2021 Year-End Estate Planning Update
2021 was an interesting year for estate planning. While transfer tax exemptions remained at historically high levels, legislative proposals threatened to put an end to common estate tax planning techniques. Although uncertainty around future legislation continues, there are a variety of strategies that taxpayers can use to take advantage of current exemption levels and techniques.
Current Transfer Tax Laws
The federal gift, estate, and generation-skipping transfer (GST) tax exemptions (that is, the amount an individual can transfer free of any of these taxes) are $11.7 million per person for 2021, increasing to $12.06 million in 2022. Thus, beginning in 2022, a married couple can theoretically transfer up to $24.12 million free of federal transfer tax — an unprecedented amount. The transfer tax exemption will be adjusted upward for inflation in future years, but under current law it is scheduled to be reduced by 50 percent on January 1, 2026. A marital deduction is allowed for assets passing directly or in qualifying trusts for the benefit of a surviving spouse. The federal estate tax rate for transfers above the transfer tax exemption that do not qualify for the marital or any other deduction is a flat 40 percent. The federal transfer tax exemptions can be used either during lifetime or at death. Using exemption during lifetime is generally more efficient for transfer tax purposes, as any appreciation on the gifted assets escapes estate taxation.
The Treasury Department has confirmed that the additional transfer tax exemption granted under current law until 2026 is a use it or lose it benefit, and that if a taxpayer uses the “extra” exemption before it expires (by making lifetime gifts), it will not be “clawed back” to cause additional tax if the taxpayer dies after the exemption is reduced in 2026. Practically, this means that a taxpayer who has made $6.03 million or less (adjusted for inflation) of lifetime gifts before 2026 will not lock in any benefit of the extra exemption, while a taxpayer who makes use of the additional exemption before 2026 (by making gifts of $12.06 million before 2026) will lock in the benefit of the extra exemption.
The Illinois estate tax exemption is $4 million per person. This exemption does not receive annual inflationary increases. As with the federal estate tax, a marital deduction is allowed for assets passing directly or in qualifying trusts for the benefit of a surviving spouse for Illinois estate tax purposes. The effective marginal tax rate for transfers above the Illinois estate tax exemption that do not qualify for the marital or any other deduction ranges from 8 percent to approximately 29 percent.
As with income taxes, state estate taxes are deductible for federal estate tax purposes. The cumulative federal and Illinois estate tax rate (for estates above both the federal and Illinois exemptions), taking deductions into account, is approximately 48 percent.
Federal tax laws allow for an annual exclusion amount that can be gifted from any one person to any other person in any given year without using up any estate/gift tax exemption. This amount, set at $15,000 per donee for 2021, will increase for inflation to $16,000 per donee in 2022.
President Biden’s campaign included a proposal to reduce the federal transfer tax exemption to $3.5 million. However, Democrats struggled with potential tax legislation in 2021 given their thin margin of control of the House of Representatives and especially the Senate. In September, the House Ways and Means Committee released an extensive tax package that would have resulted in enormous changes for estate tax planning. The package proposed reducing the current $11.7 million estate/gift tax exemption by 50 percent on January 1, 2022, eliminating the use of valuation discounts for non-operating businesses, and curtailing the use of intentionally defective grantor trusts, or IDGTs (a type of irrevocable trust commonly used in estate tax planning due to the substantial benefits it can achieve, further discussed below). This proposal set off a frenzy of lifetime gifting. However, in October, a new version of the Build Back Better Act was introduced that dropped the estate tax provisions from the original proposal.
The contours of future legislation remain uncertain. It is possible that some version of the Build Back Better Act could pass without any changes to transfer tax laws. However, the September proposals may indicate an increased awareness on the part of congressional Democrats of the IDGT strategy and a desire to curtail it.
Lifetime Transfer Strategies
Even with these provisions dropped from the current proposal, taxpayers should continue to strongly consider lifetime gifting strategies, for several reasons. First, the estate/gift tax exemption is still scheduled to be reduced by 50 percent on January 2026, even if Congress does nothing. Taxpayers who have not used the “extra” exemption before then will lose it forever. Second, any post-appreciation transfer on gifted assets accrues outside of the taxpayer’s estate. This is especially salient for younger individuals and for transferred assets with high potential for appreciation. Third, for taxpayers who live in states with a state estate tax but no state gift tax (such as Illinois), lifetime gifting may have the effect of reducing state estate tax liability. Finally, for individuals who have already used all of their estate/gift tax exemption, the current low interest rate environment makes certain advanced estate tax planning techniques more likely to succeed. Additional information on some of these techniques is available here.