During last year’s election cycle there was some discussion of tax policy changes that now President Biden wanted to make. At the time, many thought those changes were unlikely to occur because they would be blocked
by a Republican-controlled Senate. However, in January Democrats won the two open seats in Georgia, giving Democrats a razor-thin majority in the House of Representatives and the Senate for the next two years.
With the Democrats being in control of Congress and the White House, we would normally expect to see changes to tax policy. In addition to the power shift, the federal government has spent a great deal of the last year on stimulus packages to respond to the pandemic. This makes it even more likely that we will see tax reform in the next two years, especially to the income, estate, and capital gains taxes paid by individuals.
Likely Tax Changes
There are likely to be changes to the ordinary income tax regime, estate tax regime, and capital gains tax regime sometime while Democrats are in control of Congress and the White House.
First, we are likely to see an increase in the top marginal income tax rate. Currently, the top marginal income tax bracket is 37 percent. This rate was lowered as part of the 2017 Trump Tax Cuts. With the Democrats in control, we will likely see an increase in the top marginal tax rate to 39.6 percent.
Second, as part of the 2017 Tax Cuts and Jobs Act, the federal estate/gift tax exemption was doubled from the previous amount. In 2021, this means a person can gift during their lifetime, or leave to their family at death, $11.7 million without paying any federal estate tax. Each year the exemption is increased for inflation (as an example, in 2020 the exemption was $11.58 million). This doubling of the exemption, along with its inflationary increases, was to last until December of 2025. Beginning in January 2026, the exemption was set to be cut in half, so that it would be closer to $6.0 million.
It is likely that a Democratic Congress and the Biden administration will cause the expiration of the doubling of the estate/gift tax exemption to occur sometime in the next two years. That means that the estate tax exemption would be closer to $6.0 million. If the estate/gift tax exemption is reduced, it will not likely be a retroactive change. This means that if you gift the larger amount before the exemption is reduced, you will not be taxed on the value of the gift over the new exemption.
In addition to the decreased exemption, it is likely that we will see an increase in the estate tax rate. Currently, estates are taxed on every dollar over the exemption at a rate of 40 percent. It is likely that a Democratic Congress and White House will increase this rate to 45 percent.
Not only will there be changes to the estate tax regime, but we are also likely to see changes to the capital gains tax rate. Currently, the top capital gains tax rate is 20 percent; it is likely that we could see an increase of the top capital gains tax rate to 24.2 percent. In addition, we still have the Affordable Care Act surtax of 3.8 percent, so that the top combined federal capital gains tax rate will be 28 percent.
What Proposed Tax Changes Are Unlikely
You may have heard that Democrats want to close the “death tax loophole.” The loophole they are referring to is an adjustment in basis that occurs at death with respect to the capital gains tax. Capital gains taxes are imposed on the difference between what you sold an asset for and what you originally paid for the asset. What you paid for an asset when you initially purchased it is known as your basis. Under current law, when you die holding on to an asset, your family will receive an adjustment to their basis to the fair market value on the date of your death, this is also known as a step up in basis. Democrats would like to eliminate this step up as they view it as a way for wealthy persons to avoid ever paying income taxes. With the smallest possible margin, Democrats are unlikely to get this change made in the next two years.
What Estate Planning Opportunities Are Expected In 2021?
While we are likely to see these changes sometime in the next two years, many believe that it will not occur during the calendar year 2021. Congress has other items that it has prioritized. Therefore, 2021 may provide a unique opportunity to plan to avoid these increased taxes.
There is little that can be done to avoid paying higher income taxes or capital gains taxes right now. However, there is a huge opportunity to avoid paying more in estate taxes. As I previously mentioned, any change to the estate/gift tax exemption is unlikely to be retroactive. This means it will only apply to gifts made after it is passed. We also know from IRS guidance that you will not have to pay estate or gift tax if you use the increased exemption, and Congress later lowers the exemption. Therefore, for many of my clients now is time they are looking to gift land, business interests, and other discretionary assets. Making a gift now can save you a lot in potential future estate taxes!
For example, right now you could gift $11.7 million in assets, no gift tax will need to be paid and the recipient will have all that money. However, if you don’t make the gift and the estate tax exemption is lowered to half ($6.35 million), when you die with the same $11.7 million your estate will have to pay estate taxes of more than $2.5 million with a 40 percent estate tax rate (more than $2.8 million, if the estate tax rate also increases to 45 percent). After paying the tax, the recipients of your estate would only receive $9.0 – $9.2 million. In other words, you have an opportunity to give away $6.35 million tax free in 2021, which will be lost if the exemption is decreased – therefore, it is a use it or lose it proposition.
If you would like to make a gift to use your exemption, I suggest using one of two trusts to be the recipient of your gift. If you are married and want to take advantage of the increased estate tax exemption, but still need access to the income generated from the gifted assets, then you can gift to a trust created for the benefit of your spouse. By providing a benefit to your spouse, you can still indirectly benefit from the assets placed inside of the trust.
If you are not married, or want to provide your children benefits now, then I would suggest a trust for the benefit of your children. Not only will you be able to save estate taxes by gifting to a trust for the benefit of your children, with the proper planning you can avoid estate/gift tax being paid by the next generation as well.
To do this you must give assets to a Generation Skipping Trust. A Generation Skipping Trust will provide benefit to your children for their lives, and when your children pass, it will provide benefit to your grandchildren for their lives. If structured properly, the transfer from your children to grandchildren will occur without paying any estate taxes. In addition to the estate tax savings, a Generation Skipping Trust can provide protection from creditors for the beneficiaries, including potential ex-spouses of the beneficiaries.
While we are sure to see tax law changes because of the Democrats taking control in Washington, many believe it will not occur in 2021. Therefore, you may have an opportunity for tax savings now that may not come around again.
Kyle Barlow is an attorney with Fredrikson & Byron, P.A., in Fargo, North Dakota, who specializes in estate planning for business owners. If you would like to speak with Kyle regarding your estate and a plan to transition it to the next generation, contact him at [email protected].