Tax Planning Takes on Even Greater Significance in This Election Year
There has been a great deal of discussion and speculation concerning possible changes to estate and income tax laws depending on the results of the upcoming Presidential election. Due to the large increases in an already elevated national debt attributable to prior tax cuts, combined with continuing Covid-19 related stimulus costs, we anticipate there will be pressure to raise taxes regardless of which party is in power after the election.
Some of the income tax proposals have included raising individual tax rates for high earners, raising the corporate income tax rate, raising capital gain tax rates, and treating capital gains as ordinary income for those with income in excess of $1 million. Estate tax proposals have included lowering the lifetime estate and gift tax exemption and eliminating “step up in basis,” which has served to reduce income taxes on the sale of inherited assets.
It should be noted that certain provisions of the 2017 Tax Cut and Jobs Act were not permanent, including the increase in the estate and gift tax exemption and the decrease in individual tax rates. In 2026, the current 2020 estate and gift tax exemption of $11.58 million per person (indexed for inflation) is scheduled to revert back to the previous exemption of $5 million (also indexed for inflation). The top individual income tax rate is also scheduled to increase from the current 37% rate back to the previous 39.6% rate.
As noted in our previous Alerts, we have already been implementing certain estate planning strategies to take advantage of the current higher estate and gift tax exemption prior to its scheduled sunset. Because of the possibility of the reduction of these exemption amounts prior to 2026, when feasible, we have been encouraging clients to explore and implement some of these strategies prior to the end of 2020. Since little can be accomplished without Congressional approval, proposals for any future tax law changes can go through many iterations before any final legislation is passed. Also, although not often the case, if legislation is passed in 2021 there is always the possibility of it being made retroactive to January 1, 2021. In addition, the current very low interest rate environment, coupled with somewhat depressed asset values, adds additional leverage to these techniques.
Given our current environment and the uncertainty surrounding future tax law changes, we continue to implement available techniques, as set forth below.
Spousal Lifetime Asset Trust (SLAT)
A married person can gift assets to a SLAT, remove such assets from his or her taxable estate and still have access to the assets, if needed, through his or her spouse as a lifetime beneficiary.
Grantor Retained Annuity Trust (GRAT)
A GRAT is an irrevocable trust aimed to transfer appreciating assets out of the grantor’s estate while using little, or sometimes none, of the Grantor’s lifetime gift tax exemption. The Grantor receives an annual annuity payment for the GRAT term based on a low IRS interest rate. Any earnings and appreciation above this hurdle rate remaining at the end of the GRAT term pass estate tax free to the ultimate trust beneficiaries.
Charitable Lead Annuity Trust (CLAT)
A CLAT is similar to a GRAT, except the annuity payments are made to charity. At the end of the trust’s term, the remainder interest is distributed to non-charitable beneficiaries (usually family members). Again, any investment performance in excess of the IRS hurdle rate may pass tax free to the family members at the end of the trust’s term. The lower the rate, the larger the potential tax-free transfer.
Sale to an Intentionally Defective Grantor Trust (IDGT)
The IDGT is drafted in a manner that causes the trust to be ignored for federal income tax purposes, but not for federal estate transfer tax purposes. In being defective as to the income taxes, the grantor can also pay the IDGT’s income taxes (without it being deemed a gift).
The grantor makes a gift to the IDGT in order to give it a substantive value (normally 10% of the value of the subsequent sale transaction). The grantor then sells assets to the IDGT in exchange for a promissory note that is an installment sale between the IDGT and the grantor. The interest rate would be determined by the low applicable federal rate (AFR) based on the terms of the note.
Both the sale of the asset and the subsequent interest payments under the promissory note are nontaxable to the grantor because the trust is ignored for income tax purposes and the grantor is considered the owner of the property. Also, because the IDGT is ignored for income tax purposes, any earnings in the IDGT are included in the grantor’s taxable income. Any asset appreciation over the AFR will accrue to the trust rather than the donor, which is why it is attractive during times of low interest rates.
There are a number of additional income and estate tax mitigation strategies available depending on a client’s individual circumstances.
We will continue to monitor these issues and communicate with you. When there is more clarity on any future tax law changes, we will be in a position to make additional recommendations that align with your family goals and objectives. As always, we are available to address any questions or concerns you may have.