Based on recent election results, attention has focused on what is in store for the federal transfer tax system. This article discusses the status of the current transfer tax laws and President Biden’s proposals for changes.
Estate, Gift, and Generation-Skipping Transfer Taxes
Three federal taxes affect the transfer of wealth: gift tax, estate tax and generation-skipping transfer (GST) tax. Not all transfers are subject to transfer tax. The gift tax (which applies to lifetime transfers) and estate tax (which applies to transfers at death) are “unified,” meaning that a single rate schedule applies to both taxes and there is a single “exemption” amount that each individual may transfer during life or at death without paying gift or estate taxes. The GST tax is an additional tax imposed on certain transfers made to persons more than one generation below the donor. The GST tax applies to transfers during life and to transfers at and after death.
As part of the Tax Cuts and Jobs Act (TCJA) of 2017, the gift, estate and GST exemptions were doubled in 2018 from $5 million to $10 million, indexed for inflation from 2011. The 2021 gift, estate and GST exemptions are currently $11.7 million. The exemption amount is scheduled to “sunset,” or return to its pre-TCJA level, on January 1, 2026. The applicable tax rate for transfers in excess of $11,700,000 is 40%.
For married persons, the federal estate tax exemption amount is portable. This means that if an appropriate election is made in a timely manner on the federal estate tax return of the first spouse to die, the surviving spouse may receive and utilize during his or her lifetime or at death any portion of the first spouse’s unused exemption amount. Thus, if a spouse should die without fully utilizing his or her federal exemption amount, it is not necessarily lost.
Unlike the federal estate tax exemption, the GST exemption is not portable between spouses, meaning that if one spouse dies without fully utilizing his or her GST exemption, any unused exemption is lost.
During his campaign, President Biden released a number of high-level proposals that would undo much of the TCJA. Though many of the proposals lacked detail, they included the following:
Accelerate the “sunset” of increased exemptions before January 1, 2026.
Increase the estate tax rate to 45%, with exemptions of $3.5 million for estate and GST tax and an exemption of $1 million for gift tax (not indexed for inflation, but the estate tax exemption would be portable to the surviving spouse). Note that this proposal is somewhat inconsistent with returning the exemptions to pre-TCJA levels. It was originally issued during the Obama administration in the “Green Book” of fiscal proposals.
Tax appreciated assets at capital gains rates upon a transfer by gift or death (with thresholds, exemptions and other details to be determined).
Although the future of the transfer tax system is uncertain, it may be beneficial for you to consider wealth transfer strategies at this time to take advantage of today’s higher exemptions. For a discussion of some of the ways you can use your current available exemptions, see our September 2020 client alert.
If any of the proposed legislative changes are enacted, the laws could be applied retroactively to an earlier date, perhaps as early as January 1, 2021. A retroactive change in the law reducing gift tax exemptions could result in a surprise gift tax for gifts made by taxpayers at a time when exemptions were higher. Although commentators have speculated that Congress is unlikely to enact any legislation retroactively changing the transfer tax laws in 2021, Congress has in the past made some tax law changes retroactive, so the possibility cannot be completely discounted.
Hedging Against Retroactivity
Given the possibility that changes to the tax code may be applied retroactively, certain strategies may be considered now to hedge against this risk.
Under the tax code, if the recipient of a gift disclaims the gift within nine months of the date the gift was made, the gift to that recipient is treated as not having been made. (Note that there are many conditions required for an effective disclaimer which are not discussed here.) If a gift were made to an adult child in March 2021, the child would have until December 2021 to disclaim the gift. The terms of the gift could be drafted to provide that, in the event of a disclaimer, the gifted property returns to the donor and the gift will be deemed to have never occurred. This allows the decision of whether to use the higher exemption to be effectively deferred for nine months, when more may be known about tax law changes.
For a married couple, the unlimited marital deduction can help mitigate the risk that changes to the law may be retroactive. For example, a spouse could transfer assets to a trust that could contain a taxable gift or could qualify as a qualified terminable interest property (QTIP) trust for the benefit of the other spouse. The QTIP election could be deferred until the time that a gift tax return for such a transaction is due, which would be October 2022 (with an extension).
If the exemptions are reduced in 2021 and made retroactive, a QTIP election could be made, thereby qualifying the gift for the marital deduction and not incurring gift tax. The QTIP trust could also provide for a “best interests” standard for distributions which will enable easy access to the assets.
Alternatively, if the exemptions are not reduced, the donor spouse could choose not to make a QTIP election and the trust could proceed as a gifting trust for the beneficiary spouse to use the higher exemption. Additionally, such a trust could be drafted to provide that a disclaimer made by the beneficiary spouse of all of his or her interests in the trust would result in the gifted assets being held in a trust for descendants (this trust could also include the spouse as a beneficiary). These options allow flexibility to deal with possible changes to the law within the nine months following the gift, including unwinding the gift completely or using the higher exemption.
An intra-family loan can also be used to facilitate the transfer of assets now. Interest rates continue to be significantly low. For example, the AFR midterm rate for February 2021 is 0.562%. The proposed gift could instead be made as a loan, which could be forgiven, becoming a gift if the exemption continues at current levels or continued as a loan if the exemption is reduced retroactively.