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2020 Year-End Estate Planning: Planning in a Time of Uncertainty

This unsettled environment will reward sophisticated, flexible and proactive estate planning.

2020 may rank as the most turbulent year in memory for many Americans, resulting in a highly uncertain estate planning environment. In addition to the tragic health consequences, COVID-19 caused severe disruptions to daily life and dramatic fluctuations in asset prices. Uncertainty is high in the political sphere as well. As of this writing, Joe Biden has been declared the winner of the presidential election by all major news outlets, but control of the Senate will depend on the outcome of two runoff elections in Georgia in January 2021. This unsettled environment will reward sophisticated, flexible, and proactive estate planning.

Overview of Current Transfer Tax Laws

The federal gift, estate and generation-skipping transfer (GST) tax exemptions (i.e., the amount an individual can transfer free of any of these taxes) are currently $11.58 million per person, increasing to $11.7 million in 2021. Thus, beginning in 2021, a married couple can theoretically transfer up to $23.4 million free of federal transfer tax – an unprecedented amount. The transfer tax exemption will be adjusted upward for inflation in future years, but under current law is scheduled to be reduced by 50 percent on January 1, 2026. A "marital deduction" is allowed for assets passing directly or in qualifying trusts for the benefit of a surviving spouse. Thereafter, the tax rate on any assets above the transfer tax exemption is a flat 40 percent. The federal transfer tax exemptions can be used either during lifetime or at death. Using exemption during lifetime is generally more efficient for transfer tax purposes, as any appreciation on the gifted assets escapes estate taxation.

The Treasury Department has confirmed that the additional transfer tax exemption granted under current law until 2026 is a "use it or lose it" benefit, and that if a taxpayer uses the "extra" exemption before it expires (i.e., by making lifetime gifts), it will not be "clawed back" causing additional tax if the taxpayer dies after the exemption is reduced in 2026. Practically, this means that a taxpayer who has made $5.85 million or less (adjusted for inflation) of lifetime gifts before 2026 will not "lock in" any benefit of the extra exemption, while a taxpayer who makes use of the additional exemption before 2026 (e.g., by making gifts of $11.7 million before 2026) will "lock in" the benefit of the extra exemption.
The Illinois estate tax exemption is $4 million per person. This exemption does not receive annual inflationary increases. As with the federal estate tax, a marital deduction is allowed for assets passing directly or in qualifying trusts for the benefit of a surviving spouse for Illinois estate tax purposes. Thereafter, the effective marginal tax rate for assets above the Illinois estate tax exemption ranges from 8 percent to approximately 29 percent.

As with income taxes, state estate taxes are deductible for federal estate tax purposes. The cumulative federal and Illinois estate tax rate (for estates above both the federal and Illinois exemptions), taking deductions into account, is approximately 48 percent.

Possible Effects of 2020 Elections

Tax laws are, of course, subject to change by Congress. With Democrats capturing the presidency and retaining control of the House of Representatives, legislation to increase the federal transfer tax exemptions is highly unlikely. Furthermore, President-elect Biden has during the campaign called for a "rollback" of the increased federal transfer tax exemptions. This may include reducing the $11.7 million transfer tax exemption for 2021 to $5.85 million, or even as low as $3.5 million, potentially with legislation becoming effective as early as January 1, 2021. However, such measures would require passage in the Senate. This will be difficult if Republicans remain in control of the Senate (by winning one or both Senate runoff elections in Georgia), but not impossible, as one or more Republican senators could be persuaded to vote for a Democratic tax package, potentially in exchange for other concessions.

Incorporating Flexibility into Estate Plans

The highly uncertain political environment results in a premium on estate planning that is proactive yet flexible enough to take changing circumstances into account. Fortunately, estate planners have developed a number of techniques that provide significantly more flexibility than was available in past years.

Spousal Lifetime Access Trusts (SLATs): A "Spousal Lifetime Access Trust" or "SLAT" is often an ideal solution for married couples facing potential transfer taxes. As discussed above, using transfer exemption during lifetime by making gifts generally provides estate tax savings, as the appreciation on any gifted assets escapes estate taxation. Traditionally, such gifts have been made to the children of clients or to trusts for their benefit. However, many couples would be unwilling to transfer $11.7 million (let alone $23.4 million) to their children during their lifetime. A SLAT, on the other hand, is created by one spouse for the current benefit of the other spouse, generally with children only as remainder beneficiaries. This lets the beneficiary spouse "access" the trust assets, while still providing a vehicle that allows the appreciation on the gifted assets to escape estate taxation. (Additional information on planning with SLATs is available here.)

Qualified Terminable Interest Property (QTIP) Trusts: Many estate plans for married couples provide that upon the death of the first spouse to die, some or all of the predeceasing spouse's assets are to be distributed to a trust that qualifies for the "marital deduction" from estate tax. This reduces the estate tax due upon the death of the first spouse to die, but potentially increases the estate tax due upon the death of the surviving spouse. But, depending on the assets of the spouses at their deaths and the estate tax laws in effect at those times, it may or may not be beneficial to utilize the marital deduction.

A "qualified terminable interest property" trust, or "QTIP" trust, is ideal in such circumstances. With a QTIP trust, an election can be made upon the death of the first spouse to die as to whether or not to qualify the trust for the estate tax marital deduction. If the assets of the couple are relatively low at the time of the first death, or if the estate tax exemptions are relatively high at that time, it may be best to qualify the trust for the marital deduction given the change in basis for income tax purposes at death (discussed below). However, if the assets of the couple are relatively high at the first death, or if the estate tax exemptions are relatively low, it may be best to not qualify the trust for the marital deduction in order to let the trust escape estate taxation at the death of the surviving spouse. Planning using QTIP trusts gives clients flexibility to defer this decision until the death of the first spouse to die, at which time additional information will be available and a better decision can be made.

Furthermore, QTIP trusts can be used proactively during lifetime rather than only at death. If a QTIP trust is created and funded during lifetime and a marital deduction election is made on a timely filed gift tax return, no exemption is used and the trust assets will be included in the spouse's taxable estate (receiving a basis change at death). Alternatively, if a QTIP trust is created and funded during lifetime but the marital deduction election is not made, a completed gift is made and the trust assets will not be includible in the spouse's taxable estate (but receiving no basis change at death). Marital deduction treatment may be desired if the exemption remains high, and non-marital treatment may be desired if the exemption is decreased. The decision to make or not make the marital deduction election can be deferred until the gift tax return reporting the transfer is filed – potentially until October of the year following the transfer. This provides a great deal of flexibility in an uncertain environment.

Planning for Basis Change: Good estate planning incorporates income tax and other considerations rather than focusing myopically on estate and GST taxes. In general, upon an individual's death, the cost basis of any assets that are included in his or her gross estate for estate tax purposes receive an adjustment to their fair market value at the date of death. For appreciated assets, this can result in substantial income tax savings. Assets that are not included in the gross estate, however, do not receive a basis adjustment. Therefore, there is often a tradeoff between making lifetime gifts (to reduce estate taxes, but with the donee receiving the donor's "carry over" basis) and keeping assets in the gross estate (to obtain the basis adjustment and reduce income taxes).

Fortunately, there are a number of techniques to help plan for possible change in basis while still retaining estate tax benefits. Irrevocable trusts that receive lifetime gifts can be structured to allow for a possible basis change. One way to do so, especially for a SLAT, is by including a broad distribution standard by which an independent trustee can make distributions out of the trust to the beneficiary. Additionally, a trust can be structured to grant an independent trustee the power to grant (or not grant) the beneficiary a "general power of appointment," which would cause the trust assets to be includible in the beneficiary's estate for estate tax purposes and therefore receive the basis adjustment. Finally, if an irrevocable trust is structured as a grantor trust, the grantor can retain a "swap power" that can be used to transfer high basis assets to the trust and take back low-basis assets, in order to obtain the largest possible "step up" in basis.

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