Shifting Sands: Wealth Transfer Planning In Uncertain Times
Benjamin Franklin famously said that there are only two certainties in this world: death and taxes. However, even Franklin would have to agree that some taxes are more certain than others. For example, most people are all too familiar with paying taxes like the income tax, property tax and retail sales tax. But other taxes, like the federal estate tax, are far less common.
According to the most recent IRS statistics, the federal estate tax is paid by less than 0.1% of Americans who die each year. This may not be the case for much longer, however, since the exemption is scheduled to be cut in half at the end of 2025. It also does not mean that the estate tax is any less important than the other, more familiar taxes. On the contrary, the estate tax, which is imposed at a whopping 40% rate, is incredibly significant for those families who are subject to it.
Aside from the fact that wealth transfer taxes are less common, they are oftentimes also less well understood. Part of the reason is that the laws in this area are complex and can apply in situations that seem counterintuitive to most people. What’s more, the wealth transfer tax laws have been in a state of flux for much of the past two decades. These shifting sands make it difficult to implement long-term strategies to minimize the amount of wealth that is lost to taxes when assets are transferred from one generation to the next. Despite these challenges, there are still effective ways to navigate the complexity and create successful multi-generational tax plans.
This article will provide an overview and brief history of the federal wealth transfer taxes, describe recent proposals to restrict certain wealth planning strategies and, finally, explore some valuable tools for dealing with an uncertain future.
Overview of the Federal Wealth Transfer Taxes
At the federal level, wealth transfers are potentially subject to three separate, but complementary, taxes:
- Gift Tax. The gift tax is a tax on transfers of property (gifts) made during an individual’s lifetime.
- Estate Tax. The estate tax is a tax on the net value of an individual’s assets at the time of death.
- GST Tax. The generation-skipping transfer (GST) tax is a tax imposed on certain transfers of property to a “skip person” who is two or more generations below the transferor (e.g., a gift to a grandchild).
Each of these wealth transfer taxes has its own separate exemption amount (which are discussed below); hence, tax is due only in the event that the applicable exemption amount is exceeded. The estate tax exemption is also “unified” with the gift tax exemption, meaning that any taxable gifts made during a person’s lifetime will reduce the amount of estate tax exemption remaining at death. The GST tax, if it applies, is levied in addition to any gift or estate taxes.
Brief History of the Federal Estate Tax
The modern-day federal estate tax can be traced back to 1916, although it has undergone many changes over the past 100+ years. The 1916 estate tax began with an exemption of $50,000 and a top rate of 10% on estates over $5 million. That lasted just one year, however. The next year, the top rate was raised to 25% in order to help meet the revenue demands of World War I.
More recently, the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) made sweeping changes to the wealth transfer tax system, including periodic increases in the estate tax exemption amount between 2002 through 2009. It also provided for a temporary repeal of the estate tax for persons who died in 2010. EGTRRA was then scheduled to sunset at the end of 2010, with the estate and gift tax laws reverting to the structure that would have been in effect if EGTRRA had never been enacted (generally speaking, a lower exemption amount and a higher tax rate). However, shortly before the sunset went into effect, Congress intervened and ultimately established what is now a “permanent” wealth transfer regime with a higher, inflation-adjusted exemption and a top rate of 40% for estate, gift and GST taxes.
Current Federal Wealth Transfer Tax Laws
The Tax Cuts and Jobs Act of 2017 temporarily doubled the exemption amount for the years 2018 through 2025. As a result, in 2023, the statutory exemption amount is $12.92 million per individual for each of the estate/gift tax and GST tax. This exemption amount is annually adjusted for inflation (e.g., the exemption was $12.06 in 2022). Beginning on January 1, 2026, the exemption amount is scheduled to revert back to the exemption level that existed prior to the Tax Cuts and Jobs Act, which is roughly one-half of the current amount.
Certain gifts are not counted against the exemption, including any gifts to a spouse (provided the spouse is a U.S. citizen) or a qualified charitable organization. Also ignored are annual exclusion gifts (currently, up to $17,000 per recipient per year), as well as payments for tuition and uninsured medical expenses that are made directly to the service providers.
Unused estate tax exemption is “portable” between spouses. Accordingly, a surviving spouse may take advantage of a deceased spouse’s unused exemption through lifetime gifts by the surviving spouse or at the surviving spouse’s later death.
Calls for Further Changes to the Wealth Transfer Tax Laws
Despite our seemingly “permanent” wealth transfer tax system in place today, President Biden and other prominent members of the Democratic Party have advocated for further legislative changes to address perceived loopholes in the existing tax laws. Some of their more notable proposals are discussed below.
Biden Administration’s Greenbook Proposals
On March 9, 2023, President Biden issued his budget proposals for fiscal year 2024, commonly known as the “Greenbook,” which includes a number of significant estate tax provisions. One of the stated goals in the Greenbook is to “[c]lose state and gift tax loopholes that allow the wealthy to reduce their tax by using complicated trust arrangements to transfer their assets to their heirs.” The proposals include, (1) restricting how long multi-generational (dynasty) trusts are allowed to be exempt from GST tax, (2) treating the transfer of an appreciated asset between an irrevocable grantor trust and the grantor as a taxable event for federal income tax purposes, and (3) limiting the annual gift tax exclusion to $50,000 total per donor (instead of the current allowance of $17,000 to an unlimited number of recipients).
Letter to Treasury Secretary Yellen
On March 20, 2023, four U.S. Senators, including Elizabeth Warren and Bernie Sanders, wrote a letter to Treasury Secretary Janet Yellen urging her “to limit the ultra-wealthy’s abuse of trusts to avoid paying taxes.” The letter recommends that the Treasury Department use its existing regulatory authority to take the following actions (in other words, without waiting for Congress to enact legislation on these issues):
- Treat the transfer of assets between a grantor and an irrevocable grantor trust as a taxable event for federal income tax purposes, with limited exceptions.
- Issue authority to provide that a grantor’s payment of income taxes that are attributable to income/gain of an irrevocable grantor trust will be subject to gift tax.
- Revive regulations under Section 2704, originally proposed in 2016 by the Obama Administration but later withdrawn by the Trump Administration, which would dramatically reduce or eliminate the availability of valuation discounts that typically apply to transfers of minority (non-controlling) entity interests between family members.
- Determine that the assets of an irrevocable grantor trust that are not includible for estate tax purposes do not receive “stepped-up” basis when the grantor dies. (Note: The Treasury Department recently issued Revenue Ruling 2023-02 which follows through on this recommendation.)
While these proposals seek to upend certain planning strategies that are currently available, keep in mind that these changes are similar to past proposals that were not enacted for a variety of reasons. This situation seems unlikely to change, at least in the short term, given our current divided Congress. However, the legislative process is notoriously unpredictable so there can be no guarantee that these proposals will not make their way into future legislation. For this reason, flexible tax planning is key to dealing with an uncertain future.
Flexible Tools for Successful Wealth Transfer Tax Planning
Irrevocable trusts that are created today are usually designed to span multiple generations. Therefore, successful tax planning for long-term trust arrangements often requires flexible strategies that can adapt to changes in family circumstances and tax laws. Two important tools that can help to provide this desired flexibility are (1) powers of appointment, and (2) trust protectors.
Powers of Appointment
Powers of appointment are one effective way to build flexibility into a trust. A power of appointment is a power granted to a “powerholder” (someone other than the grantor) to redistribute the trust assets among a specified group of persons or entities (or both). This generally allows the powerholder, for example, to alter the existing distribution provisions, change the beneficiaries and/or modify the terms of the existing trust agreement. If a power of appointment is not exercised, the trust assets will be administered under the default provisions provided in the trust.
Note that powers of appointment can have significant tax consequences, depending on whether the power is a “general” or “limited/special” power of appointment. For example, the granting of a general power of appointment will cause inclusion of the assets subject to the power in the powerholder’s taxable estate, regardless of whether the general power is exercised or not. Therefore, careful planning is required to ensure that powers of appointment are used appropriately and that they do not cause unintended inclusion issues for the powerholder.
The concept of a “trust protector” is another valuable tool that can provide flexibility in a multi-generational trust. For tax reasons, a trust protector is typically an independent party (i.e., someone other than the grantor, the trustee or a beneficiary). A trust protector is typically given a variety of powers to deal with events that were not necessarily foreseeable when the trust was established, such as changes in tax laws or family dynamics. Such powers commonly include the ability to remove or replace trustees, add or change the beneficiaries, divide the trust and modify the trust provisions in certain specified ways. These powers allow the trust protector to protect the grantor’s intent and goals in creating the trust, oftentimes without the need for costly court involvement.
Wealth transfer tax planning requires careful consideration of a variety of factors. The laws governing wealth transfer tax planning present some difficult challenges, including the complexity of the tax laws and regulations, uncertainty regarding future legislation and proposed limitations on the use of certain strategies.
Despite these challenges, there are still a number of flexible tools that can be employed to help reduce the amount of wealth transfer taxes that are paid when assets are transferred from one generation to the next. With careful planning and guidance, individuals and families can develop effective strategies to meet their needs and goals.
If you have any questions, please contact McGrath North’s Tax and Estate Planning Practice Group.