Estate Planning: Keep Your Eye on the Sunset

“Go big or don’t bother.” 

Those are the words we find ourselves saying to clients with large estates who are considering making significant lifetime gifts to heirs. The conversation often begins with a question from a client such as, “I understand that the estate tax exclusion amount is very high under current tax law but that it is scheduled to revert back to much lower levels in 2026 when the current limits ‘sunset.’ Should I therefore make large gifts today?”

In 2018, the amount you can give tax-free to people other than your spouse doubled from $5,600,000 to $11,180,000. With adjustment for inflation, that “exclusion amount” is $11,580,000 in 2020. A married couple effectively enjoys two exclusion amounts—a combined total of approximately $23 million in 2020—via portability, as explained by George Climer in Estate Planning Update: Portability Filing Relief.

Thankfully, you can still give everything to your spouse tax-free during your lifetime or at death. And charitable giving is an entirely separate topic. In this article, we’re discussing high-value gifts to individuals to whom you are not married and the tax implications of those gifts.

You and your spouse might be thinking to yourselves, “Well, our estate isn’t worth $23 million, so this article doesn’t pertain to us since we can give away all of our assets tax-free.” On the contrary, because of the scheduled sunset of current estate tax laws in 2026, you should read this article carefully if your estate will likely be worth more than half the current tax-free gift limit when you die. Said another way, you should keep reading if your estate value exceeds $11,580,000 ($5,790,000 if unmarried).

This maximum gift amount—the basic exclusion amount or BEA—can be used during your lifetime or at death. The BEA is cumulative; any amount of the BEA that you don’t give away during your lifetime is available to reduce the amount of your taxable estate at the time of your death. Any gifts you make beyond the exclusion amount are subject to a “gift tax” when made during your lifetime or an “estate tax” if made at death.

Historically, we’ve seen the exclusion amount increase every few years with inflation or with periodic changes to the law. But now we find ourselves in a quandary. The newly doubled BEA is scheduled to sunset in 2026 to the much-lower 2017 values. A logical question is whether you should accelerate your gifting now to take advantage of this temporary increase in the exclusion amount.

For a married couple with a large estate, the potential tax savings on accelerating gifts is the current estate tax rate (40%) times the difference between the current BEA ($23,160,000) and the 2017 BEA ($11,580,000):

($23,160,000 – $11,580,000) x 40% = $4,632,000 in potential tax savings!

At Bragg, we’ve come to think of your exclusion amount as having two parts: the “base” amount of $11.5 million—the amount that the exclusion was in 2017 and will revert to in 2026—and a “bonus” amount, the additional exclusion amount available between now and 2026. Because of the cumulative nature of the exclusion amount, you can’t give away any of the bonus amount until you’ve given away the base amount. This is such an important point, we’ll say it again: You can’t give away any of the bonus amount until you’ve given away the base amount. Therefore, taking advantage of this window of opportunity to make gifts requires that you give well over $5.7 million to truly make use of this tax-saving strategy. Thus, the reason for our response to our clients when they ask about accelerating lifetime gifts: “Go big or don’t bother.”

We want to pause here and remind you that with all lifetime wealth transfer situations, the number one consideration is affordability: Can you afford to part with assets given away? Making large lifetime gifts requires a significant sacrifice; you should take care to ensure that adequate assets remain available for your use.

To illustrate the necessity to “go big” in order to enjoy tax savings, consider these three scenarios. For simplification, all scenarios ignore potential growth in assets between the 2025 gift date and the 2026 date of death, the scenarios assume you are married, and assume you have an estate of $23 million in 2025.

1. In 2025, you and your spouse give $23 million to your heirs, taking full advantage of the exclusion amount. No gift tax is due. You both die in 2026 with zero estate assets, after the exclusion amount has reverted to $11.5 million. The estate tax due would be zero. We aren’t sure what you will be living on between 2025 and the date of your death, but at least no death tax will be payable!
2. In 2025, you both give zero to your heirs, and you both die in 2026 with an estate of $23 million. Because the exclusion amount is back to $11.5 million, your estate tax is $4.6 million.
3. In 2025, you and your spouse give $11.5 million to your heirs and file a gift tax return with the IRS. No tax is due at the time of the gift. You both die in 2026 with a combined estate of $11.5 million. Because the exclusion amount is back to $11.5 million, the estate tax due would be $4.6 million, the same as in scenario two where you made zero gifts. This is because in 2025, you only gave away the “base” amount, leaving the “bonus” amount inside your estate.

Here’s a chart to illustrate these same three scenarios:

You might be wondering, “If my spouse and I give away $23 million today and we die after the exclusion amount has reverted to $11.5 million, will the IRS attempt to tax our estates on the value of our prior gifts that exceeded the amount of the reduced BEA in effect on the date of our death?” There is good news here on this “threat of claw back.” The IRS and Treasury Department issued final regulations in November of 2019 stating that individuals who “make large gifts between 2018 and 2025 can do so without concern that they will lose the tax benefit of the higher exclusion level once it decreases after 2025.”¹

If you have until 2026 before the current law is scheduled to revert, when is the best time to make substantial gifts to “use up” the bonus amount? Unless you are facing a major life change—the sale of a business or other windfall event—we advise our clients to remain on hold until after the 2020 election when we will gain a better understanding of the likely direction of the estate tax rate and exemption amounts.²

A final reminder:  As we mentioned at the beginning of this article, taking advantage of the “excess exclusion amount” requires a significant sacrifice. Take care to determine the wisdom of a large lifetime wealth transfer. 

(This article ignores the value of the step-up in cost basis applied to assets within an estate, an advantage foregone when assets are given during lifetime. More on how the step-up leads many people to defer large lifetime wealth transfers can be found in this article.)

Please call us to discuss your specific situation.

¹IRS News Release, IR-2019-189, November 22, 2019

²Presidential candidates’ various proposed changes to the estate tax law have included reducing the estate exemption amount to $1 million, $2 million or $3.5 million, and raising the estate tax rate to 45% or higher (all the way up to a top rate of 77% for estates over $1 billion). Additionally, several candidates have proposed a progressive estate tax rate and eliminating the cost basis step-up altogether.

Please consult your estate planning attorney or tax advisor prior to acting on this information. This information is intended for educational purposes only as you make your financial plans. Employees of Bragg Financial do not practice law.