Taming the Sunset – Are You Ready for a Reduction in the Estate Tax Exclusion?

By John M. Goralka

Each of my kids became certified SCUBA divers at the age of ten (10), the youngest possible age. We traveled to dive in many tropical places including Hawaii, Roatan (Honduras), Belize, Dominican Republic, Jamaica, Cozumel and Playa del Carmen. Tropical sunsets and sunsets in general have always been very special for me. Each sunset is truly unique.

This article is about another, less enjoyable sunset. We discuss the impending loss of approximately one-half (1/2) of the existing $13.61 million estate tax deduction. This sunset occurs on December 31, 2025. Note that this change is happening under current law without any legislative action or change. This article will focus on opportunities to mitigate the tax effect of the sunset.

A Little History. To understand where we are going, we should review where we have been. The estate tax exemption was $675,000 in 2001. By 2011, the exemption grew to $4,500,000. In 2018, the exemption grew to $10,500,000 (inflation). This year, 2024, the exemption is now $13.61 million per person. A married couple would have twice that amount or $27.22 million. On January 1, 2026, the exemption will drop by one-half to approximately $7 million. This amount is similar to the exemption amount prior to the Tax Cuts and Jobs Acts of 2017 (the “TCJA”). The TCJA expires on December 31, 2025.

Use It or Lose It. The estate tax exemption also provides a lifetime gift tax exemption in the same amount. The current exemption should be considered as being comprised of two halves – an “old exemption” in the amount of $6,805,000 and a “new exemption" of $6,805,000. Any 2024 or 2025 gifts are deemed to use the old exemption first. Only after aggregate gifts exceed the “old exemption” amount of $6,805,000 is there a reduction in the “new exemption”. The new exemption of $6,805,000 is lost on December 31, 2025. In other words, you must use or gift the whole exemption or at least amounts in excess of the old exemption to achieve tax reduction.

Always Do the Math. The current estate tax rate is 10%. To obtain this reduction in estate tax, the client is giving up his or her “step-up in income basis” which is otherwise received at death. This “step-up” increases the basis for income tax purposes to the fair market value at the time of death when the property is sold. Note that a basis-step-up can also allow the donor to reboot the depreciation deduction calculations to reflect the after death higher basis as if the property was purchased for that amount.

For states with higher state income taxes (such as California or New York) a 40% reduction in tax may not fully offset the higher capital gain when the property is sold.

Consider a $10 million building with a basis of $1 million. The building is located in California with a maximum tax rate of 13.3%. The maximum federal capital gains rate is 20%. High income earners may be subject to the net investment income tax (the “NIIT”) of 3.6%. This results in an aggregate tax rate of 43.8% without regard to any possible ordinary income in the sale of the building such as from depreciation recapture. The capital gains savings may be worth more than the estate tax savings. The estate tax transfer in California may trigger an earlier reassessment of property tax which may further complicate the analysis. The key is to always consider the client’s long and short term goals and do the math. This is the only way that the client can make an informed decision.

Conversely, assets held at death that have fallen in value, that are worth less, have a step-down in income tax basis. These properties, if inherited, will not permit the inheritor to obtain the tax benefit of claiming a loss when the property is sold after death. A pre-death gift of that property will provide the donor carryover basis and the ability to claim a loss if sold after the donor’s death.

Planning for Non-Taxable Estates. For this purpose, non-taxable estates are those with aggregate net asset values of $12 million married ($6 million single) or less. Wealth is less likely to exceed the exclusion amount at death even with sunset. For these clients, taking advantage of the basis step-up amount at death is critical because there is no estate or transfer tax expected at his or her death. For these clients, no specialized planning or lifetime gifts or transfers may be needed to minimize estate tax.

Planning for Potentially Taxable Estates. For this purpose, potentially taxable estates are those with aggregate net asset values of $10 million to $20 million (married) or $5 million to $10 million (single). Clients may be subject to an estate tax prior to death if the current exclusion is not extended. The estate tax is equal to 40% of the net taxable estate in excess of the exclusion amount. The exclusion is approximately $6.8 million per person in 2024. For these persons, we should consider annual exclusion gifts and gifts to Spousal Lifetime Access Trusts (SLATs) discussed below. The use of a SLAT reduces the risk or impact of overfunding such as if that life exemption is not extended.

Planning for Taxable Estates. For estates that we know will be taxable without regard to the sunset, planning to make lifetime gifts or transfers of assets equal to and often exceeding the exemption amount may be desirable to reduce or avoid the federal estate tax. The technique, tool or entity used will vary with your needs and circumstances. The discussion under larger gifts below lists just a few of all planning opportunities or alternatives.

Annual Exclusion Gifts. Annual exclusion gifts are often a great starting point. Each person may gift $18,000 (in 2024) to as many persons as he or she wishes without having to pay any tax on the gifts. For a married couple, that amount is $36,000. The annual gift exclusion is adjusted for inflation each year.

Gifting business and property interests can leverage or include more value in the $18,000 amount. Discounts for lack of marketability, lack of control, minority interests or fractional interests can result in greater value being included in the $18,000 annual exclusion gift which is moved outside the taxable estate. Future appreciation and increases in value are also more out of the estate for the asset or portion of the asset gifted. Annual exclusion gifts do not reduce the lifetime gift and estate tax exclusions for these persons, their families are more likely to owe estate tax upon their deaths with certain exceptions for farmers and certain small business owners. The entire amount of estate tax is due in cash nine (9) months from the date of death.

Larger Gifts. Larger gifts may be appropriate. A careful examination of the client family’s long and short-term goals, both financial and nonfinancial, must be made to determine the best format or tools to be used to minimize estate tax. Structuring gifts to take advantage of the valuation discounts should always be considered.

Lifetime transfers can be made to a wide range of different planning alternatives. Only a careful analysis of the client’s specific needs will identify the best planning alternatives. These alternatives include, but certainly can not be limited to the following:

Domestic Asset Protection Trusts (DAPTs)
Charitable Lifetime Income Trusts
Family Limited Partnerships (FLAs)
Grantor Retained Annuity Trusts and Unitrusts (GRATs)
Irrevocable Life Insurance Trusts (ILITs)
Charitable Remainder Trusts (CRTs)
Dynasty Trusts
Qualified Personal Residence Trusts
Sponsored Lifetime Access Trusts (SLATs)
Beneficiary Defective Inheritor’s Trusts (BDITs)
Beneficiary Defective Ownership Trusts (BDOTs)
Qualified Terminable Interest Property Trusts (QTIPs)
Retirement Plan Trusts
Qualified Domestic Trusts (QDOTs)
Self-Canceling Installment Notes
Completed Gift NING, DING or Wing Trusts

Planning opportunities provide a potpourri of acronyms promising tax savings. With all planning, some form of flexibility is needed due to the potential for change in the client’s financial and nonfinancial circumstances and increasingly in the estate tax rules and laws under which we operate. One of the more popular tools is the Spousal Lifetime Access Trust (SLAT).

The Spousal Lifetime Access Trust (SLAT). The SLAT helps minimize or limit the risk of over gifting such as if the exclusion amount is extended in 2026. A large gift tied to the amount of the unused donor’s lifetime exemption is made to the SLAT. The Discretionary beneficiaries of the SLAT are the donor’s spouse and the donor’s children. If the client resides in a community property estate, then this gift must be made with separate property. Community property gifted or transferred to the SLAT may result in that property stall by part of the donor’s estate at death. The use of community property also weakens the asset protection provided by the trust and allows creditor access.

If the client resides in a community property state, then an appropriately drafted and executed post-marital agreement may be needed to transmute property interests to separate property. Care should be taken to comply with that state’s signing formalities such as the use of separate counsel for husband and wife. For example, California and most states require that each spouse have separate independent counsel for this purpose. States with high tax rates include:

New York (15.9%)
Connecticut (15.4%)
Hawaii (14.1%)
Vermont (13.5%)
California (13.5%)
New Jersey (13.2%)
Illinois (12.9%)
Virginia (12.5%)

Funding with closely held, controlled business interest or family limited partnership interests should be avoided to prevent estate inclusion at death.

Beware of Reciprocal Trusts. If we just made one spouse’s gift or transfer to a SLAT, then we cannot use a mirror image or even an overly similar approach or trust for the other spouse. Using reciprocal trusts in that way is considered a form of abusive tax avoidance.

If identical, or overly similar, SLATs are used for both spouses, then the IRS can collapse the trusts, treating both as self-settled and causing estate inclusion. Careful planning is needed to avoid that harsh result.

The reciprocal trust doctrine was first described in 1940 in Lehman v. Commissioner (2^nd Cir, 1940) 109 F.2d 99. In that case, two (2) brothers created identical trusts for the benefit of each other. The court uncrossed the trusts finding that the brothers each bargained for a quid pro quo where each brother “paid” the other by prepaying a trust for the other’s benefit.

The Reciprocal Trust Doctrine was later refined by the United States Supreme Court in the United States v Grace (1969) 395 U.S. 316. In Grace, the court determined that consideration or a quid pro quo relationship was not required. The Grace court did not even require a tax avoidance motive be present. The Reciprocal Trust Doctrine required only that the trust “be interrelated, and that the arrangement to the extent of mutual value, leaves the settlors in approximately the same position as they would have been in had they created trusts naming themselves as beneficiaries” id at 324.

This ruling requires only (1) interrelatedness and (2) mutual value leaning the settlers in approximately the same position. This provides no meaningful safe harbor nor than that be found in the regulations.

One starting point to help avoid the Reciprocal Trust Doctrine is to design a SLAT with discretionary distributions to the spouse and to the kids for the older or less healthy spouse. The second “SLAT” is more of an irrevocable gifting trust that provides the other spouse established for the children. We would also have different Trustees, distribution and other terms to prevent application of the reciprocal doctrine.

Other Benefits. The properly drafted SLAT can provide significant creditor protection from lawsuits, creditor and other claims. Creditor protection can be achieved while still allowing you to retain indirect access to assets through your spouse.

The SLAT can also provide protection from divorcing spouses. The Post Marital Agreement will define, limit and defend a spouse’s rights in the event of divorce.