Rosio and Schnelker: How to prepare your estate plan for potential tax changes

By Dan Rosio and Stephen Schnelker

The estate tax has been getting a lot of press coverage lately for a variety of reasons. On one hand, some favorable changes that were enacted in 2017 are set to expire in 2025 if no action is taken. On the other hand, there are several proposed changes being discussed in Washington that would increase taxes on larger estates. With so much going on in this area of tax law, it’s a critical time to understand what your current plan is, identify how different rule changes might affect your plan if they become law and map out potential strategies that can be implemented if the laws change.

The lifetime gift exemption

Most people think that estate tax planning is only about how your assets are handled when you pass away. However, sometimes a taxpayer’s most effective estate tax strategy involves how assets are distributed during their lifetime.

A change enacted in 2017 helped to reduce the cost of distributing wealth while you’re alive by doubling the amount that an individual can transfer tax-free during their lifetime. As of Jan. 1, 2021, the exemption amount rose to $11.7 million ($23.4 million for a married couple) and it will continue to be adjusted for inflation annually. At the end of 2025, however, the provision that doubled the amount will expire. Unless there’s a legislative change, the exemption amount would be cut in half after Dec. 31, 2025.

From a tax standpoint, the incentive is clear. If it looks like your net worth in 2025 will be at a level that’s affected by the cut in the exemption amount, you can recognize significant tax savings by transferring assets via gifts during your lifetime while the current rules remain in effect.

Of course, not everything that saves you taxes is necessarily a good idea. If a significant portion of your wealth is derived from a controlling interest in an ongoing business, those whom you might want to receive the shares may not be ready to run the business. Even if they are, you need to think ahead and plan carefully to make sure that you’re ready to live a “reduced-asset” lifestyle. That’s why it’s important to plan now for this potential change at the end of 2025.

The unique dynamics of each family and business demand a customized approach to something as sensitive as the generational transfer of wealth.

Estate tax proposals

In addition to the change in the gift tax exclusion that we know will take effect unless a new law is enacted, there are several proposals under discussion that could result in increased tax bills for estates if they become law. They include increases to the estate tax rate, periodic taxation of unrealized appreciation in trust assets and limiting valuation discounts on the transfer of interests in family-owned businesses. The Biden administration included in its fiscal year 2022 revenue proposals an elimination of the income-tax-free cost basis step-up. Under the proposal, the decedent would pay tax on the unrealized gain and the beneficiary will receive a stepped-up cost basis.

It’s not clear which of these proposals, if any, will become law. What is clear, based on the amount of attention being given to these proposals, is that there is significant interest in increasing the taxation of wealth that passes through estates. When Congress focuses on raising revenue in the months ahead, it’s possible we could see significant changes in this area that will call for reevaluation and adjustment of many high-value estate plans.

Planning in an uncertain environment

So how should you go about revising your estate plan at this point given that we can’t say for sure what changes, if any, will be enacted? Well, there are certain steps that make sense under almost any circumstance. Beyond that, it’s helpful to outline some “what if” plans that might be useful if certain proposals become law. Depending on the extent of any change and the effective date of a new law, you might not have as much time as you need to consider options and modify your wealth transfer plans if you haven’t laid some groundwork ahead of time.

Strategies that will generally apply regardless of the legislative environment include:

Full utilization of the lifetime gift exemption before the end of 2025. Maybe you don’t have the kind of wealth today that will be affected if the exemption amount is cut in half in four years. However, if there’s a possibility you might have it by then, you need to start planning to transfer it now. It always takes more time than you think to meet the legal requirements involved in transferring ownership of assets for tax purposes, but that’s only one part of the equation. You also need to plan what your lifestyle would look like without those assets and prepare yourself for the change.

Focus gifts on assets likely to appreciate. The sooner you transfer capital assets that are likely to appreciate, the greater the amount of the lifetime exemption you preserve for additional transfers. This also provides potential protection in the event that proposals to end step-up basis treatment are enacted.

Obtain a business valuation. Regardless of your estate plan, in order to accomplish the transfer of privately held assets, you will likely need to have a qualified business appraisal completed. This will take advantage of valuation discounts that are available when transferring “minority interests” in closely held businesses. A business valuation will ensure the IRS reporting requirements are satisfied.

Consider transferring assets into trusts. Trusts provide a variety of ways to reduce the impact of taxes on your estate. Some of the most common trusts used in wealth transfer include:

• Grantor retained annuity trusts (GRATs) that provide a form of tax-free growth for the assets transferred into them. The GRAT can be structured so that there is little to no utilization of the grantor’s lifetime exemption. The grantor continues to pay the income taxes associated with the assets, thereby reducing amounts that remain in the estate while leaving the trust assets intact.

• Spousal lifetime access trusts (SLATs) allow for transfer of assets out of one spouse’s estate while still allowing the other to utilize them if needed.

Strategies to consider in the short term to plan for possible increases in the estate tax include:

Mapping out potential capital asset transfers. If the rules applicable to step-up basis change, you may have a short period of time to plan before the new law becomes effective. Planning ahead for these transfers could make it easier to accomplish them in a timely manner if it starts to look like this change will be enacted.

Grantor retained annuity trusts. An additional benefit of the GRAT is that it helps to manage transfers of assets during the grantor’s lifetime without triggering gift tax consequences. Depending on what changes, if any, Congress enacts, these trusts could become even more valuable to families that are looking to minimize the tax impacts of wealth transfer.

Change is inevitable

Your estate plan should be considered a “living document” as long as you are alive. Laws change, lives change and estate plans must change in order to keep pace. If you have an estate tax plan in place, the current legislative climate makes this an important time to consider how some of these potential changes could affect it. If you don’t have a plan in place, it’s time to create one that takes full advantage of the opportunities to transfer wealth during your lifetime and minimizes the impact of taxes on your estate.•

• Dan Rosio is the partner-in-charge of Katz, Sapper & Miller’s valuation services group. Stephen Schnelker is a manager in Katz, Sapper & Miller’s tax services group. Opinions expressed are those of the authors.