As the end of the calendar year swiftly approaches, it is an appropriate time to examine the factors affecting the estate planning landscape and personal year-end estate planning considerations. For 2022, the transfer tax exemption remained at a historically high level, and no significant legislation was passed impacting estate and gift taxes. Although future legislation remains uncertain, there are a variety of strategies available that taxpayers can use to take advantage of current exemption levels and techniques.
Current Transfer Tax Laws
The federal gift, estate and generation-skipping transfer (GST) tax exemptions (i.e., the amount an individual can transfer free of any of these taxes) are $12.06 million per person for 2022, increasing to $12.920 million in 2023. Thus, beginning in 2023, a married couple can theoretically transfer up to $25.84 million free of federal transfer tax – an unprecedented amount. The transfer tax exemption will be adjusted upward for inflation in future years, but under current law is scheduled to be reduced by 50 percent on January 1, 2026. A “marital deduction” is allowed for assets passing directly or in qualifying trusts for the benefit of a surviving spouse, and a charitable deduction is allowed for assets passing in a qualifying manner to charity. The federal tax rate on any assets above the transfer tax exemption, that do not qualify for the marital or charitable deduction, is a flat 40 percent. The federal transfer tax exemptions can be used either during lifetime or at death. Using exemption during lifetime is generally more efficient for transfer tax purposes, as any appreciation on the gifted assets escapes estate taxation.
The Treasury Department has confirmed that the additional transfer tax exemption granted under current law until 2026 is a “use it or lose it” benefit, and that if a taxpayer uses the “extra” exemption before it expires (i.e., by making lifetime gifts), it will not be “clawed back” causing additional tax if the taxpayer dies after the exemption is reduced in 2026. Practically, this means that a taxpayer who has made $6.46 million or less (adjusted for inflation) of lifetime gifts before 2026 will not “lock in” any benefit of the extra exemption, while a taxpayer who makes use of the additional exemption before 2026 (e.g., by making gifts of $12.92 million before 2026) will “lock in” the benefit of the extra exemption.
The Illinois estate tax exemption is $4 million per person. This exemption does not receive annual inflationary increases. As with the federal estate tax, a marital deduction is allowed for assets passing directly or in qualifying trusts for the benefit of a surviving spouse for Illinois estate tax purposes. Thereafter, the effective marginal tax rate for assets above the Illinois estate tax exemption ranges from 8 percent to approximately 29 percent.
As with income taxes, state estate taxes are deductible for federal estate tax purposes. The cumulative federal and Illinois estate tax rate (for estates above both the federal and Illinois exemptions), taking deductions into account, is approximately 48 percent.
Federal tax laws allow for an “annual exclusion amount” that can be gifted from any one person to any other person in any given year without using up any estate/gift tax exemption. This amount is set at $15,000 per donee for 2021, which increased for inflation to $16,000 per donee in 2022, and will further increase to $17,000 per donee in 2023.
Legislative Proposals
President Biden’s campaign included a proposal to reduce the federal transfer tax exemption to $3.5 million. However, Democrats struggled with potential tax legislation in 2021 given their thin margin of control of the House of Representatives and especially the Senate. In September, the House Ways and Means Committee released an extensive tax package that would have resulted in enormous changes for estate tax planning. The package proposed reducing the current estate/gift tax exemption by 50 percent on January 1, 2022, eliminating the use of valuation discounts for non-operating businesses, and eliminating the use of “intentionally defective grantor trusts,” or “IDGTs” (a type of irrevocable trust commonly used in estate tax planning due to the substantial benefits it can achieve, further discussed below). This proposal set off a frenzy of lifetime gifting. While these proposals were not enacted, they are an indication of the direction the Biden administration desires to take and may also indicate an increased awareness on the part of congressional Democrats of the “IDGT” strategy and a desire to curtail it. However, with a divided Congress, there is little likelihood these proposals will be enacted anytime soon.
Lifetime Transfer Strategies
Taxpayers should strongly consider lifetime gifting strategies, for several reasons. First, the estate/gift tax exemption is still scheduled to be reduced by 50 percent on January 2026, even if Congress does nothing. Taxpayers who have not used the “extra” exemption before then will lose it forever. Second, any post-appreciation transfer on gifted assets accrues outside of the taxpayer’s estate. This is especially salient for younger individuals and for transferred assets with high potential for appreciation. Finally, for taxpayers who live in states with a state estate tax but no state gift tax (such as Illinois), lifetime gifting may have the effect of reducing state estate tax liability.
Planning for Basis Change
Good estate planning incorporates income tax and other considerations rather than focusing myopically on estate and GST taxes. In general, upon an individual's death, the cost basis of any assets that are included in his or her gross estate for estate tax purposes receive an adjustment to their fair market value at the date of death. For appreciated assets, this can result in substantial income tax savings. Assets that are not included in the gross estate, however, do not receive a basis adjustment. Therefore, there is often a tradeoff between making lifetime gifts (to reduce estate taxes, but with the donee receiving the donor's "carry over" basis) and keeping assets in the gross estate (to obtain the basis adjustment and reduce income taxes).
Fortunately, there are a number of techniques to help plan for possible change in basis while still retaining estate tax benefits. Irrevocable trusts that receive lifetime gifts can be structured to allow for a possible basis change. One way to do so, is by including a broad distribution standard in the trust agreement by which an independent trustee can make distributions out of the trust to the beneficiary. Additionally, a trust can be structured to grant an independent trustee the power to grant (or not grant) the beneficiary a "general power of appointment," which would cause the trust assets to be includible in the beneficiary's estate for estate tax purposes and therefore receive the basis adjustment. Finally, if an irrevocable trust is structured as a grantor trust, the grantor can retain a "swap power" that can be used to transfer high basis assets to the trust and take back low-basis assets, in order to obtain the largest possible "step up" in basis.
Contact your Much attorney or a member of our Estate Planning & Wealth Transfer group to evaluate your circumstances and determine appropriate strategies that fulfill your estate planning objectives.