In recent decades, phased in changes to estate tax exemptions, and unexpected surprises which dramatically changed rates and exemptions have made estate tax planning more difficult and complicated. Despite the changes, the underlying strategies remained similar over the last fifty years, using tried and true techniques built on rulings and loopholes inhabited by tax lawyers and advisors who were intent on keeping their client’s wealth intact for future generations. Those strategies are now threatened, and the time to use them may be running out.
The “sunset” of the current generous estate tax Exemption of $11.4 million (after indexing annually for inflation) in 2026 presents a huge challenge. The Exemption declines back to the 2011 level of $5 million (before annual inflation adjustments are included). State estate taxes, like NY with a $5.25 million estate tax exemption, (but no gift tax) add another burden for those unwilling, or unable, to move their residence to another more favorable jurisdiction. We must now factor in the push back on the 1% from the 99% who see recent trends in wealth accumulation as unfair.
Proposals by several Democratic Presidential hopefuls have been published as templates for reform if they are elected, of if both houses of Congress become Democratic in the 2020 elections. They involve drastic increases in taxes on wealth. Of course, taxes on wealth include income taxes as well as estate taxes as we traditionally understand them. This discussion focuses on Senator Sander’s plan, which is quite specific and fully developed. Other approaches might involve annual wealth taxes, such as Senator Warren’s. Senator Sander’s plan surprisingly digs deep into the estate planning tool chest to put real teeth into the transfer tax system.
Senator Sanders proposed his own Tax Act, involving a tremendous increase in the estate tax, reducing the Federal estate tax exemption from the current $11.4 million to the $3.5 million level that existed in 2009. Some have argued to make it even smaller. The Act would also impinge upon the ability of clients to make lifetime gifts, reducing the lifetime (gift tax) exemption to just $1 million. For the wealthy the dollar value of the exemption is critical. Many wealthy clients, however, have been adopting a “wait and see” planning tactic. Sanders’ announcement and the provisions of the Act should be a wakeup call for those clients, as well as for their advisors. It should be a call to action for clients to use their exemptions wisely (discussed below), before they disappear even faster than they were slated to do so under the Tax Cuts of Jobs Act of 2017 (reducing by half to $5 million, inflation adjusted, in 2026) if there is a sufficient Democratic shift in Washington.
Mr. Sanders also proposed raising the estate tax rates with a maximum rate of 77% for estates over $1 billion—keeping in mind that this was the rate of tax on estates above $10 million until 1977. The slashing of the estate tax exemption coupled with the surge in rates will impose a real and painful reduction in the intended inheritance for our clients.
To our surprise, Sanders’ proposals include restrictions on the use of valuation discounts, grantor retained annuity trusts (“GRATs”), and proposes that if a client makes gifts this year to use their current high $11.4 million exemption, there will be a penalty for that with the gifts “clawed” back into their tax calculation. If that were to be enacted, it might already be too late to plan. The proposed restrictions on planning techniques may have an incredibly negative impact on the ability of very wealthy taxpayers to shift wealth to future generations without significant wealth transfer tax.
We consider this claw-back proposal crucial to communicate to our clients. Many likely assume that they can wait until after the 2020 election and then, based on the election results, determine whether or not to incur the cost and hassles of planning. But if this type of provision is replicated in future legislation it might negate the ability to plan effectively after new estate tax legislation is proposed if there is a Democratic sweep. This is a risk that clients should weigh carefully.
Even worse, the new Proposal aims at the heart of many estate plans, which for many decades has been the creation of grantor trusts. These are trusts whose income is taxed to the settlor creating the trust. The creator of the trust reports income and deductions attributable to the trust on their own tax return, therefore paying the income tax on trust income which is accumulating in favor of the heirs/beneficiaries, (usually in a younger generation), permitting greater growth of wealth inside the trust. It also permits the client to sell assets to the trust without recognition of gain due to that sale and shift growth outside your estate. These sales, often done for a note issued by the trust, have been a mainstay of planning in recent decades. The Act would include in our client’s taxable estates all assets held by trusts that are grantor trusts, reduced only by taxable gifts made to the trust-effectively ending the tax avoidance on the growth of gifted property.
Another foundation of planning has been to shift value to an irrevocable trust (usually a grantor trust) and allocate generation skipping transfer (“GST”) tax exemption to the trust. Properly done under the current system, the value of assets in that GST exempt trust, no matter how much they appreciate, should avoid being treated as part of the transfer taxation system. This can extend several generations, or hundreds of years, or indefinitely, depending on the state in which the Trust was created. The compounding of wealth outside the estate tax system can provide incredible wealth shifting opportunities. The Act appears to limit the application of the GST exemption to a maximum of 50 years. That change could result in a costly tax after 50 years of a trust’s existence. A change along these lines will usually “grandfather” existing trusts (i.e., the new restrictions only apply to trusts formed after the new law). Accordingly, we are urging our clients to very seriously consider creating long-term dynastic trusts now.
Valuation discounts would be severely restricted under the Act. These discounts rightly take into account the marketability of gifted assets, and lack of control which is coincidental with partial interests in privately held business and real estate assets. Their loss coupled with the other provisions of the Sanders Act would devastate the future effectiveness of long-established methods to transfer wealth to future generations before it accumulates and is taxed to the founders.
Another common planning tool has been for clients to make gifts to trusts from which a class of beneficiaries can withdraw a pro-rata portion of the gift made by the grantor, up to the annual gift exclusion amount for that beneficiary. This has facilitated the ability for clients to make large annual gifts to a trust, (for life insurance premiums, for example), and not incurring any gift tax cost due to the gift. The Act has proposed eliminating this technique. If this applied to all trusts after enactment, the results could eliminate the common Irrevocable Life Insurance Trust (“ILIT”) which has been commonplace in estate plans. Insurable clients should implement an ILIT before any changes are made to existing law, in case existing trusts are grandfathered (i.e., exempted from the new change). Clients might also consider making large gifts now (using that exemption that might also disappear) so that they won’t have to rely on annual gifts to fund their life insurance premium payments.