How to Play Defense Against Potential Tax Hikes: Estate Planning Strategies

Keywords: portfolio management, risk management, financial/
estate/retirement income planning, tax/debt management, charitable planning,
women investors, financial literacy, ESG/sustainable investing

With so much tax legislation making its way through Congress, it may be time to start thinking about how to help your clients play defense against potential tax hikes. The estate planning strategies discussed below could help wealthy clients mitigate the impact of the tax proposals currently gaining traction on Capitol Hill.

Of course, as with any estate planning decision, it’s important for your clients to consult with a qualified attorney before taking action. That said, this information may help you educate your clients, including high-net-worth (HNW) clients, about the potential impact of tax changes on their estate plans.

How Could Tax Changes Affect Estate Planning?

The lifetime federal estate tax exemption is currently $11.7 million per person. Your HNW clients may be concerned whether they’ll be able to use this large exemption in 2021. As of this writing, the answer is likely to be yes. An immediate reduction is not part of two bills currently under consideration by Congress: the American Jobs Plan and the American Families Plan.

Another bill, the For the 99.5 Percent Actdoes include gift and estate tax changes, but it does not attempt to make these changes retroactive. Accordingly, taxpayers should be able to make use of the $11.7 million lifetime estate tax exemption in 2021. The IRS has confirmed that, if taxpayers properly use this exemption during years with a higher threshold, they will not be penalized if they die when the exemption is lower.

4 Estate Planning Strategies to Mitigate Tax Hikes

Because the bills mentioned above are making their way through Congress, their details are not set in stone. But if your clients are interested in how to play defense against potential tax hikes, here’s what they need to know about some important estate planning strategies.

1) Grantor trusts. Often called “intentionally defective grantor trusts,” these trusts offer a straightforward way to use the lifetime estate tax exemption and keep assets in the family. An irrevocable trust can be set up to benefit children while allowing the trust to be taxed to the grantor for income tax purposes. This provides the multifaceted advantage of removing assets from the client’s estate and helping safeguard asset growth from the annual tax burden. Payment of the taxes by the grantor isn’t treated as an additional gift to beneficiaries.

Notably, the 99.5 Percent Act and the Sensible Taxation and Equity Promotion (STEP) Act would significantly curtail the benefits of these trusts. As proposed, funding a grantor trust would not remove assets from the grantor’s estate and would trigger a capital gains realization event. The bills appear to grandfather grantor trusts that exist before the effective date of the enacted legislation.

If your clients would like to add this component to their estate plan, they may wish to consider creating and nominally funding such a trust as soon as possible. Additional funding could be arranged later when the final legislation becomes clearer, or assets funded into the trust could be exchanged later for other property.

2) SLATs and ILITs. Spousal lifetime access trusts (SLATs) and irrevocable life insurance trusts (ILITs) focus on combining wealth transfer tactics with leveraging and protecting estate values. Typically, both types of trusts own large life insurance policies and periodically receive gifts from the grantor to cover their equally large premium payments. These contributions can be structured as larger gifts that use up the lifetime estate tax exemption or the annual gift tax exclusion ($15,000 in 2021).

SLATs are designed to allow the nongrantor spouse to access and benefit from built-up cash values in life insurance policies. SLATs and ILITs provide income tax–free death benefits because the benefit is paid outside of the grantor’s estate. In some very large estates, these death benefits might help protect other assets by providing liquidity to pay estate taxes.

The impact of congressional bills on these trusts could be dramatic. For one thing, SLATs and ILITs are typically grantor trusts, meaning the issues discussed above would apply. Although the trusts might be grandfathered, the proposed laws would apply to any new contributions—which may pose a problem because regular contributions occur by design for many of these trusts.

To plan ahead, one option that may be worth your clients’ consideration is to prefund these trusts to allow the trustee to pay up the policy, a strategy that would use the estate tax exemption this year while the threshold is high. It would also appear likely to fully grandfather the trust for the future.

3) GRATs and FLPs. Grantor-retained annuity trusts (GRATs) and family limited partnerships (FLPs) are very common estate freeze tactics. They let grantors remove future growth from their estate while still potentially receiving ongoing benefits from the assets. Both GRATs and FLPs can be designed to use little or no estate transfer tax exemption.

The 99.5 Percent Act explicitly targets GRATs, mandating that they must be more than 10 years in duration and leave at least the greater of 25 percent of the market value or $500,000 to the remainder interest. This could eliminate the common strategy of using GRATs in short, rolling increments. Therefore, 2021 might be the final year to move significant cash or highly appreciable securities out of a grantor’s estate.

Likewise, the 99.5 Percent Act introduces limitations to discount valuation rules—most notably targeting entities such as FLPs and LLCs by preventing a discount in cases where any family member continues to control the transferred entity. It would eliminate the long-standing practice of methodically transferring FLP interests to the next generation using annual valuations at minority and marketability discounts.

As with ILITs, transferring large portions of an FLP in 2021—if your client still has large exemptions to use this year—may be something they should consider and discuss with their attorney or tax professional. It’s worth noting, however, that the 99.5 Percent Act could eliminate the attractiveness of future FLPs.

4) Contingent planning. Given the uncertainty regarding congressional approval of tax changes, your clients might consider creating contingent gifts and trusts through a variety of legal mechanisms. In the case of gifts to trusts for spouses, for example, it’s possible to create a lifetime qualified terminable interest property (QTIP) trust. Since a QTIP election is due at the same time as a personal income tax return, this approach allows time to see what becomes law in 2021.

If no significant changes occur, your clients can decline to file the QTIP election with their tax return in 2022. Depending on how the attorney drafts the trust, this decision would most likely bypass a spouse and fund a trust for descendants, using any future increases in the gift and estate tax exemption.

Similarly, trusts can grant helpful options and powers while we await the outcome of 2021 legislation. One such option allows a power holder to exercise a disclaimer and send assets back to the grantor of a trust. Since qualified disclaimers must be made within nine months of the disclaimable interest’s creation, a power holder could wait until 2022 to make this decision.

The Value of Guidance

Congress is still in the early stages of the legislative negotiation process for the bills proposing tax changes. So, whether your clients are concerned about how to play defense against potential tax hikes—or even if they haven’t been paying attention—you can provide valuable education by initiating a discussion on this topic. And, of course, you should advise clients to seek an attorney’s assistance to ensure that their estate planning strategies are up to date with federal and state tax codes and new laws.

This material is for educational purposes only and is not intended to provide specific advice.

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