Summary of Key Points
- The COVID-19 pandemic, while damaging to the nation’s well-being and economy, has created an unusually advantageous economic environment for wealth transfer planning.
- If Joe Biden wins the presidential election and the Democrats gain unified control of Congress, it is expected that significant changes may be made to the estate tax and the income tax. As a result, many estate planning opportunities that are currently available could be made less effective or eliminated entirely. Changes to the tax laws could take effect as soon as early 2021.
- To avoid the risk of missing opportunities in a year-end rush, friends and clients interested in maximizing their wealth transfer opportunities should contact us now so that we can devise a proactive strategy responsive to their specific situation, the advantageous wealth transfer environment and potential imminent changes to the tax laws.
Wealth Transfer Opportunities
The recession caused by COVID-19 has led to unprecedently low interest rates, as well as reduced asset values in many sectors, creating an historic opportunity for wealth transfers with minimal transfer tax friction. Given these conditions, now may be an opportune time to consider transferring wealth to your descendants.
Depressed asset valuations allow a taxpayer to make gifts using less gift tax exemption. Potential future appreciation in the assets benefit the recipients without attracting any gift or estate tax. Clients planning to use their unified gift and estate tax exemption (“exemption”) ($11.58 million per person under current law) should consider doing so prior to a recovery in asset values, and, as discussed below, should consider doing so prior to the end of this year (when changes to the tax laws could result in a significantly reduced exemption).
If you have already used most or all of your exemption, or if you are worried that ongoing market volatility could further reduce the value of any gifted assets, a GRAT may be worth considering. GRATs are a kind of trust that allows appreciation in trust assets—to the extent they outperform an IRS-determined interest rate—to be transferred to the beneficiaries of the trust free of gift tax. This IRS-determined interest rate came into effect in 1989, and is currently lower than it has ever been, at just 0.4% for September 2020. When the rate is this low, it is much easier for the assets in a GRAT to outperform that benchmark, and thus for clients to transfer wealth to their descendants free of gift and estate tax. For clients who wish to take advantage of the low-interest rate environment to benefit charitable causes as well as their descendants, a similar estate planning vehicle called a CLAT allows assets, plus interest at the IRS-determined rate, to be transferred to charity, while appreciation in the value of those assets in excess of the IRS-determined rate is transferred to the client’s descendants free of gift tax. In certain cases, the gift to the CLAT can be made to qualify for the charitable deduction.
Sales and Loans to Trusts
As an alternative or complement to a GRAT, if you have already used your gift tax exemption by funding a multi-generational trust for your descendants (or if you are planning to do so now), you may want to consider selling additional assets, or loaning cash, to that trust in exchange for a promissory note. The promissory note can be structured as a long-term note at an extremely low interest rate (currently 1% for notes with a term longer than 9 years), with annual interest-only payments and a balloon payment of the principal at the end of the note, and with no income tax consequences to the interest and principal payments (if the trust is structured properly). Sales to trusts on credit can allow clients to shift to their descendants future appreciation in asset values in excess of the interest rate on the note free of gift or estate tax. Similarly, loans to trusts can allow the trust to purchase assets that are expected to outperform the note’s interest rate, thus allowing value to be transferred to the client’s descendants free of gift and estate tax. Unlike GRATs, which are useful principally when planning for transfers to children or other persons less than two generations younger than the grantor, sales to trusts are ideal when engaging in multi-generational — or dynastic — estate planning.
Sales and Loans to Family Members
The sale and loan techniques mentioned above in the trust context can also be used in the context of direct transfers to family members, with similar gift tax advantages (but without income tax advantages). Additionally, existing loans to family members can be refinanced to take advantage of the current historically low interest rates.
Failing Transactions and High Interest Rates
Some of you reading this bulletin, who may have done estate planning transactions (such as GRATs and sales to trusts) in recent years when asset values and interest rates were higher, may now be discovering that the transactions are underwater. While there is no way to directly rescue such a transaction short of a dramatic and sudden increase in equity prices, it nevertheless may be possible to re-use the assets that were previously transferred in new transactions which will capture any future increases in asset values over current depressed levels. In addition, if assets were previously sold or funds previously loaned in exchange for a promissory note with a high interest rate, it may be possible to refinance that note at today’s much lower rates.
Potential Tax Law Changes
The combination of a possible Biden administration and a potential Democratic majority in both chambers of Congress could result in far-reaching changes to the income and transfer tax landscape. Although tax legislation must originate in Congress, Biden has proposed a number of tax reforms which, if enacted, would significantly impact current income and transfer tax planning opportunities. Nonetheless, certain estate planning techniques, if undertaken prior to the effective date of any changes to the tax laws, can help to preserve and transfer wealth in the face of these potential tax reforms.
Decreased Exemption and Increased Gift and Estate Tax Rate
Although Biden has not officially endorsed any estate or gift tax reform proposals, the recently-released Biden-Sanders Unity Plan, which consists of policy recommendations formulated by a task force chosen by Biden and Senator Bernie Sanders, recommends that estate taxes “be raised back to the historical norm.” As mentioned above, the exemption is currently $11.58 million per person, but was only $5.49 million in 2017 (prior to a doubling effectuated by the Tax Cuts and Jobs Act for tax years beginning in 2018). When he was pursuing the Democratic nomination, Sanders proposed reducing the exemption to $3.5 million per person, which was the exemption amount in effect in 2009, prior to the passage of the 2010 Tax Relief Act (legislation that was signed by President Barack Obama but which some Congressional Democrats viewed as a compromise that tilted too far in favor of the wealthy). Moreover, the gift and estate tax rate, which is currently 40%, moved gradually from 55% to 40% from 2000 to 2010.
If the Democrats win broadly in November, taxpayers should expect that the gift and estate tax exemption and rate may become less taxpayer-friendly, given the tenor of policy proposals during the Democratic debate season, as well as the fact that the pandemic is putting extra budgetary pressure on the federal government. Depending on a taxpayer’s financial situation and goals, certain gifting, sale and loan techniques outlined above could be helpful to mitigate the effects of any changes to the transfer tax laws.
Eliminating the Basis Step-Up at Death
Under current law, when a taxpayer dies, all assets owned outright by the taxpayer receive an income tax basis step-up to their date of death value, so that unrealized capital gains inherent in those assets on the taxpayer’s death permanently escape taxation. Biden has proposed eliminating this rule.
If it appears that election results could lead to a repeal of the basis step-up at death, clients may wish to undertake transactions with trusts (or with family members directly) prior to year-end to reduce the impact of such a change.
Increased Capital Gains Rate
A Biden administration may seek to tax capital gains and dividends at higher rates for taxpayers with incomes above $1 million, and also to increase ordinary income tax rates. Under current law, the highest tax rate on long-term capital gains is 20%, while the highest ordinary income tax rate is 37%. Biden has proposed raising the highest ordinary income tax rate to 39.6% (which was the highest ordinary income tax rate prior to the Tax Cuts and Jobs Act), and taxing all capital gains at the ordinary income tax rate for taxpayers with incomes above $1 million.
Clients facing an increase in capital gains rates may wish to engage in certain transactions with trusts (or with family members directly) before year-end, allowing them to defer capital gains taxes or incur such taxes at more favorable rates, while also removing such assets (including the value of cash used to pay any capital gains taxes incurred) from their estates for gift and estate tax purposes.
Importance of Planning Now
The current low interest rates and reduced asset values caused by the COVID-19 pandemic have presented what may be a once-in-a-lifetime opportunity for tax-favored wealth transfers. Moreover, depending on your financial picture and family situation, the political winds may make it advisable for you to engage in estate planning transactions before year-end.
We encourage friends and clients to contact us now to review their estate plans in light of the current advantageous wealth transfer environment and the potential tax law changes discussed above. Speaking now rather than in November will allow you and us to have a less rushed, more forward-thinking and three-dimensional discussion, and may allow you to benefit from low interest rates and reduced asset prices that may not be available in November and December. And although some clients may prefer to wait for any changes in the tax laws to be undone by an administration after Biden’s, it might be wise to lock in tax benefits now rather than to hope that they will be reinstated in the future.