Gifting and More…While You Wait

July 22, 2021

As tax proposals circulate through Washington, DC, it may make sense to consider current estate planning opportunities before rules change.

The Biden administration’s American Families Plan, announced in April, is ambitious not only in terms of spending but also in its proposed changes to the tax code. Some features include raising ordinary income and capital gains tax rates for wealthier Americans and eliminating (above certain thresholds) the step-up (and step-down) of basis at death. However, a much-feared reduction in the current federal estate and gift tax exemption (currently $11.7 million per individual) has been excluded for now, leaving it to sunset after 2025 to its 2017 level of $5.49 million plus inflation adjustments. The plan also leaves in place annual gifting rules, which currently allow each individual donor to make tax-free transfers of up to $15,000 to as many individuals as desired without dipping into his or her exemption. Even so, much remains in flux. Various other legislative proposals do include curbs on the exemption and certain gifting vehicles, such as trusts, as well as raise the estate tax above its current maximum 40% rate (see the table below).

In the current uncertain environment, we stand by the dual principles of (1) making thoughtful, timely planning decisions and (2) where appropriate, capitalizing on the tools currently available to transfer assets. Among these tools, we believe gifting remains highly useful, often working in tandem with other strategies. In this article, we discuss several techniques that remain viable today but may be curtailed later.1 As such, they could be worth undertaking as we wait for clarity through the legislative process.

Annual Exclusion Gifts

Under current law, every person can give away up to $15,000 per year to as many individuals as he or she wants without using any federal gift and estate tax exemption. The $15,000 is indexed for inflation, which allows for potential increases in future years. Spouses can each give $15,000 to the same person, or one can be deemed to gift on behalf of both spouses, for a maximum per couple of $30,000. For those with large families, this approach can enable the transfer of substantial amounts over multiple years.

Educational and Medical Expenses

Significant transfer tax savings can also be achieved by taking advantage of the ability to make certain payments for educational and medical expenses without incurring gift tax. Under current law, any amount paid on behalf of any individual as tuition to an educational organization, or to any provider of that individual’s medical care, is not treated as a gift. For these payments to qualify under this exception, they must be made directly to the educational institution or medical provider. Reimbursements to the individual for these expenses don’t qualify.

Estate and Gift Tax Exemption Transfers

The current exemption from estate, gift and generation-skipping transfer tax is $11.7 million per individual. Assuming one is comfortable making significant gifts, using the federal exemption to make lifetime transfers generally is more advantageous than waiting to apply it at death2 : Once transferred, the growth of those assets is outside of the donor’s estate, enhancing the value for the recipients. Note that it is typically more effective to give away cash or property with a basis equal to current market value, rather than low-basis assets like long-term stock holdings, because the donor’s cost basis is carried over to the donee. This approach avoids transferring assets with a built-in income tax liability and/or losing out on the step-up at death.3 If the latter is largely eliminated, as proposed by pending legislation, we believe these issues would be less of a concern.

Gifts to Grantor Trusts

Rather than make direct gifts, it may be advantageous to transfer assets to lifetime trusts for children, grandchildren and others, which allow for professional oversight by a trustee and can offer protection against creditors. If structured as a grantor trust, the creator (grantor) of the trust is considered the owner of the trust for income tax, but not estate tax purposes. Accordingly, the grantor pays all the income taxes generated by the trust property (essentially a tax-free gift), permitting the assets in the trust to grow free of current income taxes. As a completed gift, however, the trust assets will not typically receive a step-up in basis at the grantor’s death because they would not be included in the grantor’s estate. That said, the trust can be drafted to allow substitution of other assets, typically with a high basis, to bring the low-basis assets back into the estate, where they can benefit from a step-up.

Note that under a proposal from Senator Bernie Sanders, grantor trusts created post-enactment would be includable in an individual’s estate, and transactions in and out of the trust would be subject to taxation. So, if desired, creating a grantor trust soon may be worth considering, including when used with other strategies, including loans and sales (see discussion below).

Spousal Lifetime Access Trusts

A Spousal Lifetime Access Trust (SLAT) allows couples to retain access to assets while capitalizing on the gift tax exemption. The grantor typically creates an irrevocable trust for the ultimate benefit of his or her descendants that permits the other spouse (or significant other) to draw on the assets at the discretion of the trustee, if needed. Additionally, as a grantor trust, the SLAT places the income tax burden of any trust earnings on the grantor. If structured properly, the trust removes the assets from the estates of both spouses and can potentially capitalize on the generation-skipping tax exemption to benefit heirs over time without additional transfer taxes. Keep in mind, however, that in the event of divorce, the grantor's indirect access to the assets may be cut off, as would occur with the death of the beneficiary spouse.4

Loans/Sales to Trusts

Although not a technique to leverage use of the exemption, loans by a grantor to his/her grantor trust can be another effective tool to generate wealth for heirs, particularly given current low interest rates. It may be appropriate for those who have fully used their exemption or are more comfortable giving away growth and not their principal. The grantor makes a loan to the trust and applies the applicable federal interest rate (AFR) published monthly by the IRS to avoid the loan being deemed a gift. The trust invests the loan proceeds to benefit from any appreciation beyond the interest rate charged by the grantor. The AFR is currently very low; in July, for example, the interest rate for a loan of three years or less is just 0.12%. The growth of the loaned amount in excess of the interest rate is not considered a gift and is effectively removed from the grantor’s estate. Unlike a direct loan to an individual, the grantor does not recognize income from the interest payments because the transaction is viewed by the IRS as if he is loaning money to himself. It is possible to structure loans with interest-only payments for the life of the loan and a balloon payment at the end, which can help maximize potential investment growth. Note that the loan will need to be repaid, and that any default may be treated as a taxable gift. Loans to grantor trusts can also be structured as sales, where the same rules largely apply.

Certainly, loans or sales can be made directly to individuals without the use of a trust, in which case the interest payments back to the lender are includible in his/her personal income tax return.

Grantor Retained Annuity Trusts

Like loans and sales, a Grantor Retained Annuity Trust (GRAT) is a technique that can transfer wealth for those who have used up their exemption or only want to pass on appreciation. A GRAT is an irrevocable trust to which the grantor transfers property and retains an annuity stream for the term of the trust, with the remainder passing to heirs (or trusts for their benefit). Typically, the annuity is equal to the value of the property when originally transferred, plus interest, computed using the AFR in effect at the time of the funding of the trust (the rate is somewhat higher than for the loan noted above). Accordingly, upon creation of the trust, when any gift is determined, there is deemed to be no remainder to pass to the heirs—hence, no gift. However, if the assets in the trust increase in excess of the IRS interest rate, there will be a trust remainder that will pass to heirs gift-tax-free at the end of the trust term. Usually, the terms of GRATs are short—two or three years—because if the grantor passes away during the term, some portion or all of the GRAT will be includible in the grantor’s estate.

GRATs are particularly compelling when the IRS interest rate is low, as remains the case today. However, under another proposal by Senator Sanders, GRATs would be subject to a 10-year minimum term and the projected remainder interest would need to be 25% of the value of the trust at creation, or $500,000, whichever is greater—an amount that would be subject to gift tax. Creating the trust prior to the enactment date of such legislation, if approved, could be essential.

Flexibility to Recharacterize, Unwind Transfers

Given the degree of uncertainty, we believe planning arrangements should be as flexible as possible in their treatment of gifts, trusts and other elements, so they can be unwound or recharacterized if tax laws change in unexpected ways. For example, an individual could fund a new trust this year for the benefit of his spouse with terms that would enable the trust to qualify for the marital deduction. The election to qualify the trust is made on the donor spouse’s individual gift tax return that is filed next April (or October 2022 with an extension). If, after the funding of the trust, the exemption is reduced retroactively, causing the transfer to be subject to gift tax, the donor spouse can choose to make the transfer a marital gift to avoid the tax. Although the terms of the trust may not be exactly what the couple would have wanted if it was being drafted as a non-marital trust, this approach can help achieve an appropriate outcome regardless of legislative changes.

Don’t Wait

When it comes to estate planning, a common rule of thumb is to take advantage of favorable tax treatment when available—because you never know when the policy tide will turn. Given recent trends, it seems likely that some form of additional taxation or change in tax rules could have an impact on current approaches—whether it happens in the ongoing legislative cycle or down the road because of budgetary pressures. One cause of hesitation in making current gifts has been the worry that if taxpayers fully use the current exemption and die after it has been decreased (whether due to a new law or the scheduled post-2025 sunset noted above), there could be an estate tax “clawback” on the amount used above the new level. Fortunately, the IRS has issued favorable rulings that appear to alleviate these concerns. Overall, we believe the advantages of lifetime gifts (assuming the money is available) versus testamentary transfers militates toward current action.

More broadly, decisions about wealth transfer take into consideration an array of issues beyond the tax regime, including the assets available for transfer, and choices regarding individual and personal legacy. As mentioned, it may also be important to draft estate documents flexibly, to keep options open. Talking with your advisors is a key first step in assessing whether making gifts, creating and funding trusts or employing other techniques could be effective or appropriate for your circumstances.

Personal Tax Proposals: Highlights

The President and various legislators have proposed significant changes to the current tax regime affecting individuals and their planning. Below are some key provisions, which come from the Biden administration unless otherwise indicated.*

Ordinary Income Tax Top marginal rate of 37%** Top marginal rate of 39.6% for those with income over $400,000
Deductions High standard deduction, no personal exemptions, limitations on itemized deductions** Cap itemized deductions at 28% of value. Restore Pease limitation on itemized deductions for taxable income over $400,000
Net Investment Tax 3.8% tax on passive income from passthrough entities Broader application to those earning over $400,000, likely including active owners of passthrough entities
Carried Interest Taxed at long-term capital gains rates Taxed at ordinary rates. The 3.8% Medicare surtax would apply.
Qualified Dividend/Capital Gains Tax Top rate of 20% Top rate of 39.6% for those with income over $1 million; retroactive to April 2021
Step-Up of Basis, Recognition of Gains Step-up in tax basis at death; gifts not taxable below exemption amount, donee receives basis of donor Eliminate step-up, tax unrealized capital gains at death above first $1 million, or at time of gifting
Estate/Gift/GST Tax Exemption $11.7 million exemption** Biden: No change. Sanders***: Estate tax exemption reduced to $3.5 million, gift tax to $1 million; GST (generation-skipping transfer tax) exemption eliminated. Trusts subject to GST every 50 years
Estate/Gift Tax Rate 40% top rate Biden: Unchanged. Sanders: Increase to 45% – 65% graduated rates
Annual Gift Tax Exclusion $15,000 per recipient, per donor each year Biden: No change. Sanders: Limit gifts to qualified trusts to $30,000 per donor
Annual Gift Tax Exclusion Real estate like-kind exchanges may be entitled to capital gains tax deferral Eliminate like-kind exchanges for taxpayers with income over $400,000
Trusts, Valuation Discounts Flexibility on terms, use of exemptions, allows for effective wealth transfer Biden: No change. Sanders: Grantor trusts (non-grandfathered) included in grantor’s estate; distributions to beneficiaries and conversions to non-grantor trusts would be taxable gifts. Curbs on discounts, GRATs

*Certain Biden campaign proposals did not make it into the President’s most recent tax package. These include a payroll tax on wages above $400,000 (in addition to the current tax on up to $142,800 in wages), and a cap on itemized deductions at 28% of income. Although Biden did not ultimately propose a change to the estate tax, legislation from Senator Bernie Sanders and others covers these areas.
**Set to expire after 2025 under the Tax Cuts and Jobs Act of 2017.
***All “Sanders” items are set forth in the Vermont senator’s “For the 99.5 Percent” Act. A different group of senators has sponsored the Sensible Taxation and Equity Promotion (STEP) Act, which contains overlapping and, in some cases, more stringent provisions.

Source: The Tax Foundation, news reports. As of June 30, 2021.

1 The bulk of the Biden tax proposals would be effective on January 1, 2022, although his capital gains tax increase would be retroactive to April 2021. A number of Senate proposals, including new limitations on certain trusts, would be effective upon “enactment,” which appears to mean when signed into law. Although retroactive changes to the tax law are unusual, they are not unprecedented, making it important for readers to weigh the pros and cons of planning techniques with their attorneys in light of the current legislative landscape.

2 Even if the full exemption has been used up in lifetime gifting, making additional taxable gifts may be preferable to waiting until death because any associated current tax liability is not included in the gift. Looking at a hypothetical example, at a 40% rate, a $1,000,000 lifetime gift may incur $400,000 in federal taxes, for a required asset total of $1,400,000. However, if the same amount is bequeathed at death, the decedent is taxed on both the intended gift and the taxes that would have been removed from the estate—at a 40% rate, roughly $667,000, or $267,000 more would have otherwise been needed to make the same transfer as a lifetime gift.
3 Typically, it is also preferable to avoid gifting an asset with a built-in loss, given that the recipient will not receive the tax benefit of the loss when the asset is sold.

4 Some attorneys believe that the beneficiary spouse can be provided with a limited power of appointment at death to transfer the trust assets within a group of beneficiaries, which possibly could include the grantor spouse, enabling continuing access for the grantor should the beneficiary spouse predecease him/her. Be sure to consult with your own counsel before proceeding.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This material is general in nature and is not directed to any category of investors and should not be regarded as individualized, a recommendation, investment advice or a suggestion to engage in or refrain from any investment-related course of action. Investment decisions and the appropriateness of this material should be made based on an investor’s individual objectives and circumstances and in consultation with his or her advisors. This material is not intended as a formal research report and should not be relied upon as a basis for making an investment decision. The firm, its employees and advisory clients may hold positions within sectors discussed, including any companies specifically identified. Specific securities identified and described do not represent all of the securities purchased, sold or recommended for advisory clients. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. Neuberger Berman, as well as its employees, does not provide tax or legal advice. You should consult your accountant, tax adviser and/or attorney for advice concerning your particular circumstances. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Third-party economic or market estimates discussed herein may or may not be realized and no opinion or representation is being given regarding such estimates. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. The use of tools cannot guarantee performance. Diversification does not guarantee profit or protect against loss in declining markets. As with any investment, there is the possibility of profit as well as the risk of loss. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Unless otherwise indicated, returns reflect reinvestment of dividends and distributions. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

Tax planning and trust and estate administration services are offered by Neuberger Berman Trust Company. “Neuberger Berman Trust Company” is a trade name used by Neuberger Berman Trust Company N.A. and Neuberger Berman Trust Company of Delaware N.A., which are affiliates of Neuberger Berman Group LLC.

Neuberger Berman Investment Advisers LLC is a registered investment adviser. The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.