Planning for the Sunset - Why Now is the Time to Act
September 2024
As of 2024, the lifetime exemption sits at an historic high of $13.6M per individual and is expected to increase again to around $14M in 2025. However, like many provisions of The Tax Cuts and Job Act (TCJA), the increase in the lifetime exemption amount is only temporary. The limited window of increased exemption provided under TCJA has created a unique opportunity for individuals and families to explore and implement wealth transfer strategies from now through the end of 2025.
While some individuals and planners may believe a 'wait and see' approach as to whether Congress will act to extend the provision is prudent, there are several reasons why being proactive and planning for the sunset now will yield the most desirable outcome.
The Tax Cuts and Job Act passed in 2017 ushered in sweeping changes to U.S. tax law. Among them was the near doubling of the lifetime estate and gift tax exemption, or the amount an individual can give during life and at death fully transfer tax-free, over previous levels. Barring an act of Congress, on January 1, 2026, the exemption will sunset and revert-back to pre-TCJA levels of $5M adjusted for inflation, which current estimates place between approximately $7M and $7.2M.
Use It or Lose It
As currently constituted, the increased exemption is a 'use it or lose it' proposition. This concept can be best understood through a simple illustration. Let's suppose a single individual passes away in 2024 with a total estate valued at $13M. At current exemption levels, there would be no taxable estate and no Federal estate tax due (see Appendix 1) If the same individual were to pass away in 2026 when the exemption is scheduled to drop in half to $7M, there would be a taxable estate of $6M resulting in a $2.4M estate tax bill (before factoring in any potential asset appreciation).
The 2026 scenario could be avoided if the individual in this illustration planned by maximizing use of their exemption in 2024 and 2025. Thankfully for individuals and planners, the IRS in a set of final and proposed regulations has provided a level comfort to those who do plan that there will not be a "clawback" into their estate of completed gifts if the exemption amount is lower at passing. In other words, if the individual in this example were to gift $10M in 2024 and the exemption drops back to $7M in 2026, the excess $3M would not be brought back into their estate. Note in this example, the benefit of gifting the excess is completely lost if the individual decided to not use their increased exemption.
Thoughtful Planning
For most individuals and planners, a strategy of gifting to irrevocable trusts will prove to be the most effective way to maximize use of their exemption, particularly if those trusts retain grantor tax status. Many types of irrevocable grantor trusts can be considered depending on an individual's specific goals, values, and desires (see Appendix 2). As part of the planning process with trusts, careful consideration must be given by the individual and their advisors in selecting assets over which they are comfortable relinquishing complete dominion and control, while managing cash flow needs to maintain their lifestyle, and navigating the potential loss of a step-up in basis on assets gifted. This process is time consuming and often results in multiple iterations and drafts of a trust before being finalized. Additionally, consideration during this process should be given to certain tax and legal doctrines which can result in undesirable consequences if not adhered to, particularly where transfers between spouses are concerned (see Appendix 3). Allowing sufficient time for the planning process to develop not only ensures the individual will arrive at the best possible outcome, but also mitigates the chance of donor's remorse down the road once the trust is funded.
Revisiting Existing Plans
On the opposite end of the spectrum of those who have not begun planning are those who have already taken proactive measures to fully maximize use of their exemption. They already have basic estate documents in place and have funded one or multiple trusts with lifetime gifts. It may be easy for these individuals and their advisors to assume that no further action is necessary between now and the scheduled sunset, but as estate plans are living documents, now continues to provide an opportunity for these plans to be revisited to ensure they are current and working as intended.
For example, perhaps the tax burden on a grantor trust has become difficult such that the grantor may consider "toggling" powers, or a change in values or life expectancy warrants an asset swap. The recent Supreme Court ruling in favor of the government in Connelly vs. the United States., for instance, should require plans where life insurance proceeds are to be used in a redemption buy/sell arrangement to revisit those agreements and consider alternative structures. These scenarios underscore why an estate plan is rarely a 'set it and forget it' proposition and should be revisited as facts and circumstances warrant.
Capacity
Lastly, strong consideration should also be given by individuals as to the capacity of the estate planning community over the next year and a half as attorneys, valuation experts, CPA's, and financial professionals will likely find themselves stretched for time as many race to develop or revise plans to beat the sunset clock. The sooner an individual engages their professional team in the process, the more likely they are to work with those they desire on timely terms.
Planning for effective maximization of the lifetime exemption is a worthwhile, but time-intensive process. While we may not have a crystal ball into the future of the U.S. political and legislative landscape, the best we can do is plan for the law as is before the clock expires and this potential once-in-a-lifetime opportunity for wealth preservation disappears.
For additional information, please contact your PW Partner and review the following Appendix.
Perelson Weiner is a full service Certified Public Accounting and consulting firm dedicated to serving the needs of successful entrepreneurs and their businesses, high net worth individuals and their families and international companies doing business in the United States.
APPENDIX
Considerations for New York and the "Cliff"
New York follows its own state estate tax regime that is separate and distinct from Federal. The exemption amount for NY in 2024 is $6.94M, with graduated tax rates ranging from 3-16%.
In addition to a lower exemption amount, New York's estate tax regime is figured in a different manner. Under NY law, if the value of a NY estate exceeds 5% of the NY exemption amount, the entire value of the estate is subject to NY tax. Contrast this with the Federal estate tax rules, where the estate is only taxed on the value in excess of the exemption. This difference in calculation is commonly referred to as the "cliff".
Residents of New York and non-residents with significant real or tangible property located in the state must consider these differences when devising their estate plan.
Irrevocable Grantor Trusts
Irrevocable grantor trusts are popular estate planning vehicles due to their ability to achieve multiple tax efficiencies. These trusts are structured so that the assets contributed are removed entirely from the donor's estate for transfer tax purposes, allowing future growth to accumulate to beneficiaries. As a grantor trust, for income tax purposes the donor continues personally paying the tax liability on earnings generated by the assets during their lifetime, further reducing their taxable estate by these payments. The grantor nature of the trust also allows the donor to sell appreciated assets to the trust (for instance, in exchange for a note) and not recognize gain on the sale.
Common types of irrevocable grantor trusts can include, but are not limited to:
Dynasty trust – a trust designed to hold property for more than one generation, such as for children and grandchildren. The trusts are drafted to exist as long as legally possible.
Grantor Retained Annuity Trust (GRAT) – a trust where the grantor retains an annuity interest. The value of the annuity interest is removed from value of the property transferred, making these attractive transfer vehicles for those who have exhausted most of their exemption.
Qualified Personal Residence Trust (QPRT) – a trust specifically designed to transfer a personal residence to beneficiaries. Successful QPRT's "freeze" the value of the residence by shielding future appreciation from estate tax.
These trusts can be funded with various types of assets, and the process of selecting the appropriate property for lifetime giving should take into account both tax and nontax considerations. Specific concerns regarding the cash flow needs of the donor during life, for instance, can be addressed by targeting non-income producing assets, such as tangible personal property or investments that do not pay dividends.
Reciprocal Trust & Step-Transaction Doctrines
Many married couples will find Spousal Lifetime Access Trusts (SLATs) to be particularly attractive vehicles to maximize use of their exemptions. SLATs have become popular as 'rainy day' trusts due to the spouse-beneficiary's ability to access trust cash and other assets during their lifetime. When drafting SLATs planners must beware of the reciprocal trust doctrine, which essentially prohibits spouses from creating substantially similar trusts for each other's benefit. One way to avoid this trap is by having a prolonged period of time elapse between the establishment of the two trusts, such as establishing one SLAT in 2024 and another in 2025, as it helps support the case for differentiation under this doctrine.
Along a similar vein, individuals and planners must also be mindful of the step-transaction doctrine. This doctrine essentially takes a transaction that unfolds over multiple steps and collapses it into a set of fewer or a single step. In the case of funding SLATs, where one spouse may need to transfer assets to the other before that asset is further contributed into trust, this necessitates having sufficient time pass between transfers before the SLAT is funded. While there is no bright-line test as to how much time must pass, many planners may want to have these transactions starting in 2024 and continuing into 2025 to help establish a timeline to this effect.