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Issue 41 – January, 2023
Estate Planning Considerations Leading up to 2023, Plus a Year-End Checklist
By Joshua S. Rubenstein, JD and Jonathan C. Byer, JD
During 2022, COVID-19, the war in Ukraine, global inflation, the Tax Cuts and Jobs Act (TCJA), the uncertainty about the Build Back Better Act (BBBA), the Corporate Transparency Act (CTA), and the Inflation Reduction Act (IRA) dominated the planning landscape.
We noted in our 2021 Year-End Estate Planning Advisory that there was a lot of uncertainty about whether the BBBA would be enacted and, if so, whether it would bring about a change in the estate, gift and generation-skipping transfer (GST) tax exemptions. At the end of the day, while a form of the BBBA passed the House (which form did not include a change to the aforementioned exemption amounts), the BBBA ended up being dead on arrival in the Senate.
As outlined in our previous Year-End Estate Planning Advisories, the TCJA made significant changes to individual and corporate income taxes, restructured international tax rules, provided a deduction for pass-through income and eliminated many itemized deductions. Most significantly for estate planning purposes, the TCJA temporarily doubled the estate, gift and generation-skipping transfer (GST) tax exemptions. Absent legislative action by Congress, many of the changes imposed under the TCJA — including the increased exemptions — will sunset after December 31, 2025, with the laws currently scheduled to revert back to those that existed prior to the TCJA. Given the uncertain political landscape, practitioners continue to view this temporary increase in exemption amounts as an unprecedented opportunity for valuable estate planning.
While the permanency of the TCJA’s provisions still remains uncertain, the current environment provides a great deal of opportunity for new planning. This is the time for individuals to build flexibility into their estate plans and to use this window of opportunity, where appropriate, to engage in planning to take advantage of the increased estate, gift and GST tax exemptions.
As the existing tax landscape is still in effect as of December 21, and looks unlikely to change before the end of the year, particularly in light of the results of the midterm elections, taxpayers should review their existing estate plans and consult with their tax advisors about how, where appropriate, to best take advantage of the higher exemption amounts while they are, in all events, available. The following is a summary of several items that should be considered for planning purposes:
Review Formula Bequests
Many estate plans use “formula clauses” that divide assets upon the death of the first spouse between a “credit shelter trust,” which utilizes the client’s remaining federal estate tax exemption amount, and a “marital trust,” which qualifies for the federal estate tax marital deduction and postpones the payment of federal estate taxes on the assets held in the marital trust until the death of the surviving spouse. Taxpayers should review any existing formula clauses in their current estate plans to ensure they are still appropriate given the increase in the federal exemption amounts and the implications of the potential sunset of these exemption amounts.
Income Tax Basis Planning
Taxpayers should consider the potential tradeoffs of using the increased exemption amounts during their lifetimes to gift assets to others, as opposed to retaining appreciated assets until their death so that those assets receive a stepped-up income tax basis.
529 Plan Changes
The TCJA expanded the benefits of 529 Plans for federal income tax purposes. Historically, withdrawals from 529 Plans have been free from federal income tax if the funds were used toward qualified higher education expenses. Under the TCJA, qualified withdrawals of up to $10,000 can now also be made from 529 Plans for tuition in K-12 schools. As a result, the owner of the 529 Plan can withdraw up to $10,000 per beneficiary each year to use towards K-12 education. The earnings on these withdrawals will be exempt from federal income tax under the TCJA. Note: Each state has its own laws addressing 529 Plan withdrawals, and not all states provide that withdrawals for K-12 tuition will be exempt from state income taxes, so taxpayers should consult with their advisors to confirm the state-specific rules.
Planning to Utilize Increased Federal Exemptions
Given that the increased federal exemption amounts are currently set to sunset at the end of 2025, it may be prudent to make use of these increased amounts before they disappear (with the caveat that the law may, of course, change, and as part of a deal to make other changes, the exemptions may remain where they are). While a change in the federal exemption amounts has not taken place so far under the Biden administration, it nevertheless may be prudent to make use of the increased amount in 2022 and/or early in 2023.
Gifting Techniques to Take Advantage of the Increased Applicable Exclusion Amount
Taxpayers may want to consider making gifts to use the increased federal exclusion amount. It is less expensive to make lifetime gifts than to make gifts at death, because tax is not imposed on dollars used to pay gift tax, but estate tax is imposed on the dollars used to pay estate tax. In addition, taxpayers may benefit by removing any income and appreciation on the gift from their estate. However, taxpayers should seek advice if they have used all of their applicable exclusion amount and would pay federal gift tax on any gifts. Making gifts that result in significant gift tax payments may not always be advisable in the current environment.
Review and Revise Your Estate Plan to Ensure it Remains Appropriate
Any provisions in wills and trust agreements that distribute assets according to tax formulas and/or applicable exclusion amounts should be reviewed to ensure that the provisions continue to accurately reflect the testator’s or grantor’s wishes when taking into account the higher applicable exclusion amounts. Consideration should also be given to including alternate funding formulas in wills or trust agreements that would apply if the federal estate tax exemption amounts do sunset in 2026.
Additionally, in light of the increased exemption amounts, taxpayers should also consider whether certain prior planning is now unnecessary and should be unwound, such as certain qualified personal residence trusts (QPRTs), family limited partnerships (FLPs) and split-dollar arrangements.
Allocation of GST-applicable exclusion amounts should be reviewed to ensure that it is utilized most effectively if one wishes to plan for grandchildren or more remote descendants. In addition, due to the increased GST exemption amounts available under the TCJA, allocation of some or all of one’s increased GST exemption amounts to previously established irrevocable trusts that are not fully GST exempt may be advisable.
Taxpayers should continue to be cautious in relying on portability in estate planning, as portability may not be the most beneficial strategy based on your personal situation. In addition, a deceased spouse’s unused exclusion (DSUE) may not be available upon remarriage of the surviving spouse. However, portability may be a viable option for some couples with estates below the combined exemption amounts.
Same-sex couples should continue to review and revise their estate planning documents and beneficiary designations now that same-sex marriages must be recognized by every state as well as by the federal government. Same-sex couples may want to ensure that the amount and structure of any bequests to the spouse are appropriate, as well as consider the benefits of gift-splitting for gift tax purposes. Same-sex couples should also consider amending previously filed federal estate, gift and income tax returns and state income tax returns, as well as reclaiming applicable exclusion and GST exemption amounts for transfers between the spouses made before same-sex marriages were recognized for federal tax purposes (assuming any applicable statutes of limitations have been tolled).
Unmarried couples should particularly continue to review and revise their estate planning documents and beneficiary designations, as, since the advent of same-sex marriage, it is now clear that domestic partners, even if registered as such, do not qualify for the federal (and in many cases state) tax and other benefits and default presumptions that are accorded to married couples.
Finally, in view of the potential sunset of many pertinent provisions of the TCJA, estate plans should provide for as much flexibility as possible. As noted above, formula bequests should be reviewed to ensure they are appropriate under current law, and consideration should be given to granting limited powers of appointment to trust beneficiaries to provide flexibility for post-mortem tax planning.
Mitigate Trust Income Tax and Avoid the Medicare Surtax With Trust Income Tax Planning
Non-grantor trusts should consider making income distributions to beneficiaries. Trust beneficiaries may be taxed at a lower taxed rate, especially due to the compressed income tax brackets applicable to non-grantor trusts.
Careful evaluation of beneficiaries’ circumstances and tax calculations should be made to determine whether trusts should distribute or retain their income.
Many techniques used in prior years continue to be advantageous planning techniques under the TCJA. Due to the potential sunsetting of many applicable provisions of the TCJA, consideration should be given to planning that minimizes the risk of paying current gift taxes but still allows taking advantage of the increased exemptions amounts to shift assets and appreciation from the taxable estate. Additionally, consideration should be given to selling hard-to-value assets due to the increased exemption available to “shelter” any valuation adjustment of these assets upon audit. Lifetime gifting and sales transactions remain very important in providing asset protection benefits for trust beneficiaries, shifting income to beneficiaries in lower tax brackets, and providing funds for children or others whose inheritance may be delayed by the longer life expectancy of one’s ancestors.
Grantor Retained Annuity Trusts (GRATs)
Grantor-retained annuity trusts (GRATs) remain one of our most valuable planning tools, though, given the higher interest rates as of late, their practicality has decreased since this time last year. Under current law, GRATs may be structured without making a taxable gift. Therefore, even if one has used all of his or her applicable exclusion amount, GRATs may be used without incurring any gift tax. Because GRATs may be created without a gift upon funding, they are an increasingly attractive technique for clients who want to continue planning to pass assets to their descendants without payment of gift tax in the uncertain tax environment.
Sales to Intentionally Defective Grantor Trusts (IDGTs)
Sales to IDGTs have become an increasingly popular planning strategy due to the increased exemption amounts under the TCJA.
In using a sale to an IDGT, a taxpayer would transfer assets likely to appreciate in value to the IDGT in exchange for a commercially reasonable down payment and a promissory note from the trust for the balance. From an income tax perspective, no taxable gain would be recognized on the sale of the property to the IDGT because it is a grantor trust, which makes this essentially a sale to one’s self. For the same reason, the interest payments on the note would not be taxable to the seller or deductible by the trust.
Consider a Swap or Buy-Back of Appreciated Low Basis Assets from Grantor Trusts
If a grantor trust has been funded with low-basis assets, the grantor should consider swapping or buying back those low-basis assets in exchange for high-basis assets or cash. If the grantor sold or gave (through a GRAT or other grantor trust) an asset with a low basis, when that asset is sold, the gain will trigger capital gains tax. However, if the grantor swaps or purchases the asset back from the grantor trust for fair market value, no gain or loss is recognized. The trust would then hold cash or other assets equal to the value of the asset that was repurchased. Alternatively, many grantor trust instruments give the grantor the power to substitute the trust’s assets with other assets, which would allow the low-basis assets to be removed from the trust in exchange for assets of equal value that have a higher basis. Then on the grantor’s death, the purchased or reacquired asset will be included in the grantor’s taxable estate and will receive a step-up in basis equal to fair market value, eliminating the income tax cost to the beneficiaries. Those whose estates may not be subject to estate taxes due to the current high exemption amounts may utilize swaps or buy-backs to “undo” prior planning strategies that are no longer needed in today’s environment. Particular care should be taken when considering swapping hard-to-value assets.
Consider the Use of Life Insurance
Life insurance presents significant opportunities to defer and/or avoid income taxes, as well as provide assets to pay estate tax or replace assets used to pay estate tax. Generally speaking, appreciation and/or income earned on a life insurance policy accumulates free of income taxes until the policy owner makes a withdrawal or surrenders or sells the policy. Thus, properly structured life insurance may be used as an effective tax-deferred retirement planning vehicle. Proceeds distributed upon the death of the insured are completely free of income taxes. Taxpayers should consider paying off any outstanding loans against existing policies in order to maximize the proceeds available tax-free at death, although potential gift tax consequences must be examined. Note that the decision to pay off such loans requires a comparison of the alternative investments that may be available with the assets that would be used to repay the loans and the interest rate on the loans.
Use Intra-Family Loans and Consider Re-Financing Existing Intra-Family Loans
While these techniques work better when interest rates are low, because the exemption amounts are so high, many techniques involving the use of intra-family loans should be considered, including:
- The purchase of life insurance on the life of one family member by an irrevocable life insurance trust, with premium payments funded by loans from other family members.
- The creation of trusts by older generation members for the benefit of younger family members, to which the older generation members loan funds. The spread between the investment return earned by the trust and the interest owed will create a transfer tax-free gift.
- Forgiving loans previously made to family members. The amount that is forgiven in excess of the annual gift tax exclusion amount will be a gift and thus will use a portion of one’s applicable gift tax and/or GST tax exclusion amount. This may be a beneficial strategy considering the increased exemption amounts.
Installment Sale to Third Party Settled GST Tax-Exempt Trust
Unique planning opportunities and transfer tax benefits may be available if a relative or friend of the taxpayer has an interest in creating and funding a trust for the benefit of the taxpayer and/or the taxpayer’s family. For example, a third party grantor (e.g., a relative or friend of the taxpayer) could contribute cash to a trust for the benefit of the taxpayer, allocate GST tax exemption to that gift, and then that trust could purchase assets from the taxpayer in exchange for such cash and a secured promissory note in the remaining principal amount of assets purchased. While this sale could result in payment of capital gains tax to the taxpayer (ideally at an earlier, lower value), this planning could present many benefits.
Purposely Triggering Application of Section 2701
A taxpayer may desire to utilize the increased gift and estate tax exemption prior to the scheduled sunset and may also desire to shift appreciation on this amount to a trust for the benefit of the taxpayer’s children that is removed from the estate tax system. This desire may be met with hesitation to part with $12.06 million of assets in 2022, or $12.92 million of assets in 2023. The taxpayer may also be concerned about losing cashflow from the transferred assets and not having the option of taking the property back if needed in the future. Finally, the taxpayer may also have concerns that assets available for transfer have a low-income tax basis, which will carry over if a traditional gift is made.
A planning alternative exists which can potentially address each of these concerns. The strategy is to create and fund a preferred partnership, which is structured to purposely violate IRC Section 2701.
Consider Charitable Planning
Because the TCJA increased the AGI percentage limit for cash contributions to public charities from 50 percent to 60 percent, consideration should be given to accelerating charitable giving to possibly obtain a current income tax deduction and potentially reduce one’s taxable estate (of both the contributed asset, as well as future appreciation).
A planning tool that is very effective in a high-interest rate environment is a Charitable Remainder Annuity Trust (CRAT), which combines philanthropy with tax planning. A CRAT is an irrevocable trust that pays an annual payment to an individual (typically the grantor) during the term of the trust, with the remainder passing to one or more named charities. The grantor may receive an income tax deduction for the value of the interest passing to charity. Because the value of the grantor’s retained interest is lower when interest rates are high, the value of the interest passing to charity (and therefore the income tax deduction) is higher.
Alternatively, a strategy that works better in a low-interest rate environment is a Charitable Lead Annuity Trust (CLAT). A CLAT is an irrevocable trust that pays one or more named charities a specified annuity payment for a fixed term. At the end of the charitable term, any remaining assets in the CLAT pass to the remainder, noncharitable beneficiaries. As with a GRAT, to the extent the assets outperform the IRS assumed rate of return, those assets can pass transfer tax-free to the chosen beneficiaries. A CLAT may become an attractive option if interest rates fall.
Year-End Checklist for 2022
In addition to the planning ideas, consider the following before the end of 2022:
- Make year-end annual exclusion gifts of $16,000 ($32,000 for married couples).
- Make year-end IRA contributions.
- Create 529 Plan accounts before year-end for children and grandchildren and consider front-loading the accounts with five years’ worth of annual exclusion gifts, taking into account any gifts made during the year to children and grandchildren.
- Pay tuition and non-reimbursable medical expenses directly to the school or medical provider.
- Consider making charitable gifts (including charitable IRA rollovers) before year-end to use the deduction on your 2022 income tax return.
For a deeper, more granular look at developments in 2022 and expected to come in 2023 and beyond, read our “2022 Year-End Estate Planning Advisory.” Katten’s Private Wealth Department contributed to this year-end overview and in the development of the comprehensive advisory.