Seize the increased basic exclusion amount

Editor: Alex J. Brosseau, CPA

Seize the day, or, should it be said, seize the increased estate and gift tax basic exclusion amount? Under the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97,the basic exclusion amount (BEA) was increased from $5 million to $10 million, indexed for inflation. In 2020, the inflation-indexed BEA is $11.58 million. The TCJA states that the increased $10 million BEA will be in place only until the end of 2025, after which it will revert to the previous $5 million BEA, indexed for inflation. Those in a position to make larger gifts have an opportunity to seize the increased BEA before it is lost; but, in doing so, one should not forget some long-standing gift planning considerations.

Various gift and estate planning considerations have been developed over the years that should not be forgotten. For example, with or without the increased BEA, one might consider making gifts that are excluded from gift tax and make use of the annual exclusion. Similarly, payments made directly to a medical provider or payments of tuition directly to an educational organization are not treated as transfers of property by gift. This allows a donor to pay an unlimited amount of medical expenses directly to the medical provider on behalf of a grandchild and still make an annual exclusion gift to the same grandchild. In 2020, the annual exclusion amount is $15,000; thus, an individual can give up to $15,000 each year to any person (and by extension all people) without triggering a taxable gift. The multiplier effect can be astounding. For example, a grandparent can give each of her three children and 10 grandchildren $15,000 in cash each year (totaling $195,000, or for both grandparents, $390,000) without using any of his or her BEA.

One might also consider using the annual exclusion to make gifts to a Sec. 529 plan. All 50 states offer at least one Sec. 529 plan where an account can be established and grow income tax-free if used for qualifying educational expenses. Make sure to consider each state’s specific rules on setting up and contributing to such an account. Another unique benefit of a Sec. 529 plan is that, if a gift of more than $15,000 is contributed, an election can be made to treat the gift as if it were made over five years. Thus, in 2020, a front-loaded gift of $75,000 can be contributed to a grandchild’s Sec. 529 plan, and if the election is made, there will be no taxable gift or generation-skipping transfer (GST) tax. Just be aware that a gift to the same grandchild over any of the subsequent four years could either absorb some of the BEA or cause a taxable gift because the annual exclusion may have already been exhausted.

Before discussing potential planning that may make use of the increased BEA, it is important to address one concern raised after the enactment of the TCJA regarding whether larger gifts made between 2018 and 2025 that used the increased BEA would give rise to additional estate tax once the exclusion returns to its reduced amount as scheduled under current law. On Nov. 26, 2019, Treasury and the IRS released final regulations (T.D. 9884), clarifying that there will be no “clawback” when the exclusion amount reverts to $5 million (inflation indexed) at the beginning of 2026. Instead, an estate will be allowed to compute its estate tax using the increased BEA that was in effect when the gifts from 2018 to 2025 were made.

Example 1: A single taxpayer with a taxable estate worth $20 million dies on Jan. 1, 2026. Assume the top marginal estate tax rate is 40% and the inflation-adjusted BEA has reverted to $5.6 million (and a corresponding applicable credit amount of $2,185,800). The taxpayer would have a computed tax amount before credits of $7,945,800, which, after reducing for the applicable credit amount of $2,185,800, results in a net estate tax liability of $5,760,000.

Example 2: Assume the same facts as in Example 1, except that a gift is made in 2019 of $11 million. In this case, the taxpayer may take the higher of the 2026 applicable credit amount of $2,185,800, or the applicable credit actually used in 2019 of $4,345,800. Thus, the tax before credits would be the same $7,945,800 less the higher applicable credit amount of $4,345,800 leaving a reduced net estate tax liability of $3,600,000.

The 2019 gift allows for $2.16 million more to be passed to the taxpayer’s beneficiaries than would be available absent the 2019 gift. These examples illustrate the colloquial observation that one must “use it or lose it.”

Taxpayers may obtain unique benefits when it comes to gift and estate tax planning by using trusts and responding to applicable valuation conventions. Trusts have been around since the Middle Ages, and settlors have been motivated to establish them fundamentally to separate the beneficiary from the property and to impose professional governance over trust assets. Thus, trusts are frequently used when beneficiaries are impacted by some form of legal impairment and where distributions can be made for the benefit of the beneficiaries.

Typically, a transfer to an irrevocable trust is considered a completed gift, and the assets contributed to the trust are out of the grantor’s estate, assuming the grantor has retained no interest in the trust assets or the ability to dictate changes to the beneficial enjoyment of the trust assets. A potential advantage of gifts in trust over outright gifts is that the assets, all subsequent appreciation, and all accumulated income (subject to the GST rules discussed below) are outside the reach of the estate and gift tax rules so long as those assets remain in trust.

An additional potential advantage of a trust arises if it is structured as a grantor trust. Grantor trusts, under Secs. 671-679, are often used in gift and estate planning. Grantor trust status arises when the grantor retains either an economic interest or a power over trust property, which is significant enough to require the trust’s income to be taxed to the grantor as if the trust had never been funded. The trust is considered a disregarded entity for income tax purposes, with two significant outcomes: (1) The trust grows income tax-free since the grantor is legally obligated to report and pay tax on the trust’s income tax attributes; and (2) transactions between the trust and the grantor are disregarded. If the grantor trust is structured in a manner that precludes estate inclusion, these two potential advantages allow a gift in trust to convey more wealth from the same BEA than is possible with an outright gift, until the grantor dies or revokes the grantor powers. The income tax paid by the grantor is not considered an additional gift to the trust since the payment of the tax is in satisfaction of the grantor’s legal obligation.

Example 3: A grantor contributes $11 million to a grantor trust that is structured so as not to give rise to estate inclusion. The grantor uses $11 million of the BEA and no annual exclusion. Assume the $11 million appreciates by $300,000 annually and generates income of $500,000 annually with resulting income tax liability of $200,000 each year. After five years the grantor dies. At the date of death, the trust will be worth $15 million ($11 million + ($800,000 × five years)). The grantor’s estate will have been reduced by $1 million ($200,000 × five years), resulting in an estate tax savings of $400,000 (40% of the unexpended $1 million). Had the trust not been a grantor trust, the trust’s value would only be $14 million, and the grantor’s estate, perhaps, would have the after-estate tax proceeds of $600,000 from the unexpended $1 million.

Gifting “hard to value” assets where a valuation discount can be taken is another potential planning consideration to enhance the performance of gifted assets relative to a simple gift of cash. Examples include minority interests in a closely held business or investment entities and fractional interests in real estate. While a discussion of the nature and depth of discounts is beyond the scope of this item, conveying asset values that reflect discounts allows for the gift transfer of “more” assets for the same quantum of exclusion and, as a result, may improve the possibility of greater returns to the donee since more property is “at work.” The depth of any discount is often challenged by the IRS, and the ability to discount assets has come under regulatory challenge, with the recent release and subsequent withdrawal of proposed regulations under Sec. 2704 being the most recent example. While discounts are regularly used, it is possible that future developments on the ability to discount appropriate assets may arise.

Another potential planning consideration is the increased GST exemption amount. The GST tax is a separate tax regime, put in place to impose a transfer tax at each generational level when assets are transferred to a skip person. A skip person is an individual who is two or more generations removed from the GST transferor. This includes a grandchild or a great-grandchild; or if there is no relation to the transferor, a skip person is anyone who is more than 37½ years younger than the GST transferor. Since 2010, the BEA and GST exemption amounts have been equal. The GST exemption of $10 million (inflation-adjusted to $11.58 million in 2020) is also scheduled to sunset at the end of 2025. This allows a limited opportunity to respond to the increased GST exemption to benefit a skip generation by making gifts directly to a skip person or to a GST trust (as defined in Sec. 2632(c)(3)(B)).

So-called dynasty trusts are GST trusts set up to benefit children and more remote descendants for so long a period as the applicable state’s laws permit. A dynasty trust can be exempted from the application of GST tax if it is funded with no greater amount than the GST exemption amount the transferor has available to allocate to it. In such a case, the trust will be subject to gift tax upon the initial transfer to the trust; however, estate tax and GST tax will not be imposed until such time as the assets are distributed to individual beneficiaries and they later transfer those assets by gift or bequest.

Dynasty trusts are permitted in all 50 states; however, the laws on the maximum duration of such trusts vary. A state may limit the term of the trust to anywhere from 80 to 110 years or may allow the trust to continue until 21 years after the death of the last surviving descendant of an identified person (generally the trust’s grantor). Some states allow for a trust to exist in perpetuity. Make sure to investigate what the applicable state laws are when setting up a dynasty trust. Another consideration with a dynasty trust is that the trust agreement must provide enough flexibility to govern the trust for a significant period of time. Therefore, dynasty trusts may be relatively more complex than other common types of trusts. While a meaningful example of the economics of a GST trust is difficult to illustrate, it is not hard to appreciate the compounding effect of such a trust. Assume a grantor sets up a 100-year dynasty trust with the entire $11.58 million GST exemption amount. If the trust generates a 4% yield after taxes and distributions, the trust’s value in 100 years would grow to roughly $585 million. While purposeful investing is required for such an outcome, it is almost equally important that the corpus of the trust will not have been disturbed by an estate tax for three or four generations.

The increased BEA and GST exemption amount is scheduled to remain only until the end of 2025. While it is important not to forget tried-and-true gift and estate planning, including annual exclusion gifting, gifts to Sec. 529 plans, and direct payments of medical or education expenses, now may also be the time to think differently. Whether one uses the increased BEA via outright gifts, gifts to irrevocable grantor trusts, gifts to dynasty trusts, and/or by responding to valuation discounts, the key thing to remember is that if you do not use it, you could lose it.

EditorNotes

Alex J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.

For additional information about these items, contact Mr. Brosseau at 202-661-4532 or abrosseau@deloitte.com.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.

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