The gift, estate and generation skipping transfer (“GST”) tax exemption will increase substantially in 2023. What does that mean for your estate planning?
Keep on Planning
The current estate tax planning circumstances provide continued opportunity to plan. In part that is because most estate planning techniques in your advisor’s toolkit remain viable. For some wealthy taxpayers now may in particular be an opportune time to use the temporarily increased, or bonus, exemption amounts (see below). Also, in contrast to the frenetic planning environment of 2021-2022 when everyone thought Congress might pass really harsh retroactive tax changes any minute, it seems pretty unlikely that with the Republicans controlling the House tax increase legislation could be enacted anytime soon. But because the exemption will be cut in half in 2026, planning should be considered by many. Also, because of the potential for future changes (which always seems to be the case), and the volatility of the economy and markets, everyone should build some flexibility into their estate plans.
Exemption Inflation Increases Impact Estate Planning
The gift, estate and GST exemption amounts are the amounts you can transfer free of gift, estate or GST tax. These form the focus of much of the estate tax planning for those with significant net worth (although for the uber wealthy the exemptions are relatively modest compared to their net worth, and more sophisticated planning techniques will be required to shift wealth).
This year the estate, gift and GST exemption amount (called the applicable exclusion) is $12,060,000. This number jumps a whopping $860,000 to $12,920,000 in 2023 because of the inflation adjustment in the law. That is the biggest inflation adjustment to the exemption in history. For a married couple that hasn’t made any taxable gifts they can give away in 2023 $25,840,000. That won’t help the billionaires that own rocket companies or whoever won the recent $2 billion lottery, but for most just really wealth folks that may be the foundation for all the estate planning they’ll ever consider.
This means for wealthy taxpayers who max’d out wealth transfers in prior years (e.g., before the feared introduction of Bernie Sanders’ tax plan in prior years) you will have an additional big chunk of wealth you can transfer free of gift or GST tax in 2023. More on possible planning ideas below.
2026 Brings New Worries for Wealthy Taxpayers
For those folks with less you might still have to worry as these exemptions will be cut by half in 2026. More specifically, in 2026 the current $10 million (inflation adjusted) exemption is to be reduced to its level prior to the 2017 tax act of $5 million inflation adjusted. This may have a huge impact making many wealthy (but not uber wealthy) Americans again subject to estate tax.
Just to make sure that this is more complicated, the mechanism by which the exemption is inflation adjusted was changed by the 2017 tax act to use the chained Consumer Price Index. That lowered the annual inflation adjustments. That mechanism also sunsets in 2017 and the traditional CPI adjustment will instead be used. That might result in a somewhat greater adjustment for inflation, although we all hope inflation will be tamer by then.
What this all means is that those folks who might face an estate tax when the exemption is cut in half should plan to use some or as much of the exemption they have left before the law changes.
How to Make Those Gifts
The simplest approach you can use is just make a gift to heirs, e.g., kids. But that would probably be a bad choice for many reasons. With these kinda bucks involved you really should not want to make a gift outright to any one where it can be frittered away by imprudence, lost to creditors or claimants, reached in divorce (yes gifts are generally considered to be separate non-marital or immune property but once placed in an heir’s paws they can easily be commingled and perhaps reached). And perhaps your heirs will do well enough financially (or a future Congress will make the estate tax rules harsher) that the heirs may be subject to estate tax themselves.
The likely better answer that might protect from all of these potholes is to set up an irrevocable trust to receive the gift for the beneficiaries. There is a myriad of options how to do that. But for many merely wealth people that may not be a winning move either.
While trusts for heirs is better than outright gifts for them, unless you are really really (repetition intentional) sure you will never ever need any of that money, you should consider a different approach.
Examples of Different Types of Gifts Using Your Exemption
Mom and Dad are age 65 and 66. Their net worth is $50 million. In 2023 they can transfer nearly $26 million into trusts for the kids. But at those young ages, unless there is a serious known health issue, one of them might live 30+ years. Depending on their burn rate (lifestyle expenses) gifting away more than half their wealth may leave them eating cat food in their waning years. Not a desirable result. Meow.
A better option might be to use trusts that permit one or both parents to be or to become beneficiaries of those trusts. Again, there are a zillion variations of these types of trusts and lots of other options you might incorporate to provide access. That is a discussion beyond this article, but the key point is make sure you have a budget and financial forecast out to age 95 (or perhaps longer) to make sure you understand the potential financial implications of a gift. Bringing an insurance adviser in to evaluate disability insurance (if you are still working), long term care coverage (even if you don’t need it now, if you gift 55% of your wealth you might want it) and life insurance (if a spouse dies prematurely that might offset the loss of access to a trust).
And isn’t it better to err on the side of giving yourself more, not less, ability to access the money in those trusts so you can assure your financial future?
Keep in mind that the more access you have the greater the risk might be that the IRS argues that those trust assets should be taxed back in your estate thereby defeating the planning. But you (not your advisers!) have to weigh how much access you need to sleep at night, versus how much more assurance you want that the tax objectives might be realized. And you can even mix n’ match trusts and planning techniques to get the trust porridge the temperature you want. For example, you might gift part of your assets that have a lot of access options and the remainder to a trust with less access. That might give you the mix you want of access and more assurance of success than you might get using just one trust.
The options for these types of trusts might include spousal lifetime access trust in which each spouse names the other as a beneficiary of their trust (these come in many flavors). You might use a domestic asset protection trust which is a trust you create that you are named a beneficiary of (but those have to be in one of the 19 states that permit this type of trust). There are lots of other options all beyond the scope of this article.
Some of the Many Planning Steps You Might Consider
What might you do with an additional $860,000 of exemption? If you haven’t used all of your exemption and have enough wealth to do so, review with your advisor team any of the following ideas, or other ideas they might suggest:
· Set up one or more of the trusts mentioned above and make gifts to those trusts to use up your exemption before its cut in half in 2026.
· If you sold assets to a trust, you might gift cash or other assets to the trust and let the trust, use those funds to pay back some of the note. That will help repay the note which may support the economic substance of the note sale in the event the IRS ever challenges the notes as not valid.
· If you have an insurance trust you might gift some or all of the new exemption amount to the trust and use it to fund future premiums, or if the economics make sense to increase coverage, or pay down some portion of a split-dollar insurance loan used to finance the insurance coverage.
· Set up or top off 529 plans for heirs.
· Don’t make gifts to trusts, like grantor retained annuity trusts (“GRATs”) to which the tax laws do not permit you to make additions.
· Add the funds to a family limited partnership (“FLP”) or family limited liability company (“LLC”). If you do the equity interests will have to be recapitalized to reflect an increased ownership by you for the new contribution. You might then use the additional partnership interests to fund gifts. But be sure to discuss with your estate planner how long the assets should cure in the entity before gifts are made. This might also be a bad idea because if you own any interests in the entity the IRS might argue all prior transfers are pulled back into your estate. A better approach might be to gift assets to a trust or family member and let them invest in the FLP or LLC.
Special Limitations on Certain Planning Techniques
With the exemption being cut in half some creative and smart tax advisers had developed planning ideas to satisfy clients who wanted their tax cake (preserving the current high temporary exemption) while continuing to have access to the assets used to lock in that exemption. Some of these recently advocated estate planning techniques may no longer work to lock in the current high exemption as had been hoped. These were zapped by the Proposed Regulations to limit the applicability of the anti-clawback Regulations – that is admittedly a mouthful that you might ask your adviser to explain to you if it may affect you. A bit of background to help you identify if these might affect your planning.
When the exemption was temporarily doubled from $5 to $10 million in 2017 the Republicans provided in the law that the Treasury Department should enact rules to prevent the IRS from recapturing the exemption used when the exemption is reduced in 2026 (if you remember the games we played as kids “no backsies”). In 2019, Treasury published the “Clawback” regulations which created a special rule to preserve the exemption used on lifetime gifts (made while the exemption remains doubled from 2018 to 2025) to the extent it exceeds the available exemption amount at your death (after it is cut in half in 2026). But the IRS was concerned about some of the creative techniques referred to above. These, in the IRS view were gifts which some have referred to as “artificial” or “painless” in that the taxpayer could retain an interest in or control over the assets involved, lock in exemption (at least that is what some had hoped), and in short have their tax cake and eat it too.
Other such artificial gift transfers may have included funding a grantor retained interest trust (“GRIT”) to a family member so that the gift would be deemed made of the entire amount transferred with no reduction for the interest retained because, under Internal Revenue Code (“Code”) Section 2702 the value of the retained remainder would be valued at zero.
Similarly, a preferred partnership could be structured that intentionally violated the requirements under Code Section 2701 so that the equity received by the donor in the entity would be valued at zero. The taxpayer could have retained a preferred interest structured so the entire value of the entity would be treated as a gift when certain family members acquired the common interests, thereby securing the use of the gift exemption (and permitting the allocation of GST exemption to the gift). The preferred partnership interest would be included in the taxpayer’s estate but the exemption, it was thought, would be preserved. The recently issued Proposed Regulations target these types of transactions and endeavor to exclude them from the anti-clawback rule (meaning they will be included in your estate, and you won’t have preserved the extra or bonus exemption that remains in place until 2026):
· Gifts that are includible in a taxpayer’s gross estate Under Code Sections 2035, 2036, 2037, 2038, or 2042. The anti-clawback rule will not apply so that only the exclusion available at the taxpayer’s death, not the exclusion that was believed to have been used when the transfer was consummated, will be available.
· Unsatisfied enforceable promise gifts.
· Gifts subject to the special Code Sec. 2701 valuation rules. These generally related to the valuation of intra-family transfers of entity equity interests when the parent (senior generation) retains certain preferred rights. If the taxpayer dies holding a Code Section 2701 applicable retained interest, they cannot take advantage of the anti-clawback rule.
· Transfers like a GRIT where property is pulled back into gross estate under, for example, Code Section 2036. If the taxable portion was 5% or less (see exceptions below) the taxpayer will still be able to take advantage of the general anti-clawback rule to the extent of the gift (but not the whole amount transferred).
· Certain transfers to GRATs and Qualified Personal Residence Trusts (“QPRTs”) under Code Sec. 2702 if either technique used the bonus temporary exclusion amount..
What might the increased $860,000 of new exemption mean to you if you had used any of the now possibly unsuccessful techniques above? First, speak to your tax advisers and see if there is a way to cure the issue. In some cases, like paying the promise gift, you might. If not, you should specifically evaluate what to do with the new exemption given your possible loss of exemption on planning that, because of the Proposed Regulations, may not work. For example, you might want to use the new increase in the exemption to set up and fund a life insurance trust and purchase life insurance to fund the exemption lost in the unsuccessful transaction you recently completed.
Transfer Tax Rates Impact Planning
The top tax rate for the estate, gift and GST tax is and will remain 40%. While that amount might seem high, it is much lower than historically top rates that hit 70%+. Nonetheless, for the owner of non-liquid and very valuable real estate or closely held business holdings that rate can wreak havoc with transmitting such wealth to future generations. This non-change just means that for some wealthy taxpayers with non-liquid and valuable assets, planning might remain critical to preserve a real estate asset or family business.
New exemption is a good thing for wealthy taxpayers, but it will only be a good thing if you use it before it might disappear in 2026. Consider many options for you how can use the exemption in a way that better accomplishes your goals. Evaluate carefully whether planning you completed in the last few years got zapped by the Proposed anti-clawback Regulations and if so, what protective steps you might take with the increased exemption amount.