United States

The gift tax exemption coast is clear. Time to go back into the water?

INSIGHT ARTICLE  | 

In our Dec. 6, 2018 Tax Alert, The IRS says, “Yes, there is no clawback,” we noted that IRS issued proposed regulations that would effectively ensure that where a taxpayer made gifts of their entire exemption between 2018 and 2025 when the exemption was $11 million (indexed), and then passed away after 2025 when the exemption dropped to $5 million (indexed), the benefit of the higher exemption would not be retroactively eliminated.

Taxpayers who have identified opportunities to take advantage of the increased exemption before 2026 (or sooner if the political winds suggest a mid-course correction) but have been hesitant to do so because of the risk of clawback now find themselves on firmer ground for moving forward with those plans. However, with all of the ways and means of using the exemption, what should they do…and why?

Perhaps the first place to look for uses for the exemption is to fix problems with existing planning, especially if those problems are now straining the individual's cash flow or will cause unwanted or unproductive use of exemption down the road. Here are some situations that might call for application of exemption.

Forgiving debts from the children

Children borrowed from the 'Bank of Mom and Dad' to buy a home. The parents made sure that the transaction was documented properly, secured the loan with a mortgage on the home and have, in fact, made sure that the children paid the mortgage in accordance with its terms. The children, it seems, have read about the increased exemption and, after checking with their planner, have suggested that Mom and Dad's forgiveness of the balance due on the mortgage would be a smart tax planning move. Yes, the forgiveness would be a gift, but with the increased exemption, there would be no gift tax due. Mom and Dad are happy to oblige their obligors. They also mention, albeit in a stage whisper, that with the mortgage out of the way, the children will no longer need Mom and Dad's help on funding the grandchildren's education.

Shoring up 'underfunded' irrevocable life insurance trusts and split-dollar plans

Many individuals established irrevocable life insurance trusts (ILITs) to own policies earmarked for various financial and estate planning uses. The ILITs will keep the proceeds of the policies out of the individuals' taxable estates, but the ILITs have to be funded by gifts from the individuals. Those gifts may be covered by annual exclusions by way of a Crummey power. However, the premiums on large policies often exceed the available annual exclusions by a wide margin. Many of those who established ILITs expected that they would have to make gifts, annual exclusion or otherwise, for a certain number of years. They recognized (or were certainly told) that unless the premium was guaranteed, the expectation of the policy's being self-sufficient after a certain numbers of years was just that, an expectation, not a guarantee. Fast forward to today, and many of these individuals are looking at paying premiums for perhaps twice the number of years that they originally expected. To make matters worse, some of those policies were funded by split-dollar arrangements that were calibrated to 'roll out', meaning have enough cash value to enable the ILIT to repay the party advancing the premiums under the plan and be self-sufficient thereafter, after a certain number of years. Unfortunately, the rollout was utterly dependent on the performance of the policies and, with interest rates at historic lows for so many years now, the policies are a shadow of what they were projected to be when they were put in force (at higher rates). Here again, the individuals who established these arrangements are looking at many, many more years of absorbing the income and gift tax cost of supporting the arrangement. 

Individuals who find themselves in these situations can consider using the increased exemption to fund their ILITs with income–producing (and hopefully discountable) assets such as S corporation stock or interests in family partnerships or limited liability companies. While this funding will use exemption, it will give the ILITs the means to service the policies and take over the payment of the economic benefit in the split-dollar arrangements, thereby saving the individuals significant future gifts.  

A subset of the ILIT issue involves revisiting (and rewiring) the individual's life insurance program, which may now involve more insurance than they need for estate taxes. Even if the coverage is needed, it could make sense to see if the premiums could be reduced because the coverage is not going to be needed for as many years as originally anticipated.

Shoring up 'underperforming' or under-capitalized intentional defective grantor trusts

Many individuals sold assets to their intentionally defective grantor trusts in exchange for installment notes from the intentionally defective grantor trusts (IDGTs). For a host of technical reasons, the individuals 'seeded' their IDGTs with a certain amount of cash or other property to give the transaction at least the appearance of commercial viability. In some case, seeding was not possible at all or in the amount required, so the individuals' children, perhaps, guaranteed the notes.

Again, fast forward to today, some of these arrangements are not working out so well, either because the transferred asset isn't generating the cash flow to service the notes, there is a concern that the seeding was not quite enough to pass muster or the guarantors are getting nervous. Even if things are proceeding nicely, there is a concern that the tax implications of the individual's dying before the note has been repaid are still unclear and could be problematic, though not necessarily for the individual. Therefore, the individual could consider using exemption to forgive all or a portion of the balance due on the note. Even the partial forgiveness could alleviate pressure on the economics of the transaction going forward and maybe even allow for the release of the guarantors.

Many of these transactions were done with generation-skipping trusts. In those cases, the individuals allocated generation skipping tax (GST) exemption to the seed gift. With the concurrent increase in the GST exemption, the shoring-up of the IDGT should have no GST tax implications.

Doing late allocations of GST exemption

There are a host of reasons and situations where someone 'missed' a timely allocation of GST exemption. There are also situations where the allocation wasn't missed; not allocating was informed and intentional. However, maybe now the landscape had changed and an allocation is called for or is otherwise prudent.

Pro-active planning, sometimes with income tax basis in mind

Establishing spousal lifetime access trusts

It is common for parents to be interested in using their gift tax exemptions to save eventual estate tax on what they will leave to their children. However, it is also common for those same parents to be reluctant to give up control of and the income from significant holdings. These individuals may be able to achieve their estate tax objective while retaining much of the economic benefits of the assets by using a spousal lifetime access trust (SLAT).

A SLAT is an irrevocable trust set up by one spouse for the benefit of the other spouse. Let's assume that the husband creates a SLAT for his wife's benefit and funds it with part of his $11.4 million gift tax exemption. During his wife's lifetime, the trustee (which may be the wife) can distribute income and principal as needed to her for her health, education, maintenance and support. She can also have a ‘5x5’ power and a testamentary limited power of appointment. Thus, assuming the husband remains on good terms with his wife, he will have ‘indirect’ access to the trust's income and principal. When his wife passes away, the trust property will pass estate tax free to the children.

Another perspective on the use of the SLAT is that it can function as an ILIT. This use of the SLAT may appeal to individuals who find the loss of control of a (valuable) policy associated with the traditional ILIT a bridge too far. So, the SLAT would be the applicant, owner and beneficiary of a policy on the husband. The SLAT would use the funding it received from the husband to pay the premiums. Once cash value develops, the trustee can access the policy by way of withdrawals and loans. Of course, the trust should not give the husband/insured any incidents of ownership in the policy for purposes of section 2042.

The SLAT will be a grantor trust during the lifetime of the grantor spouse, here the husband. That's probably fine with him since the asset never left home anyway, as it were. However, the mood can darken quickly if the wife dies first or the couple gets divorced. The obvious concern is that the husband would lose even his indirect assess to the trust's income and principal. To make matters worse, the husband could find that the trust remains a grantor trust even after the divorce, meaning that he loses access but keeps the tax bill! There may be ways to draft around these concerns, but the more comfortable the husband is with the trust's 'contingency provisions', the more risk there will be that the IRS will consider him as the outright owner of the trust's assets for estate tax purposes.

Where the SLAT is attractive to a couple, the planner should anticipate their question about doing one for each other, kind of, reciprocally. They can indeed get there from here, but will have to do things Grace-fully, as the case law requires that the trusts have sufficiently different provisions to not make them the mirror image of one another. As with other areas of tax planning for spouses, planners who try to create non-reciprocal, 'dueling' SLATs for a couple need to be aware of the potential conflicts of interest inherent in consulting for both spouses and document the file accordingly.

Upstream planning

Let's assume that an individual owns a highly appreciated asset with a seriously low basis. She would like to sell the asset and diversify the holding, but is reluctant to trigger the significant capital gains tax plus the 3.8 percent tip on net investment income. Her mother does not have a taxable estate. Working with her advisors, the individual transfers the asset to a trust for the benefit of her mother. The trust provides her mother with a general power of appointment that will cause the trust's assets to be includible in the mother's estate for estate tax purposes. Assuming her mother does not exercise the power in an unanticipated fashion, the trust's assets will pass back to the individual, to her own children or to a trust for family members. Because the mother does not have a taxable estate, there will be no estate tax and no generation-skipping tax. However, because the trust's assets will be included in her estate for estate tax purposes, the assets will receive a step-up in basis at the mother's death.  

Exercising 'swap' powers in an IDGT to bring low basis assets back into the estate

Particularly back in the waning days of 2012 and, no doubt, thereafter, many individuals sold highly appreciated, low basis assets to intentionally defective grantor trusts. Their objective was to convert an appreciating asset into a fixed promissory note, thereby saving estate tax on the future appreciation of the asset above the interest rate on the note. One downside of the technique if done with an asset with these characteristics is that the trust will carry over the individual's low basis, so that if the trust sells the asset, it will trigger a substantial capital gains tax. If the trust gives the individual (grantor) the right to substitute an asset of equal value in the trust, the individual can use this 'swap' power to transfer a high basis asset to the trust in exchange for the low basis asset. The low basis asset will now be included in the individual's estate, thereby giving it a step-up in basis when the individual dies. 

But, wait a minute…

Before we close, however, we should point out that there will be situations where, for income tax reasons, the family is best served by the individual's retaining an asset until death rather than transferring it during lifetime. A lifetime gift of an asset will remove any post-gift appreciation in the value of the asset from the taxable estate. However, the donee of that gift will take the individual/donor's basis in the asset. If the individual holds the asset for the rest of his or her life, it will get a stepped-up basis.

The question will be whether, all income and estate tax things considered, it would make more sense not to make the gift and to hold the asset for a stepped-up basis. With a 40 percent estate tax rate and a 23.8 percent top federal capital gains rate, a transferred asset that has a carry-over basis would have to appreciate substantially for the estate tax savings on the removed appreciation to offset the loss of a basis step-up. In some cases, perhaps involving a 'legacy asset' such as a beach house that will remain in the family for generations, the estate tax side of the argument could prevail and the individual will make the gift. However, if the children will sell the asset proximately, the math could favor retaining it in the estate for the step-up.

The coast may be clear, but the decisions remain challenging

It could go without saying that determining whether and how to use the exemption is not an easy task. Each and every application that we have described calls for careful consideration of myriad personal, economic and tax factors. Individuals should ask their advisors to explain how those factors come into play and coalesce in the context of each application of the exemption. Only then will individuals be able to make informed decisions about steps that will generally be irrevocable.

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