United States: Taking The Pressure Out Of Pandemic Planning: Drafting Irrevocable Trusts With Flexible Mechanism

Given the potential reduction of the federal gift tax exemption in the years ahead, the socioeconomic uncertainties caused by the Coronavirus pandemic, and historically low interest rates, now is a good time to consider incorporating irrevocable trusts with flexible mechanisms into your estate plan.

Introduction

The Tax Cuts and Jobs Act, signed into law at the end of 2017 (the "2017 Tax Act"),¹ changed some of the methodologies for calculating personal and entity-level income taxes and nearly doubled the wealth that individuals can transfer without incurring a wealth transfer tax from an already historic high of $5,490,000 to $11,180,000 (technically the "Basic Exclusion Amount," but often simply referred to as the "exemption"). This shift significantly reduced the number of individuals who are presently subject to the wealth transfer tax.

The federal exemption will return to $5 million on January 1, 2026 (indexed for a cost of living inflation adjustment) when many provisions of the 2017 Tax Act expire, or perhaps even sooner if a new administration legislates preemptively, as some commentators believe likely.² Even before the outbreak of the Coronavirus pandemic, many Democratic candidates touted the idea of a reduced estate tax exemption and increased estate tax rates, and others, including Democratic nominee Joe Biden, promoted the idea outlined in Obama's green book proposal to eliminate the "step-up" in basis at death.³ Now under the present circumstances, with the government relief provided by the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act"), the extension of PPP loans and other federal spending, the Congressional Budget Office projected a $1.1 trillion deficit this fiscal year, or 4.9% of G.D.P.⁴

Although a planning environment like the present, with increased exemptions and depressed asset values, would typically be an opportune time to transfer assets out of the reach of the wealth transfer tax system, many clients are hesitant to part with assets that they perceive will be needed during an economic downturn or, perhaps, a depression. For individuals whose wealth greatly exceeds their current state and federal exemptions, deciding whether to make outright or leveraged gifts may be easy. For individuals who are not subject to an estate tax under the current enhanced exemption levels, the thought of gifting may cause discomfort. Numerous factors, including the settlor's and beneficiary's states of residency, changing state and federal estate tax exemptions, federal and state tax rates and bracket delineations, life expectancies, and interest rates, to name just a few, complicate the ability of advisors to convey with precision the tax efficiencies of lifetime gifting plans.

By incorporating flexibility in the structure and mechanics of a settlor's irrevocable trusts, however, those who are uncertain about the future opportunity cost of their gifts may retain a degree of control to adapt their plans with changing family and legal circumstances. Even for those individuals who believe that they are unlikely to be affected by an estate or gift tax, several constants remain which should continue to drive inter vivos gifting, including planning to avoid or reduce income taxes, protect assets from claims of potential creditors of the settlor and beneficiaries, and even to cushion large gifts or gifts of hard-to-value assets.

A Recent History of the Wealth Transfer Tax System

Taxpayers faced a similar scenario in 2011 and 2012, when the $5 million exemption was slated to return to $1 million at the expiration of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Public Law 111-312 ("the 2010 Tax Act") on December 31, 2012.⁵ Had the exemption reverted to $1 million, many individuals, even those with typical assets such as a primary residence or life insurance, for example, would have been justifiably concerned about an estate tax. Many taxpayers who anticipated an 80% reduction in the federal estate tax exemption took advantage of the opportunity to make large taxable gifts. Those taxpayers who reside in one of the states that impose an estate tax sought to achieve an even greater wealth transfer by reducing their state estate tax base without any commensurate usage of state exemption.

Despite this gifting opportunity, many advisors cautioned clients of the possibility that large gifts made during those years, when the gift was exempt from gift tax (or was taxed at a lower rate), might be "clawed back" into their taxable estates. This "clawback," it was feared, would result if the estate tax exemption in the year of the individual's death was lower than the amount available and utilized by a taxpayer to make lifetime gifts. The American Taxpayer Relief Act of 2012 (ATRA), passed on January 1, 2013, maintained a $5 million exemption amount, so the resolution of this concern never came to fruition.

Because the "clawback" issue never materialized, advisors faced similar concerns with gifting under the 2017 Tax Act's doubled exemption. The IRS issued final "anti-clawback" regulations, in November 2019, clarifying that additional estate taxes will not be imposed if a taxpayer who made a gift within current exemption levels dies after the 2017 Tax Act has sunset and the exemption used exceeds the exemption in place at death.⁶ A taxpayer must first make taxable gifts that exhaust the taxpayer's original exemption before she will be able to achieve any benefit of the additional exemption after the sunset (this delta in exemption being referred to as "bonus exemption" and the exemption available after a reduction being referred to as "original exemption").⁷ For those individuals that decide to make gifts pre-sunset that are still within the limits of the original exemption, such individuals will have their remaining exemption available. Still, they will not be treated as having made gifts with their bonus exemption that was available at the time of the increased exemptions.

Click here to continue reading ...

Footnotes

1. Tax Cuts and Jobs Act, P.L. 115-97, 12/22/17.

2. The 2017 Tax Act implemented the Chained Consumer Price Index for All Urban Consumers ("C-CPI-U"), replacing the Consumer Price Index for All Urban Consumers ("CPI-U"). Section 2010(c)(3)(C) .

3. Senator Bernie Sanders has also put together draft legislation, known as the "The 99.8% Act," Senate Bill 309. If enacted in some form, the estate tax exemption would revert to $3.5 million with progressive tax rates and the gift tax exemption would revert to $1 million.

4. Irwin, "The U.S. Is About to Vastly Increase Its Debt. That's a Good Thing," N.Y. Times, 3/27/20, updated 8/21/20, at https://www.nytimes.com/2020/03/27/upshot/stimulus-national-debt-coronavirus.html?searchResultPosition=7; Moody's now expects it to be more like 10% to 12%. Fitch estimated it will be 13%. These numbers would exceed the previous post-World War II record for the deficit, which was in 2009, when it was 9.8% of G.D.P.  a Good Thing," N.Y. Times, 3/27/20, updated 8/21/20, at https://www.nytimes.com/2020/03/27/upshot/stimulus-national-debt-coronavirus.html?searchResultPosition=7; Moody's now expects it to be more like 10% to 12%. Fitch estimated it will be 13%. These numbers would exceed the previous post-World War II record for the deficit, which was in 2009, when it was 9.8% of G.D.P. https://www.nytimes.com/2020/03/27/upshot/stimulus-national-debt-coronavirus.html?searchResultPosition=7.

5. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312 ("the 2010 Tax Act") established an estate tax exemption of $5 million, effective Jan. 1, 2010 through Dec. 31, 2012. Sections 302(a) , 101(a).

6. TD 9884 , 84 Fed. Reg. 64,995 (11/26/19).

7. Prop. Reg. 106706-18.

Originally published by WG&L Estate Planning Journal.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.