Currently (and since the Tax Cuts and Jobs Act of 2017), we, like many other practitioners, have seen an incredible uptick in inclusion planning[1] instead of the traditional exclusion planning (getting assets out of one’s taxable estate). A primary driving force for this major shift was the essential doubling of the estate tax exemption (from $5.49 million to now, $13.61 million).[2] Consider also that since portability exists, this figure is doubled yet again for married couples.[3] Frankly, not an incredible amount of people are burdened with the tragic problem of having a taxable estate over $13.61 million dollars ($27.22 million for married couples). It would stand to reason that this substantial amount of exemption availability has resulted in most semi-wealthy taxpayers not worrying so much about their potential estate tax liability. Instead, these individuals have been able to enjoy not worrying about such an event and instead focus instead on getting assets into their estates (to the extent previous planning may have removed such assets from their taxable estates), up to the exemption amounts, so as to receive a step-up in basis to fair market value in those assets upon their ultimate demise.[4] It is worth noting that this article is not intended to be an in-depth discussion of any particular planning mechanism, but instead noting the shift in 2017 with respect to estate planning and upcoming sunset of the enhanced estate and gift tax exemptions and how such will again impact the dynamics of estate planning.
Traditional Planning
Pre-TCJA, and post for many taxpayers who are unfortunate enough to be within eyeshot of the exemption, people would undertake a multitude of estate planning mechanisms to maximize wealth, protect their needed cashflow later in life, minimize estate and gift tax, and provide liquidity for their estate to pay estate tax (often, via a life insurance policy and irrevocable life insurance trust).
Among some common planning options were A/B planning in wills and revocable trusts which work to split an estate in a portion qualifying for a marital deduction and the taxpayer’s own exemption. The idea, at least usually, was to maximize the use of exemption between spouses. There were other ways to accomplish this planning, including disclaimer and Clayton QTIP[5], but from a high view, the planning worked to optimize usage of exemption by utilizing the marital deduction.
Another planning technique, mentioned previously, is the usage of irrevocable life insurance trusts.[6] Taxpayers can gift annually to an irrevocable trust which has the purpose of providing liquidity for the taxpayer’s estate when or if the need arose. The taxpayer would make annual gifts, potentially qualifying for the annual exclusion, but otherwise utilizing the taxpayer’s exemption. This would also result in a reduction of the taxpayer’s taxable estate. In turn, when the death benefit was received, it would land in a receptacle that was (hopefully) outside of the taxpayer’s taxable estate. Such a trust with immediately available liquidity could provide for a desirable buyer for acquiring assets from the taxpayer’s estate, thus giving the estate liquidity to potentially pay estate taxes. The ILIT may also provide liquidity to the estate via a loan as well.
An additional use of trusts was to sell assets to an intentionally defective grantor trust (“IDGT”)[7]. The result of such a transaction would be that (1) there is no income taxable event yet, as of the sale, because the taxpayer effectively sold to himself for income tax purposes (the same applies to interest on an installment note), but also (2) the asset would be out of the taxpayer’s taxable estate with the low-interest note (usually at the applicable federal rate, being the minimal interest rate to be charged without being treated as a gift) being amortized to zero as the note was paid down, hopefully avoiding appreciation on the assets being the subject of the sale from occurring within the taxable estate. The IDGT is a beautiful planning tool, able to thread the needle between income tax neutral and estate tax beneficial. As an add-on, assets would be sold at appraised value. Therefore, many assets would be subject to discounts, thus reducing the note and any applicable exemption usage.
There is also direct gifting.[8] Taxpayers can make gifts utilizing the annual exclusion and exemption prior to gifts triggering current gift tax occurring following exhaustion of the exemption. Even gifts of straight cash, beyond the exemption amount, could still be effective to a degree. For lifetime taxable gifts, the taxpayer would also pay the gift tax without the amount used to pay tax being subject to the tax rate (i.e. the gift tax does not apply to the amount of money used to pay the gift tax). This is referred to as being tax exclusive. A downside here is that the gifting of any assets that may appreciate prior to death or of appreciated assets will not qualify for any step-up in basis upon the death of the gifting party. In the case of a taxable gift upon death, subject to the estate tax, the amount used to pay tax would also be subject to the estate tax. This is referred to as being tax inclusive.[9]
Charitable gifting has been utilized as well, either giving outright or in trust for qualifying charitable gifts. The works to reduce one’s estate while also accomplishing lifetime gifting goals for taxpayers. Gifting during lifetime works to reduce both one’s estate and income taxes. It should be noted too that gifts may be made of appreciated assets, getting a full fair market value deduction without the necessity of having to recognize capital gains.[10] It should be noted here that if fractional interests are given, discounts can apply to decrease the amount of the charitable deduction.
It is worth noting as well that many other planning mechanisms exist and were used as well during lower-exemption times. From qualified personal residence trusts to an assortment of other types of irrevocable trusts. In summary, the name of the game during this period was to get out of the way of the 40% estate tax.
Post-TCJA Planning Mechanisms
Once the TCJA became law, the planning landscape changed drastically, greatly extending the runway for taxpayers. With a doubling of the exemption available to taxpayers, many taxpayers no longer needed to be concerned about their exposure to estate and gift tax. As mentioned previously, this is compounded by the effect of portability (the ability to utilize a predeceased spouse’s unused exemption). However, what has happened since that time has revolved heavily around ensuring that appreciated assets are specifically included in one’s taxable estate (although likely not resulting in tax because of availability of enhanced exemptions). The benefit here is to be able to step up the basis in an asset to the fair market value as of the date of death. Assets could be held outright or includible via properly structured trust.It is also worth noting here that even if estate tax exposure is possible, it is worthwhile to review assets and trusts to see whether it is possible to swap assets (i.e. to have the grantor swap similarly valued assets with the trust pursuant to a reserved power) to ensure includible assets are appreciated assets to which the step-up would apply. In the case of the IDGT, a taxpayer/grantor of the trust may wish to swap out appreciated assets for cash or other equal value assets such that low-basis/high-value assets can benefit from inclusion. Again, from an income tax perspective, nothing happens. From an estate and gift tax perspective, the benefits could be tremendous. The funny thing is that the taxable estate value can remain the same but by having low basis assets in hand at death, tax attributes can change substantially for the better. It should also be mentioned that step-downs are possible as well. The provision cited to, IRC § 1014(a)(1) states that “the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall […] be (1) the fair market value of the property at the date of the decedent’s death[.]” In other words, if the fair market value is less than the decedent’s basis, the basis can step down in the assets.
Straight gifting is still a viable option as well. In fact, giving during this enhanced exemption period will work to preserve the benefit of the existing exemption.[11] First off, to the extent one utilizes the exemption, beyond what it goes down to in 2026, and to the extent available before 2026, one preserves the sunsetting excess, thus preserving the amount used, over the amount provided for post-sunset, for life.[12] There is also the benefit of the fact a gift can be made on a gift tax exclusive basis (i.e. the taxpayer does not have to pay gift tax on the amount used to pay gift tax, as compared to a bequest of an estate asset). Gifting can also utilize the annual exclusion as well, offloading taxable assets without utilizing precious exemption.[13]
Other planning mechanisms still exist and are utilized during this period as well, including each and every one of the options mentioned in the Traditional Planning section. From a high-level view, little has changed beyond a major adjustment to exemption amounts. Really, it was the dynamics that changed for most taxpayers.[14] The goals of most taxpayers merely shifted to focusing primarily on step-up planning instead of mitigation of estate tax.
Forecast through 2026 and Beyond
For the immediate foreseeable future, taxpayers will grow increasingly concerned about their estate tax exposure. Once the exemption drops in half, many taxpayers, previously unworried about the estate tax, will have a tax concern to the tune of 40% hanging over their heads.
I personally predict that the following will become increasingly prominent in the coming years:
- The making of large exemption gifts by taxpayers, trying to preserve the enhanced exemption;
- More taxpayers undertaking estate planning incorporating some sort of A/B or disclaimer planning, trying to optimize exemption usage;
- Irrevocable life insurance trusts and life insurance/liquidity planning will find its way back into the mainstream again for non-ultra-wealthy taxpayers; and
- Estate freezing with IDGTs involving sales of assets to these trusts at a discount will be increasing in frequency as well among taxpayers.
In short, taxpayers previously not concerned with the estate tax, considering their net worth fell substantially short of the exemption amount, will now be right in the crosshairs of the estate tax.
Now is the time to address any concern, as there is still time to plan and take thoughtful and decisive action. Taxpayers can still utilize and lock in enhanced exemptions by gifting before the sunset of the enhanced exemption. Additionally, taxpayers can try to optimize both their step up in basis, by keeping appreciated assets owned and managed appropriately, while at the same time substantially mitigating their estate and gift tax exposure.
[1] See Sage, Joshua W., Estate Inclusion: The New Estate Plan, Step-Up, Edmondson Sage Allen, PLLC, Aug. 8, 2018, https://esapllc.com/inclusion-planning/ and Allen, Charles J., All About that Basis, About that Basis, No Gains, Edmondson Sage Allen, PLLC, Nov. 8, 2019, https://esapllc.com/cja-stepupplanning-2019/
[2] See IRC § 2010(c)(3)(C).
[3] Portability is the mechanism by which a surviving spouse, upon the making of the appropriate election, may utilize a predeceased spouse’s unused exemption amount.
[4] See IRC § 1014.
[5] These planning mechanisms utilized the marital deduction by allowing the surviving spouse or someone appointed on the spouse’s behalf to disclaim certain or portions of the assets left to them which would then ultimately flow back into the decedent’s taxable estate.
[6] See Allen, Charles J., Back to the Basics with Life Insurance and Estate Tax, Edmondson Sage Allen, PLLC, Mar. 29, 2022, https://esapllc.com/life-insurance-estate-tax-review-2022/.
[7] https://esapllc.com/intentionally-defective-grantor-trusts-have-your-cake-and-eat-it-too-2024/
[8] See Allen, Charles J., The Pros and Cons of Lifetime Gifting, Edmondson Sage Allen, PLLC, Nov. 29, 2021, https://esapllc.com/lifetime-gifting-2021/.
[9] Id. See specifically the section entitled “Gift Tax is Cheaper than Estate Tax.”
[10] Gifts of fractional interests in assets can result in discounts being applicable to the gifts, reducing their tax mitigating benefits.
[11] See citation to article: https://esapllc.com/clawback-fiTalregs/ – UPDATE PRE-POSTING
[12] See Treas. Reg. § 20.2010-1(c) and Final Regulation at 84 FR 64995.
[13] The current annual exclusion amount is $18,000.00.
[14] In review of this article, my esteemed colleague, S. Gray Edmondson noted that “One of those dynamics, which predates the TCJA, is the other changes in rates. Transfer tax rates used to be 55% and [capital gains] at 15%. We now have a 40% transfer tax rate and a top 23.8% [capital gains rate, including the net investment income tax). So, not only has exemption increased, but rates have gotten closer.
