Overview
On November 2, 2017, in an unprecedented gesture of fiscal generosity, Congress passed the Tax Cuts and Jobs Act and increased the federal unified gift and estate tax exemption (“federal exemption” or “exemption”) from $5.49 million to $11.18 million and provided that the exemption would be adjusted annually for inflation.
We recently wrote a blog announcing the likely increase in the federal exemption effective for 2023 and that expected increase is now confirmed. The federal exemption will rise to $12.92 million per taxpayer in 2023, and, as a result, taxpayers will have the benefit of the largest federal exemption since the inception of the modern estate tax in 1916. However, the increased federal exemption is scheduled to “sunset” (or decrease) on January 1, 2026 (if not sooner) and return to the pre-2018 amount (adjusted for inflation). For this reason, the IRS has referred to the increased federal exemption as a “use or lose” benefit[1]; a taxpayer must use the increased exemption before January 1, 2026 or the opportunity will be lost and with it the chance to transfer a significant amount of wealth free of estate tax.[2]
Unified Estate and Gift Tax Exemption
Since 1976, each taxpayer has enjoyed the benefit of a “unified” estate and gift tax exemption – an amount against which all gifts made during life and at death are counted. Gifts in excess of the exemption during life are subject to gift tax and gifts in excess of the exemption at death are subject to estate tax.
As a result, there are two general approaches to use of the exemption:
First, a passive or “lose it” approach: a taxpayer does not make any gifts during life and his or her entire exemption is applied to the transfer of his or her assets at death. In the case of the increased exemption, the passive approach results in a “loss” of the benefit of the increased exemption, because if not used before January 1, 2026, the exemption will be reduced to the pre-2018 amount as adjusted for inflation, or about $7 million.
Second, an active or “use it” approach: a taxpayer makes gifts during life and applies his or her exemption to those transfers as they are made to remove assets from his or her taxable estate without paying a gift tax. Any remaining exemption is applied to the assets remaining in his or her estate at death. In the case of the increased exemption, the use it approach is the only way to secure the benefit of the increased exemption for taxpayers who survive beyond January 1, 2026, the date of the sunset.
The “Lose It” and “Use It” Approaches to the Sunset
To illustrate the different estate tax consequences that can result from the lose it and use it approaches, the following scenarios describe each approach in reference to a taxpayer with a net worth of $15 million on January 1, 2023, and who later dies on or after January 1, 2026.
Scenario 1: Lose It Approach
A taxpayer taking the lose it approach does not make lifetime gifts to utilize his or her increased exemption and instead retains the entire $15 million in his or her taxable estate. At the stroke of midnight on December 31, 2025, this taxpayer will “lose” his or her increased exemption, as the exemption is reduced to $7 million. Upon the taxpayer’s death, his or her estate will be liable for tax on $8 million (the $15 million taxable estate less the $7 million exemption), all of which will be taxed at the marginal rate of 40%. The result is a federal estate tax liability of $3.2 million, with the remaining $11.8 million passing to the taxpayer’s heirs.[3]
Scenario 2: Use It Approach
A taxpayer taking the use it approach will utilize his or her entire increased exemption amount by making gifts of $12.92 million before January 1, 2026. These lifetime gifts will use his or her entire $12.92 million exemption amount, remove $12.92 million (as well as any future appreciation on this amount) from his or her taxable estate, and reduce the taxable value of the taxpayer’s $15 million estate to $2.08 million. When this taxpayer dies after the sunset on January 1, 2026, his or her estate will be taxed at 40% on only the $2.08 million remaining in his or her taxable estate. The result is a federal estate tax liability of only $832,000 million, with the remaining $14.17 million passing to the taxpayer’s heirs.[4]
Therefore, as illustrated in Table 1 below, the taxpayer who “uses” the increased exemption before the sunset will pay roughly 74% less in estate tax than the taxpayer who “loses” the increased exemption. This translates to an estate tax savings of $2.37 million and means that the taxpayer who uses his or her increased exemption will pass an additional 16% of the initial $15 million to his or her heirs.
Table 1
For individuals dying on or after January 1, 2026
| Lose It Approach | Use It Approach | |
|---|---|---|
| Total Assets | $15,000,000 | $15,000,000 |
| Pre-January 1, 2026 Gift | $0 | $12,920,000 |
| Taxable Estate at Death | $15,000,000 | $2,080,000 |
| Remaining Exemption | $7,000,000 | $0 |
| Amount Taxed at Marginal Rate (40%) | $8,000,000 | $2,080,000 |
| Estate Tax Liability | $3,200,000 | $832,000 |
Leveraging the Depressed Market
The currently depressed stock market presents taxpayers who choose the active approach with the opportunity to further leverage their increased exemptions. When a taxpayer gifts an asset to remove it from his or her taxable estate, all appreciation of the value of the asset after the gift is also removed from the taxpayer’s estate. If a taxpayer’s portfolio contains securities that are currently trading at low values, and he or she expects those securities will appreciate in value significantly when the market rebounds, the taxpayer will be able to gift more of those securities at a low value, and then realize the benefit of the active approach when those securities appreciate in value outside of his or her taxable estate. In this situation, a taxpayer who takes the passive approach will not capitalize on the opportunity to leverage the depressed stock market and will remain subject to estate tax on the appreciation of the securities.
Leveraging a Discounted Valuation
A taxpayer may also explore the possibility of obtaining valuation discounts on gifted assets to compound the advantage presented by a depressed stock market. Under current law, the value of a gift of an interest in a properly structured limited liability company (“LLC”) may be discounted for (i) “lack of control” if the interest does not confer the ability to control the LLC (ii) “lack of marketability” if there is not a ready market in which to sell the interest. For instance, if a taxpayer (1) contributes securities to an LLC, (2) waits for a “cooling” period of six months to a year, and (3) then gifts the LLC interest to an irrevocable trust, he or she may obtain a discount of 10%-30% on the fair market value of the securities (in addition to the built-in discount provided by the depressed stock market) if the LLC interest is valued by a qualified appraiser.
Drawbacks
There is no one-size-fits-all approach to gifting, however, and in certain situations the use it approach may not create much of an advantage over the lose it approach.
Partial Use of Exemption
One drawback to the use it approach is the high value of gifts that must be made to properly “use” the increased exemption. If a taxpayer uses the increased exemption by making pre-sunset gifts in an amount that equals or exceeds the post-sunset exemption and later dies after the sunset, the entire $12.92 million increased exemption amount will apply to the pre-sunset gifts, leaving zero exemption to apply to the estate at death. This means that to produce an estate tax advantage, pre-sunset gifts must be greater in value than the post-sunset exemption amount (and the post-sunset exemption may not be known until the end of 2025).
For example, suppose a taxpayer makes a gift of an asset worth $7 million in 2023, as illustrated in Table 2 below. This gift constitutes a “partial use” of his or her increased exemption and reduces the value of his or her taxable estate from $15 million to $8 million. Suppose that later, the 2026 exemption amount is announced as $7 million. In this case, since the value of the pre-sunset gift is equal to the post-sunset exemption amount, there is no exemption remaining to mitigate estate tax when the taxpayer dies in 2026. Therefore, the taxpayer who gifted $7 million in an attempt to use the increased exemption would anticipate the same estate tax liability as the taxpayer who retained the $7 million and enjoyed use of the assets during life.[5]
Table 2
For individuals dying on or after January 1, 2026
| Lose It Approach | Partial Use Approach | Use It Approach | |
|---|---|---|---|
| Total Assets | $15,000,000 | $15,000,000 | $15,000,000 |
| Pre-January 1, 2026 Gift | $0 | $7,000,000 | $12,920,000 |
| Taxable Estate at Death | $15,000,000 | $8,000,000 | $2,080,000 |
| Remaining Exemption | $7,000,000 | $0 | $0 |
| Amount Taxed at Marginal Rate (40%) | $8,000,000 | $8,000,000 | $2,080,000 |
| Estate Tax Liability | $3,200,000 | $3,200,000 | $832,000 |
Step Up in Basis
Another reason to consider the lose it approach is the so-called ‘step-up’ in basis for assets owned at the time of death. For example, a taxpayer who bought a condominium in South Boston in 1980 and has benefitted from significant appreciation in the value may have a low tax basis in the condominium. In the event the condominium is sold at fair market value, the taxpayer may have to recognize a large capital gain.[6]
Rather than sell the property during life, the taxpayer may choose to die owning the condominium, which will allow the condominium to receive a ‘step-up’ in basis to fair market value, so heirs may be able to sell the condominium with minimal income tax consequences. If the taxpayer gifts the condominium during his or her lifetime, it will not be eligible for the step-up in basis at death, and therefore a sale of the condo may result in significant capital gains consequences for the recipient of the gift. This concern, however, may be mitigated by thoughtful drafting and planning by gifting the condominium to an irrevocable trust and providing the taxpayer with a power to substitute high basis assets in his or her taxable estate with low basis assets that have been gifted to the trust.
Loss of Control
Additionally, a taxpayer who uses their increased federal exemption and gifts a valuable asset must be prepared to give up day-to-day control of that asset. The IRS will include the value of gift in a taxpayer’s taxable estate if it is found that the taxpayer who made the gift retains the right to possess, enjoy, or control the gifted asset and will assess additional tax liabilities.[7] Further, if the recipient of a gifted asset seeks to return the asset to the taxpayer who made the gift, the tax consequences of maneuvering the asset back to the taxpayer can be incredibly inefficient for all parties involved.
Regulation, Legislation, and the Future of the Estate Tax Exemption
The IRS has issued regulations to explain how it will interpret law related to the increased exemption. On November 26, 2019, the IRS announced that it will honor the exemption amounts applied against completed gifts made before January 1, 2026, and will not seek to “clawback” those amounts by reducing the post-January 1, 2026 exemption amount.[8] On April 26, 2022, the IRS proposed new regulations that would allow for the clawback of exemption amounts in certain situations in which a taxpayer retained the ability to use and enjoy gifted property.[9] Therefore, a taxpayer who seeks to take active approach to the increased exemption amount should consult with a professional to ensure that his or her gifts will not be clawed back into his or her taxable estate.
The future of the increased exemption amount is also subject to the volatile political and economic climate. The pandemic created huge budget deficits and soon Congress will be trying to raise revenue quickly. The current administration and certain progressive legislators proposed reductions to the exemption amount in 2021, and the future of the increased exemption could hinge on the outcome of the mid-term elections in November 2022.
A taxpayer considering significant gifting needs to balance his or her current needs, the future needs of his or her heirs, and tax consequences which will affect all parties. Ultimately, to gift or not to gift is a question that must be approached with prudence and discussed with qualified professionals.
Conclusion
The increased estate tax exemption presents a great opportunity for taxpayers to pass more of their wealth tax-free to the next generation prior to the January 1, 2026. However, it is important to consult with a professional to ensure that the gifts are made in the proper amounts and at the proper time to ensure effective use of the increased exemption. Please contact Brendan McGrory or any of the other trust and estate attorneys in the Private Client Services Practice at Wilchins Cosentino & Novins LLP to discuss your situation so that you have a plan in place related to gifting and making the most of your estate tax exemption.
This article is not legal advice and should not be taken as such or relied upon as legal advice.