Posted by Robert L. Arone
In late May of this year, the U.S. Treasury released a publication detailing a number of the proposed tax code changes that the Biden administration would like to usher through Congress in an ambitious effort to modernize the US tax system to meet its citizens’ needs. While reasonable minds may differ strongly on the best way to stimulate the US economy and create wealth and security for the American people, one thing is certain: the need for individuals to engage in careful estate and tax planning to avoid paying more tax than necessary is not going away.
The IRS publication, sometimes referred to as the Green Book, outlines a number of key proposals that—if ultimately passed—have the potential to significantly shake up the estate planning world as we know it today by sidelining a number of tried and true estate planning strategies while potentially increasing the frequency of use and usefulness of others.
As some commentators have observed, any direction to reduce the estate and gift tax exemption amount from its current historically high level of approximately $11.7 million per taxpayer is noticeably absent from these proposals. Although there is certainly no guarantee that such a proposal will not be made in the future, we can nevertheless help our clients focus for now on what we do know about the law as written today and what steps we and they can take to address the coming changes.
One of the first things that clients need to understand is that, even with no action whatsoever by Congress, estate tax laws passed under the Trump administration will expire and reset to the prior laws in 2026. This reset will restore the estate and gift tax exemption amount to $5 million, as it was in 2016 (though it will be indexed for inflation, resulting in an exemption amount of approximately $6.6 million in 2026). Again, this is the law as it stands today; without further action from Congress, it will remain the law.
It is therefore important to consider with your clients the average rates of return on their investments, compounded annually, to determine what kind of return on their investments they can expect within the next five to ten years. Using a basic calculator or spreadsheet, many of your clients may be surprised to see that, even with a moderately healthy return of approximately 7 percent annually, their net worth could easily double in ten to twelve years. If the estate tax exemption amount is halved in 2026 and increases only with inflation at a rate of approximately 2.5 percent per year, clients could very quickly find themselves at risk of paying significant estate taxes (currently at a 40 percent rate) if they are still in the mindset of having an $11.7 million estate tax exemption ($23.4 million for married couples) available when they pass away in the next one to two decades.
What should we be doing now?
Given the current uncertainty, trying to predict the future and counsel your clients on which strategies will best accommodate their tax and estate planning goals can be frustrating to both you and your clients. This is particularly true when we consider some of the other Green Book proposals:
- Raising the top income tax rates
- Taxing capital gains as ordinary income for those earning over $1 million per year
- Treating any transfers of appreciated property (including gifts and inheritances) as a sale of the property, thus triggering capital gains taxes on the property, instead of allowing the traditional carryover basis for gifted property or stepped-up basis for property inherited at the death of the property owner
- Limitations on deferral benefits for like-kind exchanges of real estate
You and your clients should still consider certain strategies, however, because these changes have not yet been implemented and may ultimately never be enacted. For example, the following strategies are still effective tools under current tax law, and if your clients implement them now, they could realize significant tax savings.
Grantor Retained Annuity Trust
A grantor retained annuity trust (GRAT) enables a client to transfer appreciating accounts and property to chosen noncharitable beneficiaries (usually the client’s children) using little or none of the client’s gift tax exemption (depending on the value of the client’s retained interest in the trust). To accomplish this, the client transfers property to the GRAT and retains the right to receive an annuity. After a specified period of time, the noncharitable beneficiaries will receive the amount remaining in the trust.
Installment Sales to an Intentionally Defective Grantor Trust
Another useful strategy that can still be used today is to have the client gift seed capital (usually cash) to an intentionally defective grantor trust (IDGT) and then sell appreciating or income-producing property to the IDGT. The IDGT makes installment payments back to the client over a period of time. If the accounts or property increases in value over the period of the sale, the accounts or property in the trust will appreciate outside the client’s estate and will therefore avoid estate taxes. Additionally, because the client pays income taxes on the income generated by the trust, which is an indirect gift to the trust, the trust itself does not have to pay income taxes on the income that it retains.
Spousal Lifetime Access Trust
The spousal lifetime access trust (SLAT) strategy calls for one spouse to gift property to a trust created for the benefit of the other spouse (and potentially other beneficiaries like children or grandchildren). An independent trustee can make discretionary distributions to those beneficiaries, which can indirectly benefit the donor spouse, while an interested trustee should be limited to ascertainable standards when making distributions (i.e., health, education, maintenance, or support). This strategy allows the donor spouse to use the currently high lifetime gift tax exemption amount by making gifts to their spouse; pay income taxes for the trust, which allows for indirect, nontaxable future gifts to the value of the trust for the trust beneficiaries; and still benefit indirectly from the trust through the other spouse. Because the trust is designed to avoid using the marital deduction, the accounts and property in the SLAT will not be included in either spouse’s gross estate for estate tax purposes.
Irrevocable Life Insurance Trust
Irrevocable life insurance trusts (ILITs) are still a tried-and-true method for leveraging life insurance to ease the burden placed on a client’s estate if it will be subject to estate tax at their death. With this strategy, the client transfers an existing life insurance policy into the ILIT (or a new policy is purchased with money gifted to the trust). The client then makes annual cash gifts to the ILIT to pay the premiums on the life insurance policy. At the client’s death, the trust receives the insurance death benefit and distributes it according to the trust’s terms. Because the trust receives the death benefit and the premiums gifted to the trust are completed gifts, the client’s estate will not include any of the trust’s value. This strategy can be a powerful method of leveraging relatively small gift tax exemption usage to create liquidity for the client’s taxable estate as well as significant assets outside the estate to benefit the beneficiaries.
We Are Here to Help You
You can still implement these strategies today for the benefit of your clients. If you feel that you and your clients can benefit from a deeper understanding and exploration of these and other strategies, please let us know. We would love to sit down with you and discuss whether any of these strategies make sense for your clients’ particular situations. Call us today!