As the vaccine rollout continues with increased pace and we look forward with cautious optimism to a post-pandemic normality, Congress will likely shift its legislative focus beyond COVID-related measures. With Democrats in control of all three legislative branches (though by the slimmest of margins in the Senate), it is reasonable to consider potential changes to current Federal estate tax law, as well as potential planning implications that may arise. First, a little background on estate taxes and where they currently stand.
Estate Tax – Current Law
Estate Tax Defined
Often referred to as the “death tax,” the IRS officially defines the estate tax as a tax on your right to transfer property at your death. The tax is levied on fair market value of your Gross Estate at the time of your death, and not what you may have paid for the property in your estate. What is a Gross Estate? Effectively, the value of all your assets (financial and non-financial, including real estate and personal property) less any deductions. The most common deductions include debts, expenses for administration of your estate, gifts to charitable organizations, and assets transferred directly to a spouse.
For those estates subject to estate tax, any assets that incur tax will pay a 40% Federal estate tax rate.
Exemptions
All estates benefit from an exemption amount – assets valued at or below the exemption will not be subject to the Federal estate tax. In 2021, an individual can protect $11.7 million in assets from estate tax. A married couple can each protect that same $11.7 million amount, and that exemption is portable. Portability allows a surviving spouse to collect any unused exemption from the deceased spouse. Any assets passed to a spouse directly are not subject to estate tax. This is known as the “unlimited spousal exemption.” With portability (in place since 2011), a married couple can now protect $23.4 million from Federal estate tax.
Under current exemption and portability rules, roughly 2,000 estates are subject to estate tax each year - less than 0.1% of the population are paying this tax. While the estate tax law generates a meaningful share of media attention, it does not generate a significant amount of tax revenue.
It is important to note that an individual can use their exemption at her death or during her lifetime. First, each individual can make a gift of $15,000 annually to any other individual – this is called an exclusion gift. This gift is aptly named because it is excluded from any lifetime exemption considerations. Annual exclusion gifting is still a powerful and efficient tool for transferring wealth, as families can make gifts to children and/or grandchildren without using any lifetime exemption.
Large lifetime gifts to trusts and/or family members (exceeding the annual exclusion amount) will use a portion of an individual’s lifetime exemption. These gifts may not necessarily incur estate tax – if one chooses to make a large gift, a gift tax return should be filed to document any lifetime exemption used. If there is some portion of the lifetime exemption remaining, that filing is informational in nature, and there is no tax liability. Estate and/or gift tax only come into play with assets exceeding the exemption amounts, whether during one’s lifetime or at death.
Potential Changes to Estate Tax Law Under the Biden Administration
Estate Tax Exemption Reduction
The proposed Biden estate tax plan includes an approximate 50% reduction of the current estate tax exemption, meaning that $11.7M exemption would be reduced to around $5.8MM. For clients with taxable estates at or above the current exemption amounts, additional planning to utilize current exemption limits may be in order. As a note, the current exemption rules will sunset in 2026 to an amount that is roughly half the current amount. Even if the Biden administration is unsuccessful in making changes to Federal estate tax law, we’ll be looking at a decreased exemption amount in 2026, likely in the $6.5 - $7.0 million range.
Elimination of Basis Step Up
Under current law, non-retirement assets owned by an individual receive a step-up in basis at their passing. In other words, a share of stock purchased 5 years ago for $50 and now worth $100 will have a new basis of $100. The step up in basis provides a powerful “reset” for inheritors of non-retirement assets. Initial Biden estate tax plans have included an elimination of the basis step up. Such a change would likely prompt a major shift in the way we think about inherited assets with respect to estate and tax planning strategy.
Practical Implications of Proposed Changes
Lowering the estate tax exemption would cause more families to be subject to the estate tax. And families with wealth at or approaching current limits would now likely have a significant portion of their wealth subject to estate tax. Proactive planning, such as larger lifetime gifts to heirs or trusts, may be in order.
It is worth noting that permanent elimination of the step up in basis has been discussed periodically for many years. In theory, such a change would increase current tax receipts, as there would be less incentive to hold low-basis assets that would have otherwise received a step up.
While we do not advocate making wholesale changes to your estate plan in advance of potential changes in law, we do advocate proactive discussions with your Foster & Motley financial planner and your estate planning attorney. Past estate law changes have occurred late in the calendar year, leaving inadequate time to execute a thorough planning process. Making these types of changes has wide-ranging implications for each family, and advance preparation allows for better results in an uncertain legislative environment. As always, your team at Foster & Motley is here to help.