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Tax News You Can Use

The Expiring Exemption: Is Chicken Little Right?

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Tax News You Can Use | For Professional Advisors

 

Jane G. Ditelberg

Jane G. Ditelberg

Director of Tax Planning, The Northern Trust Institute

Due to quirks in the legislative process for tax bills, it is not uncommon for Congress to enact laws with provisions that remain in effect for a limited time. Changes to the law that expire, at which point the rules revert to what was in effect before the change, are said to “sunset.” In the estate and gift tax world, the Tax Cuts and Jobs Act of 2017 doubled the amount of assets that a donor can give, whether during life or at death (“exemption”), without incurring tax. That provision is scheduled to sunset on Dec. 31, 2025, at which time the exemption is set to drop from its current level of $13.61 million to around $7 million.1

The financial press and the blogosphere currently are filled with exhortations to taxpayers that there is a now or never opportunity to make gifts; that the increased exemption must be used now, or it will be lost forever. This creates a sense of urgency to make a gift. But is the sky really falling?

Consider the following facts:

  • The urgent deadline only applies, if it applies at all, to taxpayers who can make a gift of more than $7 million (the post-sunset exclusion amount). Those who are not considering a gift over that amount are not impacted by the sunset.
  • Lifetime gifts are a great tax planning strategy even if the sunset does not occur. For those who want to make a gift and can afford it, there are good reasons to proceed regardless of the sunset.
  • The sunset may not happen. Congress has time to act to change the law, so gifts made in anticipation of the sunset should be ones the donor is happy making even if the sunset is repealed.

Let’s examine these closer before following Chicken Little.

Will the exemption really sunset?

Many times, when Congress enacts a provision that sunsets, they are kicking the ball down the road to a future Congress to wrestle with. And often the stakes are extremely high with an abrupt sunset as the default, rather than more gradual adjustments. In this case, that “down the road” coincides with an election year, making the exemption an election hot topic. For veteran estate and gift tax specialists, this is familiar territory as we have found ourselves in similar situations multiple times since the estate and gift tax exemptions were unified in 1976.

Estate, Gift and GST Tax Exemption Amounts

The sunset is automatic and the default if Congress does not enact legislation to change it. And given the narrow margins of control in Congress, passing legislation that the President will sign into law has been difficult for both sides of the aisle. However, it is important to remember that the exemption has never been reduced before, and that Congress has acted to prevent sunsetting at the last minute in previous situations, even when it was belatedly and with retroactive effect.

How does the sunset of the exemption impact a taxpayer?

The “Chicken Little” argument is that if a taxpayer dies today with a $13 million estate, no federal estate tax will be due (although in some states there would be a state level tax). After the sunset, assuming a $7 million exemption and ignoring possible deductions, the federal tax on the same estate would be an estimated $2.4 million. At first glance one might ask, “Who wants to risk paying $2.4 million in tax if they don’t have to, right?” This creates an incentive to act fast before time runs out.

The argument is that by making a lifetime gift now, the taxpayer can use the exemption that would otherwise disappear upon the sunset and save the $2.4 million in tax. And while that may be true, it is not the end of the story. To achieve that result, the taxpayer would need to make a gift of their entire $13 million estate, potentially leaving nothing to support them for the rest of their life. Not many want to take a vow of poverty to save the taxes.

But, I have been asked, what if the taxpayer only gave away $5 million? Can’t they use part of the current exemption and save the tax? To understand why it doesn’t work that way, it is helpful to think of the exemption as a stack of blocks like the photo below. The taxpayer uses the blocks at the bottom of the stack (starting with the blue one) when they make a lifetime gift. When the sunset happens, it takes blocks off the top of the stack (starting with the green one). The taxpayer only gets the benefit of the green block on the top of the stack if the lifetime gifts before the sunset knock out all the blocks below it. If the taxpayer makes $5 million in lifetime gifts now, and dies after 2026, they will use up the blocks on the bottom, and when the ones on the top go away at the sunset, the estate will be taxed on the amount of assets in excess of the remaining exemption, in this case $2 million ($7 million exemption minus $5 million used on lifetime gift).

Using our example of a taxpayer with an estate of $13 million, the estate tax effect of the lifetime gift is shown in the following chart.

Are there other tax benefits from a lifetime gift?

A lifetime gift does something else that the above charts do not illustrate. When a gift is made of assets that are appreciating in value, that appreciation occurs outside the taxpayer’s estate and avoids estate tax. Moving the appreciation out of the estate is a benefit that happens whether or not the exemption sunsets. This benefit is muted slightly by the fact that the assets do not get a new basis when you make a lifetime gift as they do under current law if the transfer happens at death.

Let’s consider an example: A taxpayer with an estate of $13.1 million today could make a gift now or retain the assets until death, which, for the sake of the example, we will assume is 2044. If the taxpayer does not make a gift and retains all the assets, which grow at a rate of 5% per year, the chart on the left shows how much tax will be paid on the appreciated estate if the exemption is $7 million. If the taxpayer instead made a gift of $13.1 million in 2024, and the assets grew outside of the estate but were subject to capital gains tax, the results will be those shown in the chart on the right. The tax savings could reach $6.8 million in this example if the gift is made in 2024.

Lifetime Gifts Can Leverage Exemption

Tax Consequences; Retaining Assets Until Death in 2044 Compared to Lifetime Gift in 2024

What does this all mean?

Will the bonus exemption sunset? Possibly. But if it does, it will only be closing off tax-savings opportunities for taxpayers who are planning to use up the blocks from the top of the stack of their exemption to make a lifetime gift. Any lifetime gifts a taxpayer makes has the possibility of shifting appreciation out of the estate and saving estate tax that way, regardless of the size of the gift and whether or not the sunset happens. But it is important to keep in mind that any gift should be one the donor is confident they will be satisfied with, whether the exemption sunsets or not. Is Chicken Little right? We don’t think so, but being informed about how the changes work will provide the best umbrella for whatever falls from the sky.

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  1. The actual numbers are indexed for inflation, so it is not possible to predict the exact amount. The amounts in the chart below for 2025 and 2026 are based on estimates.

Disclosures

© 2024 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S

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.

The information contained herein, including any information regarding specific investment products or strategies, is provided for informational and/or illustrative purposes only, and is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any investment transaction, product or strategy. Past performance is no guarantee of future results. All material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

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