By: Ron Morgan
In recent years, there have been significant, and frequent, changes to both federal and Vermont estate and gift tax laws, and there is no sign that there will not be more changes in the foreseeable future. In this post, I will attempt to set out a framework for considering transfer tax minimization strategies in a volatile tax environment.
CURRENT FEDERAL AND VERMONT TRANSFER TAX LAWS
The federal individual exemption amount is currently $11,400,000. A tax rate of 40% applies to taxable transfers of amounts in excess of the exemption made during life (gift tax) and upon death (estate tax). For married couples, the federal exemption is “portable”, meaning that if a married couple executes an estate plan leaving all of their assets to the survivor, there will be no estate tax upon the death of the first spouse, and if a timely estate tax return is filed for the first spouse, the estate of the second spouse is allowed to use the first spouse’s exemption in addition to their own. In that case, the second spouse’s estate would only be exposed to estate tax if the value of the estate (plus prior taxable gifts) exceeds $22,800,000. However, note that in 2026 the federal exemption drops to $5,490,000, plus an adjustment for inflation calculated from the end of 2018.
The Vermont estate tax exemption amount is currently $2,750,000, increasing to $4,250,000 in 2020, and rising to $5,000,000 in 2021. Notably, the Vermont exemption is not portable; a Vermont couple in the example above would not be subject to tax upon the death of the first spouse, but the surviving spouse would not be able to use the exemption of the first spouse. The Vermont estate tax rate is 16%, so the estate tax “cost” of losing the first spouse’s exemption is $440,000 now, $680,000 in 2020, and $800,000 in 2021 and after. On the other hand, gifts are not taxed by Vermont unless they are made within two years of death, in which case they are included in a decedent’s taxable estate for Vermont estate tax purposes.
PLANNING FOR ESTATES VALUED AT $5 MILLION OR LESS
If you are married and your total assets are worth less than the Vermont exemption of $2,750,000–going to $5,000,000 in a couple of years–the most tax effective plan is for you and your spouse to leave all of your assets to each other in the event of death and to minimize gifts of assets which have appreciated in value since you acquired them. This is because, generally speaking, assets you hold at death have their income tax basis adjusted to their fair market value on the date of death. For example, if you own an asset worth $1 million that cost you $100,000, the $900,000 of taxable gain that would have resulted had you sold the assets during your lifetime will “disappear” upon your death. On the other hand, if you give the asset away during your lifetime, the recipient will inherit your basis of $100,000, and will pay income tax on the gain when they sell it. If you are single and below the estate tax exemption thresholds, avoiding gifts of appreciated assets and holding them until death is going to be the most tax-effective strategy as well. On the other hand, whether you are single or married, keep in mind that assets which have gone down in value should be sold before death, since the basis adjustment can go down as well as and you could “lose” the deduction for the loss.
PLANNING FOR ESTATES VALUED BETWEEN $5,000,000 — $12,000,000 (Things Get More Complicated)
For individuals or couples with assets valued in this range after 2020, I have several suggestions.
First, consider making outright gifts to remove assets from your Vermont taxable estate before you die. There are two ways to do this. One method is simply to give away any asset more than 2 years before your death. The other is to make certain types of nontaxable gifts at any time before death. Typical nontaxable gifts are those that qualify for the federal “annual exclusion” amount of $15,000 per donee, but it is important to note that the category of nontaxable gifts also includes direct payments made for medical or educational expenses, including prepaid tuition expenses. In addition, if proper elections are made, lump-sum annual exclusion gifts of up to $70,000 (or $140,000 jointly) can be made to a state-sponsored Section 529 college education plan for each individual beneficiary. These nontaxable gift options leave a fair amount of room for planning in “deathbed” situations if a substantial Vermont estate tax liability is anticipated.
Second, if you hold assets substantially in excess of the available Vermont exemption, consider more sophisticated gifting strategies designed to remove and/or “freeze” the asset value for transfer tax purposes while providing you with funds to pay for your support for a period of time. For example, you can transfer assets to an irrevocable grantor retained annuity trust (GRAT) for a term of years, in exchange for payment to you of an annuity at a specified rate, or you can transfer your residence to a qualified personal residence trust (QPRT), which you can occupy for a term of years. While these techniques remove the assets, including any future appreciation in value, from your taxable estate, the downside to these options is that the value of the assets is included in your estate if you should die during the trust “payout” term, making it difficult to determine how long to set the term to meet your anticipated living needs. If you are married, you may be able to establish spousal limited access trusts (SLATs) for each other, allowing you to make an irrevocable gift for each of your benefits while removing the assets from your respective taxable estates (if the trusts are properly drafted).
Third, consider the trade-off between the Vermont estate tax on the one hand, and federal and Vermont income taxes on capital gains on the other. As already noted, assets you hold at death have their bases adjusted to their fair market value on the date of death. So, when making gifts to avoid Vermont estate taxes, try to use cash or select assets that have not increased substantially in value since you acquired them. Keep in mind that it is entirely possible that federal and state income tax rates on the gain (up to 34%) upon sale of an asset could result in higher taxes than what would be imposed by the Vermont estate tax on the value of the asset at a 16% rate at death.
To sum up, for estates over $5 million, gifting strategies should balance the Vermont estate tax cost with the income tax cost of the loss of the basis step up. And remember that there are “last minute” gifting strategies that could result in substantial Vermont estate tax savings for your heirs.
CAN WE USE HINDSIGHT TO MINIMIZE ESTATE AND INCOME TAXES FOR VERMONT MARRIED COUPLES? (QTIP Planning Option)
In light of the trade-off between potential income taxes and Vermont estate taxes discussed above, estate planning for married couples can be problematic. For example, assume a married couple owns $8 million in assets. After 2020, the first spouse to die could arrange to have up to $5 million of their assets pass into a “bypass trust” for the benefit of the surviving spouse, so that when the surviving spouse dies, none of the trust assets would be included in their taxable estate, and the surviving spouse’s exemption would be available to shield the remaining assets from Vermont estate taxation.
But what if the assets covered by the first spouse’s exemption increase substantially in value before the surviving spouse dies, and in the meantime the Vermont exemption increases substantially, or the estate tax is repealed altogether? In that case, it would be better to include the first spouse’s assets in the estate of the surviving spouse so that they would qualify for the income tax basis step up, since the first spouse’s estate tax exemption would no longer be needed. Of course, in the absence of a reliable crystal ball at the time of the first spouse’s death, there is no way to determine whether to use the first spouse’s exemption or not. But what if we could use hindsight at the time of the surviving spouse’s death to make that decision?
A common estate planning technique involves the use of a special type of trust for the benefit of the surviving spouse called a “QTIP Trust,” which requires a formal election to be made on a federal estate tax return to qualify the assets for the estate tax marital deduction. If the election is not made, the first spouse’s available exemption will be applied to the trust assets, and estate taxes will thus be minimized upon the surviving spouse’s death. On the other hand, if the election is made, the assets will be subject to estate taxes when the surviving spouse dies, but they will qualify for the income tax basis adjustment. Based upon an IRS Revenue Procedure (Rev. Proc. 2016 – 49), and my informal conversations with the Vermont Department of Taxes, it should be possible to make the QTIP election when the first spouse dies, and then reverse it after the death of the surviving spouse if the second spouse’s estate is exposed to Vermont estate tax that would be greater than the benefit of the income tax basis adjustment. If this is correct, married couples can get the benefit of perfect hindsight to optimize estate tax and income tax results between their respective estates.
PLANNING FOR ESTATES VALUED AT $6 MILLION+ FOR SINGLES, $12 MILLION+ FOR MARRIED (After 2025)
If you fall into this category, the planning techniques discussed above still apply, but exposure to the potential 40% federal estate/gift tax, as well as the 16% Vermont estate tax, places a higher priority on gifting. “Give early and often”, using the techniques described above and more, is the best advice in these situations if transfer tax minimization is a goal.
As noted earlier, the current tax environment is a challenging one in which to plan, but there are options, at varying levels of complexity, to do that.