"Use It or Lose It"- Estate Planning in 2020 and Beyond

December 15, 2020

By Scott Testa

The unsettled Senate race has reduced the urgency to do estate planning before year-end and has given everyone more time to thoughtfully structure an estate plan. But don’t wait too long.

Two tax changes that were discussed by President-Elect Joe Biden include a reduction in the estate tax exemption to $3.5 million and elimination of the basis adjustment at death. Because of this and the prediction that Biden would win and take both houses of Congress, many clients reached out to discuss using the exemption in 2020 for fear it would disappear in 2021. However, when the sweep of both houses did not happen (we are currently awaiting a run-off in the Georgia Senate), the mad rush stalled as many believe that the chances of an estate tax overhaul retroactive to January 1, 2021 are slim. Even though we have never seen a decrease in the exemption amount, it is now very possible – either by legislation under a Biden administration or by the impending sunset of the current estate tax law put in place by the Tax Cuts and Jobs Act of 2017 (TCJA). With a possible split in Congress and bigger issues to address, the easiest option would be to do nothing and permit the increased exemption that was doubled under TCJA ($11.58 million per person in 2020; $11.7 million in 2021) to shrink to half (approximately) at the beginning of 2026.

Use It or Lose It

The current estate tax exemption is “use-it-or-lose-it.” If it is anticipated that the exemption will be cut in half because of the sunset of TCJA or reduced even lower by the Biden administration, both moderately wealthy and ultra-high net worth clients should make gifts using the exclusion amount that will disappear.

However, in order to take advantage of this use-it-or-lose-it exemption amount (let’s call it the “bonus exemption”), a client needs to be willing to give more than the anticipated reduced exemption amount. This is because the bonus exemption is only used after the original exemption amount has been exhausted. The key here is that there will be no recapture or “clawback” at death of the amount transferred using the bonus exemption that would create an additional estate tax at death.

For many, once the exemption doubled, reducing estate taxes was no longer their biggest concern. Other factors such as cash flow, asset and creditor protection, preserving wealth for the next generation and income tax planning became more important. In fact, estate planning became more about income tax planning (and the basis adjustment at death). This is the reason that having your accountant involved in your estate planning is critical.

But now that it is likely that the estate tax exemption will decrease soon (or perhaps sooner than expected), there is more of an urgency to use this bonus exemption – especially for those who do not currently have a taxable estate but will if the exemption decreases. The issue that they are facing is how much to give away while securing their own financial independence. The factors that need to be considered, as well as the size of the client’s estate, are the client’s (1) age, (2) cash flow needs, (3) liquidity and asset composition, (4) earning potential, and (5) family situation.

Estate Planning Quick Fixes

  • Review existing estate plans. This is especially important where there are formula clauses in wills or trusts. For example, a will providing that the decedent’s entire exemption amount be transferred to a credit shelter trust could result in the trust being funded with $11.58M which, in some circumstances, could be the decedent’s entire estate.
  • Build flexibility into estate planning documents (especially for the surviving spouse). Take into consideration an increase or decrease in the exemption and how assets are distributed or trusts are funded.
  • Forgive loans to children.
  • Clean up underfunded irrevocable life insurance trusts.
  • Use $11.58M generation skipping transfer (GST) tax exemption for late or missed allocations.
  • Clean up underperforming or under-capitalized an intentionally defective grantor trust (IDGT) (discussed in further detail below).

Estate Planning – Lower Wealth (<$10M)

  • In addition to the quick fixes, a simple estate plan that includes annual exclusion gifts (currently $15,000 per donee) may be the best move. A better option may be to hang onto appreciated assets in order to get the basis step up at death.
  • Income tax planning, creditor protection and cash flow planning will be more important issues.

Estate Planning – Moderate Wealth ($10M to $40M)

  • The most challenging task is dealing with a client that doesn’t currently have a taxable estate but will if the exemption is reduced. This is when careful consideration must be given to taking advantage of the bonus exemption. These clients need to delicately balance removing assets and the appreciation thereon from their estates to lock in today’s high exemption vs. losing a basis adjustment at death.
  • Cash flow also becomes a critical issue if a substantial portion of the client’s wealth needs to be gifted to use the exemption. For example, someone worth $40 million is not going to want to transfer half of his wealth without having access to it. Clients should not transfer all their assets to trusts just to use the exemption, especially if they anticipate needing the assets.
  • In order to have access to gifted assets, spousal limited access trusts (SLATs) may be the way to go. With a SLAT, the nongifting spouse is a permissible beneficiary so there is indirect access to assets. For many clients, they will not be willing or able to part with a majority of their assets to fund non-reciprocal SLATs. One option is to have only one spouse fund a SLAT using his or her entire exemption. Even if trust assets are distributed to the beneficiary spouse for the couple’s support, they will still be in a better position than if they had done nothing if exemption is significantly reduced.
  • Another planning move for clients who sold assets to defective grantor trusts is to consider gifting additional amounts to the trust to bolster the economics of the sale. 
    • Remember that an installment sale to a defective grantor trusts is a planning technique in which the grantor sets up a trust for the benefit of his or her children/grandchildren and then sells an asset to the trust in exchange for a note. The interest rate on the note can be set to the lowest allowable rate, which is the applicable federal rate (AFR). The benefit of this is that if the asset appreciates at a rate greater than the AFR, that excess is transferred gift tax free to the trust. Furthermore, because the trust is deemed to be owned by the grantor for income tax purposes, no capital gain or loss is recognized on the sale and the note interest isn’t taxable to the grantor nor deductible by the trust.
    • However, the IRS doesn’t always view these arrangements kindly, particularly if there are little to no assets in the trust other than those purchased from the grantor. If a client is concerned about the IRS challenging such an arrangement because the trust doesn’t have enough assets, the client can further fund the trust.
    • Also consider refinancing the note to take advantage of the lower current applicable federal interest rates. For December 2020, the AFRs are: short-term (<3 years): 0.15%; mid-term (3 to 9 years): 0.48%; long-term (>9 years): 1.31%.

Estate Planning – Ultra-High Net Worth (>$40M)

  • For the ultra-high net worth (>$40M), estate planning should be more or less business as usual. This means expanding upon existing planning efforts by leveraging any remaining exemption before it disappears. It also means planning beyond just using the current exemption. For these clients, plans should include transfers that utilize:
    • Valuation discounts such as those used for family limited partnerships or fractional interests in property;
    • Current low-interest rates such as in the case of sales to defective grantor trusts (discussed above), low-interest intrafamily loans (which both use the AFR) or grantor retained annuity trusts (GRATS) which use the IRC Sec. 7520 rate (0.6% in December 2020);
    • GST exemption; and
    • Any combination of the above.

Conclusion

Remember that estate planning is not one-size fits all. There are a number of factors to consider and each client is unique. Using a client’s “bonus exemption” is something that should receive serious consideration – especially in light of a sunsetting exemption or possible legislative change.

About Scott E. Testa

Scott Testa is a Tax Partner and a leader in the Trusts and Estates practice within the Personal Wealth Advisors Group.