How the 2020 Environment Differs from 2012
In 2012, the only risk taxpayers contemplated was the $4 million reduction in the exemption. Thus, the focus of planning was rather narrow because individuals sought to use that as much of the $5 million exemption as they could before the end of the year. There was no certainty whether that reduction would occur, but that was the only uncertainty.
In contrast, 2020 is far more uncertain. There are three critical uncertainties at the present time:
- First, there is no certainty as to the outcome of the election. Most planning scenarios focus on a Democratic sweep. That is because unless the Democrats capture both the Senate and White House, and retain control of the House, they may not be able to pass legislation promised in the campaign. If the Democrats do not capture the Senate, for example, changes in the tax law may have less or even no impact on the wealthy.
- Next, if the Democrats sweep the election, what will they enact in terms of tax changes? A wealth tax was discussed by candidates, as have the elimination of basis stepup on death and a capital gains tax at death. Nonetheless, the presumption underlying most 2020 planning is that the proposals contained in President Obama’s Green Book and Senator Bernie Sanders’ tax bill will be the starting point for any Democratic proposal; thus, a tax bill might include a reduction in the gift exemption to $1 million and the estate and GST exemptions to $3.5 million. Discounts may be restricted or eliminated; grantor retained annuity trusts (GRAT) may be undermined (25% minimum gift and 10-year minimum term). There have also been discussions of including in the settlor’s estates assets held in grantor trusts and possibly subjecting trust assets to a GST tax periodically.
- Third, assuming the Democrats sweep the election and pass tax legislation, what might the effective date be? While there is no way to know, the presumption underlying much planning is that legislation could be effective as of January 1, 2021 so that planning needs to be completed by year end.
Given these unknowns, it seemed prudent to plan as if there may be a Democratic sweep with tax legislation enacted effective January 1, 2021. But that now seems unlikely. If there is a capital gains tax on death or a wealth tax, it is possible that shifting assets into irrevocable trusts might (or might not) avoid those taxes. Financial advisors should caution clients that at best, the planning paradigm is an educated guess, but nothing more than that. This dynamic should have led to more flexible planning with client access. That is important to the decisions as to what to do now.
Interest rates are another factor differentiating 2012 from 2020. Rates are substantially lower today than they were in 2012. In October 2012, the long-term applicable federal rate (AFR) was 2.36%; in October 2020, the long-term AFR is 1.12%.
Some values remain depressed in the current environment because of the coronavirus (COVID-19) pandemic. Other assets, such as large tech companies, are at all-time highs. The valuation variations, and in many cases lower values, may be temporary; these valuation considerations were not prevalent in 2012. It can be dangerous to make assumptions in 2020 about valuations and the impact on planning before understanding the unique nuances of the particular asset.
Finally, an obvious but significant difference between 2012 and 2020 was the magnitude of the potential decline in the exemption amount. In 2012, the concern was that the exemption might drop from $5 million to $1 million. In 2020, the concern was that the gift exemption might drop from $11.58 million to $1 million and that the estate exemption might drop from $11.58 million to $3.5 million. Not only was the magnitude of possible decline much greater, but the numbers are also much larger in absolute terms. This raised potentially significantly greater issues today of individuals stretching to gift away more of their estates and the risks attendant to those large transfers (e.g., not retaining sufficient assets for living expenses, fraudulent conveyance concerns). As of press time, these changes seem unlikely. Clients that were stretching to use more exemption might benefit from completing the planning, but cutting back the magnitude of assets transferred.
In 2012, the sole goal was to use exemption before it may drop in 2013; in 2020, the planning goals were more complex. Most focus had been placed on using an exemption before it declines. But in 2020, individuals need to be conscious of GRAT restrictions eliminating the ability to roll or cascade GRATs after 2020. Discounts may be eliminated. A wealth tax might be an issue. This was a far more complex planning environment, which leads to planning advice that could be very different from 2012.
In 2012, if an individual was only willing to part with a $1 million gift, planning likely would not have made sense, as that would not have used and preserved any more exemption then doing nothing, even if the exemption had dropped to $1 million in 2013. What about 2020? Solely from the perspective of preserving the exemption, that construct is similar. Unless an individual is willing to gift more than $3.5 million, she may not preserve more exemption then doing nothing. If the exemption drops to $3.5 million, a gift of that amount superficially may accomplish nothing. But that is not a sufficient analysis and does not consider the more complex 2020 environment. Understanding clients’ initial motives and goals for 2020 planning is vital to assessing what remains appropriate after the election.
If a wealth tax or capital gains tax on death were enacted, shifting assets to an irrevocable trust in 2020, perhaps before the effective date of any such legislation, might avoid a capital gains tax on death or even an annual wealth tax. If new legislation taxes all trusts periodically (e.g. every 25 years) with a GST tax, or if grantor trust assets are included in the settlor’s estate, what will become of grandfathering? If trusts created before January 1, 2021 are grandfathered and hence exempted from harsh new legislation, it would be advantageous to create a GST exempt, dynastic, grantor trust right now, even if the gift transfer is modest in size; this is something that many have not considered. Extending this concept one step further, wealthy individuals should consider means to help their heirs create and fund similar trusts so that those heirs might also have a grandfathered GST exempt grantor trust to serve in the future as the foundation of their own planning. This too is very different from 2012. This type of planning may not be worth completing, or at least not yet.
2020 Planning Considerations
For most individuals, the single most important word in 2020 planning will be “access.” Transferring potentially $11.58 million (more than $23 million for married couples) may require that access be preserved to avoid the buyer’s remorse that was too common with 2012 planning that entailed gifts to descendants without access. How much wealth must a client have to sustain such transfers and yet have adequate resources to support themselves? The result is that spousal lifetime access trusts (SLAT), self-settled domestic asset protection trusts (DAPT), hybrid DAPTs, special power of appointment trusts (SPAT), and similar techniques should all be considered. Too often in 2012, transfers were made to descendants or trusts for only descendants. This is substantially different than 2012. Financial advisors should educate clients to avoid repeating the same mistakes. Now that the election results suggest these changes are less likely, it may be advisable to complete one SLAT in 2020 and defer the second spouse’s SLAT to 2021 to reduce the risk of a reciprocal trust doctrine attack.
Low interest rates make intra-family loans, GRATs, and note sale transactions more valuable today. However, there is a potential danger in the lower rate environment. There has, for example, been significant discussion in the professional literature about family loans and GRATs, but neither of those techniques secures the exemption. Professionals should be cautious of clients requesting these techniques if they are not appropriate. If an individual has a significant unused exemption, it may be preferable to plan to use and secure that exemption. Family loans, note sales, and GRATs might be best preserved for wealthier individuals who have already used their exemptions and wish to consummate additional planning. This planning might still make sense, but should re-evaluated.
GRATs are popular because of low interest rates, but 2020 GRATs may need to be structured differently than GRATs in prior years. Why? If there is a Democratic sweep, GRATs may not be feasible after 2020. So the typical application of GRATs as 2-year rolling or cascading GRATs may not be feasible; longer-term GRATs (e.g., 6, 8, or 12 years) might make more sense. Planners should address the mortality risk that using such different types of GRATs brings.
How Practitioners Might Protect Themselves
Given the large dollar values that may still be transferred in 2020—much larger than in 2012—financial planners should encourage clients to complete due diligence before any transfers to proactively deflect a future claim by a creditor that the transfer was a fraudulent conveyance, or a claim by the IRS that the donor had an implied agreement with the trustee to access the trust. This might include a full balance sheet with reasonable estimations of current values, a cash flow analysis, and even a financial forecast with an evaluation of the adequacy of insurance coverage. Advisors should apprise clients of the incredible uncertainty of the tax environment. There is no way to know what will occur.
There is also substantial risk with many, if not all, planning techniques. Clients should be informed of, and accept, those risks. It should not, for example, fall upon the professional’s liability that a New York court may not respect a domestic asset protection trust (DAPT) the client created in Delaware in order to provide more access to assets. If an individual wants the additional access to trust assets that a self-settled trust provides, in contrast to what a spousal lifetime access trust (SLAT) provides, that comes at a cost of increased risk. That risk cannot be measured; while some assume SLATs are assured, this is not the case. If there is prefunding retitling of assets from one spouse to another, the IRS may attack the plan using a step-transaction doctrine. If each spouse creates a SLAT for the other, the reciprocal trust doctrine could unravel the plan. Even if the planning is properly implemented, there are myriad ways that improper administration of the trusts can unravel the plan; often, those steps are taken by individuals without professional guidance.
Lessons Learned about Client Selection
Finally, estate planner should consider the lessons learned in 2012, when many new clients poured into professionals’ offices to do planning before a potential drop in the exemption. Advisors should be certain to ask questions and vet potential new clients before accepting them. Is the client sophisticated enough to undertake the planning involved? Does the client have realistic expectations of the risks? Is the client looking to the practitioner to guarantee the plan’s success? Does the client have reasonable expectations as to the impact the planning might have on future finances? Does the client understand that he (or his spouse) will have to request distributions from a trustee and will not merely be able write a check anytime they want? Does the client understand that proper administration of the plan is essential to success? Will the client commit to future annual meetings to review and maintain the plan?
This author’s informal discussions with colleagues suggest that a majority of new clients in 2012 never came back after the initial planning was completed. As the crush of 2020 planning grows more challenging, considering the greater risks and much greater uncertainties over 2020 planning, advisors should consider evaluating which clients to accept with a longer-term relationship in mind. If a client is unwilling to commit to return to maintain a plan, or if the client has unrealistic views of what planning entails, then perhaps that client might be rejected. Advisors should help clients evaluate any planning in process in light of the final election results and determine whether it should continue (which in many cases it should for asset protection benefits and as a step to address the scheduled decline in the exemption in 2026). But the new political results must be factored into the decision.