As of Jan. 20, 2021, control of the U.S. Senate, House of Representatives, and the White House is in the hands of the Democratic party. In view of President Biden’s pre-election statements on taxation and the extensive federal stimulus spending over the past year to combat the COVID-19 pandemic, it seems increasingly likely that new tax legislation will be forthcoming. The legislation is likely to contain changes to many of the income tax rules and may also roll back some of the cuts included in the 2017 Tax Cuts and Jobs Act (TCJA). One of the most impactful changes for wealthy families may be a decrease in the estate and gift tax exemption.
The current estate tax exemption is $11,700,000 per person; amounts transferred to heirs above this exemption are subject to a 40% tax. This exemption level was doubled by the TCJA and is scheduled to revert to the previous exemption level of half this amount on Jan. 1, 2026. However, with a new administration and fiscal priorities in place, this exemption amount could be reduced much sooner. The IRS has indicated that gifts to utilize this exemption while it’s still in place won’t be taxed at a later date, so substantial tax savings could be achieved by making gifts to heirs or trusts for their benefit before a potential change in the law.
During 2020, many wealthy taxpayers implemented strategies to utilize the current estate tax exemption before its potential decrease. Last year was an ideal year for such transfers because there was little chance of a decrease in the exemption under the previous Senate. There may still be an opportunity for families to take advantage of the still-elevated exemption in place for 2021.
Implementing large gifting transactions in 2021, however, carries more risk than that of 2020, because we have much less certainty about the level of exemption that will be in place. As mentioned, the current 2021 exemption from estate taxes is $11,700,000, but if Congress enacts new tax legislation to reduce that exemption, that change could be retroactive to Jan. 1, 2021. If that were to occur, a large gift could result in gift tax being payable on the transaction. However, these transactions may be structured in such a way that will mitigate some of this risk.
The Supreme Court has ruled that retroactive tax changes are constitutional. Additionally, there’s precedent for such legislation specific to estate taxes. While a retroactive decrease to the estate tax exemption has never occurred (in fact, no decreases to the exemption have ever occurred at all), an increase to the estate tax rate was retroactively enacted in 1993 and upheld by the courts.
The chances of retroactive tax legislation being enacted are up for debate. Since tax legislation may be enacted through the budget reconciliation process — requiring only a simple majority — the Democrats could push tax increases through the legislative process without Republican support. In addition, such legislation wouldn’t be subject to the restrictions associated with tax cuts, which prohibit deficit increases over a period of years, and therefore, there are no procedural obstacles to enacting extensive tax legislation.
Overall, it seems unlikely that the exemption would be decreased retroactively, but because it’s possible, families should be aware of the risks. What seems more likely is that the new exemption would be effective as of the date of enactment, which means that there may be a limited window in which families may make tax-free gifts to heirs. Those in a position to do so should look to complete such transactions in the near term, before Congress turns their attention to tax reform.
For information about how changes to the estate tax exemption could affect your estate plan, contact your PMFA wealth management advisor.
