The Tax Cuts and Jobs Act (TCJA, often referred to as tax reform) generally became effective in 2018 and increased the federal estate and gift tax lifetime exclusion amount (LEA) from $5 million per person to $10 million per person. On top of that, the exclusion is annually adjusted for inflation, meaning the LEA for 2020 has been inflation-adjusted to $11.58 million. However, the provisions of TCJA are temporary, and unless Congress makes changes, the exclusion will revert to the pre-TCJA amount of $5 million (estimated to be $6.2 million when adjusted for inflation) beginning in 2026.
However, the elections in November, depending on which party comes out on top, could change all that, since several of the current Democratic candidates propose to reduce the LEA, with $3.5 million the amount most often mentioned.
Recently, there has also been concern among financial experts and estate attorneys related to what will happen if large gifts are made while the LEA is at the higher lifetime exclusion amount and then the exclusion amount reverts to the pre-TCJA amount. Would those larger gifts become taxable in excess of the lower LEA?
Example: In 2020, Joe makes a gift of $8 million to his son. Since the LEA is $11.58 million, Joe would not incur any gift tax liability in 2020; but what will happen in 2026 when the LEA drops back to $5 million (adjusted for inflation)? Will the difference between the $8 million gift made in 2020 and the lower LEA in 2026 trigger a gift tax? How will Joe’s estate tax exemption–generally the amount of his LEA that hasn’t been used to offset taxable gifts during his lifetime–be impacted if he dies after 2025?
Luckily, the final regulations issued by the IRS provide a special rule that allows an estate to compute its estate tax using the higher of the LEA applicable to gifts made during life or the LEA applicable on the date of death. Thus, making large gifts now won’t harm estates after 2025, something wealthier taxpayers should take into their planning considerations.
Gifting While the LEA Is at Its Current Level – So, it may be appropriate for those with larger estates to consider taking advantage of the current larger LEA and make larger gifts before the LEA reverts to lower levels or Congress changes it to a lower amount. Of course, when considering such gifts, one would need to be sure the remaining estate would sustain one’s current lifestyle adequately without undue risk. It is also important that the gifted assets, if not cash, will hold their value so the LEA is not used up on gifting assets that might subsequently decline in value.
Another consideration in gifting assets is that the gift recipient, referred to in tax lingo as the donee, assumes the tax basis of the donor, so the gift essentially passes to the donee with any tax liability of the donor, even though the current gift amount is determined using the current fair market value of the asset.
Annual Gift Tax Exception – Gifting reduces an estate and is the reason there is a gift tax—to prevent estates from being gifted away prior to death and depriving the government of estate taxes. In addition to the LEA, there is an annual gift tax exclusion that allows a donor to gift up to as much as $15,000 (inflation adjusted amount for 2020) per year to as many recipients (related or not) as they would like. For example, a parent with four children could give each of them $15,000 without any gift tax ramification. A married couple could give each child $30,000 per year. If the children were married, the parents could gift the couple up to $60,000 per year. In addition to the $15,000 annual exclusion, there are two situations in which gifts don’t count toward the annual exclusion amount: when a donor makes payments directly to an educational institution for the tuition of a donee (does not include other education expenses) or payments are made directly to any person or entity providing medical care for the donee.
Inherited Basis – Another current aspect of estate planning is that inherited assets have their tax basis adjusted to the fair market value of the asset at the time of the decedent’s death. This is commonly referred to as a “step up in basis.” As a result, estate beneficiaries will incur little or no taxable profit if the inherited property is immediately sold. However, a number of presidential candidates are proposing to do away with “step up in basis,” adding another variable to the long-term estate planning issues.
Capital Gains Rates – Currently, inherited assets are immediately, upon inheritance, treated as being held long-term and benefit from the special lower tax rates for long-term capital gains. Virtually all of the Democratic candidates have indicated they would like to see the special long-term capital gains rates eliminated and all gains subject to the ordinary tax rates that apply to other types of income, such as wages.
Tax Planning – All these possible variations, including a probable substantial change in the LEA in the future, the possible elimination of “step up in basis” for inherited assets, and potential abolishment of capital gains rates, make it very difficult to develop estate plans with any long-term certainty.
Those with substantial estates should follow future developments and adjust their estate planning accordingly. If you have questions related to estate tax issues, please give this office a call.
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