Is sweeping tax reform right around the corner? Democratic control of Congress may increase the prospect. As a result, many individuals must decide whether to use their gift and estate tax exclusion in advance of any change. Congress’ ability to make reforms retroactive complicates the decision. Today, a large gift could result in a gift tax if Congress reduces the basic exclusion amount later this year while making it effective January 1, 2021. How should you handle the ambiguity?
Wealth Transfer Tax Proposal
Currently, the basic exclusion amount stands at an inflation-adjusted $11.7 million per person ($23.4 million per married couple). President Biden’s campaign floated the idea of reducing the exclusion amount to $3.5 million per person ($7 million per married couple). That’s more than a 70% decrease (Display). Suggestions of returning the estate tax law to 2009 levels have surfaced. In addition to the $3.5 million estate tax exclusion, that would mean a 45% transfer tax rate, instead of 40% today, $1 million gift tax exclusion available during life, and no indexing for inflation.
In general, legislation becomes effective on the date of its enactment; however, there’s nothing in the Constitution that prohibits an act from taking effect earlier. The Supreme Court has recognized that retroactive application of tax laws is a “customary Congressional practice.1” Further, retroactive tax laws are common, and the Supreme Court has upheld them on several occasions.2 For example, the Deficit Reduction Act of 1993—signed into law on August 10, 1993—retroactively increased the gift and estate tax rate from 50% to 55% as of January 1, 1993.
Yet even if “retroactivity” remains possible, what’s the likelihood of it happening in 2021? Relatively low, for two reasons: The Democrats have bigger fish to fry, and their razor-thin Senate majority (including Vice President Harris’s tie-breaking vote) makes comprehensive tax reform in general—and its retroactive application in particular—very unlikely. Plus, given the challenges facing our nation, the Biden administration seems likely to spend its political capital elsewhere, at least initially.
What Should You Do?
Those concerned with the lingering possibility of retroactive changes may wonder whether to proceed with lifetime wealth transfer initiatives in 2021. If you can afford to do so, gifting your remaining exclusion amount in 2021 should be safe—though a legislative outcome cannot be guaranteed.
A safer option? Sell, rather than give, assets to an irrevocable (“intentionally defective”) grantor trust in exchange for a promissory note at the short-, mid-, or long-term applicable federal rate (AFR) of interest (Display). The benefit? If Congress reduces the exclusion amount retroactively, assets sold would not be subject to the gift tax. On the other hand, if it becomes clear later in 2021 that Congress will not reduce the exclusion amount retroactively, you can forgive the debt and complete the gift. This strategy will use some, or all your remaining exclusion and mitigate the risk of incurring a gift tax.
Other Gifting Options
Other risk-mitigating strategies are available. For example, a “disclaimer trust” gives the trustee or another third-party nine months to disclaim a gift if Congress reduces the exclusion amount retroactively. If disclaimed, the grantor would receive the returned gift. But there’s a potential conflict of interest: how can a trustee, who owes a duty of loyalty to the trust beneficiaries, refuse a large gift in favor of the grantor, to whom the trustee owes no duties whatsoever?
Alternatively, make a gift to a “QTIP-able”—a qualified terminable interest property—trust. In this scenario, the grantor can postpone the decision to use the exclusion or qualify the gift for the unlimited gift tax marital deduction until April 2022, the deadline for filing a gift tax return. The caveat? The trust must pay all its income annually to the beneficiary spouse, which sends a steady stream of assets back into the taxable estate during the beneficiary’s lifetime.
A third option is to give a gift that’s contingent on a “defined-value clause.” This clause would allow the portion of the gift in excess of the donor’s available exclusion—wherever that final amount lands—to pass to charity, a spouse, a marital deduction trust, or some other recipient without being subject to gift tax. So long as no portion of the gift reverts to the donor, this clause should not be challenged.3
While there’s no perfect solution—and each circumstance differs—on balance, an installment sale with the option to forgive the debt later in 2021 seems optimal for those preoccupied with retroactivity.
A Complicated Dilemma
Navigating gift and estate taxes can be challenging, especially when uncertainty looms. Yet despite the ambiguities, investors have options. The key is to understand the risks associated with each scenario and assess alternative strategies and their trade-offs.
The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on his/her specific circumstances. Please consult with your legal or tax advisor regarding your particular situation.
1 United States v. Carlton, 512 U.S. 26, 33; United States v. Darusmont, 449 U.S. 292, 297.
2 United States v. Carlton, 512 U.S. 26 (1994); United States v. Hemme, 476 U.S. 558 (1986); United States v. Darusmont, 449 U.S. 292, 297); Welch v. Henry, 305 U.S. 134 (1938); United States v. Hudson, 299 U.S. 498 (1937); Milliken v. United States, 283 U.S. 15 (1931).
3 Based upon basic testamentary estate planning formulas, and a line of Tax Court cases that includes Wandry v. Commissioner, T.C. Memo 2012-88, and its progeny, such a clause should be given effect, provided that no portion of the gift would revert to the donor. See Treas. Reg. § 25.2511-1(e) (arguably, future Congressional action would not be “susceptible of measurement” within the meaning of the regulation).