When signed into law in 2017, the Tax Cuts and Jobs Act (TCJA) substantially changed the unified lifetime gift and estate tax exemption; there is now talk of another change on the horizon with the new administration in place. The exemption is the amount every taxpayer may give away during life or at death without incurring a transfer tax; it is separate from the “annual exclusion,” the amount each person may transfer to another as a gift without incurring a gift tax or affecting their unified exemption. There have been a few proposals that may change how all of this works, so 2021 is a year to thoughtfully consider if and how to use what is available under current law.
Today, the inflation-adjusted exemption amount is $11.7 million per person. As a result, fewer estates are subject to federal estate tax (there may still be state estate taxes) and larger estates will owe less tax.
That said, the exemption is temporary and scheduled to sunset, or revert, to $5 million per person (adjusted for inflation) as of January 1, 2026 unless Congress acts to extend current law. Complicating matters further, President Biden’s proposed tax plan could accelerate the sunset or even revert the gift, estate, and GST tax provision to levels lower than what they were prior to TCJA.
With that in mind, taxpayers with large amounts of unused exemption may want to consider making significant lifetime gifts, and they may want to consider doing it soon, especially when you consider that it is often less expensive to make a gift during life than at death.
What is the best approach? Well, it depends on the facts and circumstances, but here are a few options to consider in the use of lifetime and GST exemptions:
Outright Gifts
Before we begin, let’s refresh on some gifting basics:
Annual Exclusion Gifts
Individuals may currently give any number of people up to $15,000 each in cash or assets ($30,000 if your spouse joins in making the gift) without triggering gift, estate, or GST taxes. The annual gift tax exclusion applies only to “present interest” gifts, meaning the recipient (donee) must have an unrestricted right to the immediate use and enjoyment of the gift.
Tuition and Medical Expense Exception
Individuals can make unlimited gifts of tuition and medical expenses paid on behalf of others. To qualify for this exclusion, you must make the payments directly to the educational institution or medical provider. Only tuition payments qualify, payments for dormitory fees, books, and supplies do not. Payments for medical insurance qualify for the medical exclusion.
Future Interest Gifts
These are gifts in which the donee’s right to use, possess, and enjoy the property and income from the property do not begin until some future date. These gifts are generally taxable, regardless of their amount. Gifts exceeding the annual gift tax exclusion are also subject to a gift tax. The lifetime gift and estate tax exemption is available to offsets gifts such as these.
Outright gifts are the most straightforward type of gift; it is simply the outright transfer of property from one person to another (or a trust) with no conditions attached. Generally, the transferee’s basis in the transferred property is the same as the donor’s basis. Examples of gift property include:
- liquid assets such as a cash, stocks, and bonds
- valuable articles such as art, jewelry, or other collectibles
- real estate
- debt forgiveness
- It is important to note, depending upon the amount of the debt and the lifetime exemption available, there may be times when it makes sense for one spouse to transfer the debt to the other spouse and have that spouse use his/her lifetime exemption.
- Spreading the debt and subsequent forgiveness among multiple lenders can be an effective way to leverage the lenders’ lifetime exemption.
Disclaimer: There is a common theme running through the gift and estate tax bills introduced in Congress this year. That is, collect more taxes from wealthy taxpayers when they transfer their assets through lifetime transfers and transfers at death. Many of the proposed changes may negatively impact outright gifts. One should be careful about gifts of anything other than cash this year because of possible gain triggers at time of transfer, which is proposed to be retroactive to January 1, 2021. Always consult with estate and tax advisors before making any decisions.
Spousal Lifetime Access Trust (SLAT)
If there is a concern about gifting away too much and not having enough assets to live on after the gift, an individual could establish a Spousal Limited Access Trust (SLAT) for his/her spouse’s benefit. A SLAT can be an effective estate planning tool for wealthy married couples who wish to reduce estate taxes and protect their assets from creditors. Unlike other irrevocable trusts, however, one spouse can be a beneficiary of the trust and access the trust assets for his/her use (as well as including other beneficiaries such as descendants, extended family, and/or charity).
For couples who want to leave a large amount to their descendants but are worried about not leaving enough for themselves, a SLAT can act as a “safety valve.”
As with any trust, there are pros and cons that should be considered before moving forward:
Pros:
- Assets in a trust are typically more protected from children and grandchildren’s divorces, creditors, and others who might exert an unhealthy influence over them (i.e. bad actors).
- The SLAT can provide income or principal to the beneficiary spouse, as well as descendants.
- A SLAT can be a grantor trust, allowing the grantor spouse to pay the trust’s income taxes and in effect, make a tax-free gift to the SLAT.
- If the grantor spouse dies, the SLAT assets are kept separate from the beneficiary spouse’s subsequent spouse.
Cons:
- Transfers to the SLAT are irrevocable and the trust assets cannot return to the grantor spouse. The beneficiary spouse can always voluntarily share distributions with the grantor spouse but if the beneficiary spouse dies or if there is a divorce, the grantor spouse might lose any indirect benefit to the trust.
- It is possible for spouses to form trusts for one another, but the SLATs must avoid the IRS’s Reciprocal Trust Doctrine. This doctrine states that if a husband creates a trust for his wife, and the wife creates a nearly identical trust for the husband, then the two trusts may be unwound and treated for tax purposes as if each spouse had created a trust for himself or herself. Of course the way around this is to vary the dispositive terms of the trust and/or the beneficiaries. The slightest changes can make a difference, however, to further insulate yourself from an IRS challenge, it may be best to consider executing and funding the two trusts in different calendar years.
Disclaimer: Many of the proposals submitted to Congress this year would effectively end the use of grantor trusts as wealth-shifting devices by including the value of such trusts in the grantor’s gross estate for estate tax purposes and taxing distributions from such trusts as gifts from the grantor. Be sure to consult with your estate and tax advisors before making any decisions.
Qualified Severance and Late Allocation of GST Exemption
The GST tax imposes a tax on each generation-skipping transfer. This happens in a scenario when grandparents transfer money or property directly to their grandchildren (outright or in trust) without first leaving it to their children. However, GST does not apply just to gifts between grandparents and grandchildren. It applies to all "skip persons,” essentially, any donee who is at least 37 1/2 years younger than the donor.
Why the need for GST?
Before Congress changed the law in 1976, wealthy individuals were legally able to give money and property (in life and at death) to their grandchildren without incurring federal gift and estate taxes. The GST legislation effectively closed that loophole and transferors could no longer avoid estate taxes by skipping one generation.
Transfers to skip persons can be exempt from the GST tax by the allocation of the GST exemption, which currently shares the same exemption amount as the federal estate and gift tax ($11.7 million in 2021). As you might expect, the amount of one’s available GST exemption will decline as he or she make GST exempt gifts. In some cases, the amount of a transferor’s unused GST exemption can vary greatly from the amount of his or her unused gift and estate tax exemption. A reason for this is that lifetime gifts may use a portion of the gift and estate tax exemption but not necessarily the GST exemption.
In situations where the two exemption amounts wildly differ, what can you do to deplete the GST exemption without affecting the lower gift and estate tax exemption?
One option is to make a late allocation of GST exemption, effectively, converting a fully or partially GST Non-Exempt Trust to a fully GST Exempt Trust. The downside of this method is the mechanics and complexities that are involved.
For irrevocable trusts that are only partially GST exempt, the approach typically involves splitting and retitling the assets of the original trust between two resulting sub trusts. In that event, one sub trust is fully GST exempt (A Trust) and the other is fully GST non-exempt (B Trust). GST exemption is applied to the B Trust to make it GST exempt too, and finally, the A and B Trusts are merged to reform the original trust as fully GST exempt.
Sound complicated?
You bet. A qualified severance and late allocation of GST exemption is a very complex process and requires the cooperation of and coordination between the transferor’s estate attorney, accountant, and financial advisor. It is very complicated to report, particularly in a late allocation situation, and late allocations become exponentially more complicated when combined with timely allocations. Despite the complexities, it can be a productive way for a transferor to use up his/her exemption without making an outright gift.
Conclusion
It seems more than probable that Congress will pass legislation this year that will limit opportunities for gift and estate tax planning. Regardless, lifetime gifts will continue to provide significant tax and non-tax benefits and remain an important part of estate planning. In our review of approaches to lifetime giving, we focused on strategies that reduce estate taxes. Taxes aside, there are many other reasons to make lifetime gifts, such as providing for loved ones or shaping behavior of family members that may be at risk. Whatever the motivation, it is important to keep in mind that tax laws are not permanent, change is the only constant. Regardless of the amount of wealth and the laws in place, taxpayers should consider a program of regular lifetime giving.
For advice on how to maximize the use of lifetime and GST exemptions in your estate plan, please don’t hesitate to reach out and speak with one of our experienced advisors.