The U.S. Treasury recently released a publication detailing a number of the proposed tax code changes that the Biden administration would like to usher through Congress in an ambitious effort to modernize the U. S. tax system to meet its citizens’ needs. While reasonable minds may differ strongly on the best way to stimulate the US economy and create wealth and security for the American people, one thing is certain: the need for individuals to engage in careful estate and tax planning to avoid paying more tax than necessary is not going away.
The IRS publication, sometimes referred to as the Green Book, outlines a number of key proposals that—if ultimately passed—have the potential to significantly shake up the estate planning world as we know it today by sidelining a number of tried and true estate planning strategies while potentially increasing the frequency of use and usefulness of others.
As some commentators have observed, any direction to reduce the estate and gift tax exemption amount from its current historically high level of approximately $11.7 million per taxpayer is noticeably absent from these proposals. Although there is certainly no guarantee that such a proposal will not be made in the future, we can nevertheless help our clients focus for now on what we do know about the law as written today and what steps we and they can take to address the coming changes.
One of the first things that clients need to understand is that, even with no action whatsoever by Congress, estate tax laws passed under the Trump administration will expire and reset to the prior laws in 2026. This reset will restore the estate and gift tax exemption amount to $5 million, as it was in 2016 (though it will be indexed for inflation, resulting in an exemption amount of approximately $6.6 million in 2026). Again, this is the law as it stands today; without further action from Congress, it will remain the law.
It is therefore important to consider with your clients the average rates of return on their investments, compounded annually, to determine what kind of return on their investments they can expect within the next five to ten years. Using a basic calculator or spreadsheet, many of your clients may be surprised to see that, even with a moderately healthy return of approximately 7 percent annually, their net worth could easily double in ten to twelve years. If the estate tax exemption amount is halved in 2026 and increases only with inflation at a rate of approximately 2.5 percent per year, clients could very quickly find themselves at risk of paying significant estate taxes (currently at a 40 percent rate) if they are still in the mindset of having an $11.7 million estate tax exemption ($23.4 million for married couples) available when they pass away in the next one to two decades.
What should we be doing now?
Given the current uncertainty, trying to predict the future and counsel your clients on which strategies will best accommodate their tax and estate planning goals can be frustrating to both you and your clients. This is particularly true when we consider some of the other Green Book proposals:
- Raising the top income tax rates
- Taxing capital gains as ordinary income for those earning over $1 million per year
- Treating any transfers of appreciated property (including gifts and inheritances) as a sale of the property, thus triggering capital gains taxes on the property, instead of allowing the traditional carryover basis for gifted property or stepped-up basis for property inherited at the death of the property owner
- Limitations on deferral benefits for like-kind exchanges of real estate
You and your clients should still consider certain strategies, however, because these changes have not yet been implemented and may ultimately never be enacted. For example, the following strategies are still effective tools under current tax law, and if your clients implement them now, they could realize significant tax savings.
Grantor Retained Annuity Trust
A grantor retained annuity trust (GRAT) enables a client to transfer appreciating accounts and property to chosen noncharitable beneficiaries (usually the client’s children) using little or none of the client’s gift tax exemption (depending on the value of the client’s retained interest in the trust). To accomplish this, the client transfers property to the GRAT and retains the right to receive an annuity. After a specified period of time, the noncharitable beneficiaries will receive the amount remaining in the trust.
Installment Sales to an Intentionally Defective Grantor Trust
Another useful strategy that can still be used today is to have the client gift seed capital (usually cash) to an intentionally defective grantor trust (IDGT) and then sell appreciating or income-producing property to the IDGT. The IDGT makes installment payments back to the client over a period of time. If the accounts or property increases in value over the period of the sale, the accounts or property in the trust will appreciate outside the client’s estate and will therefore avoid estate taxes. Additionally, because the client pays income taxes on the income generated by the trust, which is an indirect gift to the trust, the trust itself does not have to pay income taxes on the income that it retains.
Spousal Lifetime Access Trust
The spousal lifetime access trust (SLAT) strategy calls for one spouse to gift property to a trust created for the benefit of the other spouse (and potentially other beneficiaries like children or grandchildren). An independent trustee can make discretionary distributions to those beneficiaries, which can indirectly benefit the donor spouse, while an interested trustee should be limited to ascertainable standards when making distributions (i.e., health, education, maintenance, or support). This strategy allows the donor spouse to use the currently high lifetime gift tax exemption amount by making gifts to their spouse; pay income taxes for the trust, which allows for indirect, nontaxable future gifts to the value of the trust for the trust beneficiaries; and still benefit indirectly from the trust through the other spouse. Because the trust is designed to avoid using the marital deduction, the accounts and property in the SLAT will not be included in either spouse’s gross estate for estate tax purposes.
Irrevocable Life Insurance Trust
Irrevocable life insurance trusts (ILITs) are still a tried-and-true method for leveraging life insurance to ease the burden placed on a client’s estate if it will be subject to estate tax at their death. With this strategy, the client transfers an existing life insurance policy into the ILIT (or a new policy is purchased with money gifted to the trust). The client then makes annual cash gifts to the ILIT to pay the premiums on the life insurance policy. At the client’s death, the trust receives the insurance death benefit and distributes it according to the trust’s terms. Because the trust receives the death benefit and the premiums gifted to the trust are completed gifts, the client’s estate will not include any of the trust’s value. This strategy can be a powerful method of leveraging relatively small gift tax exemption usage to create liquidity for the client’s taxable estate as well as significant assets outside the estate to benefit the beneficiaries.
We Are Here to Help You
You can still implement these strategies today for the benefit of your clients. If you feel that you and your clients can benefit from a deeper understanding and exploration of these and other strategies, please let us know. We would love to sit down with you and discuss whether any of these strategies make sense for your clients’ particular situations.
| Most of our clients desire to leave assets to their children, with the expectation that an inheritance received by their children will also be used in part for the client’s grandchildren. However, some parents want to bypass their children, either wholly or partially, and leave an inheritance directly to their grandchildren. Structuring an inheritance to minors come in different forms and can often be challenging to accomplish. Such distributions can include a specific bequest in Wills and Trusts, along with beneficiary designations of tax-deferred retirement plan accounts, life insurance policies, and annuity contracts. When financial assets which do not distribute by beneficiary designation are inherited by a minor, without establishing a Trust, a probate proceeding must be raised upon the passing of a client. For assets which do distribute to a minor by beneficiary designation, a formal Guardianship proceeding must be raised with the local Orphans’ Court. Judicial Intervention The reason for judicial intervention, for both assets which distribute to a minor under a Will or Trust, as well as through beneficiary designation, is because minors, those under 18 years of age, cannot receive property in their names. If a probate proceeding needs to be raised, for assets which distribute to a minor under a Will, the judge will entertain testimony regarding one or more individuals and/or corporate fiduciaries before arriving at a decision to appoint a Guardian or Co-Guardians. The role of the Guardian is to preserve and protect assets distributable to a minor, as well as to make distributions of income and principal for the benefit of the minor until the minor attains the age of majority. When the minor beneficiary attains eighteen, unless the minor is suffering from an incapacity, the Guardian is required by law to distribute the asset outright in one lump sum to the beneficiary, which may, or may not, be appropriate based upon the circumstances of the beneficiary at the time of distribution. Guardians are charged with the fiduciary responsibility of using the funds for the minor child’s health, education, maintenance, and support and can take into account other assets or resources available to the minor. Again, even if the minor has not achieved the financial acumen or maturity to properly manage assets, ready or not, the Guardian is required by law to turn over all assets to the minor upon the minor’s attainment of age, which can often have disastrous consequences. A much more suitable estate plan may be to leave assets to a minor beneficiary by creating a Trust and designating an individual who is financially responsible to serve as the Trustee. Creating a Trust The Trust Agreement can include specific language to guide the Trustee with respect to both permissible investments along with discretionary distributions of assets invested in the Trust. Unlike a Court appointed Guardianship, a Trust can also provide that the Trust continue beyond the age of eighteen, with distribution of principal authorized when the beneficiary attains specified ages, such as 30, 35, and 40, which allows the beneficiary to come into his or her inheritance gradually, instead of in one lump sum upon age 18. During the period of time when the Trust is active, the Trustee, (selected by our client, instead of a legal Guardian appointed by a Court) invests the funds exclusively for the benefit of the minor for the purposes enumerated above, either by distributing money directly to the minor or by paying bills on their behalf. Another major benefit of a Trust, compared to a Will, is that Trusts completely avoid the costs, delays, and publicity of a probate court proceeding. When establishing and finding a Trust, clients can make lifetime transfers of assets to their Trust, or in the alternative, the client can designate a Trust for a minor as beneficiary of IRA’s, life insurance policies, and annuity contracts. |
Occasionally, people who are not estate planning attorneys will attempt to draft and implement their own estate plan. Often, they erroneously believe they can find a document online or use a friend’s legal documents and can figure it out. Unfortunately, there are many pitfalls one could run across when they try to develop a Do-It-Yourself estate plan.
Let’s look at three (3) significant problems they will encounter, as many coupes often do when preparing their own estate plan, without the advice of a competent estate planning attorney:
Problem #1:
Bill and Mary have a house worth $500,000, an IRA valued at $500,000, and non-qualified investments of $500,000. They have three children, Aaron, Betty, and Charlie. At the death of the survivor of Bill and Mary, they want to leave the house to Aaron, the retirement plan to Betty, and the investments to Charlie.
The first problem with this plan, assuming they draw up the proper legal documents to accomplish this distribution pattern, is that they may not have considered the downsides. More specifically, Bill and Mary’s plan did not anticipate that they might sell their house in the future, which they did. As a result, the specific bequest of the house to Aaron lapsed.
Upon the sale of their house, this couple added the net proceeds from the house to their investment account. Since their plan left the investment account to Charlie, those assets went to him instead of Aaron, which was not consistent with their desires for the distribution of their estate upon the passing of the surviving spouse.
Problem #2:
The second problem with this plan, even assuming they prepared their estate planning legal documents which accomplish their desires, is that they have not considered the income tax implications.
While their three assets may have the same value currently, the house and the investments get a step-up in basis at death. In other words, when the beneficiary of these two assets will not owe income tax on them. However, the IRA is deemed under federal law to be “Income in Respect of a Decedent” or “IRD,” which is an exception to the step-up rules.
Assuming Betty has a combined marginal federal and state income tax rate of 40%, $200,000 of the IRA would be lost to income taxes. Therefore, it might have been better to distribute the IRA to Charlie, who is in a lower income tax bracket, or in the alternate, spread the income tax consequences over all three beneficiaries. After the payment of income taxes, Betty would end up with $300,000, while each of her brothers would receive $500,000.
Problem #3:
There is a third problem with this estate plan, even assuming Bill and Mary draw up their legal documents which accomplish their goals and objectives. More specifically, this couple has not considered fluctuations in the values of their assets when they are ultimately distributed to their children.
For example, let’s say they die ten years after they draft their estate plan and the assets are then worth $3 million. Unfortunately, their three children will not each receive $1 million. In fact, one of the children might get far less than the others. How is that possible? The house devised to Aaron could be in a neighborhood of decreasing, rather than increasing, property values, and it’s value could have significantly declined to $200,000.
Bill and Mary may continue to contribute to their IRAs over their working years and wherein their daughter Betty is the designated beneficiary, and which accounts may be worth $1 million at the death of the survivor of Bill and Mary.
The non-qualified investment account bequeathed to Charlie may have appreciated in value and be worth $2 million upon the death of the survivor of Bill and Mary.
Upon the time Bill and Mary’s estate is distributed to their children, Aaron would get the house worth $200,000; Betty would receive the IRA worth $1 million (but subject to income taxation of $400,000); and Charlie would inherit the investments worth $2 million.
As a result, Charlie would get more than triple the after-tax value of his sister Betty’s IRA inheritance, and 10 times the value of the bequest to his brother Aaron.
As this edition of Estate Planning Matters reflects, estate planning is about far more than just drafting and implementing the proper legal documents in accordance with both federal and state laws. It’s also about the knowledge, experience, and prudent recommendations of the attorney who designs and implements your estate plan.
Transitioning ownership of a privately owned business can be very challenging. How you handle putting a business succession plan in place, to pass your business to one or more new owners, can be a difficult task from a legal, financial, and emotional perspective.
Therefore, if you or your clients are an owner of a privately-held business and are thinking about assembling a business succession plan, this edition of Estate Planning Matters should be of value to you.
Reasons for transition: why now?
There are a variety of reasons why a business owner may choose to sell their business. The most common reasons for ownership transfers include retirement, disability, competitive pressure, financial difficulties, health issues, lack of an appropriate family member to take over running the business, or desire for liquidity.
While business transition is a natural part of a business’ life cycle, it’s important to consider all factors when deciding the timing along with the terms of a business succession plan.
Understanding goals: an imperative step
Once you begin structuring your transition process, it is important to understand your goals and objectives.
Once you have thoroughly defined your objectives and priorities, you can develop an optimal exit strategy that will bring the most value to you and your family in the event of your disability, retirement, or death.
Some of the significant questions you will need to ask yourself include: Will I stay on as part of a management transition team? For how long? Do I want to retain a financial stake in the business post-sale? Do I clearly understand what my personal financial needs are in the future?
Asking these types of questions requires an owner to consider the future strategic direction of the business. Whatever your decision, the only way to choose an exit option, that will best meet your financial needs after the transition, is through a clear understanding of your personal and business priorities so that you can choose the exit options that will best meet your needs.
When to Structure a Business Transition Plan
In many cases, privately held companies are reactive when it comes to planning an exit strategy for their business. Whether it’s because they are caught up in day-to-day operational demands, or emotional resistance to letting go of the business, many business owners fail to have a cohesive transition plan in place.
Unfortunately, a reactive mode when selling a business will never yield the maximum value when compared to a proactive strategic plan. A sufficient time frame (generally, two to five years) allows time for the company and its owner to:
- Build an effective management team to ensure future stability
- Establish customer and vendor longevity
- Properly document financial records and accounting systems to maximize value to the seller and potential buyers
- Strategically search for optimal buyers, understand their value drivers and ensure the company’s matching attributes are best positioned to maximize value
- Critically examine the company’s strengths and weaknesses and make necessary adjustments
- Continue to run the business in a seamless manner, once the time does come for a sale, without losing value
- Plan early, which can dramatically increase the leverage a seller will have during negotiations with suitable buyers
Tips for a Successful Business Succession
Many times, when owners becomes involved in a transition process, especially if they are attempting to run the process themselves, it becomes very easy to lose focus on the day-to-day operations of the business and value is lost.
Therefore, keeping all members of the business transition team coordinated throughout the process is vitally important.
If you or your clients are considering the assembly of a business succession plan, we recommend they you take a team approach to the process by consulting with legal, tax, and financial planning experts who are knowledgeable and skilled in properly handling business succession transactions.
On April 28, 2021, President Biden unveiled his $1.8 trillion American Families Plan, a ten-year plan of increased federal government support of education, child care, paid leave, nutrition and families. The American Families Plan would be substantially funded by tax increases, primarily from wealthy taxpayers, and by improved tax compliance and enforcement.
While most details of the Plan have not yet to been provided, the tax plan includes the following anticipated legislative changes:
- The highest marginal federal individual income tax rate would be increased to 39.6% from 37%.
- Capital gains and dividends would be taxed at ordinary income tax rates (i.e., like compensation income) for households making over $1 million. The 3.8% investment income (Medicare) tax would be added, resulting in a 43.4% federal income tax on such income. (That income would continue to be subject to state and local income tax, which could make the effective tax liability on such income even higher.)
- “Step-up on Basis” for transfers to beneficiaries – which allows estates to revalue assets to their fair market value at the time of a decedent’s date of death for purposes of later sales – would be eliminated for gains in excess of $1 million (up to $2.5 million per couple when combined with existing real estate exemptions.)
- This change would not apply to donations to charitable organizations.
- This change would be “designed with protections” so that family-owned businesses and farms would not have to pay taxes when such property is given to heirs who continue to run the business.
- The deferral of tax on “like-kind” exchanges of real estate – for gains greater than $500,000 – would be eliminated.
- The limitation on the deduction of large “excess business losses” would be made permanent.
- The application of the 3.8% investment income (Medicare) tax would be changed to ensure that it is applied consistently to those making over $400,000 per year.
- Substantial additional funding would be provided to the IRS, leading to better compliance and reporting.
No effective dates for these provisions have yet been proposed.
Not included in the plan are any changes to the $10,000 limitation on state and local tax deductions or an increase in the federal estate tax rate (top bracket currently 40%) or a lowering of the estate tax exemption amount ($11.7 million in 2021).
As these potential tax law changes are discussed and debated in the weeks and months ahead, considerable changes are likely to be made by Congress before a final Bill is signed into law by President Biden.
The Levin Law Firm will keep you informed as new developments continue to occur with respect to the Biden tax proposals.
