Estate Planning And The 2020 Election: Ten Planning Considerations

Written by: Wills, Trusts, & Estate Administration

Apologies for the longer than usual article….

The 2020 presidential election is in the books. (Or is it)?

Whether it is or isn’t, let’s look at some important planning considerations, especially for those who have a net worth individually of several million or more.

Why those figures? Well, let’s go through a brief review…..

Currently (2020) we have an estate tax exemption of $11,580,000 per person, and it is ‘portable’ between spouses, such that a married couple can currently pass on to heirs (children, grandchildren) $23,160,000 free of estate and gift tax.

Joe Biden‘s published tax plan calls for the exemption to sunset as scheduled at the end of 2025, and then revert back to $5M per person ($10,000,000 total for a couple), indexed for inflation.  (The unlimited marital deduction will remain in place.)

However, there are MANY (most in fact) who believe that if Biden has the votes, the exemption will be reduced to anywhere from $3.5M to $5M per person in 2021, (rather than “sunsetting” as scheduled on Dec 31, 2025),  and be retroactive to January 1, 2021 if/when passed next year. (There are even far left proposals to drop the exemption back to $1,000,000 per person, though most commentators think this unlikely). Moreover, there is reasonable belief that the estate tax rate could be increased from 40% to 50%, and that the basis step up could be eliminated.  Granted, this is likely ONLY if Biden has the votes (i.e., if Democrats take control of the Senate). If, instead, Republicans keep the Senate, that scenario (reduction from $11.7M to $5M or less) is much less likely.  (Though even if Republicans keep the Senate, we could see some compromises on the estate tax for Republicans to accomplish other legislative goals).

The year-end planning problem is that the Senate hangs in the balance of the two Georgia runoffs, which occur on January 5^th, and of which we may not know the results until mid-January 2021. Should both Georgia Republicans lose, then Democrats will control the White House and both houses of Congress, giving much broader discretion to the Democrats legislative agenda.

Meaning, depending on how you like to gamble, you either “do” or “don’t” or “may” need to make significant decisions before December 31, 2020.

So what does one do? Politics aside, if the “worst case” tax scenario plays out, then effective January 1, 2021 (regardless of when legislation is enacted in 2021), couples with a net worth over $10M combined (or maybe even over $7M combined) may face an estate tax of 40% (or more!) on assets passed to heirs in excess of that amount, instead of being able to shelter $23M combined from estate taxes.

Stated differently, if Democrats take the Senate, we may (likely) see the eligible exemption amount cut by more than 50% effective Jan 1, 2021.

So if that plays out, then instead of $23,160,000 that you and your spouse can pass tax free to heirs, you might only have $10,000,000 per couple (or maybe only $7,000,000 ) that you can pass on to heirs prior to incurring estate tax.

The “good” news is that pretty much all talking heads agree there will be no “claw back”—meaning you could use your $11.58 million exemption NOW, even if it’s reduced in the future. (And by the same token, IF it is reduced next year, you irrevocably lose that opportunity and will instead be limited to whatever the new reduced exemption amount is).  Moreover, you cannot approach this as “well, I’ll use $6.58M this year, and then still have my $5M if it gets reduced to that.”  Unfortunately, no you won’t!  While the government won’t claw back and seek tax on gifts you made over $5M, what you use this year will count against the $5M that may exist next year.

So for the high(er) net worth client, what planning options should you at least consider between now and December 31??

(And let me start with this disclaimer: I have long been one of those who say “never let the tax tail wag the dog”. Meaning anything you do should be because you are comfortable doing it, want to do it, and can financially stomach it).

That said, and this is but a summary, here are some planning options that the high(er) net worth client should consider prior to the end of 2020:

1. Grandchildren trusts. A tried and true method that frankly EVERY high(er) net worth client should be doing already. Every year. Create trusts for grandchildren that are funded each year with annual exclusion gifts from one or both parents (or funded via split gifts).  That is $16,000 per grandchild, or $32,000 with split gifts, for EACH grandchild, EACH year, without reducing the exemption.  And this is on top of the ability of the grandparent to pay for college and educational (and health) costs, without impacting the exemption or annual exclusion gifts.  This is truly a “no brainer” for the higher net worth client.
2. ILIT. (Irrevocable Life Insurance Trust). Now more than ever. ILITs are still one of the best options available for any client facing potential estate tax obligations. Under an ILIT, you create a trust to own a life insurance policy, and when done properly, the policy proceeds are not included in your taxable estate.

There is frequently misunderstanding among laypersons as to the taxability of life insurance proceeds. You’ve heard it said no doubt that “life insurance proceeds are not taxable”, correct? This is true in a sense. It is not taxable to the recipient. But is still includible in the taxable estate of the decedent who was the owner of the policy.  If you own a life insurance policy payable, for example, to your children, those proceeds are not a part of your “probate estate”, because the proceeds pass outside of your estate and they are not taxable to the child.  HOWEVER, those proceeds are INCLUDED in your gross estate for federal estate tax purposes.  But if, instead, the policy is held in a properly drafted irrevocable trust, the policy is not a part of your taxable estate, and is thus not subject to estate tax. Example: if you have a taxable estate, and you have a $5M policy in the ILIT for your children, that $5M is not a part of your taxable estate, and passes to your children free and clear of estate taxes and without reducing your available exemption amount!

3. GRATs. I often say that GRATs are “magic”. This is in part based upon the assumed rate of growth that the IRS says assets will grow.  We remain at historically low rates at the present time.  GRATs work best with a single stock where you have high concentrations of that stock, but can also work well with a small mix of stocks.  For example, let’s say you have $3M of stock in company X.  Currently, the IRS assumed growth rate is .4%.  Let’s say instead that Company X stock actually grows on average at 8% per year.  The growth differential can pass to your descendants free and clear of any estate or gift tax consequences!

For a specific example, let’s assume you create a 3 year term GRAT, with $3,000,000 of stock, and let’s assume the average annual actual growth is 8% per year. The IRS assumes the growth will be only .4% per year.  The result is that the full $3,000,000 is returned to the trust grantor, along with total interest of $23,990.31.  The balance of the growth ($506,775!!) passes to the remainder beneficiaries (usually your children) at the end of the 3 year term, without using any exemption or incurring any gift tax.  Magic indeed!

GRATS have been targeted in the past, and while legislation to eliminate them has never passed, these would likely be on a ‘hit list’ of a progressive Democrat agenda.  In other words, there is no time like right now to consider a GRAT.

4. GST trusts. (Dynasty Trusts). For the higher net worth client, consider creating GST trusts now for your children and grandchildren. As noted above, your current exemption is $11,580,000 per person. By utilizing your exemption amount now, you remove from your taxable estate not only that $11,580,000, but ALSO the growth on that value over the course of the rest of your life. If the tax laws change, and the exemption is reduced for example to $3.5M or $5M dollars, you lose the opportunity to gift this larger amount.
5. FLP (Family Limited Partnership). In addition to the very legitimate business, asset protection and related benefits these can offer, a family limited partnership (FLP) can result in significant estate tax savings. Discounts of 50% and more have been upheld by the Courts, although we would anticipate a more conservative discount in the 30-40% range.  Let’s assume for purposes of this discussion that you created a FLP with $5,000,000 in assets in net value (securities, land, etc.), in return for a 98% limited partnership interest and 1% general partnership interest.  The children would collectively have perhaps a 1% limited partnership interest.  It is your limited partnership interests which you would use to make gifts in the future to each child (or even grandchild).  You could be the sole general partner at 1%, thus retaining control of the assets and control of the timing of distributions, though at some point down the road we would encourage this to be gifted as well to your children.

For example, assuming you place $5,000,000 of  assets in a partnership, and assuming a fairly standard 35% discount, you are looking at potential estate tax savings of at least $700,000. (Because a  35% discount reduces the value included in your estate from $5,000,000 to $3.25M, and you thus save estate tax on the $1.75M difference; 40% tax rate x $1,750,000 = $700,000 tax savings.) This is in addition to the benefits of creditor protection, divorce protection for your children, asset protection from creditor claims, and the like.

6. CRTs. Charitable Remainder Unitrust (CRUT). Some advisors will tell you that these only make sense if you are charitably inclined.  Granted, if you are charitably inclined, all the better.  But these trusts serve a great purpose even if charity is not your primary objective. These trusts provide a stream of income, minimize capital gain taxes, are protected from creditors (judgments, bankruptcy, divorce, etc.), and work great as component of your retirement planning.  These can be created either for a term of up to 20 years, or for the life of an individual or a married couple.

For example, if you create a CRUT for a 20 year term with $3,000,000, and assuming that it grows on average at 8% per year, you achieve the following results: (i) an immediate income tax charitable deduction of $300,0000; and (ii) a 20 year stream of income which starts at over $300,000 per year and gradually reduces to about $200,000 per year.  Over the course of those 20 years, you would have received total distributions of almost $5,000,000, and in the end would actually leave $1.5M to go to charities of your choice.

7. Private foundation. A private foundation allows you to take a portion of your assets to set aside for charitable purposes, over time rather than making a lump sum gift to any one charity currently. It also allows your children (and later, grandchildren and beyond), over time, to be involved in choosing various charities that will benefit from annual distributions and in selecting the amounts.  Obviously, this provides a personal and social benefit of having your children actively involved in the community.  It will also provide tax benefits for you in the form of a tax deduction when the funding contribution(s) are made to the foundation.

Considering the potential estate tax liability of high net worth individuals, the cost of an amount given to a private foundation is effectively much less than the amount actually given.  Take an example of $2,000,000.  If given to children or grandchildren (and assuming your exemption has been fully used), and assuming a 40% estate tax rate, they get roughly only $1,200,000 with the IRS receiving the balance.  If, however, given to your foundation, not only does the foundation receive the full $2,000,000, you receive a tax deduction, saving additional income or estate taxes.

8. “split the difference”. The obvious concern here at the end of 2020 is that we may, or may not, still have an $11.58M exemption per person in 2021. If it is reduced next year, you lose the opportunity. That is to say, if it is reduced to $5M, then you have lost the opportunity to give the additional $6.58M free of tax.  (resulting in $2.6 MILLION in additional tax!)  One option, other than a couple giving away the full $23M combined exemption, is to have one spouse gift the full exemption of $11.58M fully utilizing the exemption of that spouse.  The other spouse’s exemption remains intact, such that even if the exemption is reduced, that spouse still has his or her (adjusted) $5M exemption available to use.
9. Don’t forget the “freebies”! There are certain steps the higher net worth client should be taking EVERY year, which are “use it or lose it”. Those include:
   • Annual Exclusion Gifts. Each year you can give $16,000 to as many persons as you choose without reducing your current $11.58M exemption. Children, grandchildren, etc.  For example, you can give $16,000 to your child, and to his or her spouse, and to each grandchild.  If you have 3 children who are married, you can give $16,000 to each child, and to each spouse, for a total of $32,000 to each couple, in addition to the $16,000 to each grandchild.
   • Split Gifts. You can give double the amount you give to each child by way of “split gifts”, even if it all comes from you, if your spouse consents to a ‘split gift’. For example, let’s again say you have 3 children, each of whom are married.  You can give each child and each spouse $16,000, and your spouse can do the same, such that each receives $32,000.  And remember, it’s “use it or lose it.”

Example: lets say you have 3 married children and 6 grandchildren.  You and your spouse can give to each child/spouse $64,000 ($16,000 to the child, $16,000 to the spouse, from EACH of you and your spouse) and $32,000 to each of the grandchildren ($16k from each of you and your spouse), such that you and your spouse can transfer $288,000 EACH year without reducing your exemption!!

• • Tuition, heath costs, etc.  SEPARATE from the annual exclusion gifts, you can pay directly the tuition and heath care costs of as many persons as you want.  All WITHOUT reducing EITHER your lifetime exemption OR you annual exclusion!!

10. Other Advanced Strategies. Finally, there are numerous other opportunities, some more complex than others, which can include installment sales to IDGTs, QPRTs for a personal residence, SLATs to benefit a spouse (and thus you indirectly) in order to use your full exemption now while not passing the assets to the children yet, recapitalizations in an S-corporation to create voting and non-voting stock to take advantage of valuation discounts, creation of DB Cash balance plans in closely held companies, and many other strategies.

Unfortunately we planners don’t have a crystal ball.  And while we never want to push a client into making a decision they are uncomfortable with, right now is certainly the time to consider or revisit some of these strategies, particularly with the uncertainty concerning the exemption amount going in to 2021.