Tax Planning Strategies for the 1% Are a Gamble

The Tax Cuts and Jobs Act of 2017 (TCJA) became law in 2018 and gave wealthy families a lot to celebrate. In addition to many tax reforms that benefit most taxpayers, the TCJA increased the federal estate and gift tax lifetime exclusion amount from $5 million per person to $10 million per person (plus annual inflation adjustments). Those annual adjustments result in an effective exclusion amount for 2020 of $11.58 million per person and over $23 million per married couple. With portability, a surviving spouse can add a deceased spouse’s unused exclusion to his or her own.

But, to avoid completely blowing up the national debt, like all recent tax laws, the TCJA must be set up as a temporary reform. The TCJA “sunsets,” or terminates, on the first day of 2026, so those higher tax rates can return on estates much smaller than today. There is always the possibility of a repeal, amendment or an extension of TCJA. Doing nothing, of course, is much easier than actually raising taxes.

What Happens When Sunset Falls

After the sunset in 2026, the beneficiaries of wealthy decedents should be prepared for the possibility that the applicable federal estate tax exclusion will suddenly drop to an estimated $6.2 million, rather than the $12.7 million per person exclusion they were expecting (both the old law and the new provide for low annual adjustments to the exclusion — it was increased by 1.58% in 2019, so I use that as the annual adjustment rate in my assumptions).

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The federal income tax portion of the TCJA could face similar changes. The TCJA lowered ordinary income taxes for most taxpayers by adjusting the tax tables and reducing the highest tax rate from 39.6% to 37%. However, it did not appreciably affect the capital gain and qualified dividend rates. But, once again, these federal income tax reductions will also sunset in 2026, triggering an alarming average 39% income tax increase in real dollars (opens in new tab).*

Capital Gains vs. Gifts: Pick One as Your Priority

For wealthy taxpayers with very large estates and very low cost-basis assets, perhaps the most difficult part of estate tax planning today is deciding which is more important: eliminating the capital gains tax on one’s assets at death or reducing one’s exposure to the estate tax. The answer differs depending on the size of your anticipated taxable estate and the cost basis you may pass on to your legatees on any appreciated assets.

Innovative tax planners are looking at ways to preserve a reduction in estate tax, but also obtain a stepped-up basis at death on assets where it is more beneficial. This discussion will focus on estates that are at least large enough to be subject to federal estate taxes but not so large that the estate tax should be the only consideration in tax planning. I tag that range to be between $30 million and $60 million. I’ve excluded state-level estate tax and inheritance tax from this discussion since those laws will be unaffected by any changes in the TCJA, although residents in the 13 states with an estate tax and of the 8 states with inheritance tax must also consider those taxes in their planning.

First, let’s tackle major gifting under the available gift tax lifetime exclusion. Should you chance a reduction in asset value and gift most or all of your available lifetime gift tax exclusion now? If you make such gifts and the TCJA sunsets, lowering the lifetime gift tax exclusion well below the gifts you already made, what happens then? Do you owe taxes on the excess? In other words, can massive gifting lock in your gift tax exclusion, or might it be a big mistake?

Tax experts asked that very question, and the proposed federal regulations they sought shortly after the new tax law passed became final on Nov. 22, 2019. The IRS confirmed that taxpayers who use their gift tax exclusion making lifetime gifts before 2026 will not have those savings “clawed back” at death. Even better, a surviving spouse who receives some estate and gift tax exclusion from a predeceased spouse can still use that exclusion for additional gifting at death.

For instance, if a single taxpayer gives away $9 million to his children this year and then dies in 2026, and the personal estate tax exclusion has reverted back to, say, $6.2 million, this special regulation will allow his estate an exclusion equal to that $9 million. His estate will still pay estate taxes on the excess above the $9 million (so he might have given away even more). It may make perfect sense to make such larger gifts if your remaining estate will sufficiently cover your lifestyle needs without undue risk and you are confident that those assets will further appreciate, or at least maintain their value. That is, unless a stepped-up basis on those assets will save you more in taxes.

A Family with Millions at Stake

Second, how valuable is a step-up in basis? Consider a fictional couple, now in their late 70s and mostly retired, who have grown their small business into a $40 million profitable enterprise with the help of their now-grown children. They don’t need or want all the income they receive; the business has grown by 4% to 8% each year and may be worth $55 million in six years. They have $5 million in their home and investments and another $2 million in qualified retirement funds.

On advice from their financial planners, they have always paid all their descendants’ education and medical costs and made annual discounted exclusion gifts of company units to an irrevocable descendants’ trust. That gift trust now owns 20% of the business that their children essentially manage. The cost basis in the business is effectively zero (and it faces depreciation recapture when it is sold, which is subject to ordinary income tax rates).

Should the couple use their combined lifetime gift tax exclusions in 2020 to transfer $23.16 million (the current lifetime estate tax exclusion amount) in discounted business units to the gift trust (effectively all their units)? This gift may eliminate estate tax on as much as $11 million in anticipated growth if they both pass away by 2026 (saving up to $4.4 million in federal estate taxes).

They will still pay 40% in taxes on more than $7 million in other assets (about $3 million in taxes) assuming that the TCJA has sunset. If the children sell the business shortly thereafter, they could pay as much as $11 million in capital gains tax. So, the entire tax costs for the transfer could be as much as $13.8 million (not counting depreciation recapture).

What if our fictional couple is convinced the TCJA will be extended and decide to hold onto all those business units until the second death to get a full step-up in basis? If, again, the parents both die by 2026, assuming all else is the same, but the TCJA regrettably sunsets, their taxable estate would be about $51 million. Their available lifetime estate tax exclusion amount will likely have reverted to $6.2 million each, or $12.4 million total with portability.

So, our couple obtains a step-up in basis. The children may choose to sell the company. They would have to pay capital gains taxes on just the 20% owned in the trust (about $2.2 million in taxes). But the estate tax the children must pay would likely be about $15.5 million. Therefore, the parent’s decision not to gift their business units to an estate tax exempt trust because they relied wrongly on a TCJA extension with its much higher lifetime estate tax exclusions, would ultimately cost their descendants as much as $3.9 million in additional taxes.

Alternatively, if their reliance on an extension of the TCJA pays off, the estate tax the children must pay would be only about $10.2 million. Add in the $2.2 million in capital gains the children pay by subsequently selling the company, and the total tax is $12.4 million.

So, a comparison chart looks like this:

* Lifetime gifts are discounted with no estate tax on the subsequent appreciation.

This is an oversimplification, but it is clear that those with highly appreciated estates between $30 million and $60 million must gamble on whether the TCJA will sunset or not. By not making lifetime gifts, you’re betting on continuously high lifetime gift and estate tax exclusions. If you act and make lifetime gifts, you may be wagering that the TCJA will sunset.

Now, to put a bow on top, your legal counsel may be able to add provisions to your gift trust that allow you to pull your lifetime gifts back into your taxable estate, if that is advantageous. This would allow you to obtain a stepped-up basis against capital gains taxes in the event the TCJA is extended and your entire anticipated estate at death would be eclipsed by the available lifetime estate tax exclusion.

Either way, you should have your financial advisers crunch the numbers to see if making lifetime gifts of your highly appreciated assets to a properly structured flexible irrevocable gift trust can reduce the total taxes levied on your descendants.

* The calculations for this assertion are derived by comparing similar information under two separate tax codes for a typical family. The increase illustrates what happens in actual dollars when a tax liability under the new tax code is $12,000 and, then when that tax code sunsets it reverts to $16,680 under the old tax code.