The recent results of the Georgia Senate runoffs effectively handed control of the U.S. Senate to the Democratic Party. The shifting control of the Senate, along with Democratic Party control of the House of Representatives, makes it more likely that the incoming administration of President Joe Biden will pursue ambitious legislative goals. As it relates to taxation, this potentially includes reducing the estate and gift tax exemption from $11.7 million per person to $3.5 million, raising the estate and gift tax maximum rate from 40% to 45%, and eliminating the rule allowing for a tax-free step up in the basis of assets upon death. How likely these changes are to occur and wheen are speculatory at this point. Consideration of the legislative process, particularly in the Senate, may provide some insight.
Legislating Through the Budget Reconciliation Process
With Senate seats evenly split between Democrats and Republicans, the Biden administration will have to rely on Kamala Harris, as president of the Senate, to break any tie votes on proposed legislation. In circumstances where one party holds such a slim majority, bi-partisan Senate support is often necessary in order to achieve the necessary 60 Senate votes to overcome a filibuster. However, proposed legislation may pass the Senate with a simple majority through a procedure known as “budget reconciliation.” In recent years, budget reconciliation has been used to pass legislation such as the Tax Cuts and Jobs Act of 2017, and the Patient Protection and Affordable Care Act.
The Congressional Budget Act requires that the House and Senate adopt a budget resolution each year. Senate rules prohibit a filibuster to budget resolutions. As part of the budget resolution process the House and Senate must agree on “reconciliation directives,” which direct congressional committees to prepare legislation that will increase or decrease spending, increase or decrease revenues, or raise or lower the public debt. Senate rules provide that there may be a maximum of three reconciliation bills each year, one for each of these three areas of reconciliation directives. Reconciliation directives don’t dictate specific legislative changes, rather these occur through the normal committee process. Legislation enacted through the budget reconciliation process must have a budgetary impact and cannot increase the federal deficit outside the period covered by the reconciliation meaure, generally 10 years (which may necessitate that legislation automatically “sunset” or expire at a specific date).
Generally the budget reconciliation process occurs once each year. However, because Congress did not pass a budget resolution for the 2021 fiscal year in 2020, Congress can pass a 2021 budget resolution during the first 100 days of the Biden administration. Thereafter, the Congress can turn to a 2022 budget resolution, which likely would not be fully reconciled, and related legislation enacted, until the fall of 2021. Given the complexities of the Internal Revenue Code, the President’s desire for COVID-19 relief, and measures to strengthen the Affordable Care Act, address climate change, and immigration reform, significant tax legislation might have to wait.
Even if significant tax legislation is delayed, it doesn’t necessarily mean the effective date of any new tax legislation is also delayed. As unfair as it may seem, retroactive tax legislation is entirely legal if related to a legitimate legislative purpose, and raising revenue on account of the economic conditions brought on by a pandemic would seem to be a legitimate purpose. Fortunately, retroactively effective tax legislation is uncommon.
Astute taxpayers might ask about the consequences of making a gift utilizing any available unified credit to avoid gift tax, only to find out that the reduction in the unified credit amount is retroactive to a date preceding the date of the gift, effectively causing a gift thought to be tax-free to become taxable. One way around this problem is to condition the actual amount of the gift made on the available unified credit through the use of a formula clause in legal documents effectuating the gift. Great care must be taken in utilizing formula clauses as the IRS has indicated a willingness to challenge the use of formula clauses. Another option that might be utilized in the case of gifts to a trust would be to provide that if the primary beneficiary of the trust disclaims (forgoes) an interest in the gifted property, it would revert back to the taxpayer making the gift in the first place.
As for whether the reduced exemption might even be applied retroactively to gifts made in prior years (e.g., 2020 and before), I addressed a similar situation in 2012 when a prior law was set to sunset and a lower unified credit would return. My analysis concluded that a mere revision of the unified credit could not cause prior tax-free gifts to become taxable (41 Colo. Law. 57 (Sept. 2012)). More recently, the existing $11.7 million unified credit is scheduled to expire after 2025. In 2019 the IRS confirmed (IR-2019-189) that taxpayers taking advantage of the higher unified credit would not be adversely impacted when the unified credit dropped, as scheduled, to a lower level.
Despite the risks of retroactive application of the law, it’s highly recommended that estate and gift tax reduction strategies be undertaken now as the benefits outweigh the slight risk of any retroactive application of a change in the law.
Tax Planning At This Time
If you believe that a reduction of the exemption from estate taxes is likely to occur, this would be an opportune time to engage (or reengage) in some estate and gift tax planning. What follows are some tax minimization strategies you may want to consider at this time, many of which make use of any available estate tax exemption.
Outright Gifts to Younger Generations
This is the simplest strategy to employ. It relies solely on the outright gift of money or property free of trust, and utilizes all or a portion of your available estate tax exemption. It may, however, be an inefficient use of any available unified credit.
Gifts of Interests In Closely Held Businesses
Gifts of interests in closely held business can either be made outright or in trust, and the gift tax avoided by utilizing any available unified credit. If partial interests in the business (as opposed to the entire business) are conveyed, the value of the interests transferred are often discounted significantly. Discounts allow you to convey more than you might otherwise be able without incurring gift taxes.
Spousal Limited Access Trust
A spousal limited access trust (SLAT) is an irrevocable trust established for the benefit of your spouse. To the extent you have all or part of your available unified credit, no taxes are owed on the gift of assets to this trust. Because your spouse is the beneficiary of the trust, access to trust assets is not forever lost. Often married couples will create SLATs for each other, but care must be exercised in doing this. If the two trusts are too similar they may be entirely disregarded under something known as the reciprocal trust doctrine.
SLATs might be desired for an additional reason. If the unified credit is reduced retroactively, which would cause a previously tax-free gift to become subject to the tax, a properly structured trust could qualify for an unlimited marital deduction, which would serve to defer any tax liability until the spouse’s death.
Grant Retained Annuity Trust
A grantor retained annuity trust (GRAT) is another irrevocable trust, but one in which the creator of the trust (known as the “grantor”) retains the right to be paid an annuity for a predetermined period of time. The value of that annuity is subtracted from the value of assets transferred to the GRAT in arriving at the amount of the taxable gift (which tax liability can be eliminated or reduced using any available unified credit). The larger the annuity, the smaller the taxable gift. A GRAT is particularly attractive in our present low-interest rate environment if trust assets appreciate at a rate in excess of the presently assumed rate of growth of 0.6%.
Qualified Personal Residence Trust
A qualified personal residence trust (QPRT) is essentially a GRAT that holds your primary residence. Instead of an annuity, you are provided with the right to live in the home rent-free. It similarly works very well in a low-interest rate environment and the property appreciates at a rate greater than the present 0.6% assumed rate of growth.
Low Interest Rate Loans
Loans to family members can take advantage of extremely low rates of interest. Essentially the benefit to you of these loans is freezing the value of a part of your estate by converting these assets to a below-market-interest loan. Unfortunately, this strategy doesn’t take advantage of any available estate tax exemption that could disappear with new legislation.
Sale To A Grantor Trust
This is another strategy that doesn’t necessarily make full use of any available estate tax exemption. It involves the creation of an irrevocable trust, to which an initial amount of cash or property is contributed. The initial gift makes use of the unified credit to avoid gift tax. The grantor then sells property to the trust in exchange for a down payment (the amount of cash used to initially fund the trust) and low-interest loan. No capital gains are recognized on the sale of appreciated property to the grantor trust, the beneficiaries of whom are usually children or more remote generations. This is another strategy that freezes the value of part of your estate by converting highly appreciating assets to a below-market-interest loan. To the extent the underlying property sold appreciates at a rate greater than the interest rate on the loan, you have effectively made an additional tax-free loan to the trust beneficiaries.
Elimination of Stepped-Up Basis
Lastly, the President’s proposed tax plan includes the elimination of the tax-free step up in basis rule. The existing rule allows the tax basis of property (think the cost of property, though that isn’t an entirely accurate explanation of “basis”) to be increased tax-free to market value at a taxpayer’s time of death. Often, this rule allows the heirs of an estate the ability to sell appreciated property free, or near free, of capital gains tax, or where property decreases in value following death might allow heirs to recognize a capital loss when the property is sold.
When property is gifted to someone, the recipient of the gift takes the property at the donor’s tax basis, and the property receives no step-up upon the donor’s death (this is known as “carryover” basis). Under current law the estate and gift tax savings obtained when making a lifetime gift needs to be contrasted with the potential savings to be had if property is retained and the tax-free step up taken advantage utilized. If the step-up in basis at death rule is repealed and the capital gains tax savings eliminated, lifetime gifts become more attractive.
Our firm is happy to assist you if you are interested in implementing any tax minimization strategies, including those outlined above, or would simply like to chat about how any potential tax legislation may affect you.