your Cake and Giving it Back in 2021 – The Wait-and-See QTIP
A married donor can sign and fund a flexible Qualified Terminable Interest Property (“QTIP”) trust that must pay all income to the spouse. This trust may only be used for the spouse’s benefit during his or her lifetime.
The donor can file a gift tax return as late as October 15, 2021, if properly extended, to treat the QTIP trust as one or a combination of the following:
a. A pure 100% marital deduction trust. In this event, the grantor has not used any of the grantor’s $11,580,000 exclusion and the trustee of the QTIP trust may elect to pay all of its assets to the spouse.
b. The donor can elect to have the entire trust treated as a gift and use the donor’s estate tax exemption. If individuals use this option, the trust will never be subject to estate tax in the estate of the beneficiary spouse.
This is the case even if the beneficiary spouse appoints the trust assets so that they benefit the grantor with expenses as reasonably needed for health, education, and maintenance after the donee spouse’s death.
c. A partial election can be made by formula or dollar amount so that a certain portion of the QTIP Trust becomes a credit shelter trust like subsection b. above, with the rest being a marital deduction trust as described in subsection a. above.
Example: A donor owes a $10,000,000 note that may be worth only $8,000,0000. The donor’s estate tax exemption amount is somewhere between $6,000,000 and $9,000,000, depending on whether discounts taken with prior gifting are challenged.
The donor has filed gift tax returns in the past using $1,580,000 of her estate and gift tax exclusion, leaving $10,000,000 that she can gift in 2020 without incurring a gift tax.
The donor puts the $8,000,000 note and $2,000,000 of marketable securities into the QTIP trust in 2020.
In 2021, the donor makes a formula election to treat the note and marketable securities as being in the credit shelter trust to the extent of the value of the note plus sufficient marketable securities to use the entirety of the donor’s 2020 estate tax exclusion.
Upon audit, the IRS may conclude that past gifts exceeded what was reported by $1,000,000 so that the donor’s exemption is only $9,000,000. The IRS may also value the note at $9,000,000 and conclude that the credit shelter portion of the QTIP trust consists entirely of the note, with the remaining $2,000,000 of marketable securities being in the marital deduction part of the QTIP trust.
The IRS will not be able to impose gift tax if the documents are drafted properly and an appropriate election is made in 2021. Please note that there are no “reasonable cause” exceptions to filing the marital deduction election by the due date in 2021. Be careful out there!
2. Run the Numbers
Anyone who has ever spreadsheeted or used estate tax planning software knows that the numbers that result from a given situation may be quite different than what was otherwise expected.
The below numbers show that an installment sale to an irrevocable trust in exchange for a low-interest note can have a much bigger impact on estate tax avoidance than simply gifting $11,000,000 before year-end.
The below numbers assume that a married couple has $44,000,000 in assets that consist of a $4,000,000 house growing at 3.5% per year and $40,000,000 of investments growing at 5.5% per year. If the husband dies in 6 years, the wife dies in 15 years, and the two have done little in the way of estate planning, then the estate tax due on the death of the wife would be $42,434,027.
If one spouse dies in 2026 and could leave $6,790,000 in a credit shelter trust to be established on the death of the first dying spouse, then the estate tax liability on the second death in 2035 would be reduced to $40,752,567.
This is illustrated by the following table, which summarizes the below described planning steps and the significant savings from sale and installment note arrangements which dwarfs the savings from only making an $11,000,000 gift to a grantor trust:
One possible option for this hypothetical couple would be to transfer $11,000,000 to an irrevocable trust in order to reduce their estate tax burden. Even if the couple does not wish to do further planning, this alone would result in an estate tax of $34,605,171 for a total savings of $6,147,396 in estate tax.
If the couple would instead both fund an $11,000,000 trust and sell the trust another $10,000,000 in assets in exchange for a 3-year promissory note bearing interest at 1%, the estate tax on the second death will now be reduced to $30,571,612. This simple installment sale would save $4,033,559 in estate taxes.
If the couple were to go one step further and place $15,000,000 in an LLC and sell a 99% non-voting member interest in the LLC to the trust in exchange for a $10,000,000 note, instead of a sale for $10,000,000 in cash, then the additional estate tax savings would be $4,464,953.
If the couple would instead put $32,000,000 of investments into an LLC and sell a 99% non-voting interest to the trust in exchange for a $21,333,333 note, then the estate tax savings from putting $32,000,000 in the LLC in lieu of $15,000,000 and having the note be for $21,333,333 instead of $10,000,000 would be another $9,631,647.
Please note that the estate tax savings from funding the first $11,000,000 into an irrevocable trust is only $6,147,396 and that the additional savings from having the trust purchase a 99% limited liability company interest would range from $4,464,953 to $9,631,647.
This may be difficult, but it is more than worth the effort for advisors to educate clients on how this works.
The above numbers assume that the clients will pay annual income taxes on the investments based upon 1.5% of the value and that no income tax would be imposed upon the trust that they establish if and when one or both of them die.
3. Working with a Spousal Limited Access Trust – It is as Good as the Marriage Itself
The most popular variety of trust for married couples in 2020 year-end planning, is the Spousal Limited Access Trust (SLAT). This trust can be held by the donating grantor’s spouse for his or her health, education, and maintenance, and it is also held for the health, education, and maintenance of their descendants. Additionally, the spouse can be given the power to make dispositions to charity, and to direct that the assets may be held for the health, education, and maintenance of the grantor if the grantor survives the surviving spouse.
The trust might also be established in an Asset Protection Trust (“APT”) jurisdiction, and the grantor might be added as an additional beneficiary of the trust if and when the grantor would have unforeseen financial setbacks.
I do not recommend that a “reciprocal SLAT” be established by each spouse for the other, even though the case law in this area has permitted reciprocal SLATs. One concern is that a creditor may successfully claim that reciprocal SLATs, formed by a married couple who do not live in a creditor protection jurisdiction, could be invaded by creditors if they are formed in a domestic jurisdiction and the law of the state where the married couple resides is found to be controlling. If creditors are able to reach into the trust, then either spouse could run up debt and have it paid by the trust and therefore be considered to have obtained a lifetime interest under Internal Revenue Code 2036(a). This could cause each trust to be subject to federal estate tax on the assets of the trust that he or she is a beneficiary of.
New PPP Transfer Limitations Will Hurt Many Families.
Lastly, it is important to remember that PPP borrower entities are subject to transfer limitations pursuant to SBA Notice 5000-20057. To learn more about this notice, click HERE to read my October 4th post.
It is imperative for families to know that there are many planning opportunities that they can attempt to use to save taxes and facilitate sound decision making before the end of 2020.
While the question of whether to “unplug Great Grandpa” will be a difficult one for many, families who plan ahead will not have to face this terrible dilemma.
Maintaining close contact and communication with CPAs, tax lawyers, and financial advisors are crucial elements that are necessary for families that want to maximize the benefits of detailed estate planning. This helps to ensure that the best advice is provided, especially between now and year-end, where the time and energy of such advisors may be relatively limited given the number of individuals and families that may be seeking advice “at the last minute” after the election.
Remaining calm, evaluating all alternatives, planning well ahead of time, and staying out of intensive care are all good strategies that conscientious advisors can apply to help assure that as many clients as possible have the opportunity to evaluate their options.
PLEASE DON’T TRY THIS AT HOME – EVEN GOOD ESTATE TAX PLANNERS OFTEN CONFER WITH OTHERS BEFORE DECIDING WHAT THE BEST STRATEGY IS, AND QUITE OFTEN THERE ARE MANY CHIPS LEFT ON THE TABLE.
Source: Forbes – Money