Use It or Lose It: Utilizing Estate Tax Exemption Before It Goes Away

The U.S. imposes an estate tax of approximately 40% on the net estate of U.S. tax residents. The current exemption from estate tax is $11,700,000 per person, leaving very few estates actually subject to the tax. Under current law, the exemption will revert to $5,000,000, adjusted for inflation, on January 1, 2026. However, President elect Biden has proposed reducing the exemption to $3,500,000. After democratic wins in Georgia this change could be made as soon as this year.

Who Does this Affect?

The proposed change affects individuals with estates of $3,500,000 or more or married couples with more than $7,000,000. Your net estate includes the fair market value of all your assets worldwide net debts.

Planning Opportunities

The exemption from estate tax is actually a unified credit against estate and gift tax. This means that right now individuals can make gifts of up to $11,700,000 without incurring a gift tax. Gifts can be made outright to individuals or in trust. So long as the trust is irrevocable and meets certain requirements, the assets will no longer be included in the individual’s estate for estate tax purposes. There are several ways to do this:

Spousal Lifetime Access Trust (SLAT)
A SLAT is one type of irrevocable trust that can effectively transfer wealth outside of your estate while at the same time leaving a safety net for your spouse for his/her lifetime. Many estate tax plans focus on shifting assets to the next generation. While this is an effective strategy, depending on your age and your spouse’s age and your total assets, you may not be comfortable giving away all of your assets to a trust for your children and grandchildren.

While it may be tempting to create a SLAT for each spouse, such a plan should be carefully considered. First, depending on your circumstances it may make sense to keep one spouse’s exemption intact, even if it is reduced. Second, the Internal Revenue Service frowns on what is referred to as reciprocal SLATs, which means that if two SLATs are created they should be substantially different.

Generation Skipping Trusts
For those of you in a position to transfer wealth to the next generation the best option is a generation skipping trust. The trust can be set up to benefit your children and their descendants but if done properly will pass down multiple generations without any additional estate tax.

Whether you transfer assets outright to your children, or to a trust for your spouse or descendants, all appreciation on the assets transferred will be outside your estate for estate tax purposes. Further, in the event the estate tax exemptions decrease, as is likely to happen, if you have a gross estate in excess of $7,000,000 you will be using a portion of your unified credit for gift tax that will not later be available for estate tax. In other words, use it or lose it.

How to Address Uncertainty

Tax legislation could potentially be made retroactive to January 1, 2021. Therefore, careful planning should be done to make sure that if this happens there is not an inadvertent gift tax. This can be done with formula clauses, disclaimer provisions, and QTIP elections in a trust for a spouse. Ideally, legislation will be enacted prospectively but it’s best to be prepared.

Meredith Mazzola
Partner, Tax Group
mmazzola@gibney.com