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Use it or (Maybe) Lose it: Urgent Estate Planning Ideas Before 2020 Ends

By Peter A. Rivellini | Categories: Articles, COVID-19 task force, Trusts & EstatesPrint PDF August 2020

There is no question that the consequences of the upcoming presidential election will be potentially far reaching. Specifically, the current estate and gift tax laws have become a political seesaw, and attempts to implement sweeping tax law changes, including transfer taxes, can be expected should Biden win the presidency or the Democrats win a majority in the Senate this November. It is imperative that clients consider their current plans in light of this possibility before the end of 2020. These considerations when combined with the economic downturn caused by the COVID-19 pandemic and low interest rates create a rare opportunity that should compel many clients to take action immediately.

What’s the Urgency?

The gift and estate tax exemption for 2020 is currently $11,580,000 per individual. This historically high exemption amount is temporary and is scheduled to drop to $5,000,000 (adjusted for inflation) after 2025. However, the Democratic tax plan includes an immediate reduction to $5,000,000 (and some proposals have suggested a reduction to $3,500,000). Depending on the results of the November elections, the new gift and estate tax laws could be made effective as early as January 1, 2021.

The tax rate for gift and estate taxes is 40%. The Democrat’s new tax plan does not change this rate.

The Treasury Department and the IRS issued regulations in 2019 confirming that if the current tax exemption amount is reduced in the future there will be no “clawback” for gifts made under the increased estate and gift tax exemption currently in place.

An individual can transfer property with value up to the exemption amount either during lifetime or at death without paying any transfer tax.  In other words, any portion of the exemption used during lifetime reduces the amount of exemption available at death for estate tax purposes. For example, if you made a lifetime taxable gift of $4 million in 2017, your remaining exemption amount available to make additional gifts during your lifetime or upon your death would be $7.58 million ($11.58 million 2020 inflation adjusted exemption, less the $4 million lifetime gift).  However, should the exemption amount drop to $5 million (adjusted for inflation), you would lose the ability to transfer on a tax-free basis approximately $6.58 million.

For the balance of the current year, individuals and families have an opportunity to maximize the benefits of the current laws.  Those who do not act during 2020 could miss the opportunity to use the exemption after December 31.  However, those who do act now may be able to benefit from factors caused by the economic impact of Covid-19.

How does COVID-19 play a role?

COVID-19 was, and continues to be, devastating to our economy.  However, the recession caused by the pandemic is a boon to estate tax planning in that it creates an opportunity for clients to save taxes, transfer wealth, and protect assets more effectively.  The benefits of the recession for estate planning include depressed values of assets and historically low interest rates.  Both factors are crucial components to many investment-driven estate tax planning strategies.  Although a few strategies are outlined below, an estate planner’s toolbox contains many others that may be more suitable for a client’s needs.

Outright Gifts

For those who wish to “lock in” and take advantage of the current exemption amount, the simplest method is to make “outright” gifts to children or other individuals (as opposed to gifts in trust). 

Outright Gifts to an Irrevocable Trust

Often, though, simplicity has drawbacks.  The donor of an outright gift relinquishes all control over, and access to, the property transferred. The recipient of the gifts may not be sufficiently mature to handle sudden wealth or may have creditor issues, which would jeopardize the assets.  A common solution is for a client to create an irrevocable trust for the benefit of the recipients and make the outright gifts to the trust, possibly naming a different individual or institution to serve as trustee.  This structure will mitigate many of these drawbacks and maintain controls preventing over-access to the wealth by the recipients and providing asset protection from their potential creditors. Irrevocable trusts can be set up to last multiple generations (known as “Dynasty Trusts”), thereby ensuring protection for children, grandchildren, and beyond.

Some (ok, most) clients are reluctant to give away large amounts of their net worth out of fear of future uncertainty and they may one day need it. There are many ways to structure an irrevocable trust to give the client and client’s spouse protection if future access is ever needed.  One of the most common ways is to include the client’s spouse both as a trustee and as a beneficiary, thereby ensuring a certain amount of continued access to the trust assets.  However, these concerns can often be resolved and should not keep a client from considering options.

Installment Sale to Irrevocable Trust

While outright gifts are easiest to implement, more sophisticated methods can provide even greater flexibility and additional tax savings, especially if the client is hesitant about making large outright gifts ahead of the election.  Some of these gifting strategies require several months to properly carry out.  Once the results of the November election are known, little time will remain before the end of the year to accomplish these strategies. 

One such strategy is the sale to a “defective trust.”  The client creates an irrevocable trust, naming family members as beneficiaries and a trusted advisor or trust company as the trustee. The client then sells property to the trust in exchange for a promissory note.  The trust is created  to be ‘intentionally defective” for income tax purposes, meaning it will not be taxed separately.  Therefore, the sales transaction between the trust creator and the trust will not trigger any income tax. 

The IRS requires that the trust must pay interest at least equal to the published IRS rates  in effect for the month the assets were transferred to the trust (the “Hurdle Rate”). Any appreciation of the trust assets in excess of the Hurdle Rate passes to the beneficiaries free of gift tax.  The lower the Hurdle Rate, the more effective this strategy is to transfer assets on a gift tax-free basis. For September 2020, the Hurdle Rate is 0.4%.

The sale transaction is a classic “freeze” transaction because the client replaces an appreciating asset (the asset sold to the trust) for another asset that will not appreciate (the promissory note), thereby removing the future appreciation from his or her estate.  If the client chooses to “lock in” the balance of any remaining gift tax exemption, part, or all of the outstanding promissory note payable from the irrevocable trust equal can be forgiven. 

Grantor Retained Annuity Trust

The Grantor Retained Annuity Trust (“GRAT”) technique is similar to the sale to defective trust technique, whereby assets are transferred to an irrevocable trust, but instead of a promissory note, the trust pays an annuity amount to the grantor for a fixed number of years.  The annuity amount is determined based on the applicable Hurdle Rate.  Any remaining principal following the term of the annuity payments will be held in trust for the trust beneficiaries. 

There is no downside to an under-performing GRAT because if the asset does not produce sufficient income, the asset itself can be distributed back to the grantor as payment or partial payment of the annuity.  It is optimal to fund the GRAT with concentrated asset classes, selecting those that have the best opportunity for appreciation.  This contrasts with the sale to defective trust technique, which can be improved by pooling assets inside of a limited liability company.

Charitable Lead Annuity Trust

Clients who are charitably inclined can set up a technique similar to a GRAT, but instead of receiving the annuity themselves, the annuity is paid to one or more charities.  This is called a Charitable Lead Annuity Trust (“CLAT”) and is another strategy that can work well in low interest rate environment. If the CLAT’s investment performance exceeds the Hurdle Rate, then the excess earnings and growth at the end of the annuity term pass to the family beneficiaries free of gift tax. The lower the Hurdle Rate, the larger the potential of shifting wealth.

Final Thoughts

The opportunity to “lock in” the current exemption amount may be fleeting and may not exist after December 31, 2020 depending on the outcome of the November elections. Nonetheless, even if the estate and gift tax laws do not change, our current economic environment has created an unprecedented opportunity to shift large amounts of wealth on an estate tax- and gift tax-free basis due to the combination of several factors, including depreciated asset values caused by the COVID-19 pandemic’s effect on the economy, record-low interest rates, and historically high exemption amounts.

Time is running out. Clients who are interested in taking advantage of the current estate and gift tax laws should act soon. The techniques described above are only a few of the strategies available, and clients are encouraged to speak with their estate planning attorney to discuss tailoring a strategy specifically designed to achieve their individual goals.

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