As of the writing of this article, it appears more likely than not the United States is headed towards a split government in 2021. For purposes of this article, let’s assume that control of Congress is divided between Republicans and Democrats and we have a Democratic President. This result should temper some clients’ worst fears, i.e., a drastic reduction of the current estate tax exemption amount (“ETEA”). In reality, however, the events unfolding have just “kicked the can” down the road, in that the ETEA, absent a subsequent change, will sunset on December 31, 2025, and return to $5 million, adjusted for inflation. Simply speaking, the tools that estate planners recommended on November 2 remain viable today and beyond.
1. The estate planning “can has been kicked.” With a split government, the risk of a substantial reduction of the ETEA prior to 2025 is remote, however, the threat sunset remains high. If the sunset does occur, it will eliminate over $6.58 million of ETEA available for sheltering the transfer of wealth on a tax-free basis. For this reason, techniques such as a Spousal Lifetime Access Trusts (“SLATs”) remain a viable option for clients. At its most basic, a SLAT is a gift from one the donor spouse to an irrevocable trust for the benefit of the beneficiary spouse. The beneficiary spouse can receive distributions from the SLAT, but the SLAT is designed to be excluded for the beneficiary spouse’s “gross estate” and is not subject to estate tax when the beneficiary spouse dies. SLATs are popular amongst married couples because the SLAT property remains accessible to the donor spouse through their spouse as beneficiary. Typically the surviving spouse is the Trustee with the ability to distribute trust principal to himself or herself for their “health, education, support and maintenance.” Upon the death of the beneficiary spouse, the assets remaining in the SLAT pass to the children free of estate tax. While SLATs can be created by both spouses to benefit each other, extreme care must be taken to avoid the IRS’s “reciprocal trust doctrine” and the “step transaction doctrine,” both of which can cause the gifts to be challenged and undone. In these instances, a knowledgeable practitioner should be engaged to avoid undesirable consequences.
2. Interest rates will continue to be low. The Federal Reserve’s decision on November 5 to keep interest rates at historically low levels has extended the ability for clients to utilize freeze techniques such as a Grantor Retained Annuity Trust (“GRAT”) or a Charitable Lead Annuity Trust (“CLAT”). Both techniques utilize the IRS’s 7520 rate, which currently sits at .4%. A GRAT pays a fixed amount back to the client for a fixed number of years, and the remainder typically passes to the client’s children. A CLAT pays a fixed amount to a named charity for a defined number of years, and then the remainder typically passes to the client’s children. If the GRAT or CLAT assets outperform the applicable Sec. 7520 rate of .4%, then the trust will produce wealth transfer benefits. Normally a GRAT or CLAT is most successful when a client transfers an asset that has significant appreciation potential, such as a closely held entity where the owner expects a successful sale in the future, or is funded with a depressed stock portfolio where appreciation is expected to occur because of a rebounding stock market. Last, clients can look into creating or refinancing intra-family loans to take advantage of the historically low interest rates. These loans can be used to help a child buy a first home, start a business, etc.
3. Consider your domicile. The pandemic has shown the ease at which the workforce can transition to a full work from home capacity. This environment presents the opportunity for certain clients to legally change their domicile to a lower tax jurisdiction. Many clients who had second homes fled their urban office and worked through the pandemic at their lake or vacation home. While the long term shift remains unclear, for certain clients who live in high tax jurisdictions such as Illinois or California, but have second homes in low tax jurisdictions such as Florida or Nevada, a change in state domicile may be a viable alternative to lower the overall tax burden faced. In changing domicile care must be taken as each state has its own intent driven indicators such as voter registration, driver’s license, church membership, doctor location, etc. States have also taken a more aggressive stance in these circumstances as a result of tax revenue being slashed by the pandemic. A skilled practitioner can help guide a client through the process and build up a defense to a possible state income tax audit.
In conclusion, there is no time like the present to utilize these techniques. SLATs, GRATs and CLATs all are freeze techniques where the client is ensuring future appreciation of the assets are not taxed in the client’s estate. Likewise, domicile calculations are based upon days present in each state. While the full results of the United States election will not be known until early January, time marches on.
Ryan Holmes is a member in Clark Hill’s Tax & Estate Planning practice in the Chicago office.
