In light of the recent election, the nature of the tax code may be changing significantly in the near future. As 2021 approaches, it is crucial to understand potential changes to estate, gift, generation-skipping and related income taxes, and consider planning options immediately. In some cases, it may be advantageous to complete certain planning techniques prior to the end of calendar year 2020. However, it is important to keep in mind that, with the exception of Proposition 19 (which is now law), the matters discussed in this memorandum are potential changes. Future tax law and its effect on estate planning matters remains uncertain.
Estate and Gift Tax Exemptions and Rates
Currently, each individual has an estate/gift/generation skipping transfer tax exemption of $11.58 million, which allows each individual, during lifetime or at his or her death, to transfer assets equal to $11.58 million (reduced by the amount of any lifetime gifts), to whomever he or she would like. This $11.58 million figure is currently set to “sunset” following 2025, at which point such figure is scheduled to be reduced to approximately $6.0 million.
However, it is now possible that the estate and generation-skipping transfer tax exemptions could be reduced to as low as $3.5 million next year (possibly with an effective date as early as January 1, 2021), with the gift tax exemption being further reduced to only $1 million. Obviously, this would subject a much larger percentage of individuals and families to estate tax exposure, and would significantly reduce the ability to plan with lifetime gifts. Moreover, it is also possible that the rate at which estates and gifts are taxed will significantly increase.
Step-Up in Tax Basis
Currently, at an individual’s death, the recipients of the decedent’s assets will receive a “step-up” in the income tax basis of most of the inherited assets. This means that the recipient’s income tax basis in the assets are the value of those assets as of the decedent’s date of death. This feature of the tax code protects recipients of inherited assets from exposure to capital gains taxes if the assets are subsequently sold by the recipient. It is possible that these rules may change in the future. While it is unclear exactly what these changes will look like, there appear to be two primary options:
1. Inheriting or “Carry-Over” Basis.
Under this tax scheme, the step-up in basis at death would be eliminated in its entirety, and recipients of inherited assets would inherit the decedent’s tax basis in those assets. If the recipient subsequently sold the inherited assets, capital gains tax would be calculated based on the difference between the decedent’s basis in the assets and the eventual sale price.
2. Tax Due on Gain at Death.
Under this less likely and more radical tax scheme, the step-up in tax basis technically would not be eliminated, but rather, any taxes on built in gains would be due at a decedent’s death. Under this scenario, estates that did not have enough liquid assets to pay capital gains taxes due at death might have to liquidate assets to meet their tax liabilities.
Limitations on the Use of GRATS.
A “GRAT,” or a Grantor Retained Annuity Trust, is a popular estate planning tool that allows a client to transfer assets to a trust for the benefit of one or more family members or other beneficiaries, while retaining an annuity interest for a specified term. At the end of the trust term, the assets remaining in the GRAT pass to the remainder beneficiaries. If the assets in the trust appreciate during the trust term (after making the annuity payments), significant assets can be distributed to the remainder beneficiaries, gift tax free. Under current law, it is common to structure a GRAT with a trust term as short as two years, and without any gift tax consequences to the grantor. However, the rules governing GRATs may be changing, with some speculation that GRATs may require at least a ten (10) year term moving forward, and may require that the retained interest of the grantor produce a taxable gift at the creation of the GRAT.
Termination of Tax Benefits for Grantor Trusts.
Under current law, an irrevocable grantor trust is a widely used estate planning strategy. It is possible that the benefits associated with these types of trusts may be limited after 2020. In such a scenario, it is possible that the termination of grantor trust status could result in gift tax (if during life) or estate tax (if at death). The mechanics of any possible changes is not yet known.
Valuation Discounts for Intra-Family Transfers
When gifting less than the entirety of certain assets (partnerships, LLC, real property, etc.), the value of such transferred asset for gift tax purposes is typically discounted– usually, either due to “lack of marketability,” “lack of control,” or both. However, it is possible that legislation may be enacted in 2021 prohibiting such valuation discounts for “intra family” transfers of assets, substantially limiting the ability to gift assets to children, grandchildren or other beneficiaries at reduced gift or estate tax cost.
Proposition 19 (California Real Properties Only)
Currently, each individual may transfer to his or her children (and in some cases grandchildren), during lifetime or at death, without causing any reassessment for property tax purposes (a) a personal residence of any value, and (b) other real properties with a total combined assessed (property tax) value of $1.0 million. However, as a result of the passage of Proposition 19, effective February 16, 2021:
1. A transfer of a principal residence to a child will only be exempt from reassessment for property tax purposes if the child resides in the home, and only up to a certain dollar amount; and
2. The $1.0 million exclusion for transfers of other real properties to children and grandchildren is entirely eliminated.
The ability to transfer a principal residence, and other real properties to children and grandchildren, and trusts for their benefit, without triggering reassessment of the transferred properties for property tax purposes, has been an important consideration in many estate planning strategies.
STRATEGIES TO CONSIDER NOW:
Because there is a great degree of uncertainty regarding tax policies after 2020, there are several estate planning strategies that clients should consider implementing as soon as possible in order to take advantage of the current tax laws before such changes occur.
1. Make Gifts Prior to End of 2020.
Clients seeking to make transfers of assets to children or grandchildren should give serious consideration to doing so prior to the end of calendar year 2020, particularly because:
- (a) The legal status of valuation discounts following 2020 are unclear at best; and
- (b) Making a gift now can serve to lock in the higher estate, GST and gift tax exemptions currently available ($11.58 million per person), as opposed to potential future exemptions as low as $3.5 million for estate and GST taxes, and $1 million for gift taxes.
2. Spousal Lifetime Access Trusts (“SLATs”).
The Spousal Lifetime Access Trust, or SLAT, is a methodology in which each spouse creates an irrevocable trust for the benefit of the other spouse. Each spouse generally gifts assets into the other spouse’s trust in an amount not exceeding his or her remaining estate tax exemption (currently $11.58 million). If properly structured, the assets of each spouse’s trust, and all appreciation of those assets, will be removed from the estates of both spouses for estate tax purposes. Because the estate tax exemption is anticipated to decrease substantially following 2020, a SLAT can be an effective way to lock-in today’s higher exemption levels while also providing the spouse access to the trust assets during life.
3. Sale or Gift of Assets to an Intentionally Defective Grantor Trust.
An Intentionally Defective Grantor Trust (“IDGT”) is a trust in which the Grantor makes a lifetime gift and/or sale of assets to an irrevocable trust for the benefit of children or others, and yet continues to pay the income taxes on the income generated by the assets of the trust (while the income either remains in the trust or is distributed to the trust beneficiaries.) The payment of the income tax by the Grantor is not considered a gift, and the assets of the trust are not part of the Grantor’s estate at death. This may be accomplished by the Grantor gifting assets to the trust and/or selling assets to the trust in exchange for a low-interest note, rendering this strategy particularly useful in a low-interest environment. However, consideration must be given to the possibility of changes to the grantor trust rules moving forward.
4. Transfer of California Real Properties.
Due to the new property tax reassessment rules under Proposition 19, which take effect on February 16, 2021, in many instances it may be beneficial for clients to transfer one or more of their California real properties, either outright or in further trust, to one or more children (or, in certain cases, grandchildren) prior to the effective date of the new reassessment rules. Transfers prior to the enactment date may allow each parent to transfer a primary residence to one or more children without reassessment, and to transfer other real properties (commercial, rental properties, etc.) with the first $1 million ($2 million for a married couple) of the assessed property tax value of such properties being exempt from property tax reassessment. For example, each parent could now transfer multiple rental properties with a total assessed value of $1.0 million without reassessment of those properties, even if the total fair market value of those properties was significantly more. Transfers of fractional interests in these real properties should also be considered in order to take advantage of valuation discounts while they are still available.
Following enactment on February 16, 2021, there are a number of unanswered questions for which advice will be forthcoming in the near future. In order to preserve the parent child exclusion for the primary residence, the child will need to agree to make the residence his/her primary residence. What if there is more than one child? The proposed law does not address this question. Is there a trust structure or an entity structure which will permit transfers outside the limitations of the statute as it is now interpreted? We are working on these questions and are happy to discuss ideas with clients at any time.
5. Conversion of Traditional IRA to Roth IRA
Converting a traditional Investment Retirement Account (“IRA”) to a Roth IRA is a wealth transfer strategy that IRA owners who do not need to take distributions during their lifetime should consider. While high income earners are typically prohibited from contributing directly to a Roth IRA, they are permitted to convert a traditional IRA to a Roth. On conversion, an IRA owner will be taxed at ordinary income rates on the value of their pre-tax contributions and the IRA’s accumulated earnings. While the up-front tax cost of converting an IRA is high, the wealth transfer benefits may significantly exceed such cost. For one, while an owner of a traditional IRA must take “required minimum distributions” (“RMDs”) starting at age 72 (70 ½ for owners that were born before July 1, 1949), an owner of a Roth IRA (other than an inherited owner) does not have to take any RMDs. This means if a Roth IRA owner has no need to take distributions during their lifetime, the assets they leave to their beneficiaries can continue to grow tax-free in their IRA until death. In addition, a beneficiary of an inherited Roth IRA can receive distributions tax-free (assuming the IRA has been a Roth for at least 5 years before the death of the decedent), but a beneficiary of an inherited traditional IRA must include the full amount of all distributions in their taxable income. This is particularly important because IRA assets do not receive a step-up in basis at death. Another important factor to consider is that all IRA assets are includable in a decedent’s estate for estate tax purposes. The income tax paid by the IRA owner to convert the IRA to a Roth will reduce the value of the owner’s estate at death, which in turn may reduce the owner’s estate tax liability. Because the cost of converting an IRA increases as the marginal tax rates increase and the incoming administration has proposed increasing the marginal tax rates, it is important for IRA owners to consider converting sooner rather than later. The foregoing also generally applies to conversions of traditional 401(k) accounts to Roth IRAs.
6. Other Strategies.
In addition to the estate planning strategies discussed above, clients may benefit from more unique strategies, such as Special Power of Appointment Trusts, Domestic Asset Protection Trusts, charitable lead and remainder trusts, among many others. For clients contemplating a liquidity event (e.g. sale of company, etc.), consideration might also be given to transferring assets to certain types of out of state trusts that may minimize or eliminate California state income taxes at the time of sale.
We encourage clients to reach out to us to discuss these strategies as soon as possible. In doing so, clients may be able to preserve significant tax advantages currently available but likely to change in the near future.
This update is provided to our clients, business associates and friends for informational purposes only. Legal advice should be based on your specific situation and provided by a qualified attorney.