It is more likely than not that the Democrats will reduce the unified federal estate/gift/GST tax exemption amount to the level at which these exemption amounts would have been set this year if the 2017 Tax Cuts and Jobs Act[x] had not doubled the basic exclusion amount for the 2018 through 2025 taxable years;[xi] in other words, we can expect an acceleration (by five years) of the existing time table under which these changes would otherwise have occurred in 2026.[xii]
It is also likely that the so-called “portability” rule, by which a deceased spouse’s unused exemption (“DSUE”) amount would carry over to their surviving spouse, will remain intact.
In addition, the reduction of the exemption amount will probably not be applied in such a way as to retroactively deny some future estate the full benefit of the higher exemption amount that may have been in effect at the time of a decedent’s taxable gifts;[xiii] for example, those made in the latter part of 2020.
The reduction of the exemption amount may be accompanied by an increase in the top tax rate for the federal estate/gift/GST tax, from 40 percent to 45 percent.
Speaking of tax rates – and although it is not part of the estate tax regime, it is closely related thereto – one may reasonably expect the Democrats to increase the highest tax rate applicable to long-term capital gains,[xiv] and to qualified dividends, from 20 percent to 24.2 percent.[xv] Assuming the Supreme Court does not strike down ACA,[xvi] the 3.8-percent surtax on net investment income[xvii] would continue to apply as under current law. Thus, the maximum capital gains and dividend tax rate, including the surtax, would rise to 28 percent.
These figures were not picked out of thin air; the 24.2 percent rate for capital gains, for example, was included in President Obama’s Fiscal Year 2017 Budget.[xviii] Indeed, much of the tax plan presented by Mr. Biden during the presidential campaign was derived from this proposed budget. It also appears that most of the individuals to be nominated or appointed by Mr. Biden to his Administration were once members of the Obama Administration. Reasonable conclusions may be drawn based upon the foregoing.
What is Unlikely?
It is unlikely, however, that the Democrats will try to eliminate the basis adjustment (usually a “step-up”) for assets acquired or passing from a decedent upon the death of the decedent,[xix] or that they will seek to treat a decedent’s death as a recognition event resulting in the imposition of an income tax on the built-in gain (i.e., the untaxed appreciation in value) of a decedent’s assets as if such assets had been sold for fair market value on the date of death.[xx]
Based upon the reduction in the number of House seats held by the Democrats (from 235 to 222)[xxi], and upon what will be, at best, an even split in the Senate, it would be delusional for the Party to believe – and misleading for it to state – that it has a mandate to eliminate the basis step-up rule, or to treat death as a recognition event for purposes of the income tax. Although some of the Party’s more “radical” thinkers – almost entirely in the House – will most likely seek these changes, they are being blamed by many Democrats for what has been described, under the circumstances, as the Party’s relatively poor performance last November.
Moreover, the political foundation and theoretical underpinnings for such significant changes have not yet been laid. Although campaign slogans, like “tax the rich” – whatever that means – may resonate with some voters, they do not provide a basis for the enactment of meaningful and effective legislation.
For example, the long-standing basis adjustment rule is premised on the rationale that a decedent’s death is the equivalent of a sale of the decedent’s assets to their beneficiaries at fair market value without income tax consequences.[xxii] It will likely take many years to convince the targeted population[xxiii] – or the legislators whom they support – of the fiscal or other need to abandon this principle, let alone to introduce the imposition of an income tax upon a decedent’s estate in the absence of an actual sale or exchange of the decedent’s assets.
In other words, don’t expect the 117th Congress – which was officially convened yesterday – to blaze any new trails.
Planning for the Future
The re-election yesterday of Ms. Pelosi as Speaker of the House probably does not bode well for Democrats in the long-run, given her ideological bent, but stranger things have happened. In other words, notwithstanding this development, the Democrats may still be in a position two years from now to enact additional changes to the federal estate and gift tax regime, including, for example, a further reduction in the exemption amount, and perhaps the elimination of certain planning techniques or vehicles.
With this possibility in mind, those taxpayers who acted before the end of 2020 to make gifts in an aggregate amount equal to or approaching their remaining unified federal estate/gift tax exemption amount may believe that they have exhausted their ability to further reduce their otherwise taxable estate.
To some extent, it will be more difficult under these circumstances to reduce one’s future estate without incurring a gift tax liability.[xxiv] However, there remain a number of tools by which one may reduce, freeze, or control the growth of, one’s estate.
The annual exclusion gift remains safely ensconced in the Code;[xxv] at $15,000, it allows a married couple to make nontaxable gifts (in cash or in kind) with a fair market value of $30,000 to each of their issue every year.
Where the gift is made in-kind, meaning in the form of minority and/or non-voting equity interests in a closely held business entity, the ability to discount the value of such interests will have the effect of leveraging the annual exclusion amount.[xxvi]
Assuming the continuation of the low-interest rate environment in which we now find ourselves, taxpayers may take various steps to effectively “freeze” the value of part of their estate by “converting” these assets into the principal of a below-market-interest loan, and to shift the future appreciation of these assets (or of the assets acquired with the loan proceeds) to their issue.[xxvii]
Intra-family Loan. A taxpayer with liquid assets may consider making a low-interest loan to their issue, or to business entities owned by their issue. Although interest will have to be paid (and other indicia of debt will have to be present) in order to support the loan’s treatment as such for tax purposes, the younger generation’s investment of the loan proceeds may yield a return well in excess of the low amount of interest payable.
Sale to Grantor Trust. In general, a “grantor trust” is one with respect to which the grantor has “retained” certain rights such that the grantor will continue to be treated as “owning” the trust’s property and income for tax purposes.[xxviii]
Many of the gifts made in 2020 involved the use of grantor trusts. There were several reasons for this: (i) the grantor wanted to leverage the use of their exemption by remaining liable for the income taxes attributable to the assets gifted (see below); (ii) the grantor wanted to be able to repurchase the gifted property from the trust if future circumstances warranted such a transaction; and (iii) the grantor wanted to utilize part of their exemption amount but was unable to obtain an appraisal before the year-end – they made a gift into the trust of liquid or marketable assets with a value equal to the exemption, with the intention of exchanging these for the property that they actually intended to gift once such property has been appraised in early 2021.
These same trusts may now be used to purchase other assets from the grantor (which have the potential to appreciate) in exchange for a term note[xxix] that bears interest at the applicable federal rate,[xxx] payable and compounded annually, with a balloon payment at maturity. Because of the trust’s grantor trust status, the sale will be ignored for income tax purposes, as will the interest payments;[xxxi] for purposes of the gift tax, however, the grantor will be treated as having received adequate consideration. Moreover, the grantor will continue to be taxed on any income or gain recognized by the trust, thereby further reducing their estate, while effectively making a tax-free gift to the trust beneficiaries.
GRAT. A variant of the sale to a trust is the statutorily blessed GRAT, or “grantor retained annuity trust.” It, too, works well in a low-interest rate environment, meaning that the GRAT will be viewed as having succeeded if its assets appreciate at a rate that exceeds the discount rate applied in determining the present value of the annuity.[xxxii]
The grantor would establish and fund a trust in exchange for a “fixed” amount that would be payable to the grantor at least annually over a term of years.[xxxiii] Because the trust is typically a grantor trust, it will enjoy the same benefits described above (for example, the annuity payment will not be taxable to the grantor).
The amount of the gift made by the grantor will be equal to the fair market value of the assets transferred to the trust over the present value of the grantor’s retained annuity interest; thus, the longer the term, or the greater the annuity amount, the lesser the amount of the gift. Indeed, under present law, it may be possible to enter into a GRAT arrangement with very little gift tax exposure.[xxxiv]
As in the case of annual gifts (described above), an in-kind contribution of equity interests in a business, especially one organized as a non-taxable or pass-through entity, may be used to leverage the benefit of a sale to a grantor trust or to a GRAT.
In appropriate circumstances, certain business transactions may be utilized to shift appreciating assets to a younger generation of owners. For example, where a business entity, such as a corporation, or an LLC treated as a partnership for tax purposes, is engaged in two or more lines of business, it may be possible to separate the lines of businesses on a tax-deferred basis by distributing to the younger generation the faster-growing line, which is often the one in which the younger generation is more engaged.[xxxv]
Alternatively, a parent-owner may reduce the owner’s interest in the business – for example, by a partial redemption or liquidation of their interest therein – such that the owner is no longer in a position to control such business, or to block action by other family members who are owners, thereby allowing the value of the owner’s interest to be discounted for purposes of the estate tax.[xxxvi]
Of course, not every business owner will be able to take advantage of these strategies, and many will simply not want to do so.
In that case, it may behoove the owner to ensure that their estate will be in a position to take advantage of the estate tax installment payment rules under Section 6166 of the Code.[xxxvii]
Alternatively, or even in conjunction therewith, the owner – or more appropriately, an irrevocable grantor trust in which the owner has no interest – should consider obtaining life insurance on the owner’s life (or on the joint lives of the owner and their spouse, depending upon their estate plan) in order to provide a source of liquidity from which their estate tax liability may be satisfied.[xxxviii]
Unfortunately for business owners, Mr. Biden is beginning to realize that he may not have the ability to pass legislation that would implement most of his tax agenda. News organizations have started reporting that the President-elect will likely be expanding his focus to include regulatory changes, the effect of which will be to increase estate and gift taxes.
In particular, one should expect the reintroduction of the 2016 proposed changes to the regulatory valuation rules applicable to transfers of interests in a closely held business, which were subsequently withdrawn by Mr. Trump. As originally drafted, these were definitely overbroad – for instance, they treated investment entities the same as operating businesses – but otherwise were properly targeted at some clearly abusive situations.[xxxix]
Query what other transfer tax-related regulation projects the Administration may have in mind for the Treasury and the IRS?
For example, will the IRS increase the number of gift tax audits?[xl] Will the income tax exam function cooperate more closely with their transfer tax brethren? In each case, they should – but will the funding for such activities be forthcoming?
Unlikely to Pass, But Worthy of Consideration?
Other notable estate tax reform possibilities, none of which are likely to be passed under the presently constituted Congress – but which probably deserve serious consideration, regardless of one’s political affiliation – include the following: (i) requiring a minimum term for a GRAT (thereby increasing the mortality risk); (ii) requiring a minimum value for the remainder interest (the gift, thereby eliminating zeroed-out GRATs) at the time property is contributed to the GRAT; (iii) eliminating (at least in part) the inconsistent treatment of transactions involving irrevocable grantor trusts for income tax vs estate/gift tax purposes (think sales to grantor trusts); and (iv) limiting the use of dynasty trusts – for example, by increasing the inclusion ratio of the trust to one after a specified number of years (thereby subjecting future trust distributions to the GST tax).
Taxpayers and their advisers should be attuned to the introduction of such proposals, which I believe is inevitable, and should time their use of the targeted planning vehicles accordingly – they won’t last forever.