IN "GAME OF THRONES", THE FEAR WAS THAT WINTER WAS COMING
FOR MODERATELY SUCCESSFUL TAXPAYERS, THE ESTATE PLANNING FEAR MUST BE THAT "SUNSET IS COMING"
Don’t Be a Grasshopper
Named after the grasshopper in Aesop’s famous fable, who, failing to plan ahead, saved no wheat during the summer and faced starvation in the coming winter.
“Use it or Lose It” Regs to Cut Estate and Gift Tax Exemptions in Half after 2025
THE MORAL OF THIS FABLE IN 2021 IS STILL: "IF YOU FAIL TO PLAN WELL NOW, PLAN TO FAIL"
If your investments let you amass even moderate wealth, you probably cheered the Tax Cut and Jobs Act (“TCJA”) provisions that doubled Estate and Gift Tax Exclusions beginning in 2018. For many apartment owners and other clients, these provisions increased the Exclusion to $11.7 million for a single person, and $23.4 million for a married couple in 2021.
Unfortunately, the doubling was only temporary, scheduled to expire at the end of 2025. We call this scheduled expiration the “Sunset”. Now, , about two years after enactment of the TCJA, the IRS has adopted “permanent” regulations on how these Exclusions will work after 2025. These regulations are partly good news (for those who plan for SUNSET), and partly bad news (for those who "FAIL TO PLAN WELL NOW" for SUNSET!).
The good news: TO THE EXTENT that you use your doubled exemption in full before 2026, the IRS will not take it back if you die or make gifts after 2025.
But, the bad news (which we expected): IF you do not “use it” (the expanded Exclusion) before 2026, the increased exemption evaporates, unless the House, Senate and President approve an extension. And, as a result of the recent election, it looks likely that Estate and Gift tax rules will soon tighten dramatically.
No one can be certain what the law will provide in future years, but I believe that, in the current environment, as fiscal deficits grow, the odds that the expanded exclusion will be extended extension are slim. In fact, I think the risk of even further reductions in the Exclusion is greater than the likelihood that the expanded Exclusion will be extended. Senator Sanders has introduced legislation to reduce the estate tax exclusion to just $3.5 million per person, while President Biden has proposed eliminating the step-up in basis at death. Worse, while proposals to add a California estate tax have failed recently in the legislature, liberal domination of the legislature makes the addition of a California Estate Tax a real risk.]
Unfortunately, the new regulations make it clear that most partial uses of the increased exemption will not benefit your family after 2025 except to the extent they exceed the (reduced) 2026 exemption.
WHO SHOULD WORRY ABOUT THIS
Many people have been lulled into inaction by the current $11.58/23.16 million Exclusion. So, they are likely to forego planning to use the expanded Exclusion. They think that need not worry about Estate Taxes since, today, they have less than $11.58 million as a single person, or less than $23.16 million as a couple.
However, this creates two “HAZARDOUS” traps for family wealt
First, if your net worth continues to grow (as you probably hope it does), it may take you beyond the expanded Exclusion even without Sunset.
Second, many of you will live beyond 2025. If so, unless you do effective planning before 2026, the Exclusion will be cut in half, exposing your estate to unnecessary Estate, Gift and/or Generation Skipping Taxes!
PRUDENT INVESTORS NEED TO CALCULATE THE RISK OF ESTATE TAX EXPOSU BOTH WITH AND WITHOUT SUNSET
Remember, if your estate grows at a compounded rate of 4.5% per annum, it will increase by about 50% in ten years, and double in about 16 years. A woman age 75 has a 50% statistical chance to survive more than ten years, while those with more wealth probably have an even better chance due to lifestyle advantages.
I believe that most of our healthy 75 year-old female clients will live long enough to double their estates at a 4.5% growth rate.
ESTIMATING YOUR RISK
The math to estimate your exposure before and after Sunset, through your life expectancy, can seem daunting.
To simplify this, I have developed a spreadsheet I call the “Estate Tax X(posure)-Ray” to do rough projections of your exposure.
The X-Ray allows for quick “what if” projections using either my assumptions, or your assumptions, regarding anticipated inflation, growth in net worth and life expectancy to calculate your family’s projected exposure. It can give you an idea of how much in Estate Tax your family can save with timely sound planning. The spreadsheet allows you to project the savings using different sets of assumptions (we can show both conservative and aggressive assumptions if you like). We have updated the X-Ray to project the effect of Democratic proposals to dramatically narrow your ability to leave property to heirs free of death taxes. Families need to take action before the effective date (which we cannot predict, but could even be earlier than the date new law is enacted) of any new legislation.
A FEW EXAMPLES
Paul Grasshopper Fails to Use Any of His Exclusion before 2026
Suppose that Paul Grasshopper, a single man, with a net worth of $10 million, figures he does not need to worry about Estate Taxes, since his net worth is almost $1.6 million below the 2020 Estate Tax Exclusion. So, he makes no reportable gifts before 2026.
If he dies at the end of 2025, his estate will have grown to approximately $12.5 million (assuming his estate grows at 4.5% per annum, compounded), and the projected Exclusion will just barely shelter his estate from the death tax.
But, if he dies on January 1, 2026, after the scheduled Sunset, his exclusion will only be about $6.33 million (all 2026 Exclusions are calculated here with an estimated 1.5% inflation adjustment, roughly equal to the adjustment used for 2020). His heirs will then face unnecessary Estate Taxes (based on current law) of about $3.7 MILLION! And, if he survives longer, the problem will only get worse unless the exclusions expand again.
2. Paul Uses Part of His Exclusion before 2026
Suppose Paul instead makes his first reportable gift of $3 million in 2020, thinking that will certainly protect his estate from growing enough to have Estate Tax expsoure. He will not need to pay any gift tax, but the gift reduces his remaining Exclusion.
At the end of 2025, Paul’s remaining Exclusion projects at about$8.33 million, plus an inflation adjustment that would likely bring it to $9.47 million. Assuming his net worth grew at 4.5% per annum, his net worth would then be about $8.7 million, leaving no Estate Tax exposure in 2025.
But, come January 1, 2026, his remaining exemption will drop to an estimated $3.33 million. If he dies in 2026 instead of 2025, his wealth will be hit by approximately $2.2 million in totally unnecessary Estate Taxes due to his “Failure to Plan Well” before 2026!
3. Paul's cousin, Jimmy Ant, Makes Use of Jimmy's Exclusion before 2026
Paul's cousin, Jimmy Ant remembers Aesop's fable and believes in planning for the future. So, he decided to do sound planning in 2020, so that he could completely eliminate the projected risk of Estate Taxes, even if rates increase, Exclusions decrease or California adopts its own death taxes.
This kind of planning was designed to provide Jimmy all the cash flow he thought he might ever need over his life expectancy to maintain his lifestyle. He made himself "poor" for estate planning purposes, but not in reality.
These same principals work for married couples, and even better as they get the benefit of two sets of Exclusions!
THE BOTTOM LINE
As onerous as they may seem, Estate (and Gift) Taxes are stil purely voluntary in the United States for almost anyone. Congress has given us the tools to pass enormous wealth free of any Estate, Gift or Generation Skipping Tax.
These tools will work best, however, only for those who "PLAN WELL" and implement them before the anticipated Sunset of the doubled Exclusion in 2026, before the Democrats increase rates or decrease exclusion, and before California adopts its own Estate Tax.
So, the bottom line for the moderately successful apartment owners remains consistent with our motto:
“If you fail to plan WELL NOW, plan to FAIL!”
But, good planning requires projection of life expectancy and future growth in your net worth. If you want help with that, I can assist you to do projections using my “Estate Tax X(posure)-Ray.”
If it projects a substantial Estate Tax, I can show you strategies that can eliminate such taxes for your family and still provide for your personal well being during your life. A sample X_RAY is included here.
This article is general in nature and not intended as advice for clients. Please get advice from counsel you retain for your own planning.