End of Year Estate Planning Opportunities

It’s hard to believe that we are already approaching the end of 2020—what a year!  With Election Day right around the corner, many of you have expressed concerns about potential tax law changes that could occur depending on the outcome of the election. Over the next few months, estate planners, financial advisors, appraisers, and CPAs will be busy assisting clients with year-end planning to capitalize upon the favorable estate tax laws currently in effect.

Refresher: Overview of Current Estate and Gift Tax Exemption Levels

Under current federal estate and gift tax laws, the first $11.58mm you give away during your lifetime (in excess of the annual exclusion amount) or own at your death will be exempt from estate tax.  If you’re married, this $11.58mm exemption amount may be combined with your spouse’s exemption to give you, collectively, an exemption amount of $23.16mm.  Every dollar gifted or owned at death in excess of the exemption is taxed at 40%.  

Window of Opportunity

Depending on the outcome of the election, some reports suggest that the estate tax exemption amount could be reduced to as low as $3.5mm per person, or $7mm for a married couple, in a worst-case scenario. If this reduction occurs, many more Texans will face estate tax liability after death.

For individuals with a net worth greater than $3.5mm, and married couples with a net worth greater than $7mm, there’s a window of opportunity between now and the end of the year to utilize the historically high 2020 exemption amount.  By making a large gift now, you have the ability to take advantage of the $11.58mm exemption currently in place.  Additionally, the IRS has indicated that if you make a gift in 2020 that exceeds the estate tax exemption amount in place the year you die, the IRS will not penalize you for the gift made in 2020 (this is sometimes referred to as anti-clawback legislation).  

Strategies

We recommend two key strategies to utilize the historically high 2020 exemption amount.  The first strategy involves making a large, one-time gift of more than $3.5mm.  The second strategy involves making a sale to an irrevocable trust, with the option to forgive loan payments if the threat of a reduced exemption becomes more imminent. Both strategies are addressed in more detail below.

             1.         Large End of Year Gift.  The first strategy involves making a large gift either outright to children, or in trust for your spouse and/or children.  Many of you may be concerned with the idea of parting ways with $5-10mm, especially those of you who are younger and may need access to those assets for future business ventures or liquidity needs.  For this reason, I personally prefer making a gift to an irrevocable trust for the benefit of a spouse and/or children. While your spouse is a beneficiary of the trust, you retain some ancillary benefits of the gift.  The gift will utilize the increased exemption amount currently in place for 2020, and any appreciation of the gifted asset(s) will pass outside of your estate for federal estate tax purposes.  

When funding the trust, you want to consider gifting assets that are expected to appreciate in value, and you should keep in mind the income tax basis of assets contributed to the trust.  And of course, you should also consider the risks of this strategy. Among them, if you become divorced or your spouse dies, you lose the ancillary benefits of the trust assets and your children step-in as primary beneficiaries. 

Example:  John and Jackie are married and have a net worth of $25mm.  They have two children, Alex and Bradley, who are both adults.  John and Jackie’s portfolio includes $5mm in cash and stocks, $5mm in real estate, and a family business valued at $15mm. 

 In December 2020, John creates an irrevocable trust for the primary benefit of Jackie, and the secondary benefit of Alex and Bradley.  The irrevocable trust is funded with the real estate and $2.5mm in cash.  The real estate is appraised to support the value of the gift, and a gift tax return is filed to report the $7.5mm in total gifts to the trust (no tax is due with the filing).  The $2.5mm in cash is invested in the stock market, and the real estate continues to appreciate.  As a result, the irrevocable trust assets are valued at $12.5mm at John’s death in 2022.  

Let’s assume that as a result of the election, the estate tax exemption amount is reduced to $3.5mm per person in 2022.  As a result of John’s quick thinking, all $12.5mm will pass outside of his estate for estate tax purposes.  If John had not funded the trust in 2020, then the $12.5mm in assets would have been included in his estate, and John’s estate would pay an additional $3.6mm in estate taxes.  

             2.         Sale of Assets to Trust.  For some of you, making a large gift to an irrevocable trust may be intimidating and the benefits may be outweighed by the perceived risk of tax law changes.  If so, a trust can be created just like the one discussed above for the benefit of your spouse and/or children.  However, instead of making a large gift to the trust, you make a smaller gift and then sell a large asset to the trust in exchange for a promissory note.  The trust makes payments back to you for the purchase of the asset (with interest), so the impact of the transfer feels less permanent.  Then, if the estate tax exemption amount is reduced, you should have a window of opportunity to forgive the balance of the note, which would lock in the gift and take advantage of the historically high estate tax exemption currently in place. And regardless of whether the loan is forgiven, the appreciation of the assets in trust passes outside of your estate for federal estate tax purposes.

 When funding the irrevocable trust in this manner, you should consider gifting assets that are expected to appreciate in value and generate income sufficient to make the loan payments.  And while the sale to the trust won’t trigger capital gains, you should still keep in mind the income tax basis of assets contributed to the trust.  

 One caveat: Some planners are concerned that a change in the estate tax exemption amount may be applied retroactively.  If this is the case, then the sale-forgiveness strategy would not work unless the loan is forgiven prior to the retractive effective date.  

            Example (same facts as above).  John and Jackie are not confident that the election will result in estate tax changes, and they also are concerned they may need their assets in the future as their expenses increase.  Instead of gifting the real estate and $2.5mm in cash as discussed above, John gifts $2.5mm in cash to the trust, but then sells the $5mm of real estate to the trust in exchange for a promissory note that is payable over a 10-year period.  The 2020 election results in a change in political power, and the estate tax exemption amount is scheduled to drop to $3.5mm per person, to be effective for all transfers made on or after January 1, 2022.  In December of 2021, John decides to forgive the note.  The loan balance forgiven is treated as a gift that utilizes the higher exemption amount in place for 2021.  As a result, all $12.5mm in the trust at his death passes free of estate taxes.

 Conclusion

 If a potential change in estate tax laws puts you in the crosshairs of federal estate tax liability, now is the time to act.  Between now and the end of the year, you have a window of opportunity to capture all or a portion of the historically high estate tax exemption amount.  If the strategies described in this post sound beneficial to you, please contact us and we will develop recommendations specifically tailored to your unique situation.

NOTE: The calculations above have been greatly simplified for the sole purpose of showing the benefits of this strategy.  The actual math is more complicated.  Additionally, one down-side of gifting assets during lifetime is that the beneficiaries of the gift may experience greater capital gains impacts when the gifted assets are sold by the beneficiaries at a later date.