On January 5, 2021, Georgia Democrats Jon Ossoff and Raphael Warnock defeated GOP incumbents David Perdue and Kelly Loeffler in their Senate runoff elections, giving the Democrats 50 seats in the Senate. Vice President Kamala Harris has the power to break a 50:50 tie, which gives the Democrats effective control over the Presidency, Senate and House.
Below is a summary of possible changes in tax law as a result of the democratic turnaround and strategies that taxpayers may consider to implement should those changes in tax law occur. This discussion complements our previous warning of October 19, 2020 (available here) after the election results are final.
Possible changes in tax law
Below is a non-exhaustive list of possible changes to tax law under a democratic administration:
- Lower Transfer Tax Exemptions – Under applicable law, inheritance, gift, and generational (GST) tax exemptions are $ 11.7 million per person or $ 23.4 million per couple, respectively. These large transfer tax exemptions will be indexed for inflation through 2025. However, by 2026, exemptions are expected to drop to $ 5 million per person or $ 10 million per couple, which in turn are indexed for inflation. Most experts believe Biden would try to cut the tax exemptions on transfers to $ 3.5 million per person, or maybe even less, before their planned sunset in 2026.
- Higher Tax Rates on Transfers – The current tax rate on transfers that exceed a taxpayer’s estate, gift, or GST exemption is 40%. In addition to lowering the amount of exemption, the transfer tax rate could also increase, possibly to 45% or more.
- No Income Tax Base Adjustment On Death – Currently, most assets going through the estate of a deceased taxpayer receive an income tax base adjustment up or down to the fair value at the time of the taxpayer’s death. This can be extremely beneficial for highly valued assets such as low-base securities or a closely held company, as all capital gains are wiped out before the asset dies. Biden has proposed eliminating this base, which could lead to significantly higher capital gains taxes on inherited assets.
- Taxation of Capital Gains at Ordinary Income Tax Rates – Long-term capital gains are currently taxed at a maximum rate of 20%. Biden has proposed taxing capital gains at normal income tax rates, which means the new maximum rate could be 39.6% or possibly higher.
- Eliminating Other Popular Estate Planning Tools – The Democrats could also dust off old transfer tax proposals last seen during the Obama administration. For example, they could seek to eliminate short-term Grantor Retained Annuity Trusts (GRATs), limit the use of valuation discounts, impose a term limit on GST trusts, and / or limit the use of Grantor Trusts in estate planning transactions.
If transfer tax laws change, one may wonder when those changes will take effect. It is also fair to ask whether such changes could be made retrospectively from the Effective Date. While there is no guarantee, it is unlikely that tax laws will be applied retrospectively as of January 1, 2021. Changes to tax law are more likely to take effect when they go into effect or possibly January 1, 2022, but if tax law is in effect, it will be postponed to the third or fourth quarter of 2021. However, no one can predict the future, and strategies may be available to reduce the risk of a retrospective gift tax.
- Use “Bonus” Exemptions Before They Expire – When transfer tax exemptions are lowered either under the new administration or in 2026, taxpayers will face a scenario where they will either use it or lose it. In other words, taxpayers must take advantage of their “bonus” exemptions before leaving or risk losing them forever. If a taxpayer elects to take advantage of their bonus exemption in 2021, the IRS has stated that there should be no “clawback” if the exemption is reduced in 2021 or in future years. Consequently, taxpayers who may have a taxable estate should consider taking advantage of their bonus exemptions while they still can.
- Use Popular Planning Tools Before Eliminating Them – As mentioned above, it is possible that many popular estate planning tools like valuation discounts, GRATs, and other Grantor Trust techniques could be eliminated or at least severely limited. Taxpayers who have pondered these strategies should consider implementing them now before tax laws change.
- Take advantage of low interest rates and depressed assets – In many cases, planning capital transfers works best when interest rates are low and assets are low. Applicable Federal Rates (“AFRs”) are at or near historic lows, and many companies have suffered severe economic losses as a result of the COVID-19 pandemic. In January 2021, the short-term AFR (for loans with a maturity of less than 3 years) is only 0.14, the medium-term AFR (for loans between 3 and 9 years) is 0.52% and the long-term AFR (for loans with a maturity of more than 3 years) 9 years) is only 1.35%. The 7520 rate used for GRATs and other strategies is nearly all time low at 0.6%. These historically low interest rates will certainly benefit new transactions, but they also provide an opportunity to enhance existing transactions by renegotiating lower interest rates on existing promissory notes.
- Incorporation of Potential Access to Transferred Funds – Some taxpayers cannot afford to surrender their full bonus exemptions, but could face significant transfer tax liabilities if the exemptions are reduced. For example, imagine a married couple with a net worth of $ 20 million. This couple do not have a taxable estate today, but could owe significant estate tax on the death of the surviving spouse if the laws change. To avoid all of their assets being given away, these taxpayers may need to “have their cake and eat it too” by implementing a strategy that takes advantage of the bonus exceptions before they expire but allows potential access to funds transferred when they are in Future are needed. For married couples, SLATs (Spousal Lifetime Access Trusts) are still viable planning tools. Other strategies are available for individual taxpayers to improve potential access to gifted property. Every taxpayer’s situation is of course different and our group has prepared a white paper discussing possible gift strategies which we will be happy to share on request.
- Consider Accelerating Capital Gains – We typically don’t recommend selling a business or making capital gains just because tax rates might change. However, taxpayers with pending sales may consider closing those sales in early 2021 to take advantage of the 20% capital gains rate in case tax laws change later in the year.
- Have a Conversation Now – Waiting until the last minute to complete an estate planning transaction is usually not a good idea, and it could be a particularly bad idea in 2021. We may have very little time before possible changes to tax law come into effect and many experts anticipate a large number of cases in 2021. The time for these talks is now so that taxpayers don’t get flatfooted. when the tax legislation is passed.
Although the tax landscape could change significantly in the coming months, we encourage everyone to “check before you jump”. To do this, it is important to realize that each person’s situation is unique and requires individual analysis and advice.