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Estate tax planning in 2020, it’s deja vu all over again! Time to consider gifting strategies in some cases

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Estate tax planning in 2020, it’s deja vu all over again! Time to consider gifting strategies in some cases

Authored by Glenn A. Henkel and Samantha Heaton

Recent developments with the coronavirus have caused some proactive and wealthy clients to consider whether tax law changes may create an increased tax burden in the future.  As a result, some are revisiting the tax rules and determining whether immediate action is warranted. Similarly, in 2012, the federal estate tax exemption threshold, then $5,000,000, was potentially going to be reduced to $1,000,000 per individual. Some families chose to take irrevocable steps to “lock in” the exemption before expiring. As it turned out, the American Taxpayer Relief Act of 2012, enacted in 2013, maintained the existing $5,000,000 exemption from estate tax making such steps unnecessary. However, now, in 2020, in light of the current pandemic and an upcoming election which could see a change in administration, the potential for future reduced exemptions has some families considering whether they should use exemptions so they do not lose exemptions.


By way of background, the Federal Estate tax and the Federal Gift tax are combined together to result in a single “transfer” tax system.  When an individual makes gifts during life, the gifts consume the amount of the exemption from the testamentary federal estate tax calculated at death.  As noted, the federal estate and gift tax exemption amount was set at $5,000,000 in 2010, indexed for inflation, and retained from expiring in 2013.  The 2017 Tax Cut and Jobs Act “doubled” the exemption but only until January 1, 2026, resulting in a current 2020 exemption threshold of $11,580,000 (when considering inflation adjustments).  Last year the IRS announced that a gift made under the existing law would be “grandfathered” from estate taxation in the event of future change to the law. This means that, if a person gifts away $11,580,000 in 2020 using their full exemption, and then passes away after 2027 when the exemption has been hypothetically reduced to $5,000,000, the $11,580,000 gifted in 2020 will still remain exempt from taxation. See “Final Clawback Regulations Released” Posted in December 16, 2019 and Treasury Regulation § 20.2010-1(c). Of course, no one knows what the future holds for tax legislation, but several bills have been introduced in Congress that would limit the estate/gift tax exemption, some as low as $3,500,000[1].


One unfortunate and disfavored method for preserving the current exemption is the passing away of an individual. Obviously, that is not an option to plan for. A more palatable and appealing option is for a client to make an irrevocable gift, in which case the current available estate/gift tax exemption can shelter the gift from tax. The normal “downside” to a lifetime gift is the loss of the “step up” in income tax basis that occurs when an individual passes away owning an appreciated asset.


Generally, gain on the sale of an asset is calculated by using the seller’s cost “basis”, or, for real estate, the depreciated “basis.” However, when a person passes away with an appreciated asset, the basis of the asset is “stepped up” to the fair market value of the asset on the date of the decedent’s death. The estate of the decedent or beneficiary of the asset can then calculate the gain on the sale of the asset based on that stepped up basis, often resulting in the elimination of any gain and thus any income tax. This is therefore a significant exception to the normal cost basis rule and capital gains tax. The exception is lost, however, if the asset is gifted to the recipient during the donor’s life rather than on death; in that case, the recipient will receive a “carryover” income tax basis from the donor and lose the possible income tax benefit of the stepped up basis.[2] Thus, while a lifetime gift can preserve the current available estate/gift tax exemption, such gift comes at the cost of losing the possible benefit of the step up in basis.


Nevertheless, if a taxpayer/donor is interested in making a gift to preserve the exemption, the gift can be made, either outright or in a trust. The use of a trust is an age-old mechanism to separate control of the gifted property from the benefits of the property. A trust can also be used to defer the timing of receipt of the benefits of the gifted property. Thus, if the donor wanted to have the property go to the heir after the donor has passed, the trustee can hold the funds until passing (or sooner or later) to coordinate with the donor’s wishes.


There is another tax benefit that can be achieved through the use of an irrevocable trust. A trust can be structured in a fashion where the trust is considered the “alter ego” of the grantor for income tax purposes. This is known as a “Grantor trust” pursuant to I.R.C. Section 671 et seq. If a trust is structured as a “Grantor trust” the grantor/donor must pay income tax on all of the trust’s earnings. While originally enacted to discourage irrevocable trusts of this type, the “Grantor trust” is now used as a tax planning strategy. Under the grantor trust provisions, the payment of income tax on earnings is the legal obligation of the grantor. This payment is not considered a gift for gift tax purposes even though the benefits of the income inure to the beneficiary of the trust. The Internal Revenue Service recognized long ago in Revenue Ruling 2004-64, I.R.B. 2004-227, that the income tax payment could not create an additional gift. Thus, some clients use the “Grantor trust” mechanism to further reduce their estate to the benefit of family members by paying the income tax liability on trust earnings.


Not many clients can afford to permanently relinquish the substantial sums that need to be gifted in order to preserve this tax benefit; however, for some married spouses, an alternate approach could be considered. Suppose one spouse creates a trust for the benefit of the other spouse. The gift could be structured as a gift to the trust under which the donor spouse has no legal right to any benefit, but yet, during the life of the recipient spouse, the benefits of the trust could be available to the family unit, including the donor spouse if the recipient spouse chooses to use his or her distributions from the trust for the benefit of the donor spouse. This approach has been referred to as the “Spousal Lifetime Access Trust” (or “SLAT”). The recipient spouse can be a trustee, can receive income from the funds and can invade the principal of the trust for “health, maintenance and support in reasonable comfort.” This was a very popular technique late in 2012 as the reduction loomed large, and is becoming once again a popular technique to preserve the current estate/gift tax exemption.


However, like all planning techniques, there are drawbacks. First, the donor spouse is not a beneficiary of the trust, so if the recipient spouse passes away, the benefits of the trust pass to the remainder heirs (away from the donor). This can be mitigated in some cases if the recipient spouse can obtain (or owns) a life insurance death benefit that can provide for the donor spouse. Similarly, if the spouses divorce, the benefits of the trust will presumably not be available to the donor spouse. Second, the trust for the spouse will always be a “grantor trust” which, as noted, can be a good thing. However, there are certain situations where a donor spouse might want to cease paying the income tax bills. With such a SLAT trust, that is not possible.


For some spouses, there might also be an opportunity for each spouse to create a trust for the other spouse in order to capture not only one large exemption, but two. If so, the trusts need to be different from one another to avoid the application of the “reciprocal trust” doctrine. For example, in United States v. Grace, 395 U.S. 316 (1969), spouses created nearly identical trusts for each other and the Internal Revenue Service asserted that the trusts should be disregarded for tax purposes, as if each spouse created the trust for his or her own benefit. The United States Supreme Court agreed with the IRS, and  any tax benefits from the creation of the trusts, including the removal of the trust assets from the donors’ estates, were denied on the premise that a person cannot retain an interest in a trust and receive the desired gift tax benefits. Thus, in this scenario, the trusts need to be sufficiently different from one another in order to receive the tax benefit of utilizing the current gift tax exemption and removing the assets transferred to the trust from the donor’s estate. See Estate of Levy, 46 T.C. Memo 910 (1983), a New Jersey case where the trusts were found to be sufficiently different because powers were granted to the wife in the trust created by the husband that were not granted to the husband in the trust created by the wife.


In sum, making irrevocable plans to minimize tax, particularly taxes that will be due after your demise, is always a difficult decision. However, some families may consider the existing rules to be more advantageous than they might be in the future and, with that in mind, may choose to embark on opportunities that exist today.

[1] It should be noted that some Congressional bills propose repeal of the estate and gift tax in their entirety as well.

[2] While vague, the plan proposed by Democratic nominee, Vice President Biden seems to imply that it would repeal the step up in income tax basis at death.

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