While there are many new tax policy implementations that may be imminent with the new Biden administration, there are two changes in particular that estate planning attorneys are watching closely. These include (1) a reduction in the estate tax exemption and (2) an elimination of the basis step-up for inherited property. Unfortunately, there is still no way to predict exactly what will happen or when those changes will take effect, but the current climate does provide individuals with a unique opportunity to take advantage of some wealth transfer planning strategies, such as lifetime gifting, if they are so inclined.
REDUCTION OF ESTATE TAX EXEMPTION
Under the current provisions of the Tax Cuts and Jobs Act, the exemption amount for estate, gift and generation skipping transfer (GST) tax is $10 million, adjusted for inflation, which provided for an increase to $11.58 million in 2020 and $11.7 million in 2021. This means that last year individuals could transfer during life and at death up to $11.58 million of assets without paying federal estate, gift or GST tax[1]. Any transfers above such exemption amount are subject to a tax rate of 40%. Married couples can double that amount and last year could transfer collectively $23.16 million without estate tax consequences.
This current federal exemption is set to automatically revert back to approximately $6 million on January 1, 2026. However, with a new president and a rebalancing in the House and Senate, we may see a reduction in that exemption much earlier. There is speculation that these new exemption amounts would be set to $6 million, but they could also be set as low as $3 million. Further speculation surrounds whether these tax changes will be effective only going forward or if they will be made retroactive to the beginning of the year that they are enacted.
What can individuals do about it?
Individuals have options but ultimately they must make a decision about whether to use their tax benefits now before any changes can become law, keeping in mind that the change could be retroactive, or wait to see how the year plays out. Individuals looking to go ahead and use the benefits can make small and large gifts that take advantage of that tax exemption as it stands now. However, considering that these options consist of irrevocable transfers, the benefits of doing so will always need to be weighed against the individual’s practical need for cash flow for the remainder of their life.
Besides the well-known annual exclusion gifts, currently at $15,000.00 per donee, beneficial gifting strategies may include gifting current interests in family businesses or the creation of an Irrevocable Life Insurance Trust (ILIT), where payments to insurance premiums are made. Spousal Limited Access Trusts (SLATs) are also a popular tool for high net worth individuals as they allow for use of the full exemption, but still retain the assets for the benefit of the donor’s spouse, and indirectly, the donor. Grantor Retained Annuity Trusts (GRATs) and intrafamily loans are other effective estate planning strategies, so long as interest rates remain low. Regardless of the strategy used, they can all assist in getting assets out of an individual’s estate, which would help to reduce any future estate tax consequences.
ELIMINATION OF BASIS STEP-UP
Another possible policy change includes the elimination of the basis “step up” at death, which has the potential to affect more taxpayers than the reduction of the tax exemptions. For decades, assets have been valued at the time of the owner’s death, even if the value had increased or appreciated. For example, if your uncle bought a house for $150,000.00, but at the time of his death the house is worth $350,000.00, the gain on that house is $200,000.00. However, that gain is wiped out when that asset is passed on to his heirs because the base value has “stepped up” to $350,000.00, and thus no capital gains tax is owed. This treatment applies to any asset, from real estate to securities to partnership interests. If the total value of the estate is less than the current exemption level, then your uncle would also not need to pay any estate tax.
In contrast, if the Biden administration eliminates the basis step-up rule, this means that that gain could now be recognized upon transfer. If gain is recognized, it could potentially cause significant tax consequences for people inheriting assets with high appreciation values.
What can individuals do about it?
In a situation where the step-up basis is eliminated, individuals might take a look at their entire financial portfolio and again strategize about which assets might benefit from being put into a trust. Assets with a greater embedded capital gain could be placed in the trust while other assets, like cash, could be gifted now or otherwise left directly to heirs. This could potentially help minimize the capital gains tax their heirs would pay.
While we cannot be sure what changes will occur or when they will go into effect, if you are concerned, there are options to consider that could help to protect your estate and heirs from future undesirable tax consequences. Individuals who are ready and willing to gift assets now may want to consider different strategies available to utilize the current higher estate and gift tax exemption before it is reduced. These strategies can include a variety of different types of trusts, including ILITs, SLATs, and GRATs, to name a few, which are designed to protect assets against estate taxes and capital gains. Talk to your attorney and tax planning professional to determine if any of these trusts are right for you.
[1] This article does not address any state implemented estate, gift or GST taxes.