Planning for the Sunset of the Basic Exclusion Amount
Planning for the Sunset of the Basic Exclusion Amount
A one-hour video course, with transcript and slides included
A hot topic, and popular choice of educational program for many bar associations, estate planning councils, and CE providers of late has been planning for the sunset of the estate and gift tax basic exclusion amount. To assist you, I decided to put together my own companion program free of charge. The video is embedded and linked below, but I have also provided a link to download slides along with an audio transcript.
To preface, this program is not about the full alphabet soup of trusts and gifting techniques. Instead, I have focused on the transfers and issues that currently have the most impact when it comes to the use of exclusion pre-sunset.
And, while I have not applied for CE credit (yet), the slides should have the information necessary to seek self-study credit if available. That being said, if you would like for me to present this course in-house or as part of an upcoming program, please reach out.
Video
Slides
Transcript
Note that because of the transcription, the text of the transcript may not be as polished as the articles I usually prepare. Please forgive any grammar, spelling, or formatting errors.
Table of Contents
Intro
Hi. My name's Griffin Bridgers. This program is called Planning for the Sunset of the Basic Exclusion Amount. This is a course for attorneys, CPAs, financial advisors, trust officers and other wealth transfer professionals who deal with gift estate and GST tax issues on a daily or frequent basis. Before we get started, I want to remind you this presentation is not intended to substitute for legal or tax advice and is being provided for educational purposes only.
[Promotion for newsletter is included but not transcribed here since you are reading the newsletter].
Now, this course is not being provided for continuing education credit and I have not sought accreditation. But if you are in a jurisdiction or have a credential that allows you to seek self-study credit, oftentimes the materials will request a bio of the speaker. So I have provided that information here for you at your convenience. (See attached slides above).
Intro to Basic Exclusion Amount (BEA)
Let's go ahead and get started with our material. So what is the exclusion amount? The exclusion amount sets a floor over which the estate or gift taxes apply. And this is applied comprehensively to, on a cumulative basis, lifetime wealth transfers and then transfers made at death with the variance between those being just the value on the date or deemed date of each transfer.
Now, to start with, under current law, this exclusion is set as a base of $10 million, which is adjusted for inflation each year for years after 2011. And with these inflation adjustments, this figure is now increased to $13.61 million for 2024. Now because the Tax Cuts and Jobs Act had a number of provisions with a limited shelf life of nine years, we're going to see this inflation adjusted base of $10 million be reduced back to $5 million after December 31 of 2025 unless Congress takes action between now and then to extend or change the current laws about the exclusion amount.
So likely this will include an inflation adjustment to this $10 million base for 2025 and then when we sunset in 2026, will have an inflation adjustment to the $5 million base at that time. And this reduction, given estimates and current rates of inflation, will probably bring the ultimate figure to around 7 to 7 and a half million dollars.
Now, as part of the Tax Cuts and Jobs Act, inflation adjustments were changed to use the chained CPI starting in 2018, and that change is permanent and that will not sunset as part of the Tax Cuts and Jobs Act. So the method of inflation adjustment we've used for the last several years will continue on with respect to the then reduced exclusion amount, if indeed the sunset occurs.
So this exclusion amount is given to each and every U.S. citizen and resident, and it offsets estate and gift tax for all worldwide property. Now, in this vein, residency is determined primarily by domicile and intent to be domiciled within the U.S. instead of what we often use on the income tax side, substantial presence within the U.S.. Now, I want to note that any portion of this exclusion that's not used and an individual's death can also be preserved for a surviving spouse.
This is often called the deceased spousal unused exclusion amount or DSUE, and it is preserved by having the estate of a deceased spouse file Form 706, which is colloquially called a portability election. When you complete the part of that form that allows this unused exclusion to be preserved. I want to note that if a 706 is not otherwise required to be filed, which would usually be the case if lifetime adjusted taxable gifts plus the gross estate does not exceed the basic exclusion amount, which is a term we're going to talk about in a minute, then you have a longer window of time under Rev. Proc. 2022-23, which gives us a five year window to file a return solely for purposes of making this portability election to preserve the DSUE for a surviving spouse. But again, that only applies in a situation where a return is not required to be filed. Otherwise, a 706 is usually due within nine months of date of death, with a six month extension usually being given upon request.
So with the exclusion, there's really three elements that are going to be relevant to our discussion today. One, we've already talked about, which is the basic exclusion amount. Again, that $13.61 million figure given to every U.S. citizen and resident. The second element is the deceased spousal unused exclusion amount, which is any amount that might be preserved for a surviving spouse by the estate of a pre-deceased spouse through the valid making of a portability election. Then finally, I'm going to refer to what we're going to call the bonus basic exclusion amount or bonus BEA, which is the one half amount of the inflation adjusted BEA that might sunset after 2025. So all three of these elements have relevance here, but we're going to look at each in turn and how they apply to the grand scheme of things.
Now I want to note that the DSUE and technically the non-bonus BEA, because that reflects the part after reduction by one half are not subject to sunset. So the next part of this program is going to look at ways we can preserve or use bonus BEA. Now in order to understand how we need to take into account how the BEA and the dish DSUE are actually used to offset gift and estate taxes.
Now, this applicable exclusion amount, which is really the sum of the BEA and the DSUE, including the bonus BEA, is applied as a credit against your tentative gift tax on lifetime transfers or your tentative estate tax on the sum total of lifetime transfers plus your taxable estate, which is property you own death minus deductions in this credit against tentative tax is called the applicable credit. So instead of treating this necessarily as a floor over which a 40% gift or estate tax applies, what you end up doing is calculating the gift or estate tax on cumulative transfers each time there's a gift or estate tax return filed and then subtracting out from that the applicable credit, which is really the applicable exclusion (DSUE plus BEA) plugged in to the gift and estate tax rate tables.
Greater Of Formula
Now the amount of BEA that will be available as an applicable credit against estate tax at death was recently changed under regulations in 2020 that we're going to talk about. And what we're going to see is that post-sunset, what we're going to be able to use as our applicable credit is based on the greater of either of the BEA that's available post-sunset under law, which is that non bonus BEA part we talked about or the BEA that was actually used as an applicable credit against gift tax for lifetime transfers (before the sunset).
And what we're going to find out is under this kind of greater of formula, which is what we're going to call it, any transfers that do not exceed the bonus BEA may not move the needle much in terms of using the BEA post-sunset or giving us a benefit for that BEA that might go away. So ultimately what we have in our calculus here is that gifts up to the bonus BEA won't generate any additional credit against estate tax under that greater formula because the lifetime gifts aren't going to be greater than the post-sunset BEA that is indeed available, but gifts that use BBA in excess of that bonus BEA will generate additional credit against estate tax after the sunset under that greater of formula. Now this doesn't apply to all gifts or all lifetime transfers. There are some proposed regulations out there that can limit the types of gifts to which excess BEA can be applied and counted for purposes of that greater of formula only.
So as I mentioned, we're going to call this formula the greater of formula. And it's a formula that was added under regulations that were proposed and finalized in 2020. And ultimately, as I mentioned, this formula allows anyone that makes transfers equal to or less than the bonus BEA to not necessarily end up better off or with more applicable credit than they would have had had they not made lifetime gifts. And the maximum benefit here, which isn't always practical, is derived where double the bonus BEA is gifted away before the sunset.
Now keep in mind that we have inflation adjustments taking into account as well. So if you just take one half of the BEA today and give that away, most likely that's going to be much less than the one half that actually goes away as bonus, BEA, because we still have at least one year of inflation adjustments that are taken into account in that calculus.
Examples
So to look at what I mean and where we get maximum utility here, ignoring other principles of gifting that we're going to look at in a bit, we're going to consider some examples.
So an example, one we have Johnny who dies in 2027 having made $7.2 million in lifetime transfers, and that should say that those occurred before 2026, before the sunset, and then having a taxable estate, which is your gross estate minus deductions of 7.2 million. Now, recall earlier I mentioned that your applicable credit applies to the sum of your lifetime transfers and your taxable estate. Now, again, we're going to assume the sunset did occur here. So Johnny's tax base with these gifts plus taxable estate is going to be 14.4 million. However, the credit to offset our estate tax is only going to be based on the post-sunset BEA of 7.2 million under the greater of formula because the amount of lifetime taxable gifts did not exceed the taxable estate under this greater of formula.
For example two, we have similar facts, except this time Johnny died in 2027 having made 10.4 million in lifetime transfers before the sunset and having a taxable estate, which is your gross estate minus deductions again of 4 million. Now we still add up to have a tax base of 14.4 million here. I want to note the sunset did occur. And as we're going to look at in a minute with proposed regulations, Johnny made no “abusive” gifts, which are going to be important for purposes of determining that greater of formula and the scope of application.
So in this case, the credit that we're going to use to offset estate tax is going to be based on an exclusion of 10.4 million and not the post-sunset exclusion of 7.2 million. The reason being is that under the greater of Formula R pre sunset lifetime transfers or greater than our post-sunset BEA. So by gifting over the bonus BEA, we get that excess portion over that bonus BEA preserved as applicable credit against estate tax for the future. So that's how the math works out. Generally, any dollar you gift over the anticipated bonus BEA that might go away is going to give you more applicable credit than you would have had had you not made lifetime transfers, but subject to some proposed regulations we're going to look at in a minute.
Issues with DSUE
As I mentioned, the BEA, as you recall, is only part of your applicable exclusion. If you have a DSUE, then there are ordering rules that kick in that say that if you're making lifetime gifts pre sunset, you have to use your DSUE first as a credit against gift tax before you can use your BEA or bonus BEA, which can force somebody with DSUE to have to gift away way more than they anticipated, needing to gift away and possibly put themselves in a bind.
But I want to note, especially against the backdrop of some regulations we're about to look at, that the DSUE, one, is not subject to sunset, and it's also not subject to those proposed regulations which might limit the application of the greater of formula. Now, before we get into the rest of this course, I want to remind a couple notes on the DSUE. One, it is not adjusted for inflation, so it's a flat amount. And as we're going to look at in a bit, the DSUE does not preserve any unused generation skipping transfer tax exemption. So that's still a planning gap that has to be addressed as well. And even if you're making gifts that use the DSUE before using the BEA, you also have essentially a BEA for GST tax, which is going to get preferentially used for that transfer, and that can create a mismatch at death against comparing your applicable exclusion to your remaining GST tax exemption.
Use of BEA – New Issues
We'll touch a little bit more on that towards the end of this program, but I want to highlight the fact that we've been focused so far, almost myopically on this use of bonus BEA, which is not always the optimal outcome or even the traditional goal. Traditionally the primary purpose of making lifetime gifts and sales was to you was to freeze the estate tax value of the transferred assets because any transfers during life, although part of the estate tax calculation use date of gift values against your entire exclusion and applicable credit, whereas transfers at death use the fair market value based on date of death or the alternate valuation date if it is elected -a subject a little bit outside of the scope of today's discussion. But with this freezing of estate tax value, we have an issue where certain lifetime transfers or the value of them can get unfrozen for estate tax purposes if certain code sections, namely 2035 through 2038. And also couple we're not going to mention today, 2041, 2040 and 2042 apply to that transfer.
Most often these are the usual suspects 2035 to 2038, which essentially act to disregard any lifetime transfer of title. If the decedent holds at death certain benefits or control, or alternatively, if they release certain benefits or control within three years of death over that transferred property. So ultimately what this would do is generate unanticipated estate tax. It would cause estate tax to apply as if that lifetime transfer never actually occurred, which traditionally with a lower exclusion amount was a bad outcome.
However, people started to realize that the greater a formula decreased that risk. So it used to be the case that you tried to avoid the application of code sections 2035 through 2038 like the plague. However, with the onset of the greater of formula, some practitioners started theorizing that perhaps we could intentionally make a transfer to which those code sections would apply because it would still be a completed gift during life that might use that bonus BEA or the entire BEA, and thus give a higher post-sunset applicable credit against estate tax.
And even though the estate tax will be against a broader base of assets, including the value at death, as if the transfer had never actually occurred, there is still this higher applicable credit than one would have otherwise gotten. And the IRS looked at that and said, You know what? That's a loophole that we don't necessarily like. And while there were some practitioners out there theorizing that there are others who said work in this situation, there could be perhaps a loophole that is being abused here. And the IRS might look at various arguments to say, you know what, we're not going to count that lifetime use of BEA if, for example, gifts are intentionally included in the gross estate under code sections 2035 through 2038 or even unintentionally included under those code sections. So there were proposed regulations that came out which have not yet been finalized that address this gap and this loophole.
Proposed Anti-Clawback Regulations
And while we have some guidance based on the proposed regulations, there is a possibility that they get changed before being finalized or don't get finalized at all. But as long as those regulations are looming, it may not be safe to make gifts (using BEA) that intentionally will be included in the gross estate under Code sections 2035 through 2038. Given this potential loophole, whether intentionally or unintentionally triggering inclusion in the gross estate, the proposed regulations generally provided that your use of BEA for purposes of the greater of formula for lifetime transfers will be disregarded if those transfers are later included in the gross estate under Code Sections 2035 through 2038.
I want to note this isn't a trigger for gross estate inclusion that's already covered under those code sections. Instead, this is looking at a completed lifetime transfer in determining solely whether or not the BEA that was technically applied to offset gift tax for those lifetime transfers will then be used to post-sunset as part of that greater of formula. So long story short, for any gifts that fail this test, you don't get to use that pre-sunset BEA and worst case, you're stuck solely with the post-sunset BEA to offset the total of your lifetime transfers plus your taxable estate, which would technically include the date of death, fair market value of these lifetime transfers getting pulled back into the gross estate.
Now there are certain other transfers that are also disregarded that are a bit outside of the scope of this discussion - things like donative promises and releases of retained interest that were previously valued at zero. And there is also a threshold for the gift tax value of certain lifetime transfers like GRATs and other retained interest trusts, where if your gift tax value is below a certain threshold or percent of the total value of the transfer, it won't get counted in this anti-clawback mechanism, even if it's included in the gross estate at death.
So ultimately, if you've made a gift and you see the risk of this occurring, you still get a second bite of the apple to avoid this. And you can release those powers that might otherwise trigger gross estate inclusion or complete the donative promise, for example. But that release has to occur no less than 18 months prior to death in order to still use the greater of formula.
I want to note that's kind of similar to the three year rule under Code Section 2035, but for a different purpose, because 2035 applies for purposes of determining whether released retained interests are included in the gross estate. But this test, the 18 month test, looks to whether lifetime use of BEA for gross estate included gifts get counted as part of that great greater of formula.
I want to note too, that each of those look backs - the 18 months and the three year rule - have a bona fide sale exception. It's not as easy to meet that exception as you might think, however, especially when it comes to valuing interests such as these that we might have.
Now, I want to note that these regulations only apply to the lifetime use of your BEA. They don't apply to the lifetime use of DSUE for purposes of that greater of formula. And again, remember, those regulations don't have any utility outside of the use of BEA in that greater of formula. So in addition to the DSUE being excluded from the proposed regulations and still being able to be used for purposes of that greater a formula, even for quote unquote abusive gifts, it might be intentionally included in the gross estate.
Joint Tenancy Gifts
We also have joint tenancy interest excluded under this. So I have a separate video and set of articles on how joint tenancy interests are valued for estate tax (see link here). But generally joint tenants have to own property in equal shares. But if a joint tenant receives a gift, interest through a zero or less than proportionate contribution to the purchase or funding of an asset, then the portion that was gifted gets pulled back into the gross estate of the deceased joint tenant who over contributed. And in that case, if you were to, for example, make a gift of a joint tenancy interest by the over contributing joint tenant, that amount that gets pulled back into the gross estate would be would still be eligible for the greater of formula.
Traditional Gifting Principles
And it's also important to note that as I mentioned, certain retained interest trust that appear safe could still be subject to code sections 2035 through 2038, again with a certain valuation threshold and also certain things like family limited partnerships.
And it may even be the case that there is no intent to trigger those code sections. But we're in dangerous territory here where there's a lot of BEA to be used, and in particular Code Section 2036 calls out a situation where if a donor has to impoverish themselves for purposes of making the gift, then that gift could get pulled back into the gross estate.
That's a little bit outside of the scope of today's discussion, but it's still an important thing to note that ultimately giving away more than you can afford to violate traditional gifting principles. And if you're leaving the donor with the inability to pay their own expenses or even gift or estate taxes, that could blow up the whole thing anyway, and now have this added wrinkle of not getting to use that BEA for that later included gift under the greater of formula.
So by myopically focusing on the use of BEA, we are losing sight of, beyond freezing value, a few other key gifting principles that traditionally have been very important. Those include but are not limited to these principles which are really at the top of the bell curve. One is that gifting of high basis assets is typically preferred because the gift that assets don't get a step up in basis at the donor's death, they get a carryover basis to the donee or the donee trusts, meaning that any appreciation in value while using basic or applicable exclusion will still be subject to income tax in the hands of the donee of a lifetime gift was also traditionally important to focus on gifting high growth potential assets because ultimately that's what gave you the most leverage by removing future growth in those assets from the gross estate. That was the whole impetus of the value freeze portion. But you can't just look at the intention and go a value freezing in a vacuum. You have to consider what assets are best able to leverage that potential for growth.
Hence, that freezing of value gives you the most mileage compared to other assets that you could otherwise have gifted away. Then finally, as I just mentioned, you shouldn't gift away so much that you cannot meet your ongoing living expenses that will put you in a bind here that can create issues. Now, if you were to create, for example, a grantor retained trust and receive interest that will be included in your gross estate so that you can meet your ongoing living expenses, then that would use BEA for lifetime gifts. But again, this wouldn't necessarily count for purposes of that greater of formula. So ultimately violating these principles just for the sake of using BEA pre-sunset may not ultimately be wise in the grand scheme of things from an income tax perspective, this is another wrinkle to gifting during life versus holding on to assets. So assets that are owned or deemed to be owned at death under code sections 2035 through 2038 or some of the other code sections we talked about, although they're still a subject to estate tax, will get a step up in income tax basis.
Income Tax Versus Estate Tax – Step-Up
But that's not the case for gifts made during life, as I mentioned, that get a carryover basis. So ultimately, as we're going to look at in a minute, paying some estate tax, even post-sunset may be better when you compare effective rates that are the result of this basis step up. So, for example, we have a top estate tax rate of 40%, but again, it only applies to transfers in excess of the applicable exclusion.
So when you weigh in the applicable exclusion itself (again, apply it as a credit), your effective estate tax rate may be much lower than 40%. Normally, you can determine that by dividing the total estate tax by the tax base, which is your taxable estate, plus your lifetime taxable gifts to determine what that effective rate might be. And if ultimately that effective estate tax rate is lower than the potential income tax savings that could be generated by the base, a step up then not gifting certain assets may create a better outcome and may save capital gains for the inheritors.
And it may also increase the amount of depreciation that inheritors could use because they get a stepped up basis and a new holding period for purposes of certain cost recovery deductions.
Use of SLATs
Now there's a ton of alphabet soup trusts out there that we can use for making lifetime gifts that might use BEA. And if that's a driving concern, there is a few that kind of bubble to the surface as the primary suspect and perhaps the most efficient method of transfer is the spousal lifetime access trust or the SLAT.
Now with a SLAT ultimately what you end up doing is having one beneficiary spouse and one grantor spouse. So it's the grantor spouse that funds that slat, and then it's the beneficiary spouse who can receive distributions. So while this wouldn't necessarily use the BEA of both spouses, it would use the BEA at least of the grantor spouse.
Now, what we're not going to discuss here today is the fact that if both spouses set up SLATs for each other, you run the risk of triggering what's known as the reciprocal trust doctrine, which will ignore those lifetime gifts and again cause an issue under that greater of formula because it would uncrossed the identities of the spouses under each trust, such that each has retained powers under 2036 or 2038.
But ultimately, if we look at it in isolation at one SLAT at least, and ignore the reciprocal trust doctrine, for now, the benefit of the SLAT is that the grantor, while they can't have direct asset access, can have indirect access through the beneficiary or their spouse, so long as the couple remains married, which is really the biggest risk factor for the SLAT.
But before we look at the risk vectors, it's important to note that ultimately one of the biggest risks we've talked about so far is the risk of impoverishing oneself, because the sheer size of the BEA necessitates irrevocably giving away a large chunk over the bonus BEA amount if you want to have any traction under that greater of formula.
So ultimately the SLAT can at least give some relief to that. Otherwise, this highly risky situation where somebody makes an irrevocable gift but then lacks the ability to pay ongoing living expenses or taxes. Now we have to consider not just gift or estate taxes, but also income taxes, as we'll see in a minute. And in addition to that, we have to look at divorce, as I mentioned, because this indirect access to the trust only continues as long as the spouses are married and while grantor trusts are a little bit outside of the scope of this discussion, what a SLAT will usually be, at least as long as the couple was married, is a grantor trust, which means the grantor spouse has to pay income tax on behalf of the SLAT and they have to do it out of their own pocket. The SLAT can't necessarily always reimburse the tax of the grantor or pay it directly, which is deemed to be reimbursement, at least not without having an independent trustee who has the discretion to say yes or no to tax reimbursement or payments at a minimum.
And based on a recent IRS Chief Counsel memorandum that right to reimbursement - or I wouldn't even say right, that option for reimbursement - has to be in the trust from the inception and can't be added by modification later without there being a deemed gift back from the trust beneficiaries.
Intentionally Defective Grantor Trusts
Now, beyond slats, we can continue to leverage this idea of grantor trust to create what's called an intentionally defective grantor trust or an IDGT, which allows us to potentially use some BEA or freeze the value, as I'm going to mention in a minute for BEA, use purposes pre-sunset, while also preserving some flexibility.
And this might create a little more flexibility than the funding of a SLAT by gift for reasons we'll look at. But what we want to have here is an intentional triggering of the grantor trust rules and also a retained power to turn off grantor trust status. So because of that, a spouse usually would not be the beneficiary and this would usually be limited to children, maybe other family members.
But ultimately, what the intentionally defective grantor trust allows is usually the retention of what's called a substitution power that allows the grantor spouse to use swaps of equivalent value with the IDGT to maximize their income tax planning. So even if they're on their deathbed, they could take their own high basis assets and put those into the trust and then take out low basis assets so that we could still get that step up in basis.
And ultimately that doesn't increase or decrease the gross estate because the exchange has to be of equal value. And there are certain requirements after we met for that to take place, but including this power is the common way to trigger grantor trust status and also to turn it off. Because if we want to have the trust pay its own income taxes, the grantor can release this power. Now they lose the power to make swaps then, but they shift the income tax burden to the trust - although at more compressed income tax brackets.
And as long as the grantor trust status is on and the grantor is paying income tax on behalf of the trust that can allow the grantor to deplete their gross estate at a lower effective tax rate.
If you make lifetime gifts after you've used your BEA, that's subject to a 40% gift tax. But the IRS has deemed that the payment of income tax on behalf of a grantor trust by the grantor is not an additional gift to the trust beneficiary. So if you have a lower income tax rate or even effective income tax rate, this allows depletion of the gross estate at a lower arbitraged tax rate than you would have for gift tax purposes. (Note that lifetime payment of gift tax may also be a better rate arbitrage than payment of estate tax, but that is beyond the scope of this discussion.)
Now, ultimately, there's going to be a lot of hesitancy, I think, as we approach the sunset to make permanent gifts, especially for those who lived through 2012, because this is not the first time we've seen the potential sunset of the exclusion amount. In 2012, the exclusion was scheduled to go back to a million at the end of the year. And what happened is that a lot of clients made gifts to SLATs, QPRTs, and similar vehicles. But then at the very end of 2012, the law was made permanent so that the exclusion that has a base of 5 million became new law. So from that point forward, many who had gifted regretted in part making those gifts, especially if the other gifting principles I discussed had been violated.
So if you adhere to those other gift principle rules that will help reduce some of that regret, especially the idea of keeping enough to maintain ongoing lifestyle. And second, as I mentioned, with intentionally defective grantor trusts, and this could even be done with SLATs we could leverage instead of making gifts sales instead to create a little more flexibility pre-sunset.
Sales to Intentionally Defective Grantor Trusts
So let's look at how so with a sale to a grantor trust, as long as we have a sufficient seed gift to the trust, usually about 10% of the anticipated purchase price, then you can turn around and sell assets to a grantor trust in exchange for the trust's promise to pay back the guarantor over time. Usually that would be through a promissory note.
This allows you, at the time of sale to lock in the gift and estate tax value without actually using BEA, because the BEA is only used for gifts and not sales. And as long as the sale is for fair market value, there is no bargain that could be deemed to be a gift and thus no gift tax, applicable credit or BEA.
But of course you'd have to use BEA for that initial seed gift. And so long as we maintain grantor trust status, this allows you to importantly be able to call an audible if the sunset does indeed occur. So let's look at two situations. So let's say you're somebody who sits on the fence and waits until the end of 2025 and wants to make a gift.
But then you have to jump through the hoops, getting an appraisal, setting up a trust, making the transfer and making sure all of this is booked and occurs by December 31 of 2025. Let's assume in the mix maybe the law gets changed and you regret that. What if instead you could go ahead and get the appraisal and lock in the gift tax value now through a sale and then wait until the 11th hour, perhaps the sunset of the BEA, and at that point, just simply forgive part or all of the note and then forgiving that note, which is payable from the trust to the grantor, is a deemed gift from grantor to the trust. And you could forgive a face amount of the note up to your BEA and have a valid gift without any gift tax. And importantly from the income tax perspective, because this is a grantor trust for income tax purposes, the grantor is treated as the deemed owner of the assets that were sold and of the note that is being forgiven. So this is really a sale for income tax purposes from the grantor to the grantor and forgiveness of the Note from the grantor to the grantor, or neither of which are income taxable events.
But the IRS respects the trust as the actual gift and estate tax owner of the assets that have been transferred. Now, if you want to go this route of having that flexibility to forgive the note, typically your taxable gift amount would be based on the face amount of the note or the portion that is forgiven. Now, there are some thought leaders and valuation experts out there that believe that it may be possible to to get a discount on the value of that note.
But remember, again, that we're adding another layer of valuation. If you want to make that argument, which is another hoop to jump through in a time crunched situation at the end of 2025, where valuation experts may be scarce and the opposite could hold true too. If you're really trying to push that issue that perhaps a note could have a premium attached if, for example, we have a high interest rate now and then interest rates go down below what the original interest charge was under the note.
Documenting Sales Transactions
Now, if you're going to go this route, we have a lot of paperwork to do upfront in exchange for little paperwork that can be done in the 11th hour in case of the sunset. So ideally we have the original sale for a note getting reported on a gift tax return so we can start the three year limitations period on the gift tax value because the risk we are on is that the IRS comes back and says, hey, you didn't sell this asset for enough.
So the bargain you gave to the trust is an additional gift for gift tax purposes. So filing a gift tax return now can help limit that. And ultimately, when you forgive the note, you're going to want to file a gift tax return to use BEA at that time as well. And this can also keep you from having to scramble to get a valuation for illiquid assets later on in 2024 and 2025 in a situation where appraisers and valuation experts are already going to be quite busy. Now, this is not risk free. Much like we have gift principles, there's even more principles that apply to a sale that we need to follow.
One, the note should bear interest of at least the applicable federal rate based on the term of the note for the month of issuance.
Another that the assets that are purchased for the note should generate enough income tax or enough income to pay off the note during the term of the note, which shouldn't be longer than the grantor's life expectancy.
We want the note to be paid off before the grantor’s death because if it's not, then at the grantor’s death we now have a taxable sale equal to the unpaid portion of the note and the fair market value or the date of death value of the asset being transferred.
We also have to look at 2036 issues which necessitate the note payments being different from the income that's coming from those purchased assets to the grantor trust. Otherwise we run the risk that the IRS says, hey, since all the income is flowing through to the grantor, it's as if they never released their ownership and are still that (gift and estate) tax owner anyway.
So that's an outcome we want to avoid. We also want to have the note and all terms of the transaction be similar to those that would be commercially enforceable or offered to third parties. So we typically want security for nonpayment of the note where if the trust doesn't pay, the grantor has the right to enforce a default and perhaps take back, at least in part, the property that was sold for payment of that note, or at least to the extent of the payment of the note,
We also want to have a purchase agreement which has a price adjustment clause in case of a gift tax audit. We'll talk about that in a minute. And then if there is an intent to forgive the note, we don't want a document that as part of the overall transaction because that could cause the IRS to turn around and recast this entire transfer as a gift.
Now, it's often assumed that you could forgive the note and use an annual exclusion here, but there's a couple limitations to that.
One, the forgiveness has to not just be of interest, but also a significant chunk of principal in order for forgiveness to be a gift, which if you have a high enough interest or a high enough note, may not be possible. Two, since this is technically a gift to the trust, unless you're giving the beneficiaries a Crummey right to withdraw a portion equal to the note forgiveness each time there is indeed forgiveness, then that wouldn't be an option. Just the forgiveness of the note itself would be a future interest gift that doesn't qualify for the gift tax annual exclusion.
Adjustment Clauses – Formula Gifts and Purchase Price
Now, as I've been alluding to, there's a backlog of valuation for a lot of valuation experts and appraisers. And that means that if you want to make a gift or a sale now, you may have to wait on an appraisal and at least get the thing papered right now.
And there's a couple solutions we might have do this, especially if we get to the 11th hour later in 2025. And those are known as a formula gift or a price adjustment clause. Obviously, the formula gift applies a gift and the price adjustment clause applies to a sale. And what a formula gift clause does - this is often called a Wandry clause based on the Tax Court case in which this was first blessed is that this type of clause - reflects an intent not to gift a specific asset, but instead a specific dollar amount.
That is not a cash gift, but instead is comprised of the worth of one or more assets being sold or gifted in-kind. And what this can do is reduce the risk of gifting more than your BEA, because you can say, I'm going to gift away my BEA and it's going to be made up of these interests that are maybe hard to value and I'm going to get a qualified appraisal after. But if the IRS comes back and determines that the gift tax value I reported was too low, then the amount of assets transferred to make up that dollar amount will be reduced and relate back to the time of the gift.
Similarly, we can have a price adjustment clause that reflects an intent to peg the purchase price to the gift tax value as finally determined in case of IRS challenge.
Ultimately, each clause is going to be designed as an audit hedge against the IRS coming back and changing the gift tax value. Now, even though we have this audit hedge, it's not foolproof. There's still some risk. And the wording of these formula clauses counts more than we think, especially for formula gifts. Now, I'm not going to give you the specific language to use, but if you go to the two cases that really are keys to the formula gift in the formula sale, which are Wandry v. Commissioner and King v. United States, I've cited both of them here.
Both opinions have almost verbatim the language that was used. So looking at those opinions can give you a good template for language to use and adjust for your purposes. But again, especially for formula gifts, I want to mention those can be risky because you want to use certain nomenclature primarily that the value of the property being used to make up a gift of a dollar amount is value as “finally determined for federal gift tax purposes.”
And if you do all that right, including those magic words, typically with a formula gift, the amount of in-kind assets making up that formula dollar amount will revert back or back to the time of the gift itself. In other words, the gift locks in the dollar value being transferred and all you're doing after the fact is trying to settle what exactly the percent interest or fractional interest in property might be that's being transferred then for a sale.
For a price adjustment, really what we're doing is adjusting the purchase price and the note payable back from the trust to reflect what the IRS might later predetermined as the gift tax value of the assets that are being purchased now.
Usually a price adjustment is going to be the safer alternative because of the long line of cases that the IRS says litigated where they've deemed a formula gift to be against public policy because it discourages the IRS from ever pursuing collection of gift tax. But although a price adjustment might be safer from the IRS perspective, it is more costly from the perspective that interest has to accrue on the promissory note for this to be a valid sale. And even if the interest isn't paid, it has to be capitalized and there has to be an intent to, you know, at least try to pay the interest during the term of the note itself.
Now, price adjustment clauses don't necessarily always note this, and I haven't seen a good example, but it might help to bake in a contingency as to what might happen if the IRS tries to recast that sale as a gift.
Finding a Valuation Expert
Now, I've been alluding to appraisal issues so far, but for both a gift and a sale, you should get a qualified appraisal for the assets that are being sold now for certain types of assets like business interests and real estate.
These can be quite pricey. And as I've been alluding to, demand may outstrip supply for valuation experts as we get closer to the sunset date. So the earlier you can get this process started, the better. And I don't have any incentive to say that from valuation experts. I'm saying that more from the perspective of being an attorney who doesn't appreciate being rushed at the end of 2025 like I was as an associate at the end of 2012.
So if you're going to make the gift, get the ball rolling now and don't wait until the last minute. Otherwise you may just be out of luck and you may not be able to use your BEA on a lifetime gift or make a sale that could later use BEA to plan around the sunset. And if you're worried about this, what you can do now as I mentioned is lock in with a formula, gift or price adjustment so that even if you can't get a qualified appraisal until after the sunset, you've at least made the irrevocable gift, leaving only the open term of the final price or the final percent interest comprising the dollar value of a gift.
Generation-Skipping Transfer Tax
Now, I'd be remiss if I didn't mention the generation skipping transfer tax.
As I briefly mentioned earlier, our GST tax exemption is pegged to the BEA, but the DSUE does not preserve unused GST exemption. So you need to consider that when you're looking at lifetime gifts. So if you're making lifetime gifts that use BEA, that may use a tandem amount of GST exemption, but you need to take care in terms of how you report and allocate GST exemption on a gift tax return.
And it may be the case that based on the type of trust, some trusts apply for automatic allocation for GST exemption, but not all trusts. If a trust is not a GST trust, there is no automatic allocation unless you file a gift tax return to elect to treat that trust as a GST trust. And ultimately if we have a sale, those would not use GST exemption and thus those would be GST exempt.
And likewise the forgiveness of the note, like we mentioned earlier, would use BEA and also GST exemption, and you need to make sure the amounts used are a tandem amount and I alluded to the annual exclusion gift where if you can swing it, the annual exclusion may not use BEA, but the annual exclusion for gift tax purposes doesn't always qualify for an annual exclusion for GST tax purposes. So you may have to allocate GST exemption to certain annual exclusion gifts in trust.
Estate Plan Structures
And ultimately we have no way of knowing what the BEA will be at death if somebody outlives the sunset by a long time. So we have to consider to what our actual estate plan looks like in terms of the documents that will take effect at death.
And our optimal goal would be balancing the contingency of what the BEA might look like and other options we might have, such as a step up in basis, the GST exemption allocation and really the income tax effect of a sale to a grantor trust if The note is not paid off prior to the death of the grantor.
Now traditionally to optimize tax planning within an estate plan pre-portablity, we would use a formula clause that funded a bypass or credit shelter trust up to the unused applicable exclusion, which recall includes the DSUE plus the BEA. Then the excess, at first death for a married couple would go to a marital trust or for a single individual sometimes we could use the charitable estate tax deduction for that excess to pass to in part or in full to reduce estate tax as well.
Normally for those types of plans that have this traditional formula clause, the BEA, if used during life, can skew the operation of this clause because what it can result in is an overfunded marital trust at the expense of remainder beneficiaries, because remainder beneficiaries can't be current beneficiaries of the marital trust.
So what this means is that if you've used BEA during life, all the non-spousal beneficiaries may have to wait until second death to benefit at least significantly from the plan unless you pay some estate tax, or unless your lifetime transfers really benefit those remainder intended beneficiaries (instead of the surviving spouse). So you have to balance the two pools of assets to say, okay, if we're going to use BEA, maybe it's better to preferentially benefit children and descendants over the spouse and also to maybe balance the spousal amount under the marital trust versus the SLAT to say that if and when a marital trust is created, the SLAT switches over to give preference to the marital trust for distributions to the spouse before taking into account spousal needs under the SLAT.
And instead at that point the needs of the secondary beneficiaries, descendants and children who could be parallel beneficiaries under the SLAT would then get higher priority than they would have had during the grantor’s life while the SLAT was the only gifting or inheritance vehicle that was in place.
Now, I also want to mention, too, that if there's assets that you want to specifically pass to non-spousal beneficiaries at second death like business interests or heirloom assets, the marital trust may not be the optimal receptacle.
So we have to plan around that issue that all income of a marital trust has to be distributed to the surviving spouse, because what's ancillary to that is that the spouse has an unqualified right to demand that any unproductive property be sold and be reinvested in income producing, “productive” property. So if you have any of those heirloom assets, you might have the need for some deeper planning to look at how specifically we get those assets to the next generation.
So that could be a valid use of BEA, notwithstanding the gifting principle, as we previously discussed, because if you want to get those to the next generation, it may be better to have some control over that now instead of leaving it up to a formula clause that may put those all into the marital trust and risk an outside sale.
You may also want to consider that in some cases, paying some estate tax at first a death could be good. But then again, you run the risk that if there is a later increase to the exclusion, perhaps that estate tax that was paid was unnecessary. So with this, we've talked about the marital trust being bad, but it can also be good because there's a lot of plans now that forego the usual credit shelter or bypass trust focused funding formula to instead overqualify the estate on the first to die for the estate tax marital deduction.
And this has a specific income tax benefit we'll talk about in a minute. But ultimately this gives some flexibility to the executor or the spouse or both, usually through the use of a QTIP-type marital trust, where, for one, the spouse or beneficiary could disclaim to a bypass trust to use the BEA of the first spouse today.
Or alternatively, we could apply marital deduction to more assets than necessary to zero out estate tax and thus preserve BEA as the DSUE for the surviving spouse by making a portability election, we could also look to the trust level where, instead of looking specifically at spousal rights, we have the executor make a partial QTIP election to use the first spouse's BEA on the non-elected portion of the QTIP Trust.
Or we could defer, like with the portability election to make a greater than necessary QTIP election to use the BEA and the DSUE of the surviving spouse.
Then finally, when we make that partial QTIP election, what we can say is that the non-elected assets don't have to be administered as a marital trust. Instead, they can be administered as a bypass or credit shelter trust. This is often called the Clayton QTIP election.
So there's all sorts of options there. And I have a couple other videos and write ups on my newsletter about that that I'm happy to link here, but ultimately with this type of plan, whether we have the traditional dual trust funding formula or if we preferentially fund a marital trust, all assets of the first spouse die or get a step up in tax basis.
But traditionally, if we funded a credit shelter or bypass trust, those assets would not get a second step up at the survivor's death. So one of the biggest benefits of a DSUE is that even though it doesn't preserve GST exemption and even though it is an indexed for inflation, it does help to create a second step up in basis that would not otherwise have applied to a bypass trust if it was created.
So we can think of the DSUE as being almost like a phantom credit shelter or bypass trust in and of itself that the only the survivor can benefit from, but that nonetheless creates a second step up in basis for the survivor with additional coupon that can be applied for offsetting estate tax.
We also need to remember that if we're planning to use the GST exemption of the first spouse to die, it can't be preserved through disputed election, but it could be preserved if we have an overfunded QTIP trust. Because what we can do is use what's called a reverse QTIP election to allow the first spouse to apply their GST exemption, even though the assets in that QTIP trust will ultimately be included in the gross estate to the of the survivor to the extent the QTIP election has been made and importantly, this is an exception to the estate tax inclusion period or ETIP rule that says that otherwise if the survivor were to allocate their GST exemption and the spouse were to later die, then at best the spouse becomes the new transferor then and has to allocate their own GST exemption or at worst no GST exemption be allocated period until that ETIP has expired.
We also need to be cautious that, as I mentioned earlier the BEA applies to a US citizen or resident but on the opposite side, the estate tax marital deduction is only available for citizen spouses. If you have a non-citizen spouse, in order to get the estate tax marital deduction, you have to specifically use what's called a qualified domestic trust or QDOT, which is structured like a traditional marital or QTIP trust.
But you lose the ability to make a partial QTIP election. It's an all or nothing type of funding formula there. So in this situation, it may help to consider more the traditional bypass trust using, the traditional funding formula or disclaimer. And importantly there the DSUE could be used by a non-citizen spouse, but usually it can't be used until the non-citizen spouse dies or releases their entire interest in that QDOT.
DSUE and QTIP Trust Gifts
Now if we have DSUE recall again that this has to be used before any BEA. So if you're planning around the sunset, note that the DSUE could be used for purposes of the greater of formula, but it's only the BEA and not the DSUE that is subject to those proposed regulations we talked about earlier. So for example, we could have the grantor spouse or the surviving spouse, I should say, with the DSUE fund, a grantor retained income, trust or GRIT that will be included in the survivor’s gross estate under 2036.
But we'd still have the use of the DSUE to fund that trust be respected under that greater of formula post-sunset. And then the BEA could be used for other gifts or transfers at death. And also DSUE does not preserve GST tax exemption, so using the two in tandem can create a substantial mismatch, which may not be a good idea. Which is another justification I think for this DSUE GRIT type of trust that I mentioned a couple points ago.
Now, ultimately, if you have a spouse that has the DSUE or BEA but not enough assets, you can look to the marital trust because ultimately the marital trust will be included in the survivor’s gross estate anyway, so we can make gifts of assets in a marital trust, really as interest in that marital trust and use the DSUE first and then BEA once the DSUE is used up.
Now this is more of a gift of the trust interest itself, but we're still using the values of the underlying assets. But ultimately, what this is, is a gift of the lifetime income right and the underlying principal and really those two valuation concepts are merged together under Code Section 2519. And if we have the reverse QTIP election that was made, this lifetime gift should not cause a loss of GST exemption.
So in this case, the surviving spouse making a gift of a portion or all of the marital trust would not have to allocate their own GST exemption to maintain that GST exempt status.
Conclusion
I hope you enjoyed this program. If you have any questions, you can reach me at (address in slides) and I'd encourage you to check out my newsletter at (link in slides). Thank you again for listening to this program and I look forward to seeing you in my future content.