An important part of the pending expiration of certain provisions of the Tax Cut and Jobs Act (TCJA) of 2017 is the “estate tax cliff." The estate tax cliff refers to the estate tax exemption that will be reduced from approximately $14.5 million to approximately $7 million automatically on 1/1/26. The current tax rates of 40% for taxable estates over $13.61 million remain unchanged.
How did we get here?
Back in 2017, the process Congress used to pass the TCJA required budgetary constraints preventing most nonbusiness provisions from being permanent. As a result, unless Congress and the President act, the estate tax provisions of the TCJA are set to expire at the end of 2025.
In anticipation of the pending cliff, the IRS has enacted special relief that addresses some of the concerns. The IRS clarified that unless the law changes, any unused estate tax exemption over and above the base amount in effect on 1/1/26 will lapse.
The special rules that the IRS enacted provide that any lifetime exemption used prior to 1/1/26 will not be subject to recapture/clawback to the extent it exceeded the base in effect on 1/1/26. In other words, think of the $7 million exemption in 2026 as the base and the amount above it as a bonus amount.
The base amount will be considered used first prior to 2026 such that if the full base and bonus amounts are not used before 2026, any remaining bonus amount will be lost.
They also clarified that the existing Deceased Spouse Unused Exemption (DSUE) rules will continue to apply post-2025. This is good news to those surviving spouses that have made the portability election prior to 2026.
For example, if a DSUE (portability) election was made in the amount of $12 million prior to 2026 when the exclusion is reduced; the surviving spouse keeps the DSUE of $12 million post 2025.
Let’s take a brief look at the changes President Biden has proposed about estate and gift taxes and what former President Trump and the Republican Party have proposed.
President Biden does not support extending the current estate tax rules. Biden’s proposals would generally take effect at the start of 2025 as part of his proposed 2025 budget, rather than waiting for the TCJA to expire.
The first proposal we’ll discuss pertain to the rules regarding realization events for gift and death tax transfers. Currently, assets transferred to most irrevocable trusts are removed from the estate of the individual making the transfer, which make those assets exempt from estate tax. The reason for this is that as part of the transfer, the trust grantor signs over control of the assets to the trust itself.
If the irrevocable trust is considered a grantor trust, meaning the grantor is still required to pay all income tax arising from income earned by the trust assets, then most transfers/sales between the trust and the grantor are exempt from income tax. This may also include transfers between trusts and any taxes paid on their behalf by the trust grantor.
One proposed change in the realization rules would require that sales or other transfers between a grantor/beneficiary and a trust require the recognition of taxable gain/loss to the seller/transferor.
The next proposal would treat tax payments made on behalf of a trust to be counted as a gift, subjecting it to gift tax rules (stay tuned for more on proposed changes to the gift tax). The exception to this rule would be if the trust reimburses the individual that made the payment.
Currently, properly structured loans from trusts to their grantor or beneficiary don’t have any tax implications. The next proposal would treat loans a trust makes to a grantor/beneficiary as an income distribution. In addition, the loan would also be subject to the GST rules, which could result in GST tax being assessed. Trusts may be liable for the taxes if the grantor/beneficiary fails to or is unable to pay. This rule would also apply retroactively to existing loans that predate the law.
Another proposal would change the generation skipping tax (GST) inclusion ratio rules. Under the proposal, most transactions that result in a change in trust assets would require the inclusion ratio to be redetermined to account for that change.
GST is imposed on transfers between one generation and one removed from the next generation. Another proposal is to modify the GST rules to limit the allocation of any exemption to two generations below the transferor and to taxable terminations that occur while an eligible beneficiary is alive.
The stated goal of this is to ensure that the benefits of the GST exemption would expire before the trust does. This rule is intended to affect all trusts subject to GST tax regardless of the trust’s inclusion ratio on the date of enactment.
Currently, most assets still considered part of an individual’s estate receive a cost basis adjustment up to their fair market value (FMV) as of the individual’s date of death. Under the proposal, the grantor/owner of an appreciated asset would realize a capital gain at the time of the transfer.
The amount of the gain realized would be the excess of the asset’s fair market value on the date of the gift or the decedent’s date of death over the decedent’s basis in that asset. That gain would be taxable income to the donor or to the decedent’s estate on the federal gift or estate tax return.
The final rule change on this topic that we’re going to explore is the proposed forced recognition events. Most of these proposals only affect those making more than $400,000 a year.
Under the proposed rules, when an appreciated asset is transferred via gift either during the owner’s life or as part of their estate settlement, a taxable gain would be recognized by the individual or their estate.
The next proposal would require gain recognition on the unrealized appreciation on assets that have not had a recognition event within the prior 90 years. The holding period for purposes of this proposal starts the clock at 1/1/1944 when measuring the 90 years. This would put the first deemed recognition events to occur after December 31, 2033.
The proposal applies to both individuals and entities. The proposal has several exceptions included for assets like personal property and homes. There are also special rules for family owned and operated businesses that can defer a recognition event and stretch any tax due over 15 years.
How will the gain be determined for this and other situations? Stay tuned as we are going to look at the proposed changes to the way certain transactions will be valued.
Split interest trust rules, such as a charitable lead annuity trust that transfers its remaining interest to a noncharitable beneficiary after a series of annuity payments to a charitable organization, are also due for an overhaul in the President’s proposed budget.
One of the changes would be how the annuity and remainder interest are determined by establishing a minimum value along with a minimum and maximum term. Additionally, the proposal would prohibit exchanging trust assets without triggering a realization event.
Under the current gifting rules, individuals can give up to $18,000 annually to an unlimited number of recipients. One of the requirements under the current rules is that gifts must be of a present interest. The present interest rules requires that the recipient have an immediate and unrestricted use of the gift.
A work around to this rule that evolved for trusts became known as a “Crummey power.” Under the Crummey power a beneficiary only needs to have a limited right of withdrawal to meet the present interest requirements.
The President’s budget proposal would set the annual gifting limit at $50,000 per donor. Gifts that exceed this new limit could be subject to tax. The proposal also eliminates the Crummey power as there would no longer be a present interest requirement for gifts.
Currently, various valuation discounts such as lack of marketability and lack of control are permitted to be considered for closely held businesses. Under the proposed rules, the various valuation discounts would be eliminated.
Currently, there are no requirements for trusts to disclose the nature or value of their assets (after the initial and certain subsequent transfers). The proposal would implement new reporting requirements on trusts like that of private foundations. The amount of information required to be reported under this depends upon the value of the assets or income exceeding a threshold amount.
How this new information will be reported will be determined after the proposal takes effect. The stated goal of this proposal is to assist with tax administration matters such as evaluating compliance with applicable statutes and regulations, as well as developing future statutes and regulations.
Now that we know what the President’s proposals are, what does the other major candidate and their party propose to do about the estate tax cliff?
There aren’t many specifics available about their priorities should they win the Presidency and Congressional majority. Despite this, Trump and the Republican party have voiced support for making the expiring estate tax provisions permanent. There is some support for eliminating the estate tax altogether, with republicans in the House of Representatives recently reintroducing the Death Tax Repeal Act. Another proposal exists that seeks to reduce the maximum estate tax rate from the current 40% to 20%.
Now that we’ve had a chance to look at what the future may look like, we can tell that a great divide exists between the overhaul that the President has proposed and keeping the status quo as former President Trump has proposed. So, what are the likely possibilities in the near term (pre-election) and long-term (post-election)?
One can expect that the current divided government limits the prospects for significant tax legislation before the election. This is supported by Congress being unable to pass a budget for the current fiscal year that began last October, relying on multiple temporary spending measures instead.
Both parties will want to wait to see if they have a sufficient majority to confidently move their legislative priorities ahead or at least block the opposition party’s priorities.
The specific outcome of any overhaul of the TCJA tax reforms will depend on which party controls the White House and Congress and the strength of federal budget deficit concerns. Elected officials on both sides of the aisle may prioritize keeping the TCJA tax cuts for the middle class and pass-through businesses.
Due to budgetary pressures, both parties may need to consider revenue raisers to “pay” for extending the expiring provisions by increasing the corporate rate and the individual rate for high-income earners along with other alternative revenue-raising options.
Should you have any questions or concerns, please reach out to your SVA relationship manager for a personalized conversation on how the estate tax cliff may impact you.
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