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Year-end planning just got a whole lot more complicated

November 13, 2020

As Election Day 2020 approached, there was much talk about planning that individuals should consider doing before the end of the year. The impetus for this was an assumption that the Democrats would win the Presidency and take over a majority of the Senate, which could mean a significant reduction in the estate and gift (and generation-skipping) exemptions in 2021. This reduction might even be retroactive to January 1, 2021, in which case gifts needed to be made before the end of 2020 in order to preserve one’s transfer tax exemptions.

Election Day has come and gone, but any hoped-for clarity about the political situation in 2021 did not come with it. Although it seems more likely than not that Joe Biden will be President next year, that issue continues to be the subject of much discussion. Even if that does come to pass, the determination of which party will control the Senate will not be made until early January when two runoff elections in Georgia will be held. Thus, we will not know by the end of 2020 whether the Democrats will indeed control the Presidency, Senate and House. Obviously, this makes advising clients and planning by clients much more difficult.

There are many individuals who will ultimately have taxable estates regardless of the size of the exemption. (It should be noted that even if the law does not change in 2021, it is currently set to revert back to pre-2018 levels (around $6 million) on January 1, 2026.) For them, making large gifts to use their gift tax exemptions may make sense in any case. One has to take into account the potential loss of basis step-up resulting from a gift, but the math usually favors a gift. For them, making a gift in 2020 to use their exemptions would still be a prudent course of action.

The harder situation is for those individuals who might not have a federal tax due at death if the exemptions stay where they are, but would owe tax if they were to be cut by 50% or more. Those of us who lived through 2012 have already seen this movie. In these cases, there may be ways to structure the gift to give a family more time to make the decision.

One way that may help is through use of a disclaimer. Under Code section 2518, if a donee disclaims a gift within nine months of the date of the gift, the gift to that donee is treated as not having been made. (Note that there are many conditions to make an effective disclaimer which are not discussed herein.) So, if a gift were made to an adult child in December 2020, the child would have until August 2021 to disclaim the gift. If the terms of the gift were that in the event of a disclaimer, the gift property returns to the donor, then the gift will be deemed to have never happened. In essence, the December 31, 2020 deadline for making the decision about whether to use exemption would have been extended by eight to nine months.

Beneficiaries of a trust can also disclaim gifts to the trust. The trust can provide for alternative dispositions in that event. However, there are some unanswered questions with respect to these disclaimers. If the trust were a simple trust that had one adult child as a beneficiary and provided for any property remaining at the child’s death to be distributed to the child’s probate estate, a disclaimer by the child that resulted in the gift reverting to the donor should not raise any transfer tax issues. However, if the child’s descendants are remainder beneficiaries, it is not clear if all of the beneficiaries would need to disclaim or whether the trust could simply provide that the child’s disclaimer would be sufficient to negate the gift. If the remainder beneficiaries are minors and also would need to disclaim, that might require a guardian ad litem to be appointed. It is unlikely any client would want to make a gift knowing that a court appointed guardian would be the result.

For a married couple, the unlimited marital deduction may be of help. For example, W could transfer assets to a trust that can qualify as a QTIP trust for the benefit of H. If the gift is made prior to the end of 2020, W’s gift tax return would not be due until October 2021 (with an extension). Assuming one would know by then whether the exemptions were reduced, W could either make the QTIP election, thereby qualifying the gift for the marital deduction and not using exemption, or not make the OTIP election in order to use exemption. H could set up a similar, though not identical, trust for W in order to use H’s exemption. Granted, in this case, if the election is not made and exemption is used, the trust would still require that all income be distributed to H and that the trust could only be used for H during H’s lifetime. But in many cases, that would not be a bad result, as the couple might not want assets going to descendants while H or W is alive. Moreover, the investments could be structured to minimize income if H or W wished to do so.

It might be possible to provide for different trust terms depending on whether the QTIP election is made. This is permitted when a trust is to be created at the death of an individual (a so-called “Clayton” election). However, it is not clear in a gift situation whether this type of alternative planning would bring about the desired result. The IRS might argue that the right to change the terms of the trust by making or not making the election was a retained right in the donor causing the gift to be incomplete.

A more conservative option would be to draft a trust eligible for the QTIP election and provide that a disclaimer by the spouse of all of his or her interests in the trust will result in the transferred assets being held in a gift trust for descendants. The QTIP trust could also contain a “best interests” standard for distributions or give the spouse a full withdrawal right over the assets that starts nine months after the date of the gift. If it turns out that the donor does not need to use gift tax exemption, the QTIP election can be made, and the spouse can later withdraw all of the trust property or the trustee can distribute it to the spouse pursuant to the best interests standard. If the donor does need to use gift tax exemption, the donor does not make the QTIP election and the spouse either disclaims the withdrawal right so as to keep the trust out of the spouse’s estate (but still keeping the trust for the spouse) or disclaims all of his or her interests in the trust, allowing the property to pass to the gift trust for descendants.

As should be obvious, there are many complications in year-end planning for 2020, and not much time in which to make decisions. There is an old saying—“Not to decide is to decide.”  Anyone who was thinking of making gifts should consider the options, consult their attorney and affirmatively decide whether to do so while there is time to implement any desired planning.