Has predicting the future, and its long term financial planning, just gotten harder?
by Tim TikalskyMr. Tikalsky is a tax principal at Sensiba San Fillippo LLP
The Biden Administration’s tax plans have the estate planning world alert and anxious. The proposed changes to current tax law will have far reaching implications for estate planning professionals and their clients. This makes it critical for advisors to get up to speed on the potential changes quickly to best guide their clients and potentially save them and their loved one’s millions in taxes.
There are three major changes to estate planning taxes to be aware of:
Elimination of the Stepped-up Basis
Under the proposed tax plan, the stepped-up basis for calculating gain or loss on the sale of inherited property would be eliminated. Under current rules, assets transferred to heirs upon death receive a tax basis equal to the assets’ fair market value on date of death (or the alternative six-month value, if qualified). If this rule were eliminated, heirs would likely pay capital gains on the assets when sold. In addition, the proposed plan would tax any appreciation on gifts made either during life or at death to the donor.
Decrease in Tax Exemption Amount
The estate tax exemption currently applies to estates up to 11.7 million dollars. This amount is scheduled to change to $5 million (adjusted for inflation) in 2026. An estate is not subject to the federal estate tax unless it is over the exemption amount. At $11.7 million for individuals and $23.4 million per couple, the exemption is higher now than ever before. Once the amount goes down to $5 million (adjusted for inflation), a much larger number of estates will be subject to estate taxes in 2026. The proposed tax plan would reduce this exemption amount to $3.5 million.
Taxation of Trust Assets
Another potential change is a proposal to tax assets held in a trust, or other flow-through entities, for more than 90 years. While the details of this are limited, it is assumed this will apply to assets held for a very long time over several generations. The Biden Administration wants certain entities to recognize these gains and tax them at the current tax rates. Of all the proposed changes, in this author’s opinion, this one is least likely to pass. There’s no analog for a change like this and, frankly, it’s just too complicated. Imagine having to go back through 90 years of bank records to find out how much Great Uncle Don paid for that Bank of America stock in he bought in 1931. For a lot of these entities, it may be impossible to find the original records for these assets to determine their original cost basis.
Guiding Clients Through the Changes
With all the changes in the pipeline, we recommend advising clients to do what makes financial sense for them. For example, if they are going to give their property and assets to their kids anyway, why not do it now while the exemption is at an historical high? It can be a difference of millions of dollars in savings. Their children won’t receive a stepped-up basis on death, but Biden’s planning to eliminate that anyway, so it makes sense to take advantage of the law as it exists today.
This presents another big question of whether clients should be buying or selling their assets now. This discussion is heavily colored by the potential tax changes. On the holding assets side of the equation, motivations revolve around not wanting to pay the capital gains tax, potential for a 1031 exchange, and the stepped-up basis for their heirs. All these traditional motivations for holding onto their property might be going away or curtailed under the proposed changes.
Considering this, it’s important to remind clients that estate planning is ultimately about planning one’s legacy. For one client, that might be their children, another might want to preserve their life’s work, while others might be focused on funding a charitable endeavor they support.
When you get to the estate-planning phase of your life, we discuss Maslow’s hierarchy of needs. In the hierarchy of needs, altruism is the highest point of the pyramid. At that point, you’ve satisfied your needs in your life, you have enough to survive happily and it’s time to give away the “excess”. For clients in this category we advise they look at the real estate market today. If they have what they need and want for the future, why not sell now? Usually the reason is a possible large capital gain. With the proposed changes, the capital gains tax is just going to end up on their heirs in 2026 when the exemption changes. Giving it away while the exemption is high may save their legacy and lower their taxes in the long run.
Estate Planning Best Practices
Good estate planning starts with good financial planning. Helping your client determine if they have enough assets to survive the rest of their life is critical. Determine what they need to live out their days, including any increases in medical expenses. Anything else is potentially “excess wealth” and, with the changes in the tax plan it doesn’t do them or their heirs any good to hold on to it.
In the past, the gold standard in Estate Planning was to use a formulaic approach. Estate plans were written to fund Beneficiary Trusts up to the maximum exemption amount available. But many of these plans simply don’t have the safeguards to protect against a high exemption amount.
For example, lots of trusts were written to fund an Exemption Trust to the maximum unified credit amount available on death. That amount ended up being the entirety of the estate for a lot of people, which wasn’t desirable. Survivors wanted more access to their money outside of the constraints of a trust.
One way around this is to give the surviving spouse the ability to determine whether you want the trust to be funded (via Disclaimer) and to what amount. Doing this allows the surviving spouse to determine the optimum funding amount for an Exemption Trust, if any.
New Tools to Help Serve Your Clients Better
Estate planners have been breaking out more sophisticated tools in recent years. Many techniques that people didn’t understand or know existed apply to today’s estates. These tools can be used to save your clients money and create greater ease as they plan their legacy.
Some interesting tools to keep an eye on include GRATs, CRATs, and CRUTs.
In this author’s experience, it’s been almost 20 years since charitable remainder trusts have been in wide use, but with the current tax plan changes that tool is coming back into play. It’s a good option if your client is already planning to leave their wealth to a charity. By utilizing a CRUT (or CRAT) they won’t be paying nearly as much tax on the estate once it transfers hands.
With policies changing from administration to administration, it is essential to help your client’s keep their estate plan up to date. That dusty estate plan from ten years ago isn’t going to cut it anymore. It is critical to connect with your clients and start thinking outside the box on potential tax-saving plans.
Oftentimes estate tax is called the neglect tax. If you neglect to plan, you will pay it. Ten years ago, the current exemption rate was unthinkable, but it shows us how essential it is to not only encourage your clients to create an estate plan but to review it regularly, especially considering any legislative changes. This will allow you and your clients to pivot or make new decisions as needed.
If they create their estate plan with the existing law today, it is unlikely they will get whipsawed in the future. It is critical to advise your clients to be nimble in their planning in order to give their surviving family members, charity of choice or other legacy piece to have as much flexibility as possible in addition to potentially saving them millions in tax dollars.