2021 Gifts – Buyer beware of the risk of retroactivity


Authored by RSM US LLP

The Tax Cuts and Jobs Act (TCJA) in 2017 doubled the estate and gift tax exemption to approximately $11 million per spouse. Without an intervening change in law, this amount is set to sunset on Dec. 31, 2025. With the Democrats now holding the White House and having the majority of votes in the House and Senate, many taxpayers and advisors are concerned that the increased exemptions will change prior to their scheduled sunset date. Other potential estate and gift tax legislative changes taxpayers are most concerned about include increases in rates and the elimination of the basis adjustment upon death. If these changes do occur, the next concern is when they would be effective. If the changes are retroactive to Jan. 1, 2021, planning done today could cause undesired tax consequences, so if you are still considering gifting your assets, time could be of the essence. 

Generally, new laws require 60 votes in the Senate, but a new tax law could be passed under budget reconciliation with only 51 votes. Simply counting votes by affiliation would appear as if the administration and Democrats in Congress have a blank check; however, there are many other factors at play that will impact major estate and gift tax legislation. With tight margins in both the House and the Senate, moderate Democrats will have a great deal of control and can’t be ignored. This will likely lead to some moderation in any passed legislation.

Until the new law is passed, nobody knows the changes with certainty. Democrats have hinted that they are looking for ways to increase tax revenue and they have signaled that they are looking at the gift and estate tax provisions of the tax law. Many of these proposed tax law changes have been around for several years and several were published as recommendations by the Department of the Treasury in 2016, during the Obama administration. Thus, the current estate and gift tax law is most likely more favorable now than it will be in the future.

This article will discuss the benefits of gifting assets as well as provisions and techniques that may expire.  It will conclude with ways to hedge against retroactivity.

Generally speaking, why gift?

You may think that your heirs will simply receive your assets once you die; however, the largest beneficiary of any sizeable estate is often the government. This may or may not be what you desire. One way to minimize your taxable estate at death is to gift assets now. A properly completed gift will remove future appreciation of an asset’s value from your taxable estate.

Why now? The current economic environment and possible increases in gift and estate tax

Economic environment

Due to COVID-19 and the current economic crisis, you may have assets with temporarily depressed values. Consequently, you may be able to transfer a larger portion of your assets without paying taxes. Additionally, some gifts are valued based upon the current interest rates. Interest rates are at historically low levels. Many of the key March 2021 interest rates are less than one percent, but we are seeing them start to climb.

Estate and gift tax exemption

The exemption is the amount you can transfer during your lifetime, or the amount that can be transferred to your heirs upon death, before the transfers are subject to gift or estate tax. When TCJA was passed, there was a lot of political debate and it was decided that the estate and gift exemption would temporarily increase and sunset on Dec. 31, 2025. The lifetime exclusion for 2020 was $11,580,000 per donor and for 2021, under current law, it is $11,700,000 per donor. There is discussion surrounding a possible reduction in the exemption amount. Thus, if you have a home in a more expensive city or substantial amounts in retirement funds, you may hit this limit quickly.

There is also an annual exclusion for gifts made to individuals who have a current unrestricted access to the gift. Currently, the annual exclusion is $15,000 per donee. This means that you can make gift up to this exclusion without using any of your lifetime estate and gift tax exemption. There are additional unlimited exclusions for payments directly to medical and education institutions.

Loss of the basis step up

It would be straight forward if the tax rates were simply increased or the estate and gift exemption was  decreased. However, there are other less direct ways to increase estate and gift tax revenue. Under the current tax law, most assets receive a step-up in basis upon the death of the owner. For example, when heirs inherit a house, their basis is the fair market value of the home on the decedent’s date of death, not the decedent’s basis. Think about houses that were purchased in 1950 for $50,000 and are now valued at $3 million or Google stock purchased at its IPO. This step up allows heirs to sell inherited assets without recognizing any pre-death gain. Prior to his election, Biden proposed a plan to eliminate this step up in basis. Under today’s tax law capital gains receive a preferential tax rate. The Biden plan also proposed to eliminate these preferential capital gains tax rates for individuals with income in excess of $1 million. Thus, the new proposal would potentially tax a larger piece of the inherited asset at higher tax rates.

Elimination of discounting

Another indirect avenue to raise taxes is to limit the availability of valuation discounts for closely held entity interests. The idea of a valuation discount is that when one person or entity owns the asset, he or she is able to make decisions faster and with less restrictions. With fractional ownership no one individual can drive decisions thus decreasing the amount someone would pay for that interest. For example, the total value of a building owned by one person is more valuable than a 20 percent interest in an entity owning the same building. In this case, valuation experts may consider a discount for lack of control and/or lack of marketability according to the standards of that industry.

There were proposed regulations to limit the availability of valuation discounts during the Obama administration. The Trump administration withdrew the regulation package and there is a concern that the Biden administration could again issue proposed regulations curtailing the ability to use valuation discounts. 

What if there is a retroactive change in law?

While there exists a risk that lawmakers will change the existing law and make it effective retroactively or effective on a date other than the beginning of next year, it still may be advantageous to make transfers now and risk retroactivity. If you have concerns about the unforeseen tax consequences of retroactivity there are several ways to make transfers while hedging against this risk. 

Disclaimers and marital trusts

For a gift to be considered completed, the donor has to give up dominion and control over the asset transferred. It cannot be contingent on other events or revocable by the donor. One technique would be a gift to a carefully designed trust permitting the use of a qualified disclaimer to undo the gift.

The trust agreement could provide that if the disclaimer is executed, the assets will revert to the donor. In order to avoid any adverse gift tax consequences, the disclaimer must be qualified. Under a qualified disclaimer, the beneficiary has nine months to disclaim the gift and must not take possession or receive any benefits from the gift. If the gift was made early in the year, the beneficiary would have almost the entire year to disclaim the gift and for the assets to revert back to the donor. Note, this places the burden and power in the hands of the beneficiary to undo the gift.

The trust also could be potentially structured so that the trustee would be the party executing the disclaimer. However, this raises potential fiduciary issues that would need to be considered i.e. a trustee would typically not refuse to keep assets transferred to the trust which are intended to benefit the beneficiaries.

Marital trusts

Marital trusts are typically structured so that a qualified terminable interest property (QTIP) election can be made by the donor. Often these trusts are funded as part of the estate administrative process, but the election can also be made for a trust during the donor’s life where the surviving spouse is the beneficiary. This election requires income be distributed, at least annually, to the spouse, and the spouse can be the only beneficiary of the trust during his or her lifetime. The assets of the trust will be included in the spouse’s estate upon his or her death. The election is made by the donor on his or her annual gift tax return, due three and a half months after the end of the year (or due within nine and a half months if an extension is requested).

Staying with our risk mitigation theme, one option would be to set up a trust that qualifies for the QTIP election. If the estate exemption decreases and there is retroactivity, the donor can make the QTIP election on their gift tax return qualifying the trust for the unlimited marital deduction. If the QTIP election is not made, the assets would not qualify for the marital deduction and would use the donor’s lifetime exemption. Another possible play on this would be to design the provision regarding the spouse being the sole beneficiary and the mandatory income distributions to the spouse dependent on whether the donor makes the QTIP election. This would preserve the income in the trust and permit distributions to additional beneficiaries if the donor does not make the QTIP election. This hedge against retroactivity gives the donor until the filing of the gift tax return to make decisions about the taxability of the gift today.

Life insurance or insurance related to a contingent tax liability

Another option is to purchase a term life insurance policy for the amount of the potential gift tax liability. If the law does not change retroactively, the policy can be cancelled. If the law does change and the donor dies during the year, the policy can be used to pay the tax. The donor also has the option to continue the policy and maintain the benefit for their estate.

Another option is to purchase insurance for a contingent tax liability which would mature as a result of a retroactive change resulting in a gift tax liability.

Installment sale and loan forgiveness

Another opportunity using an existing technique would be a sale to a grantor trust. In this technique the sale is between the donor and a trust structured such that the trust is treated as a grantor trust and the income generated in the trust is taxed to the grantor, who is also the donor. Income and deductions generated on transactions between the trust and the donor are disregarded for tax purposes. This means that any gain on the sale as well as any interest income or expense on the installment note will be disregarded for income tax purposes. The tradeoff is the asset will be held within the trust at the donor’s tax basis and the trust will not receive a new tax basis in the asset at the donor’s death.

This technique would allow the donor to expeditiously forgive the note prior to any law changes. That forgiveness would be a gift on the date it is forgiven. This would allow the donor to sell an asset that may be at a depressed value today and then forgive the note later in the year taking advantage of the large gift tax exemption. If the exemption amounts do change or the donor decides to not forgive the note, remember that interest rates are at a historic low, so this would allow a large amount to be transferred at a very low interest rate.

In summary, when considering gift and estate planning there are many non-tax considerations that come into play. It is important that you don’t jump into something today that may not be beneficial five or more years down the road; however, from a tax standpoint a gift today may make sense for you. If it does and you are concerned about potential retroactivity, there are planning techniques that can be implemented in order to protect against undesired tax consequences.