January 15, 2021
By Joe Price
On January 6, Jon Ossoff and Rev. Raphael Warnock won their respective Senate runoffs, giving Democrats control of Congress and the White House for the first time since 2011. This news raises questions around potential changes to tax laws.
I think an income tax increase is more likely than an estate and gift tax increase. However, if you are concerned about the possibility of an estate and gift tax increase, there are actions you could take that would create income tax problems for your heirs. Fortunately, there are better actions you can take that will reduce your estate taxes without creating income tax problems.
Note when you read this article that I am writing it on the evening of President Trump’s second impeachment and more gatherings of the Boogaloo movement are scheduled four days from now, so things are in flux, to put it mildly. But assuming the nation holds together for another week, I predict that we will wind up with an income tax increase; I see less chance for an estate and gift tax increase.
I say that because with only 50 seats in the Senate and a mere 11-vote margin in the House, the Democrats can pass a tax increase but they certainly won’t get everything they want, and it will be a drawn-out, arduous process. It is difficult enough to pass a tax reduction in today’s politically charged climate; it is far more difficult to pass a tax increase. Ever since George H.W. Bush uttered the words, “Read my lips, no new taxes,” and then had a tax increase passed midway through his term, politicians have known how damaging it can be to one’s career to be associated with a tax increase.
On top of that difficulty, the Democrats will have to use a process known as “reconciliation” to pass the next Tax Act. What is that? The simplified definition is it is the process that can be used to pass revenue and spending legislation if one does not have 60 votes to overcome a filibuster in the Senate. It must be used in connection with a budget resolution. If the proposed bill violates the spending and revenue targets of the budget resolution, then any senator can raise a point of order that requires 60 votes to overcome. Generally, tax bills passed by reconciliation expire after 10 years.
What If I’m Wrong?
So, what if I am wrong in my prediction on estate and gift taxes? What if the Tax Act reduces the lifetime exemption for estate and gift taxes to $5.85 million from its current $11.70 million? There are all sorts of tax reduction actions you could take, but keep the following in mind: Assets held until death obtain a step-up in income tax basis; assets gifted during one’s life retain the donor’s historical tax basis. The savvy client thinks about the estate tax-income tax trade-off before he or she does anything rash.
Fortunately, there are things you can do that allow you to have your cake and eat it too. That is, you may be able to reduce your estate taxes without exposing your heirs to higher income tax down the road. I will discuss three of those things.
I will mention that I am aware that the Biden Tax Plan currently proposes repealing the full step-up in income tax basis at the time of death. In the following discussion, I ignore that because I don’t believe that “carryover basis” (the legal term for disallowing basis step-ups at death) will be part of the final bill. The reason is that it will create such administrative difficulties for the financial services industry and middle-class individuals that it will either (1) be left out of the final bill altogether or (2) be so pared back from its current form that planning for basis step-ups at death will still be a viable strategy. Carryover basis was enacted twice before and proved so toxic that it was repealed before it came into effect the first time (1976) and was done away with after the one strange year that there was no estate tax (2010).
Gifts of Cash
Let’s say that you own a valuable parcel of real estate with a very low tax basis and huge upside. Does it make sense to contribute that parcel into a LLC and make gifts of LLC interests to the younger generation(s)? Maybe, but before you do that, find out if it is possible to borrow against the real estate and make gifts of cash to the younger generation instead. You can preserve the basis step-up potential if you hold onto the real estate until death.
Right now (January 2021), the interest rate that you must charge on intrafamily loans to avoid serious problems with the IRS is 0.14% on short-term loans (up to three years), 0.52% on midterm loans (three to nine years) and 1.35% on long-term loans (greater than nine years). So for example, you could lend $100,000 to your child for nine years and charge interest of $520 per year ($43.33 per month). The great thing about intrafamily loans is that they are unlimited and they don’t reduce your lifetime exemption. [Estate Planning 101 teaches us that any portion of your current $11.70 million lifetime exemption that you use on gifts during your life reduces the amount that your estate is able to use at death.]
Are you afraid that it seems less benevolent to make a really low interest loan than a gift to a child? Yes, if you have ingrates for children, it might. But most children will be able to understand that you are making a loan rather than a gift to help out their tax situation later. If your child can’t understand that, maybe he or she should be skipped over.
The Lifetime QTIP Trust*
In the old days (prior to 2018), lifetime qualified terminable interest property (QTIP) trusts were used by wealthy individuals in second marriages to reduce the size of their estates and thereby save on estate taxes, knowing that their less wealthy spouse would not have a taxable estate even with the added amount from the QTIP trust. At the less wealthy spouse’s death, the amount remaining in the QTIP trust would revert to the wealthy spouse’s children.
The new use of Lifetime QTIP trusts is a defensive play to make use of your $11.70 million exemption before it gets taken away by the Biden administration. If that last sentence offends you, substitute “to pay for Trump’s pandemic” in place of “by the Biden administration.”
So, let’s unpack that last sentence to see what exemption preservation is possible on a nearly risk-free basis. If you make a gift of, let’s say, $8 million to a lifetime QTIP trust for the benefit of your spouse before the effective date of the Biden Tax Act (if there is one), you have made a taxable gift that uses up a large portion of your $11.70 million lifetime exemption but does not cause you to pay one cent of gift tax. If later, the Biden Tax Act reduces the lifetime exemption to $6 million, you still won’t owe any gift tax because you used your exemption while it was higher than $6 million.
How do I know you won’t be taxed on that gift that would exceed the reduced exemption by $2 million? Because “anti-clawback” regulations were passed in November 2019 that announced that no taxes would be imposed in that exact situation.
So what is the takeaway? If you are concerned about a Biden Tax Act, and you think there is more than a remote chance that the lifetime exemption will be reduced, the best way to use your full exemption without (1) allowing the funds to escape the “family unit” or (2) sacrificing the potential for a step-up in basis at the spouse’s death, is the lifetime QTIP trust.
If you have concerns that the lifetime QTIP trust might be too restrictive for your family situation, be aware that the IRS allows a lot of leeway in determining whether a trust qualifies for the benefits of “QTIP treatment.”
*QTIP trusts are a form of trust that qualifies for the marital deduction. They allow the donor spouse to dictate where the remaining trust assets wind up at the recipient spouse’s death.
This information contained in this publication is for general informational purposes only and is not intended, and should not be construed, as legal, accounting or tax advice. The author expressly disclaims all and any liability and responsibility to any person or corporation who acts or fails to act as a consequence of any reliance upon the whole or any parts of the content above.Bottom of Form