On the Chinese lunar calendar, 2021 was the Year of the Ox, but for many in the estate planning world, it was the “Year of the Exclusion.” Due to concerns that Congress might reduce the gift and estate tax exclusion, perhaps retroactively, from $11.7 million to something much lower, estate planners encouraged their wealthiest clients to make large gifts in 2021, and many followed that advice. As the year evolved, Congress withdrew proposals to reduce the exclusion, and some clients who were on the fence held off on making big gifts in 2021. Today, it appears that the exclusion amount—now a lofty, inflation-indexed $12.06 million—may remain intact until 2026, when it is scheduled to be halved.
For clients who waited and can afford to make a big gift—and especially for those who live in a jurisdiction that imposes an estate tax at death, but not a gift tax on transfers during life—current use of the exclusion may be the optimal strategy. But with the heightened exclusion amount seemingly safe for the next four years, and with interest rates and inflation running hot, should clients and their advisers perhaps think differently about the exclusion in 2022 than they did in 2021? On March 11, 2022, Congress passed a bipartisan $1.5 trillion spending bill that will fund the government through September. Now, with the government funded, congressional Democrats will revive efforts to enact the party’s social agenda, called the Build Back Better Act, which stalled last December primarily due to objections raised by Sen. Joe Manchin (D-W.Va.). Manchin has indicated willingness to support a bill that is narrower in scope—i.e., fewer initiatives—the costs of which are fully offset by tax increases and other revenue raisers, and the party seems to be coalescing around this structure. Most commentators believe that a slimmed-down bill will be limited to childcare, health care, and climate initiatives, and will exclude paid leave, free community college, Medicare expansion, and certain other ideas that Democrats floated in 2021.
Sen. Bernie Sanders (I-Vt.) has suggested a separate vote on each initiative, which would force lawmakers to specify the spending programs they support and those they oppose, but House Speaker Nancy Pelosi (D-Calif.), the House majority leader, recently indicated that all proposals would be part of a single bill. Sen. Chuck Schumer (D-N.Y.), the Senate majority leader, has expressed an intent to pass the legislative package late in the second quarter of 2022, which probably means June. Under current protocols, a bill generally requires 60 votes to pass in the Senate. Because the Democratic caucus essentially controls 50 votes, any bill that lacks the support of at least 10 Senate Republicans may need to be passed using an alternative procedure called “reconciliation.” When reconciliation applies, the votes of just 50 senators, with the concurrence of Vice President Kamala Harris, are necessary. But reconciliation is limited to matters relating to taxes, spending, and the debt limit. A key procedural component is that absent extraordinary circumstances, there can be just one omnibus reconciliation bill each fiscal year, which ends Sept. 30. It’s unclear how Sanders aims to introduce and pass multiple reconciliation bills before Oct. 1 without any Republican cooperation.
Whether these initiatives advance as a single bill or multiple bills may be extremely important. If there is a single, omnibus reconciliation bill that has the same price tag—approximately $1.75 trillion—as the bill that was stranded back in December, then the revenue raisers in that stalled bill presumably would be brought forward into the new one, with no need to introduce additional income or transfer tax increases. But if each initiative advances as a separate bill, as proposed by Sanders, then the cost of each such bill would need to be offset, presumably by some of the revenue raisers from the stranded bill. But what if there isn’t a perfect economic match of cost versus revenue for each bill? Could some other tax proposals that fell by the wayside in 2021—a reduction to the estate and gift tax exclusion, changes to laws governing so-called “grantor” trusts, restrictions on valuation discounts for transfer tax purposes, and the like—be revived in 2022? This possibility seems more likely if there are individual bills, rather than a single, omnibus bill.
Is the Exclusion Now Tamper-Resistant? The gift and estate tax exclusion currently stands at an inflation-adjusted $12.06 million per person or $24.12 million per couple. Under current law, the exclusion will continue to grow with inflation until 2026, when the sunset of the Tax Cuts and Jobs Act of 2017 will cause it to be halved, absent action by a future Congress. Unless the Republicans were to sweep the White House, Senate, and House of Representatives in the 2024 election, such future action seems unlikely. As shown in Display 1, we expect the exclusion amount to increase to about $13.1 million by 2025, then drop to about $6.8 million in 2026. These figures assume 3% inflation in each of the next three years. In other words, without further action, the exclusion should remain elevated for the next four years. A year ago, the estate planning community was focused on President Joe Biden’s proposal to halve the exclusion amount. Sanders proposed to reduce the exclusion even further, to $3.5 million, with only $1 million of that amount available during life. In addition, there appeared to be a very real chance that any such cut might be effective retroactively, perhaps to Jan. 1, 2021. All last year, but particularly during the early part of 2021, many attorneys prepared wealth transfer plans that would use a client’s full exclusion, but in a way that would not result in the imposition of gift tax in the event of a retroactive reduction to the exclusion amount.
Today, are we right back where we were at the beginning of 2021? Could Congress enact legislation that retroactively reduces the gift and estate tax exclusion for gifts made this year? It’s possible, but such a retroactive reduction seems unlikely for several reasons. First, the Democrats seem focused on downsizing the Build Back Better Act, not on adding provisions that could complicate already delicate negotiations. Second, the current focus appears to be on tax provisions that raise substantial revenue; a decrease to the exclusion does not seem to fall within that category. Third, a reduction to the exclusion could rankle some influential contributors to political campaigns—a concern for candidates facing tightly contested races in the fall elections. Nevertheless, there was no great hue and cry from centrists in 2021 when Biden and Sanders, among others, proposed a reduction to the exclusion amount, unlike the proposals to eliminate the step-up in income tax basis at death or to increase individual income tax brackets, which met resistance. Most Democrats don’t seem opposed to reducing the exclusion; they just may not consider it a high priority in the current climate. In sum, a retroactive reduction to the exclusion is possible but seems much less likely in 2022 than it did early in 2021.
If Exclusion Use Is No Longer a Priority, What Is? If the Democrats don’t reduce the gift and estate tax exclusion this year, they may not get the chance to do so in 2023 or 2024. Many analysts believe that the Republicans will regain control of the House of Representatives in the 2022 election, although adjustments to gerrymandered congressional districts in several states are still under review. If those analysts are correct, then it seems very unlikely that a GOP-dominated House would vote to reduce the exclusion before 2026. And even if the Democrats were to regain control of Congress in 2024, how likely is it that they would expend political capital to reduce the exclusion retroactively in 2025 when that reduction is already on track, without further action, for 2026? It seems that if the Democrats want to reduce the exclusion before 2026, they need to do that now, but it doesn’t seem to be a priority. Should estate planners concentrate their attention elsewhere? In many cases, we advise our clients to think beyond the exclusion to consider other possibilities. Three specific issues merit particular attention:
Rising interest rates. Without question, the high exclusion amount and low interest rates are key drivers of estate planning today. But the threat of a near-term reduction to the exclusion appears to be minimal, while interest rates are starting to move in a direction that is detrimental to our clients, as shown in Display 2:
When advice depends primarily on two key variables, one of which—the inflation-adjusted exclusion—is moving in our clients’ favor and the other—interest rates—to their detriment, which should you lock in first? Today, all other things being equal, consider locking down currently low interest rates. For example, a client could sell rather than give assets to an irrevocable, intentionally defective, grantor trust and take back a promissory note that bears annual interest at a rate of as little as 0.59%, the short-term applicable federal rate for February 2022. The client could forgive that debt and complete the gift at any time, if legislative developments make that step necessary. In the meantime, the client can simply keep the debt in place, assuming the growth rate of the assets sold to the irrevocable grantor trust has a high probability of exceeding the interest rate on the note.
Rising inflation. Until recently, inflation had not been a serious threat in the U.S. for nearly four decades. But the recent uptick in inflation threatens investors—and has a trickle-down effect on estate planning strategies. Here’s how:
Inflation increases the value of capital—at Bernstein, we call that amount core capital—that clients need to maintain on their personal balance sheets to meet their lifetime spending goals with a high level of confidence. Lower return expectations for both stocks and bonds exacerbate this problem.
As a result, many clients may be unable to afford a current gift of $12.06 million for the benefit of, say, children and younger descendants.
How can this risk of portfolio depletion be hedged?
One option is to give away only future growth of investments rather than the underlying investments themselves. Fortunately, the very same installment sale strategy that can lock in current interest rates also provides a hedge of sorts against future inflation. In other words, a sale has the potential to hedge both legislative risk—i.e., the risk that the exclusion amount may be reduced sooner than we expect—and inflation risk—i.e., the risk that a client may be unable safely to afford a big gift.
For married clients, a spousal lifetime access trust, or SLAT, may be a viable hedge against future inflation. In a SLAT, the grantor’s spouse is a permissible—perhaps the primary—current beneficiary of the trust. If necessary, the trustee of the SLAT could distribute assets to the beneficiary spouse, bringing assets back onto the marital balance sheet and thus giving the grantor an indirect “string” on the trust assets. Given the potential estate tax and creditor protection benefits, a SLAT arguably should be thought of as the distribution source of last resort. Note that a SLAT is not a panacea; divorce or death of the beneficiary spouse effectively would cut off the grantor’s indirect access. As a further hedge, assets could be sold to rather than given to the SLAT, providing two means of continuing access to trust assets: repayment of the grantor’s note and trust distributions to the beneficiary spouse.
Finally, the client could give the exclusion amount directly to the intended beneficiaries or to a nongrantor trust for their benefit. The client would need to retain enough core capital to meet her or his lifetime spending needs but would not need to maintain a separate reserve to satisfy annual grantor trust income tax obligations.
Basis and income tax planning. The current exclusion amount will shelter more than $24 million per couple from gift and estate tax. At that level, very few families—only about one in 1,500 or so—will have an estate tax problem in the event of a death prior to 2026. For those whose estates fall below the exclusion amount, income tax planning should take priority over estate tax planning in most cases.
Income tax planning may take priority even for the one in 1,500 families who have looming estate tax issues. Consider, for example, an older client who owns highly appreciated assets. Transferring those assets prior to death would eliminate any estate tax on future growth of those assets but also could result in the loss of a step-up in the income tax basis of those assets upon the transferor’s death. The key question for such a client is: How long will it take the transferred assets to appreciate enough so that the benefit of avoiding estate tax on the future growth will exceed the detriment of losing the step-up, not just on the future growth, but also on the built-in appreciation of the assets at the time of transfer? The lower the basis, the longer it will take for the expected estate tax savings to exceed the income tax damage done due to loss of the step-up. The expected halving of the exclusion amount in 2026 adds a complex mortality component to this analysis.
Although anticipated increases to income tax rates did not materialize in 2021, our clients remain interested in strategies that can defer or eliminate income taxes. Two such strategies stand out as we look ahead to 2022: Charitable remainder unitrust (CRUT). For holders of very-low-basis investments, potentially including interests in a closely held business, a CRUT may provide an attractive way to defer the recognition of capital gain income that a client otherwise would recognize upon sale. To implement this strategy, the client would contribute appreciated assets to the CRUT in advance of sale. At that time, the trustee would invest the cash proceeds and book the capital gain; as a charitable entity, a charitable remainder trust pays no income tax. After the sale and during the client’s lifetime, the CRUT would pay her a specified percentage of the trust assets, revalued each year. Each such payment would carry out a portion of the previously deferred capital gains tax liability to the owner on a Schedule K-1.
In many cases, the economic benefit of deferring the capital gains tax hit over one’s lifetime will greatly exceed the incidental benefit payable to charity upon the owner’s death. But as with many estate planning strategies, there are potential downsides. With any charitable remainder trust, a portion of the sale proceeds would be effectively locked-up for the client’s lifetime. Further, the strategy, if funded with S corporation stock, will negate the corporation’s subchapter S election. For businesses that are taxed as partnerships, there are a host of issues prior to sale, including the potential for unrelated business taxable income. And there is mortality risk: If the client dies shortly after the creation of the charitable remainder trust, the charity would disproportionately benefit from the strategy. Finally, deferring income taxation into the future may cause the owner to pay tax at higher marginal federal and state rates; the same may be said for deferred compensation arrangements and qualified plans. A client with a very long investment horizon stands to benefit most from deferral using a CRUT. All these benefits and risks must be identified and assessed by the client’s tax and investment advisory teams before implementing a CRUT. Private placement life insurance (PPLI). Properly structured life insurance potentially offers unique income tax benefits, including tax-free growth during the insured’s lifetime and a full step-up in basis at death, even if the insured does not then own that policy. Given these benefits, qualified purchasers and accredited investors should consider investing in certain high-returning, tax-inefficient alternatives through low-cost PPLI rather than investing directly. The potential for future tax rate increases—e.g., proposed 5% and 3% surcharges that were part of the House version of the Build Back Better Act—make investing through PPLI even more appealing. Estate planning today is as complicated as ever. Leverage your Bernstein adviser and the resources of our firm to help you quantify the wealth transfer opportunity. We will continue to monitor the progress of any tax legislation and keep you informed. As always, we are eager to work with your tax professionals to provide analysis and develop a plan that fits your individual circumstances. This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information Andrea Kushner is a senior vice president and director of the Wealth Strategies Group and is located in Bernstein’s Los Angeles office, where she works with Bernstein’s clients and their professional advisers to develop comprehensive wealth management and wealth transfer strategies. Tom Pauloski is national managing director for Wealth Strategies, the research division of Bernstein’s Private Wealth Group, where he works with private clients and their advisers on wealth transfer strategies, focusing on tax-efficient wealth management and asset allocation decisions. Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.