Estate Planning: What Are They Waiting For?

Take-Away: We now have historically high federal estate and gift tax exemptions per individual, enhanced by a deceased spouse’s unused applicable exemption amount (the DSUEA.) However, these transfer tax exemptions are only temporary; they are set to expire on December 31, 2025. Unfortunately, those large amounts and the delayed expiration date are causing a dangerous sense of complacency among many wealthy individuals. We also now have Bernie Sander’s ‘For the 99% Act” proposal which promotes a $3.5 million estate tax exemption, and a $1.0 million gift tax exemption per person. This proposal is receiving considerable bandwagon support from the numerous Democrat candidates running for President. If the Blue Wave of 2018 continues through 2020, there is a good chance that the temporarily enhanced federal transfer tax exemptions may have an even shorter shelf life than 2025. With these potential tax changes in mind, what are the wealthy individuals waiting for? Why don’t they act to exploit their enhanced transfer tax exemptions before they disappear? It would seem that adopting a wait and see approach is not a wise planning strategy.

Background: As noted, the current large federal transfer tax exemptions are only temporary; all are set to expire at the end of 2025. In March Bernie Sanders proposed, effective as of 12/31/2019 ( which means if ultimately adopted, some provisions could have retroactive effect), an estate tax exemption of $3.5 million per person and a $1.0 million federal gift tax exemption per person, far below the current $11.4 million unified gift and estate tax exemption amount. In addition, many of the tools that have historically been used by the wealthy to successfully transfer their wealth tax-free in order to reduce the exposure to estate and gift taxes, like grantor retained annuity trusts (GRATs), valuation discounts in intra-family transfers with the use of FLPs and FLLCs, and dynasty trusts, would all be effectively curbed if the Blue Wave continues. All of which means that if the transfer tax exemptions are actually reduced to much lower levels, historic planning steps used to shift wealth will not be available to mitigate the exposure to gift, estate, and GST taxation.

While wealthy individuals obviously are tired of the endless change in tax laws, and they have come to resent incessant changes to their estate planning documents to accommodate those tax law changes, their fatigue should not prevent them from taking full advantage of the current tax exemption environment, as these available exemptions will probably only become smaller, not larger, in the years to come.

Implications of the ‘Blue Wave:’ If there is a change in the make-up of Congress and the President’s party, many conventional planning steps will have to be modified. In some instances, since planning techniques will either be curtailed or eliminated. A few examples follow:

• DAPT Curtailed: Example-Assume a physician wants to transfer assets to a Michigan Qualified Dispositions in Trust, aka a domestic asset protection trust, for ease of reference, a DAPT. The transfer to the DAPT would be covered by the physician’s gift tax exemption, meaning no federal gift tax would be paid on funding the trust. Accordingly, the physician could transfer up to $11.4 million to the DAPT and continue to be a discretionary beneficiary of that DAPT, arguably still enjoying the assets that he/she moved out of his/her taxable estate and away from creditors and predators. If the gift tax exemption falls to $1.0 million, fewer assets could be transferred to the DAPT by the physician gift tax-free, thus leaving more assets in the physician’s name and exposed to satisfy creditor claims. Alternatively, if the physician intends to use the DAPT as an alternative to a prenuptial agreement, the amount of assets that could be protected ‘inside’ the DAPT in the event of a future divorce would be greatly diminished.
• Credit Shelter Trusts Return?: In recent years, especially with portability of the deceased spouse’s unused exemption amount (DSUEA) and the large estate tax exemption amounts, conventional planning has been to eschew the use of a credit shelter trust and rely on an unlimited marital deduction trust [e.g. a QTIP.] With this approach the surviving spouse possesses the right to disclaim the assets from the marital trust back to a credit shelter trust, if so desired, in order to avoid estate taxes on the first spouse’s death yet preserve a ‘step-up’ in the income tax basis of the marital trust’s assets on the survivor’s death. This results in no federal estate tax exposure if the survivor’s taxable estate, including the marital trust’s assets, is less than $22.8 million.  A dramatic drop in the federal exemption amount back to $3.5 million (even with portability of the DSUEA) could cause a renewed use of a credit shelter trust to avoid estate taxation (at a 40% tax rate), but use of the credit shelter trust will the sacrifice of a loss of a second income tax basis adjustment on the survivor’s death, which will lead to exposure to a capital gains tax when the credit shelter trust assets are later liquidated (at a 20% tax rate.)
• ‘Free-Basing’ Curtailed: With the large federal estate tax exemption, some families have engaged in ‘up-stream’ income tax basis planning, where a parent is given a testamentary general power of appointment over an irrevocable trust that is funded by their child. The parent’s death would cause an income tax basis adjustment to all of the trust owned assets merely by the presence of the parent’s testamentary general power of appointment. This ‘up-stream’ income tax basis planning may no longer be wise move. Example- Son funds trust with $5.0 million in assets with son’s children named as the trust beneficiaries. Son’s mother is given a testamentary general power of appointment over the trust so as to intentionally include the value of the trust’s assets in the mother’s taxable estate, in order to obtain an income tax basis step-up of the trust’s assets on the mother’s death, whether or not the mother actually exercises the testamentary general power of appointment. This strategy works extremely well if the mother has an estate tax exemption of $11.4 million. The strategy is much more dangerous if it creates an estate tax liability for mother’s estate when the estate tax exemption available on the mother’s death drops to $3.5 million.
• GRATs Curtailed: If the gift tax exemption is reduced to $1.0 million, the ability of an individual to leverage wealth out of his/her estate using a GRAT will be limited. Planning around a $1.0 million lifetime gift tax exemption will be far more restricted. Add to that limitation the inability to claim discounted values for FLPs held inside the GRAT, or the use of ‘rolling’ GRATs, and wealth transfers with only a $1.0 million gift tax exemption will be frustrated.  The Sanders proposal would eliminate the use of a short-term GRAT, as it requires a minimum duration of the GRAT of at least 10 years, making it more difficult to ‘beat’ the interest rate hurdle, which is how a GRAT shifts wealth gift tax-free. In addition, under the Sanders proposal, there is a required minimum gift of the GRAT remainder interest equal to 25% of the amount of assets contributed to the GRAT, effectively eliminating the currently popular ‘zeroed out’ GRAT planning technique.
• Dynasty Trusts Curtailed: Currently an individual’s $11.4 million generation skipping transfer tax (GST) exemption can be leveraged to shelter that amount of assets, plus all appreciation in those assets, from any transfer tax, arguably in perpetuity if the transfer is made to a dynasty-like trust, which is expected to last for and benefit multiple generations. The Sanders proposal permits that avoidance of all GST taxation for up to 50 years. Consider the GST tax imposed on 50 years of growth when the dynasty-trust must terminate on its 50^th anniversary, a 40 % GST tax that will all be incurred in one tax year when the trust makes a terminating distribution.
• Crummey Trusts Eliminated: A crummey trust permits the donor to use his/her annual exclusion gift opportunity to transfer assets into an irrevocable trust without paying a gift tax. If the transferred assets are not withdrawn by the trust beneficiary within 30 days, the annual gift tax exclusion is satisfied and treated as a present interest. The Sanders proposal eliminates crummey annual exclusion gifts, which is how many irrevocable life insurance trusts (ILITs) are funded in order to pay the annual insurance premium obligation. What happens to existing ILITs when the settlor can no longer pay the trust’s premium obligation using annual crummey gifts to the ILIT?
• Annual Exclusion Gifts Curtailed: Under the current rules, an individual can make as many $15,000 annual exclusion gifts as he/she wishes in a year. Example: Father can reduce his taxable estate by making $15,000 gifts to his five children, and his five sons and daughters-in-law, and to each of his grandchildren. If each child had four children, (grandchildren) Father could gift $450,000 in one year gift tax-free, i.e.  $15,000 times 30 donees = $450,000. These gifts could be made on December 31, and two days later on January 1 of the next year, another set of annual exclusion gifts could be made by Father. In short, $900,000 could be removed from the Father’s taxable estate in two days just through these annual exclusion gifts without paying any gift tax or eroding the Father’s gift tax exemption amount. The Sanders proposal limits the number of annual exclusion gifts of $10,000 to five donees in one calendar year, or a maximum of $50,000 that could be gifted gift tax-free in one year.

Proactive Steps Now: Some planning steps wealthy individuals can take now to use their large transfer tax exemption amounts, while they still exist, might include the following:

• Fund Irrevocable Trusts: The large gift and GST tax exemption amounts could be used now with a taxable transfer to an irrevocable trust for the benefit of children and grandchildren. The trust could add a trust director who could possess the power to add the settlor as a potential beneficiary in the future, if the settlor was concerned about giving away too much of his/her wealth at the present time.
• Prefund ILITs: Those individuals who have already set up irrevocable life insurance trusts (ILITs) often resent the need to send annual notices of their crummey transfer to the ILIT, so as to give the trust beneficiaries notice of the transfer into the trust, and their limited right to withdraw the transferred amount from the trust. Each year generating that paper trail becomes a real hassle for the settlor of the ILIT. If the settlor currently has an $11.4 million gift tax exemption available, the settlor should consider prefunding the ILIT with enough income producing assets to never have to send another crummey notice to the ILIT beneficiaries ever again, thus using part of their large lifetime gift tax exemption while it exists and eliminating one more irritant in their life. Often the insured’s spouse is a lifetime beneficiary of the ILIT, so if income or other assets are later needed by the married couple, the settlor’s spouse, as beneficiary, will have indirect asset to the trust’s income and principal.
• Adopt Non-Reciprocal Lifetime Access Trusts (SLATs): Each spouse should consider creating an irrevocable non-marital deduction trust for his or her spouse. The donor thus will utilize his/her current federal gift tax exemption amount when assets are transferred to the SLAT. The transferring spouse thus retains indirect, through their spouse-beneficiary, access to the income the SLAT’s assets generate. The transferring spouse could also act as the investment advisor of the directed trustee. If both spouses create and fund the SLATs for each other, so long as the trusts do not look too much alike i.e. they are not reciprocal, and preferably they are created and funded at different times, the married couple could move $22.8 million in assets (and all future appreciation in those transferred assets) out of their taxable estate(s), now, and shelter the transfers from any gift or GST taxation, and still enjoy the income from the SLATs. The SLATs would also provide lifetime creditor protection to each spouse. If the spouses wait too long, this opportunity could disappear, or the amount they are able to transfer to the SLATs could be dramatically reduced.
• DAPTs: If an individual, like a professional or real estate developer, is concerned about liability exposure, it is easy these days for that individual to use their current large gift tax exemption to transfer their assets into an asset protection trust (DAPT.) If the individual waits until it is too late, the ability to protect assets from estate and gift taxes, not to mention from creditors, could be permanently lost. The same reasoning could apply if the DAPT is intended to function as an alternative to a prenuptial agreement on the eve of a marriage –there is a big difference in sheltering $11.4 million in a divorce and $1.0 million in the divorce.
• GRATs: If an individual is currently using ‘rolling’ short-term GRATs in an effort to shift wealth gift tax-free to the GRAT remainder beneficiary after two years, he/she should continue that strategy, as it is possible that some existing GRATs may be grandfathered if the Sanders proposal becomes law. Rather than name children as the renewed GRAT remainder beneficiaries, an existing ILIT or irrevocable trust should be named as the GRAT remainder beneficiary, especially if crummey gifts will be greatly restricted in the future, that will reduce the amount that can be transferred gift tax-free to the trust.
• Trust ‘Clean-ups:’ Some existing irrevocable trusts may be outdated and need to be modified in some manner in order to better address the needs of the trust beneficiaries. Now might be the time to consider a formal trust modification or a trust decanting of that ‘old and stale’ trust instrument to a newer version that better serves the beneficiaries or makes the trust’s administration more efficient. With the currently available large federal gift tax exemption amount, if a gift tax is triggered by a decanting in reliance upon the beneficiary’s consent, or through trust modification that is agreed to by a beneficiary which shifts his/her beneficial interest to another individual, there would presently be a large gift tax exemption available to protect the beneficiary who would be treated as making an indirect gift upon their consent to the trust’s modification or decanting.

Conclusion: The obvious point in this discussion is that adopting a wait and see approach to estate planning can be dangerous for individuals, especially those of wealth who could soon face a federal estate tax that they thought they had permanently avoided. Those individuals currently sitting on the fence should be alerted that a wait and see approach to the tax law changes is not really a plan, but an abdication of their responsibility to plan. Those individuals, especially those who still have access to large gift and estate tax exemption amounts, should be strongly encouraged by their advisors to become proactive with regard to their estate planning now, and not wait until after the 2020 election results becomes clear- by then it could be too late.