While festivities may be somewhat dampened this year due to the coronavirus, the holiday season seems to foster a spirit of giving. This year might be a good time to indulge the spirit, according to wealth planners.
“It’s always a good idea to make gifts,” said Lawrence Mandelker, counsel in the tax and wealth planning practice at law firm Venable. “For those that have sufficient means to live on after they make the gift, it’s a good idea to get any appreciation out of their potential estate, and move tax-free dollars to their kids.”
“We’re telling clients that now is a very good time to gift,” he said.
Among other advantages, based on the way taxes are calculated, you pay estate tax on the entire estate, but for gift taxes, you only pay tax on what's transferred, according to Mandelker.
Of course, the biggest motivation is the likely change in tax and exemption rates with the coming change in the executive branch. “We’re in a situation now where there is a need to raise revenue, and a Biden administration has indicated they will look to increase taxes to do so,” Mandelker said. “Traditionally, transfer taxes are a good source of raising revenue. They’re an available resource even if they’re not that huge.”
Naturally, the lifetime exemption, now at $11.5 million, will be a target. “Some of the proposals suggest $3.5 million per person,” Mandelker said. “Currently, a husband and wife can transfer $23 million free of federal estate taxes. If exemptions decrease, that number will go down. If it goes to $3.5 million, a husband and wife would be limited to $7 million between them, so that’s a swing of $16 million. At a 40 percent tax rate, that’s a significant amount.”
The $11.5 million exemption is set to sunset in January 2026. “Of course, we knew that the $11.5 million amount would not last forever,” he said. “We’ve been telling clients for years to consider making gifts. We didn’t know exactly where the exemption would fall, but we thought it would go to roughly half of what it is now.”
There is a risk in waiting too long to make a gift, Mandelker noted. “If legislation is passed, we don’t know when it will be effective,” he said. “It might be effective the day it is signed, or it could be retroactive to Jan. 1, 2021. That’s why we’re telling people to get it done before the end of the year. If they can’t do that, do it as soon as possible. They don’t want to be on the wrong side of the effective date and lose the benefit of the increased exemption.”
Raising tax rates and decreasing exemptions are both easy ways to increase revenue, Mandelker observed: “But from things they mentioned during the campaign, and from proposals that were made during the Obama administration that were never enacted, they were looking to use both the hammer and the scalpel. So the focus will also be on some of the tools that estate planners use.”
For example, Mandelker cited grantor-retained annuity trusts. Under a GRAT, the grantor sets up an irrevocable trust for a designated period of time. The grantor receives an annuity every year, and the beneficiaries receive the assets in the trust tax-free at the end of the term. The value of the gift made is equal to the value of the property put in reduced by the value of the property taken back in the form of the annuity. The object in calculating the payout to the grantor is to set it high enough so that the actuarial value to the beneficiaries is as close to zero as possible.
“The determination of the value of the annuity is based on the IRS rates for the month the transfer is made, called the IRS Section 7520 or “hurdle” rate. “The hurdle rate is currently 0.4 percent,” Mandelker observed. “So if the assets in the trust increase faster than the hurdle rate, there’s actually a larger gift to the beneficiaries.”
“The Obama administration, and presumably Biden, wanted to cut back on the effectiveness of GRATs and other planning tools,” he said. “They proposed making the trusts last for a specific amount of time; for example, 10 years. If the person setting up the trust dies during the term, the estate tax benefit is lost. It’s more likely that the grantor will die within that period than if they’re only required to live two years. Another proposal was that the grantor has to make some sort of taxable gift. We don’t know what the minimum requirement would be, but the grantor would not get the full benefit of the increase above the hurdle rate. Under Biden, the Obama proposals would quite possibly be resurrected.”
To avoid these issues, the client should be making these gifts as soon as possible, Mandelker emphasized. “It’s safer to make the gift in 2020 than to wait until 2021 to make the gift,” he said. “And if you must make the gift after the first of the year, do it as soon as possible.”
