Introduction

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced major changes to the tax system, including an approximate doubling of the unified lifetime exemption of assets that can be passed to recipients free from gift and estate taxes. The unified lifetime exemption for 2017 was $5,490,000 per taxpayer, meaning that an individual could make gifts during life, pass assets at death, or some combination of both to the extent of $5,490,000 without paying any gift or estate taxes. The $490,000 excess above $5,000,000 is the result of annual indexing for inflation since 2010 when Congress set the base exemption value at $5,000,000.

Effective as of 2018, the base exemption value is now doubled; it is indexed for inflation as though Congress had set the 2010 amount at $10,000,000 rather than $5,000,000. This resulted in a unified lifetime exemption of $11,400,000 in 2019 and $11,580,000 in 2020. Importantly, the current doubled base exemption value of $10,000,000 is slated to “sunset,” meaning that it will revert to $5,000,000 effective January 1, 2026, unless Congress acts to extend current law. Regardless, the unified lifetime exemption will continue to be indexed for inflation.

The magnitude of the newly-doubled base exemption value and its potential reversion in 2026 has major implications for estate plans. This article will explore those implications and the need for specifically tailored plans for three differently situated U.S. citizen taxpayers: very wealthy Sally Supper ($20+ million net worth), moderately wealthy Debbie Diner ($10 million), and modestly wealthy Bob Banquet ($3 million). For the sake of brevity, this article presents a high-level overview that cannot address all the complexities of gift and estate planning. Please contact your LBMC tax professional to address your specific planning needs and opportunities.

Exclusions and the Unified Gift and Estate Tax Exemption

As discussed above, each taxpayer is entitled to give away one unified lifetime exemption amount whether during life or at death. This amount is distinct from the so-called “annual exclusion,” a separate right to gift assets up to a certain dollar amount each year to as many people as one wishes. Like the unified lifetime exemption, the annual exclusion amount is adjusted annually to account for inflation. For both 2019 and 2020, the annual exclusion amount is $15,000. Annual exclusion gifts need not be cash; the limit is $15,000 of value regardless of the kind of property the donor gives away.

There are also two types of unlimited gift exclusions: certain tuition payments and certain medical payments. It is critical to note that both types of gifts must be made through direct payments to the applicable educational institution or medical service provider. For example, a grandfather would not be able to exclude the $30,000 he pays for his granddaughter’s college tuition if he makes the check out to his granddaughter rather than directly to her university. Tuition payments are defined narrowly. Though this exception has been extended to cover the entire educational process from kindergarten to graduate school (as well as many vocational programs), the exception generally does not apply to the costs of books, lodging, and other education-related expenses. On the other hand, the definition of medical payments is quite broad; it encompasses a range from doctor visit fees to long-term care costs to health insurance premiums. One major category of medical expenses not eligible for the exclusion is payments made for purely cosmetic plastic surgery.

Here is an example involving both unlimited exclusions, the annual exclusion, and the unified lifetime exemption, assuming that Sally Supper has made no past gifts. In January 2020, Sally pays her nephew’s $10,000 fourth grade spring tuition directly to his private school and pays a $250 doctor bill directly to his pediatrician. In February 2020, she makes cash gifts of $15,000 each to her only daughter and a family friend. Finally, in March 2020, Sally gives her daughter Apple stock valued at $10,000,000 on the date of transfer.

None of these gifts would trigger gift tax for Sally. First, the direct payments of tuition and medical expense fall under unlimited exclusions. Second, both cash gifts are tax-free due to the annual exclusion of $15,000 per donee. Finally, Sally’s gift of Apple stock to her daughter would use $10,000,000 of Sally’s unified lifetime exemption amount, $11,580,000 in 2020. Upon Sally’s death in December 2020, Sally’s estate would be exempt from estate tax on the first $1,580,000 of remaining assets. Thereafter, a flat estate tax rate of 40% would apply.

An additional benefit applies to married couples. Such couples can take advantage of so-called ‘portability,’ by which the first spouse to die leaves any remaining unused exemption for the surviving spouse to use. The executor of the estate for the first-to-die spouse qualifies the surviving spouse for portability by checking a box on the timely filed estate tax return Form 706 for the first-to-die spouse. No further action is required.

Traditional Estate Planning

The conventional estate planning wisdom has been to use various techniques to “get assets out of the estate.” Commonly, wealthy taxpayers have frozen the value of appreciating assets by making current gifts. This was particularly so when the unified lifetime exemption was lower.

Just over a decade ago, the unified lifetime exemption was only $2,000,000, less than one-fifth of the current amount. At that time, rather than waiting five years for $2,000,000 of Nike stock to appreciate to $3,000,000, a taxpayer would make an immediate gift, thereby freezing the gift value at $2,000,000 and potentially avoiding estate tax liability on the additional $1,000,000 in appreciation.

The Importance of the Basis Step-up

The vast majority of Americans hold considerably less than the 2020 unified exemption amount of $11,580,000 in assets. Under current law, these taxpayers will likely never pay the federal government a dime in gift or estate taxes. However, income taxes remain in full effect. Thus, it is vitally important to consider minimizing income taxes by leveraging the so-called ‘basis step-up,’ which adjusts the basis of a decedent’s assets to fair market value measured typically as of the date of death.

When a donor makes a gift during life, the donor’s basis in the gift carries over to the gift recipient. On the other hand, when an asset passes through a decedent’s estate, the recipient takes the property with a new, ‘stepped-up’ basis. For example, say single taxpayer Bob Banquet buys a rental property for $50,000 in 2018. Assume Bob makes two gifts to his son in 2019: a cash gift of $15,000 and a gift of the rental property when its value has increased to $70,000. The $15,000 gift would not use any unified lifetime exemption, because it would be covered by the annual exclusion. Thus, Bob has made a taxable gift of only $70,000, the fair market value of the rental property. Bob’s son takes Bob’s $50,000 basis in the rental property. If the son turns around and sells the property one year later for $80,000, the son will owe capital gain income taxes on $30,000.

Alternatively, assume the same facts except that Bob is aware that his roughly $3,000,000 estate will incur no estate tax. Thus, he decides to leave the rental property to his son by will rather than gifting it during life. Upon Bob’s death in 2020, Bob’s son would inherit the property with a basis equal to the fair market value as of the time of Bob’s death, $80,000. If Bob’s son is in the top tax bracket and subject to the net investment income tax, the basis step-up will save Bob’s son $7,140 (23.8% of $30,000).

It is important to note that the so-called ‘step up’ in basis can also be a ‘step down.’ That is, if Bob had bought the $50,000 rental property in 2018 but the value dropped to $40,000 at the time of his death, Bob’s son would inherit the property with a basis of $40,000. In these circumstances, the more effective tax strategy is for Bob to sell the rental property and gift the proceeds, taking advantage of the $10,000 capital loss that would otherwise disappear.

An Illustration: Different Net Worths Call for Different Estate Plans

To further illustrate the way in which tax focal points should vary depending on clients’ different net worth situations, let’s compare the very wealthy Sally Supper and the more modest Bob Banquet. Recall that Sally made a taxable gift of $10,000,000 of Apple stock to her daughter. Her only other assets are a house worth $2,000,000 and a brokerage account with $20,000,000 of marketable securities. On the other hand, Bob Banquet’s only taxable gift was a rental property valued at $70,000. Bob’s other assets are his primary residence worth $1,000,000 (with an identical basis) and $2,000,000 of marketable securities (with a total basis of $500,000).

The key planning goal for Sally is to avoid gift and estate taxes. Given that she has used $10,000,000 of her 2020 $11,580,000 exemption, Sally’s estate would owe a 40% flat estate tax on all but $1,580,000 of her remaining $22,000,000 estate if she were to die today. Because the 40% gift and estate tax rate is nearly double the highest long-term capital gain income tax rate of 23.8%, Sally should prioritize preventing an additional dollar from passing through her estate (cost: 40 cents) rather than avoiding her beneficiaries having to pay capital gain income taxes on an additional dollar of built-in appreciation due to the basis carryover (cost: 23.8 cents). Sally should consult an estate planner about strategies to freeze the value of her estate and to transfer additional value without incurring gift tax liability.

On the other hand, given the modest size of his estate, Bob’s most important planning goal is to avoid income taxes. Of course, it is also vital for Bob to keep sufficient assets to be able to maintain his lifestyle in retirement. Fortunately, both of these factors favor Bob choosing to retain his assets during life, letting them pass at death according to the terms of his will. Under the facts above, Bob has used only $70,000 of his 2020 $11,580,000 unified lifetime exemption. If he were to die in 2020, he could pass his entire $3,000,000 estate to his son without any gift or estate tax liability. The 40% gift and estate tax rate is simply inapplicable. However, by leaving the securities in his estate rather than gifting them during life, the son benefits from the step-up in basis in the securities from $500,000 to $2,000,000, avoiding up to 23.8% in capital gain income taxes on $1,500,000 of appreciation.

The Doubled Unified Exemption: Sunset in 2026?

The best courses of action for Sally Supper and Bob Banquet depend both upon tax rates and the current unified gift and estate tax exemption. Recall that the current doubled exemption base amount of $10,000,000 per taxpayer is slated to ‘sunset’ back to its former $5,000,000 level at the beginning of 2026. It is also possible that 2026 doubled exemption sunset will not happen. In fact, this exact scenario unfolded at the end of 2012 when Congress passed legislation to prevent a sunset, rendering permanent an expansion of the unified exemption base amount under the Tax Relief Act of 2010 from $1,000,000 to $5,000,000. Regardless, the exemption base amount will still be indexed for inflation, so it is likely that should the sunset occur, the 2026 unified exemption amount will exceed $6,000,000 per taxpayer.

Whether the sunset occurs is likely immaterial to Bob, since his net worth of $3,000,000 would not be large enough to trigger any estate tax under either scenario. However, the potential sunset amplifies the importance of Sally taking advantage of the doubled exemption base amount by December 31, 2025. Specifically, assume that annual inflation adjustments raise the 2020 $11,580,000 unified lifetime exemption to $13,000,000 in 2025. Ahead of the sunset on January 1, 2026, Sally will want to be sure she has gifted $13,000,000. Otherwise, if the sunset occurs, Sally will lose the ability to make gifts free from gift and estate tax on half that amount.

The IRS has indicated that it will not attempt a so-called ‘clawback:’ imposing gift and estate taxes retroactively to gifts made between 2018 and 2025. In other words, assuming inflation adjustments bring the 2025 unified lifetime exemption to $13,000,000, Sally can rest assured she can make a $3 million gift in 2025 in addition to the $10 million gift of Apple shares she has already made without the IRS attempting to impose gift or estate taxes on that $3 million gift in 2026 when the exemption base amount is cut in half.

Planning for the Possible Sunset

The uncertain future of the unified lifetime exemption amount has limited impact on Bob Banquet; he will still need to prioritize minimizing income taxes regardless of the sunset. On the other hand, Sally Supper will certainly want to act to gift high-basis assets before the sunset. But consider the situation of our third taxpayer, Debbie Diner. Debbie has a net worth of $10,000,000, placing her in the ‘bubble’ range between the single and double base exemption amounts.

If new legislation makes the doubled exemption permanent, the assumed 2025 inflation-adjusted unified lifetime exemption of $13,000,000 will fully cover Debbie’s estate. Thus, she would share Bob’s focus on minimizing income taxes, gifting high-basis assets such as cash as desired while retaining low-basis assets in her estate to benefit from the basis step-up. However, if no legislation is passed before 2026 to prevent the sunset, Debbie’s unified lifetime exemption will be cut in half to an assumed $6,500,000. Debbie needs a flexible plan in place by 2025 to be prepared to swiftly transfer additional amounts as desired before the sunset.

In addition to helping clients to achieve traditional estate planning goals such as asset protection and providing for chosen beneficiaries, estate planning professionals can minimize tax consequences in light of the potential sunset by tailoring flexible estate plans based on individual clients’ needs.