What You Need to Know About the Sunsetting of the Estate Tax Exemption

As expected, there has been much talk at Heckerling about the sunsetting of the estate tax exemption and what to do about it. In the session “Happily Ever After—Securing Both Exemptions,” Charles A. Redd focused on the expiring exemption and how to effectively use it and minimize any risks.  

The Expiring Estate Tax Exemption  

Estate planners have warned clients about the “use it or lose it” exemption for the past few years. If no tax legislation is passed that extends this provision of TCJA, the estate tax exemption will be cut in half from $13,990,000 in 2025 to about $7,000,000 in 2026. Therefore, clients should use their exemption before they lose it in 2026. The question is whether this is still the case post-election. 

Mr. Redd stated that with the Republican trifecta, it is less likely than before that the sun will set on the exemption. But a lot could happen. Anything could derail the passage of new tax legislation, including addressing the immigration issue first. It will take some time before any new tax laws are passed. Therefore, planning now and building flexibility into an estate plan would be wise. Even if the law doesn’t sunset, it’s always a good idea to use the exemption sooner rather than later to remove future appreciation out of one’s estate.  

With this in mind, Mr. Redd discussed several things to watch out for when using both spouses’ exemptions.  

Gift Splitting 

If both spouses plan to use their remaining exemption amounts but only one spouse has sufficient assets, gift splitting may be the answer. There are some caveats, however, and proper planning is necessary. First, note that if gift splitting is elected, all gifts made during the year must be split unless they can’t be (as discussed below). If spouses have different unused exemption amounts, this could make gift splitting tricky, so it may be best not to split gifts in this situation.  

Second, suppose there is a gift to an irrevocable trust where the grantor’s spouse is a permissible beneficiary. In that case, a gift to this trust cannot be split even if gift splitting is elected unless the spouse’s interest is both ascertainable and severable (which is usually not the case for discretionary trusts).  

A further caveat applies here if there are Crummey powers in the trust. Gifts subject to the Crummey withdrawal power are considered gifts to the power holder and therefore, may be split.  It that is the case, then since any part of gift may be split for gift tax purposes then for Generation Skipping Transfer (GST) tax purposes, the entire gift to the trust must be split.   

Step Transaction Doctrine 

As an alternative to gift splitting, the wealthier spouse could transfer assets to the other spouse so that the less wealthy spouse can make gifts of their own, for example, to a trust for the benefit of the wealthier spouse. The danger here is the step transaction doctrine.  

To minimize concerns that the IRS may collapse the transactions and treat the gifts as if they all came from the wealthier spouse, the transfer to the spouse must not be a conduit as part of a prearranged plan. It must stand on its own. The less wealthy spouse must be able to do whatever she wants with the property while she owns it.  

Therefore, there should be sufficient time between receipt and gift, and the property itself should be subject to economic risk in the hands of that spouse. One suggestion to address this is to not make the transfer to the spouse in the same amount as the spouse’s gift.  

Defined Value Clauses 

Clients want to make gifts using their remaining gift tax exemption but don’t want to pay any gift tax. However, the IRS is more likely to challenge the value of gifts of hard-to-value property (e.g., closely held businesses and family limited partnerships), especially if valuation discounts are taken. Because of this, planners should consider using a formula clause to facilitate the transfer.  

Several types of formula clauses are available. One suggestion is to divide the transfer into two segments. The first segment would go to the primary recipient as a stated dollar amount equal to the donor’s remaining basic exclusion amount. The balance would go to charity, such as the donor’s private foundation. That gift would be stated as an amount equal to the difference between the stated dollar amount and the fair market value, as finally determined for federal gift tax purposes, of the property transferred.  

Another approach is to state the gift as a number of shares equal in value to the donor’s remaining basic exclusion amount and no more.  

Spousal Lifetime Access Trusts (SLATs) 

When planning to use the remaining exemption amount, the spousal lifetime access trust, or SLAT, is an effective tool for making gifts. It allows clients to have their cake and eat it, too. A SLAT is an irrevocable trust with a spouse and heirs as beneficiaries. This provides flexibility since the trustee can make distributions to the spouse if needed.  

In addition to a defined value clause, Mr. Redd suggested other ways to minimize the risk that the gift of a hard-to-value asset will trigger a taxable gift. 

1. Make the SLAT a “QTIPable Trust.” To the extent a QTIP election is not made, the gift to the trust will not qualify for the marital deduction and will use the donor’s gift tax exemption.  A formula QTIP election could then be made on the donor’s gift tax return “with respect to the smallest amount that will result in no gift tax being payable.” The regulations under IRC Section 2523 have sanctioned this. In this scenario, unlike the next one, the beneficiary spouse could hold a testamentary non-general power of appointment over the elected and non-elected property. 
2. Use a discretionary trust with backup QTIP provisions. The SLAT could be designed so that it is not a QTIP trust but contains a provision that any disclaimed property by the beneficiary spouse passes to a QTIP trust. This technique has the advantage that the property not disclaimed could be held in a discretionary trust, thus offering more flexibility for trust administration. 

Portability  

The session next shifted gears to portability and its role in estate planning. One of the benefits of portability is that those assets inherited by the surviving spouse are entitled to a second basis step up on the surviving spouse’s death. Therefore, portability is usually the best option if the surviving spouse does not have a taxable estate. However, if that is uncertain, it is not an easy decision on whether to use a credit shelter trust or portability.  

First, there are several disadvantages to portability. It is not inflation-adjusted, it doesn’t apply to the Generation Skipping Transfer (GST) tax exemption, there may be state issues, it could be lost if the spouse remarries and the new spouse dies, and finally, it requires the filing of a return, Form 706.  

With a credit shelter trust, there is no step-up on the basis of the surviving spouse’s death, but all trust assets, including the appreciation on those assets, are not included in the surviving spouse’s estate. Whether sacrificing the basis step up at the surviving spouse’s death will worth excluding the assets from the surviving spouse’s estate depends on a number of factors, including how much the assets will appreciate, the amount and timing of the capital gains tax as well as the potential estate tax savings. 

The speaker suggested including a formula testamentary general power of appointment in the credit shelter trust as one way to get an additional step up in basis.  This power would only exist at the surviving spouse’s death if it won’t generate federal estate tax. The power would cause trust assets to be included in the surviving spouse’s estate but only to the extent of his or her remaining exemption, thus permitting the basis of those assets to be adjusted to the date of death value.  

It is virtually impossible to achieve the step up in basis and an exclusion from the estate. If there is any chance the surviving spouse will have a taxable estate (which may depend on whether the exemption sunsets), it is a matter of picking your poison.    

Conclusion  

Proper planning is essential to navigate the complexities of the estate tax exemption and create the best outcomes for your estate. Contact our estate planning team today to discuss how you can make the most of your estate tax exemption and protect your assets for future generations.