Actor Will Rogers is widely credited with stating that “the only difference between death and taxes is that death doesn’t get worse every time Congress meets.” While most taxpayers fear tax laws changing for the worse, estate and gift taxation has only grown more favorable to taxpayers over the last decade despite very public opposition.
In 2010, the estate tax was phased out entirely and a $9 billion estate passed without any estate taxes being paid. Though estate and gift tax laws are rarely updated, such a large tax-free wealth transfer did not sit well with a lot of legislators. This prompted the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 and the American Taxpayer Relief Act of 2012. These laws collectively reinstated the estate and gift tax regime, but exempt estates at or below $5,000,000 in value (adjusted for inflation) in the form of a tax credit. The Tax Cut and Jobs Act of 2017 doubled this credit but includes a sunset provision that will, in 2026, return the estate tax credit down to the amount established by the American Taxpayer Relief Act of 2012 automatically. That is, unless new legislation is enacted.
While we should never plan for taxes to go away entirely, we should always plan to minimize the tax burden. One popular strategy for this is to use trusts to plan for the step-up in basis, or to remove assets from the taxable estate entirely. Recent political pressure is mounting against strategies like these, and the window may be closing to take advantage of these strategies.
When property passes through the taxable estate of a decedent, the property receives a step up in basis to the fair market value. For example, if a decedent purchased a house for $25,000 (and kept the $25,000 basis throughout the decedent’s lifetime) but the house is worth $500,000 as of the decedent’s date of death, the basis in the hands of decedent’s heirs is $500,000. This means the heirs could sell the house for $500,000 the next day, and there would be no taxable gain. This result applies to other assets as well, creating planning benefits to any taxpayers who have appreciated assets at the time they are preparing their estate plan.
Seasoned estate planners have used revocable trusts to transfer assets outside of their probate estate, while keeping the assets in their taxable estate. By placing assets in a revocable trust, legal title to the asset is vested in a separate legal person. In many jurisdictions, a probate estate only includes the assets to which the decedent owns legal title. This simplifies the probate process. Though legal title is vested in a separate legal person, the revocable trust is treated as being the same taxpayer as the decedent, as the decedent has full power and authority to revoke the trust and take the assets back from the trust. This means the property will stay in the decedent’s taxable estate and any income earned on trust assets will be passed through to the decedent’s tax return until the date of death.
Experienced tax planners can use these rules to accomplish the opposite treatment through the use of irrevocable trusts. A properly structured irrevocable trust can remove assets from the taxable estate of the decedent, effectively eliminating estate taxes on the assets, but still pass through income tax to the grantor (which will ultimately be paid at a lower tax rate). This is a particularly helpful strategy when a taxpayer has assets that have not appreciated significantly prior to the time of the transfer or that are expected to appreciate significantly following the transfer. On March 29, 2023, the Internal Revenue Service released Revenue Ruling 2023-02 that reaffirms this tax planning strategy, by acknowledging that the assets have been removed from the taxable estate, notwithstanding that the irrevocable trust being structured to pass income taxes through to the grantor.
On March 9, 2023, the Biden Administration released its General Explanations of the Administration’s Fiscal Year 2024 Revenue Proposals (also known as the 2024 Greenbook), which incorporates a variety of proposed changes to the tax code. Many of the proposed changes were considered throughout the Obama and Biden Administrations. In fact, some of these proposals were in the Build Back Better Act when it was being negotiated in 2021, but they were ultimately not included in the Infrastructure Investment and Jobs Act that was promulgated on November 15, 2021.
One proposed change is to tax the decedent’s estate upon the transfer of appreciated assets to heirs, applying income tax to the difference between the decedent’s basis and the fair market value. This would effectively reverse the benefits that come with the step up in basis; instead of escaping income taxation following the date of death, this would accelerate income taxation on appreciated property, creating a tax obligation as of the date of death.
In addition, another proposed change would create a minimum income tax of 25% on estates having a net value of $100 million or more, which would seem to include the acceleration of capital gains discussed previously in this article. The minimum tax would only be calculated on the value that is in excess of the $100 million threshold. The payments of this minimum tax would be treated as a prepayment of subsequent taxes owed when the assets are eventually sold.
While this article focuses on federal estate tax planning strategies, these strategies can be applied to state estate taxes as well. Currently, 12 states and the District of Columbia impose estate taxes, and six states impose inheritance taxes (which are taxed to the recipient, rather than the estate). Each state can set its own tax rates and its own exemption. For example, the estate tax exemption in Rhode Island is $1,733,264, in New York it is $6,580,000 and in Connecticut it is $10,000,000. The maximum state estate tax rate in each of those states is 16%, 16% and 12%, respectively. This means the estate of a decedent in New York would be paying 52 cents of every dollar over $13 million of value in the taxable estate (absent adequate tax planning). The legislative landscape at the state level is constantly shifting, so plans should be reviewed and updated regularly to ensure that both federal and state changes of law are taken into account.
Many of the federal proposals described above have been included in the 2023 Greenbook and other legislative proposals, and such sweeping changes could remove many of the gift and estate tax planning strategies used by taxpayers over the last decade. Given the current economic climate, we could see a groundswell of support for changes to the estate and gift tax laws much like we saw in 2010 and 2012, making now the time to act to take advantage of existing rules before new ones take effect.