With all the uncertainty we have faced during the COVID-19 pandemic, the need for effective estate planning has become more apparent than ever. Further, the prospect of significant changes to the federal transfer tax regime makes 2021 the perfect time for attorneys to help their clients focus on updating outdated estate planning documents, create new documents to ensure assets pass to clients’ intended beneficiaries, and advise clients about wealth transfer techniques to take advantage of the current federal transfer tax laws before any changes occur.
Estate Planning in 2021
If 2020 has taught us anything, it is to expect the unexpected. So now, more than ever is an ideal time for clients to review or put in place their “basic” estate planning documents – wills, revocable trusts, powers of attorney, and health care directives – to ensure they are up to date, accurately reflect their wishes, and are flexible enough to take into consideration potential changes to the transfer tax laws.
In 2021, the federal transfer tax laws permit each person to transfer $11.7 million free of federal estate and gift tax to their heirs or intended beneficiaries. That federal exemption amount is set to expire on December 31, 2025, and revert to $5 million per person, adjusted for inflation. However, it is anticipated that Congress will enact new tax legislation, possibly in 2021 or 2022, reducing the federal estate tax exemption amount to $5 million or even $3.5 million before then. Also, new legislation could be enacted that would eliminate the favored step-up in basis for income tax purposes of a person’s assets at death.
Currently, New Jersey does not have an estate tax, having repealed it on January 1, 2018. However, some think that a permanent repeal of the New Jersey estate tax is unlikely, and it might be reinstated in the future.
Things to Know About Estate Planning
Flexibility to address changes to the transfer tax laws is key for an estate plan. For married couples, having assets pass outright to a surviving spouse at the first death is simple, but provides little flexibility for tax planning. Attorneys might recommend that married clients instead consider options for their estate planning documents that allow certain tax decisions to be deferred until after a person’s death. Two options are utilizing a “Disclaimer Trust” or a “Clayton Qualified Terminable Interest Property (QTIP) Trust.”
The Disclaimer mechanism provides that assets pass outright to a surviving spouse at the first death, but he or she would have the option of disclaiming assets, so those disclaimed assets would instead flow to an estate tax-protected trust for the benefit of the surviving spouse. A Clayton QTIP Trust provides that assets would be held in trust for the surviving spouse at the first death but allows flexibility to wait and make tax elections after the death to determine if some or all of the trust should be estate tax-protected. Both options allow the decision of whether to fund an estate tax-protected trust for the benefit of the surviving spouse to be delayed until after the first death.
Additionally, it is important to remind clients that wills and trusts do not control the transfer of joint accounts or pay on death (“POD”) accounts, nor the disposition of assets for which there is a beneficiary designation on file, such as retirement accounts or life insurance. Thus, an estate planning update should include consideration of how a client’s assets are titled and a review of their beneficiary designations, to ensure that any insurance and retirement assets are distributed consistent with the client’s wishes.
Also, the Setting Every Community Up for Retirement Enhancement Act of 2019 (the “SECURE Act”), effective January 1, 2020, made significant changes to the rules regarding the distribution of a qualified retirement account after a person’s death. A review of the SECURE Act is beyond the scope of this article, but changes to a client’s estate planning documents might be required due to the SECURE Act, particularly if qualified retirement assets flow to a trust for the benefit of a spouse or descendants.
Important Estate Planning Options
For clients who would have a federally taxable estate if the exemption amounts were reduced, and who have not yet taken advantage of wealth transfer techniques to capture the current high federal transfer tax exemption amounts, there still may be the time in 2021. Many wealth transfer techniques are available, and some popular ones are summarized as follows:
- Outright Gifts to Descendants or Others: This option is straightforward and cost-efficient but does not provide flexibility for the donor or creditor protection for the recipient.
- Gifts to Descendants in Trust: A donor can create an irrevocable trust for the benefit of his or her descendants (or other beneficiaries) and transfer assets to the trust as a gift. The transferred assets (plus all the appreciation on those assets) would be removed from the donor’s estate. The trust could be structured as a “dynasty trust,” which could potentially pass from generation to generation free of transfer taxes. Further, the trust could be structured as a “grantor trust” so the donor would pay the income tax attributable to the trust’s income, thereby further reducing the donor’s taxable estate in future years without adverse tax effects. Such a trust provides transfer tax benefits as well as a protective arrangement for the trust beneficiaries.
- Spousal Lifetime Access Trust (“SLAT”): This is an option for a married couple and might be preferable to transferring assets to a trust for descendants. A SLAT is an irrevocable trust created by a donor for the benefit of his or her spouse, designed to capture a donor’s federal gift tax exemption amount before it is potentially reduced by new legislation. Children and more remote descendants also may be current or remainder beneficiaries of the trust. The assets transferred to the SLAT (plus all the appreciation on those assets) would be removed from the donor spouse’s taxable estate. Distributions from the trust to the beneficiary spouse would be allowed during his or her lifetime. At the spouse’s death, assets could pass on to the donor’s descendants or other chosen beneficiaries.
High-Net-Worth Wealth Transfer Techniques
Wealth transfer techniques have pros and cons, including the loss of access to transferred assets and potentially trading estate tax savings for capital gains tax savings. There are several factors to consider, but the techniques are worth contemplating now, particularly for high-net-worth clients.
If new transfer tax legislation is enacted, the question is when the new laws will be effective. New legislation could be effective on the date of enactment; at a future date, such as January 1, 2022; or possibly retroactively to January 1, 2021. Given the uncertainty of what future exemption amounts might be and when they might take effect, for clients seeking to make lifetime wealth transfers in 2021, it is prudent to build in flexibility to avoid an unintended gift or generation-skipping transfer (“GST”) tax due to a retroactive change in the federal transfer tax laws. A few options include the following:
- Formula Gift: A donor could make a gift of an interest in an asset-based on a formula that would self-adjust so the amount of the gift could be limited to the amount of the donor’s remaining federal gift tax exemption amount (or possibly the donor’s GST tax exemption amount) as finally determined for federal estate and gift tax purposes, even if that amount is changed retroactively.
- QTIP Election: A married person could make a 2021 gift to an irrevocable trust for the benefit of his or her spouse, which could qualify for the marital deduction if a QTIP election is made. The trust could provide that if no election is made, the assets would pass to an estate tax-protected trust for the beneficiary spouse and would use some or all of the donor spouse’s lifetime gift tax exemption amount. If there is a retroactive change in the transfer tax laws, a QTIP election could be made to avoid an unintended gift tax. The donor spouse would not have to decide whether to make the QTIP election until the gift tax return is due. Thus, for a 2021 gift, the donor spouse would not have to make the QTIP election until April 15, 2022 (or October 15, 2022, if the gift tax return is extended), which would allow time to determine whether any changes to transfer tax exemptions will be retroactive.
- Disclaimer: If a donor creates an irrevocable trust in 2021, the trust could include a provision permitting a beneficiary to disclaim some or all of the assets transferred to the trust. If assets are disclaimed, they could be returned to the donor and the transaction would be treated as if it never occurred, thereby avoiding an unintended gift tax and/or GST tax due to a retroactive change to the transfer tax laws. To be effective, the disclaimer must be made no more than nine months after the date of the gift. Therefore, if a gift is made on April 1, 2021, or later, a valid disclaimer could be made up until January of 2022, again allowing time to determine whether any changes to the transfer tax laws will be retroactive.
What’s Most Important Now?
For many clients in 2020, estate planning became a pressing need, and that need has continued in 2021. If the COVID-19 pandemic has taught us anything, it is that preparedness and flexibility are key. Given today’s uncertainty, for those who have not yet done so, the time to focus on estate planning is now.
Reprinted with permission from the March 16, 2021, issue of the New Jersey Law Journal. © 2021 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
For questions about this or any related topic, please do not hesitate to contact Estate, Trust, and Individual Tax Group co-chairs Judith A. Harris or James J. Costello, Jr. or a member of our Estate Planning & Administration Group or Taxation Group..