Your Questions Answered: Wealth Planning and the 2020 U.S. Election

While the results of the upcoming election are unknown, there are strategies to prepare your wealth plan for an uncertain future. Pam Lucina, Chief Fiduciary Officer and President of the Northern Trust Institute and Paul Lee, Chief Tax Strategist, answer common client questions as we head into the 2020 election.

1. How would the proposal to eliminate the “step-up” in (cost) basis at death affect concentrated securities positions and real estate (e.g., farms)?

If elected, Democrat candidate Joe Biden has proposed repealing the “step-up” rule. Currently, the cost basis of assets is “stepped-up” to fair market value as of date of death, resetting the tax basis to fair market value. However, there are few details available on how the repeal would ultimately look if implemented under a Biden administration.

Three possibilities come to mind:

1. The death of the property holder could become a tax realization event for the estate;
2. Heirs might receive a carry-over basis, meaning they retain the same basis as the deceased, and gain would only be triggered when the property is eventually sold by the heir; or
3. A “modified” carry-over treatment could be used, where some assets are stepped-up and others receive a carry-over basis. Similar to what was temporarily available in 2010 for certain estates, this scenario could lead to some assets receiving a “step-up” in basis, while other assets are transferred with a carry-over basis. If history is a guide, there could be some leeway for heirs to step-up their basis for some assets, such as farms, at least up to a certain value.

If it looks like these rules will be implemented, and the likelihood that an individual’s estate will not receive a full step-up in basis at death, individuals with large concentrated positions may want to consider trimming their holdings to take advantage of lower tax rates while they are still available, with the likelihood of higher federal (and state) income tax rates in the future.

2. What are the estate tax implications of making a gift in 2020 using the full exclusion amount ($11.58 million) and subsequently having the exclusion reduced to $3.5 million? Is there a possibility of being taxed retroactively?

In this instance, being taxed retroactively is unlikely. In 2019, the IRS published “anti-claw back” regulations clarifying that a donor who makes lifetime gifts, when the increased exclusion amount is in effect, and dies after 2025, when the increased exclusion amount reverts to the 2017 level of $5 million (indexed for inflation), the decedent’s estate will not “claw back” the excess and make the value of the gift subject to estate taxes. Presumably, these anti-claw back regulations would also apply if the exclusion amount were to be reduced before 2026.

3. Because of the uncertainty surrounding the election and tax laws generally, you advise making gifts into “flexible trusts.” What types of provisions make a trust flexible?

If making gifts to trusts, ensure current and new trusts are drafted to reflect your goals and wishes while providing maximum flexibility. This includes reviewing funding formulas to ensure trusts are funded as intended, no matter what the exclusion amount may be, and determining that trustees have the appropriate amount of discretion to adjust for changing circumstances. For trusts that are intended to last multiple generations, consider giving spouses and/or children powers of appointment. This allows the power holder to make certain changes and adjustments to how, when and even who receives distributions based upon prevailing needs and circumstances. Some trusts can be drafted to appoint a trust protector who has broad powers to modify irrevocable trusts, including the right to add beneficiaries, change the situs of the trust, and change distribution standards. There are other provisions that enhance flexibility, including the power to swap high basis assets for low basis assets, and the power to make loans in lieu of distributions.

Families who determine that they have enough wealth to fund their lifetime goals and fulfill family wealth transfer objectives, but are concerned about access to funds transferred, may want to consider making a spouse a beneficiary of a trust to provide flexibility for future use of assets for the family. However, note that death of the spousal beneficiary or a divorce would shut off this indirect access to these funds.

Learn more about drafting flexible trusts with our Modern Trust Provisions.

4. Given the advantages of “harvesting gains” especially when tax rates might increase for the coming tax year, is it advisable to sell a stock position at year end, while lower rates are still in effect, and immediately buy back the same position?

Technically, you could do this. Unlike “harvesting losses,” where the “wash sale rule” prohibits you from claiming a tax loss if you repurchase the same security within 30 days of incurring the loss, the wash sale rule does not apply to realizing gains. However, there are at least three things you will want to consider before making such a move.

First, there is the time value of money, the potential cost of paying tax on the gains today versus in the future. Second, the market is difficult to time and you may miss an unexpected run up in the stock price in between your sale and repurchase. We recommend harvesting gains only if it supports your long-term goals. Third, regardless of the prevailing administration, it is likely that not all taxpayers would be subject to higher long-term gain tax rates. The Biden campaign has proposed taxing long-term capital gains at the ordinary income tax rate (39.6%), but only for those taxpayers with income greater than $1 million. No additional details have been provided, but one possibility is that any long-term capital gain included in the first $1 million would nevertheless be entitled to the preferential 20% rate.

5. What is a GRAT, does creating a GRAT require using any of your tax-free exemption amount and are they at risk of going away after the election?

Families who intend to transfer significant wealth to future generations should also consider employing techniques that are especially effective in this historically low rate environment for tax-free transfers of wealth, including grantor retained annuity trusts (GRATs) and intra-family loans.

A GRAT is a type of trust designed to transfer property to beneficiaries with little or no gift taxes. If structured properly, the amount transferred via a GRAT is not counted against your allowable lifetime gift exemption.

To form a GRAT, the grantor transfers property to a trust in exchange for the right to receive an annuity payment for a period of years. At the end of the term, assuming the grantor has survived the term, any remaining property in the GRAT passes to the “remainder beneficiaries.” A GRAT can be structured so that it is “zeroed-out,” meaning that the gift is deemed to have a zero value and does not use any of the gift tax exclusion in the creation of the trust. If there are assets remaining in the GRAT after the final annuity payment is made, those assets will pass to the remainder beneficiaries free of gift, estate, and income taxes. 

Essentially, any appreciation above the interest rate in effect when the GRAT is funded will pass to the remainder beneficiaries. That interest rate today is at a historical low of 0.4%, so this is an ideal time to create a GRAT. Retaining a longer term with a GRAT would generally leverage this appreciation potential, but that should be balanced with the risk of the grantor dying during the term, which causes the GRAT assets to be included in the grantor’s estate. Of course, that would have been the case if the GRAT had not been created, so it isn’t detrimental, but in that case, the GRAT would not reduce the estate tax liability.

GRATs have not been specifically addressed by either candidate in this election. Nevertheless, GRATs are likely to be a topic of debate if Congress looks for tax law changes to raise revenue. In 2016, the Obama administration’s budget proposal included many provisions to curtail the use and the effectiveness of GRATs. These proposals could resurface.

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This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.