Wealth Transfer Strategies to Consider in an Election Year
The 2020 election is almost upon us. The recent past has taught us that trying to predict the results of an election can be futile at best. Still, our clients need timely counsel regarding their wealth management, and I am sure that you will agree that it is our role as advisors to keep them as informed as possible when it comes to potential tax changes on the horizon. While we do not know for sure what the future holds, we do have strong clues as to what the future tax laws may look like if the balance of power shifts in 2021 from Republican to Democratic hands.
Much of what we know about the potential tax landscape under a Democratic majority has been pieced together from reviewing campaign speeches and debates, observing interviews with candidates, and poring over drafted legislation that is just waiting to be dusted off and introduced into Congress for passage.
It is important to note that the chances of these changes being implemented in the near future is not limited to what happens in the November elections. Some commentators suggest that even under a continued Republican-controlled government, many of the changes discussed below could be implemented as the nation grapples with the economic pressures stemming from the coronavirus pandemic of 2020.
Proposed Policy Adjustments under a Democratic Presidency
Some of the key proposals most relevant to Estate and Tax Planning include adjustments to estate, gift, and income taxation laws.
Estate, Gift, and Generation-Skipping Transfer (GST) Taxes
In 2020, the estate and gift tax exemption is set at $11.58 million (indexed for inflation), with any wealth over that amount taxed at a 40 percent rate as it passes to heirs. This exemption amount is scheduled to be lowered to $5 million (also indexed for inflation) on December 31, 2025, unless new legislation is passed before then.
Presidential candidate Biden has suggested that he would support legislation to reduce both the estate and GST tax exemptions to $3.5 million per individual and would lower the lifetime gift tax exemption to $1 million.
In addition to reduced transfer tax exemption amounts, a number of Democratic tax reform proposals have discussed returning estate tax rates to historic norms. What does that mean? In the 1940s, the top estate tax rate was 77 percent, and under 2001 federal tax law, it was as high as 45–55 percent. It therefore seems likely that we could see an upward adjustment in the transfer tax rates.
Capital Gains Taxes
Our current law taxes capital gains as regular income if those gains are realized on property held for less than one year. For long-term capital gains (gains on property held for a year or longer), there is a graduated tax rate depending upon the tax filer’s income level (0 percent, 15 percent, or 20 percent). For individuals and couples who earn more than $200,000 and $250,000 per year respectively in net investment income, there is an additional 3.8 percent surtax added to their capital gains tax rate.
In addition, the current law allows for a step-up in basis to the date-of-death value on appreciated property transferred after the owner dies. This allows for selling or liquidating inherited property shortly after the death of an individual with little to no capital gains taxes assessed on the sale of the property.
Today’s law also allows for like-kind exchanges on appreciated property such as artwork and rental properties. These laws allow people to reinvest the gains that they earn on appreciated property into similar types of property without ever having to pay capital gains taxes when sold. If the individual keeps making such like-kind exchanges on appreciated property until the individual’s death, the capital gains accumulated in that property will be erased by the basis step-up rules.
Presidential candidate Biden has proposed changes that would either (1) limit the step-up basis rule for inherited property and impose a carryover basis rule for inherited property or (2) impose recognition of gain on property at the owner’s death. Additionally, the Democratic tax plan proposes eliminating like-kind exchanges as well as imposing a 39.6 percent long-term capital gains tax rate on individuals earning more than $1 million per year. If the law leaves the 3.8 percent surtax on net investment income in place, the effective top federal tax rate on long-term capital gains could reach over 43 percent.
If these changes are implemented along with the changes to the estate tax exemptions and rates, many estates could see significant tax bills at the estate owner’s death.
How Can You Help Your Clients Prepare?
There are a number of possible Estate Planning strategies that you should discuss with your clients as soon as possible so they do not get caught by surprise should the election usher in the above changes. Here are four strategies for consideration:
1) Grantor Retained Annuity Trust: A properly structured grantor retained annuity trust (GRAT) allows your client to transfer more property to beneficiaries at a lower gift tax value than if the client were to make gifts outright to those same beneficiaries. GRATs are excellent estate planning techniques that are still available today. However, it is important to note that a number of Democratic tax law proposals have identified the use of multiple short-term GRATs as a tax loophole that needs to be curtailed. Thus, the window of opportunity for using a GRAT to transfer large amounts of wealth at a significant discount may be closing soon.
2) Installment Sale to an Intentionally Defective Grantor Trust: This technique allows the client to sell appreciating property such as real estate or even a family business (such as a family limited partnership) to a carefully drafted trust in return for an installment note using the currently low applicable federal interest rate. Cash should also be transferred into the trust (a taxable gift) so that the trustee has cash with which to make payments on the installment note (usually 10–15 percent of the property’s fair market value) in order to avoid an argument from the Internal Revenue Service that the sale is actually a gift. The installment note can be structured as an interest-only note with a balloon payment at the end of the loan term or even as a self-canceling installment note. Property in the trust must obtain a rate of return or growth in excess of the interest rate for this strategy to succeed. In a low interest rate environment like today, there is a much greater chance of obtaining that favorable result.
This strategy requires that your client be prepared to pay income tax on the income generated by the trust property. However, this feature allows for even more indirect and tax-efficient wealth transfer. At the end of the loan term, income and appreciation exceeding the required note payments pass to the trust beneficiaries, free of gift, estate, and GST tax (if designed to do so). This planning tool works well for clients with income-generating real property or business interests that are expected to appreciate.
3) Spousal Lifetime Access Trust: The spousal lifetime access trust (SLAT) strategy requires the client to make a gift of property into an irrevocable trust for the benefit of the client’s spouse (as a beneficiary of the trust) and other beneficiaries (children or grandchildren). The trust names an independent trustee who has discretion to make distributions among the various beneficiaries. The transfer to the trust is intentionally designed to not qualify for the unlimited marital deduction. This allows for fuller utilization of the gifting spouse’s estate exemption and shields the appreciation on the transferred property from future gift and estate tax.
This strategy is designed to take advantage of the current high exemption amounts. A SLAT is a grantor trust for income tax purposes (the trust will not pay income tax, allowing trust property to grow estate tax free during the donor’s lifetime).
Ideal clients for a SLAT strategy are happily married couples (because the SLAT is irrevocable) who own property that is expected to significantly appreciate and who can transfer such property irrevocably without jeopardizing their current standard of living. It is important to understand that there are carryover basis considerations associated with this strategy that should be carefully calculated and weighed before implementation.
4) Irrevocable Life Insurance Trust: Although the irrevocable life insurance trust (ILIT) strategy has not been utilized as much recently as in the past, it is still a highly effective one—especially in an environment where the estate and gift tax exemption amounts may be reduced significantly in the near future, putting clients in a use-it-or-lose-it scenario. This technique calls for a client to transfer property (usually cash) to an irrevocable trust. The gift can be made all in one year and may reduce the client’s gift tax exemption to some extent. However, the cash in the hands of the trustee can be used to purchase life insurance on the client which, when the policy pays out at the client’s death, passes to the trust free of income tax and then on to the trust beneficiaries outside of the client’s estate, and therefore free of estate taxes. Your client typically must have sufficient cash reserves to be able to contribute to the trust and be in good enough health to qualify for a life insurance policy.
Working Together
Even if your clients are not fully prepared to pull the trigger on any of the above strategies before the 2020 election results are known, you should nevertheless plant the seed in their minds so that when the time comes to make a decision, they will be that much more prepared to move quickly. Educating your clients about these and other valuable wealth preservation strategies has the potential to solidly embed you as an essential and trusted family advisor to multiple generations of clients.
By working together, we can help our clients navigate whatever changes these uncertain times may bring. Thoughtful Estate Planning can provide our clients with peace of mind while they are living and ensure that their wealth is passed on to their loved ones in the most efficient and protected manner. Give Kerlin Walsh Law a call at 708.448.5169 to discuss how we can weather these changes together.
