Gift and estate exemption: Use it before you lose it

| 9/17/2020
Gift and estate exemption: Use it before you lose it

With the presidential election just around the corner, taxpayers might be wise to use their 2020 $11.58 million gift and estate tax exemption before it is too late. The gift and estate tax exemption is the amount that each individual may use to transfer property either during their lifetime or at their death without incurring tax. The amount is indexed for inflation and temporarily was doubled as part of the Tax Cuts and Jobs Act of 2017 (TCJA), but it currently is scheduled to revert to the pre-TCJA indexed amount of approximately $5.8 million after 2025.

President Donald Trump has said that if reelected he would extend the higher exemption amount past its 2025 expiration date. Vice President Joe Biden has not addressed this specific issue on the campaign trail, but it is unlikely that he would support extending the higher exemption amount given his proposal to eliminate the tax benefit of a stepped-up basis for appreciated property transferred at death. However, the economic downturn and increasing deficits caused by the COVID-19 pandemic could make increases in the estate tax an attractive option for enhancing revenue regardless of who wins the election.

Given the uncertainties, individuals should consider acting now to take advantage of the higher estate and gift tax exemption.

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Intentionally defective irrevocable trust (IDIT)

One way to take advantage of the exemption is to create an IDIT, which is a trust that is disregarded for income tax purposes but that removes the assets from the taxpayer’s taxable estate. An IDIT is funded with an initial gift, typically cash, in an amount that provides the trust with sufficient net worth to be a qualified purchaser. As a qualified purchaser, the trust can purchase highly appreciated assets (for example, stock in a family business), discounted as appropriate. In exchange, the trust provides the seller with a promissory note obligating the trust to pay principal and interest at the IRS’ minimum required interest rate, currently 0.14% for notes with a term of less than four years, 0.35% for notes with a term of four years or more but less than nine years, or 1.00% for notes with a term that is nine years or longer. 

Forgiving the note and reporting the loan as a gift to the trust or gifting the note receivable to someone else (such as a family member) will use a portion of the gift and estate tax exemption equal to the amount of the loan forgiven or the amount of the receivable gifted. In either case, the IDIT provides the donor with the flexibility to determine the amount and timing of the gift.

Qualified terminable interest property (QTIP) trust

Alternatively, the note could be contributed to a separate QTIP trust, which allows the grantor to provide for his or her spouse but maintain control of where the trust assets will be distributed when the surviving spouse dies without incurring any gift or estate tax because it qualifies for the marital deduction. The QTIP trust can be drafted so the donor can elect at a later date whether it will benefit only the donor’s spouse, in which case no taxable gift has occurred, or others in addition to the donor’s spouse, in which case the nonspouse recipients will receive a taxable gift. This election can be made any time up until the extended due date of the donor’s gift tax return for the calendar year during which the gift is made. If a gift is made in calendar year 2020, the gift tax return, if extended, is not due until Oct. 15, 2021. 

Planning ahead

The unusual challenges facing the economy as a result of COVID-19 make it difficult to predict with any certainty what will happen with the gift and estate tax in the near future. Therefore, it is important for individuals to consult with their tax advisers to consider planning options that can provide flexibility. Trust agreements must be drafted by an attorney, and a valuation will be needed if the trust will be purchasing an interest in a closely held business. Therefore, the sooner taxpayers begin this process, the sooner they can put a plan into effect.

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Sally E. Day
Sally Day
Managing Director