Election Season, Exemption Sunset and Planning with US Assets
Updated: Mar 29, 2020
By: William Bricker, Juliya Ismailov and Daniel King
With the 2020 US presidential election season upon us, the million-dollar question for estate planners is whether a new administration—incumbent Republican or new-broom Democrat—will, in the case of the former, extend the higher exemption and/or make it permanent, or, in the latter case, allow the higher exemption to “sunset” and return to the pre-2018 level, or lower it even further.
The Tax Cuts and Jobs Act of 2017 (“TCJA”) was signed into law by President Trump on December 22, 2017 and became effective January 1, 2018. It made extensive changes to the US tax law impacting transfer taxes by domestic and certain foreign individuals. Most notably, it doubled the lifetime gift and estate exemption for US citizens and resident aliens[i] (hereinafter, each a “US person” and collectively “US persons”).
US Transfer Tax System
The US tax code imposes a tax on the transfer by a US person of any property (“real or personal, tangible or intangible, wherever situated”) while living (gift tax) or at death (estate tax).[ii] (Credit for estate taxes paid by a US person for property situated in a foreign jurisdiction may be available for estates of US persons.)
Property typically would include a residence, investment accounts, as well as personal property such as household furnishings and jewelry. Property that is not owned directly in an individual’s name may also be included in his or her estate if it was transferred to a trust that the individual has a right to revoke, or over which he or she has retained certain powers.
The less obvious examples of property ownership for purposes of the US transfer tax system include joint tenancy with the right of survivorship (even if the decedent did not financially contribute to acquire the asset); “incidents of ownership” obtained through the right to, for example, designate a beneficiary in an insurance policy held on the individual’s life (even though the insurance proceeds are not payable to such individual’s estate), or direct distributions to oneself as a trust beneficiary. There are also limited rules that “pull back” into a decedent’s estate gifts or proceeds of an insurance policy transferred within three (3) years of death.
A non-US person is subject to US transfer taxes only on any property situated in the United States (also known as “US situs” assets or property), such as US real estate. Note that while shares of a US company owned by a non-US person at death are US situs property subject to US estate tax, US gift tax on transfers of such shares by a non-US person during life only applies to US situs tangible property. Since shares of a US corporation are intangible property, a planning opportunity exists for a non-US person to transfer US shares out of his or her estate to avoid US estate tax on such assets at death.
The maximum federal transfer tax rate is 40% on either a gift during life or estate transfers at death. Gift tax is generally applied against the value of the gift after reduction by any applicable discounts and annual exclusion amounts. The federal estate tax is calculated on the value of the aggregate property owned by the decedent at death, net of deductions for estate administration, such as funeral expenses, and debts of the estate, as well as marital and charitable deductions. State death taxes are also deducted from the total value of the estate.[iii]
The following table summarizes the current exemption amounts available for transfers made by US and non-US persons:
1. In 2020, a US person has a lifetime combined gift and estate tax exemption of $11.58 million. Thus, a US person can transfer up $11.58 million to one or more persons, during his or her life or at death, without incurring a US transfer tax.
2. Furthermore, a person (US and non-US) may transfer, during life or at death, unlimited amounts to a US spouse tax-free.
3. There is no unlimited exemption for transfers to a non-US spouse. The annual exclusion for gifts to a non-resident spouse is $157,000 per year (as of 2020, indexed for inflation).
4. A US or non-US person may gift $15,000 annually to any person gift tax free without using up any of his or her lifetime transfer tax exemption.
5. Other than the annual exclusions described above, a non-US person is not entitled to any gift tax exemption during life and is entitled to a $60,000 estate tax exemption at death.
TCJA Increase to the Lifetime Exemption for US Persons
The estate tax exemption has been increasing steadily for decades: from $1 million in 2002 and $5 million in 2012, to $10 million since 2018 (annually indexed for inflation). But, this large jump in the estate tax exemption amount under the TCJA is not permanent. It is scheduled to “sunset” and revert back to the 2017 level of $5 million (indexed for inflation) in 2026. While there is speculation about whether the exemption may be made permanent closer to 2026 to prevent the scheduled reversal, estate planners are urging clients to gift now and take advantage of the doubled exemption during this limited window of opportunity.
In fact, the IRS confirmed in late 2018 in proposed regulations that there will be no “claw back” of the unified exemption for a decedent dying after 2025, if at such time the exemption reverts to $5 million (indexed for inflation). This means that any gifts made between years 2018 and 2025 using more than the exemption amount in place after year 2025 (assuming it is lower than the 2018-2025 exemption) will not be taxed retroactively. In other words, the US government has confirmed it will not penalize such gifts made during the higher-exemption period, essentially handing a two-for-one deal that will not last to wealthy Americans.
Estate Tax for Non-US Persons
The TCJA estate tax changes (and proposals) do not apply to non-US persons, even though these individuals are subject to US gift and estate taxes whenever they: (i) make lifetime gifts of US situs (tangible) assets, or (ii) die owning US situs tangible and intangible assets.
As discussed above, the $60,000 estate tax exemption available to non-US persons at death is nowhere near the millions of dollars available to a US person and is unaffected by the 2017 legislation. And while non-US persons are entitled to the annual gift exclusion of, as of 2020, $15,000 per beneficiary (and increased annual exclusion on transfers to non-US spouses), there is no lifetime gift tax exemption available to them.
That said, since gifts by non-US persons of US situs intangible assets (e.g., stock of a US corporation) are not subject to the US gift tax, a non-US person who acquires US situs assets through a US corporation can gift such shares to remove them from his or her US estate.
For some non-US persons, it may be possible to further gift such intangible assets tax-free to a trust for the benefit of descendants who may now or in the future become US persons. Since such descendants would then be subject to the US transfer tax regime on any assets held in their own name, a non-US parent or grandparent can plan ahead and move the assets to a trust and out of such descendants’ future estate.
Finally, for US persons, as for their foreign compatriots, a layered entity-and-trust structure can help further leverage the currently large lifetime exemption (for some wealthy estate holders, it is not large enough) by gifting certain restricted entity ownership rights at up to a 30% discount.
We frequently advise our foreign clients on all of these issues.
The Election and the Next Five Years
Democratic front runners, Senators Bernie Sanders and Elizabeth Warren, and, as of lately former New York City mayor Mike Bloomberg, of the current 2020 US presidential election are proposing dramatic tax overhauls with major consequences for wealthy estates. These plans focus on: (1) the introduction of an annual “wealth tax” (by Sanders and Warren), and (2) decreasing the current estate tax exemption (by all 3 candidates).
Warren plans to roll back the TCJA, and specifically restore the previous transfer tax exemption of $5 million (indexed for inflation). Sanders plans to lower the exemption even further to $3.5 million and would increase the current 40% maximum tax rate to a staggering 77% for estates valued at over $1 billion.
In Bloomberg’s recent tax reform proposal, he proposes to lower the estate tax exemption, but does not specify the amount of the lower exemption. Furthermore, he plans to eliminate income tax savings for capital assets held in someone’s estate at death. The savings currently result from a step-up in basis to the asset’s value as of the decedent’s date of death, thus wiping out, in a subsequent sale, any taxable gain accumulated through such date.
In light of the potential adverse consequences of the 2020 election for US persons, it is even more imperative for large estate holders to act quickly and make tax-efficient trust transfers for the benefit of the next generation.
But even if the current gift and estate exemption avoids immediate post-election casualty and remain secure through 2025, the time to start thinking about this planning is now. For both US and non-US persons who would benefit from the layered entity-and-trust structure, it can take some time to set it up, especially as the quicksand of our daily lives makes the next 5 years fly by in the blink of an eye.
[i] For US transfer tax purposes, a foreign person is a “resident alien” if he or she is domiciled in the US, which means that he or she intends to return to his or her US home whenever absent.
[ii] A generation-skipping transfer (GST) tax also applies to certain gifts that skip a generation, including to GST trusts, for which a matching lifetime exemption is available (in 2020, $11.58 million), but this concept is outside the scope of this article.
[iii] Only Connecticut imposes and enforces a tax on gifts (Minnesota no longer enforces its gift tax). Some 15 states (including Connecticut, New Jersey and New York) and the District of Columbia impose an estate and/or inheritance tax ranging from 16% to 20% maximum rates. The tax generally applies if the decedent was domiciled in the state or owned real estate property there.