Upcoming Changes to Exemption Amounts for GST Taxes
By Phoebe Stone, JD, MA (Bioethics)
Exemption amounts for gift, estate, and generation-skipping transfer (GST) taxes are at historically high levels as of the writing of this article. However, absent congressional action, these exemptions are scheduled to revert to pre-2017 levels ($5 million adjusted for inflation) as of January 1, 2026, under the terms of the 2017 Tax Cuts and Jobs Act (TCJA). This is what is referred to as the coming “sunset.” Even if this dramatic decrease occurs as scheduled, the vast majority of American taxpayers are still likely to have estates below federally taxable thresholds. However, the sunset is likely to impact higher-net-worth clients, who may wish to take action now to preserve the benefits of the historically high exemptions.
The current anticlawback rules provide peace of mind that, if the exemption amounts decrease as scheduled, transfers made now in excess of the anticipated lower limits will be grandfathered in under the old rules. In other words, if clients make large transfers now (in order to take advantage of the historically high exemptions) and then die after December 31, 2025, they will not be treated as having made taxable transfers in excess of applicable post-2025 exemption amounts. Thus, a large part of planning for the sunset rests on taking full advantage of historically high exemptions by making large transfers before 2026, while large transfers can be made without adverse tax consequences. Put differently, a primary sunset-planning technique is to decrease the estates of wealthy individuals during 2024 and 2025.
Transfer Tax Primer
In their most basic form,
the federal estate tax is a tax on property transferred at death,
the federal gift tax is a tax on gifts made during life, and
the federal GST tax is a tax on transfers that skip a generation (e.g., from grandparent to grandchild) that can be imposed on lifetime gifts or bequests at death.
Federal estate taxes are only imposed on estates that exceed an applicable exclusion amount (AEA), so only estates over a certain size are taxable. The AEA in turn is based on the basic exclusion amount (BEA), which is a threshold that varies annually due to inflation adjustments or acts of Congress. The federal gift tax and the federal estate tax are unified such that gift givers must keep track of any lifetime gifts made in excess of the annual gift tax exclusion amount (which is another threshold that varies annually based on adjustments for inflation or acts of Congress). These large gifts eat into the BEA available to the gift giver upon death. If the gift giver exceeds the available exemptions with lifetime gifts, they are generally responsible for paying the tax on those transfers. The federal GST tax is imposed on intrafamily transfers that skip a generation (e.g., grandparent to grandchild) and on transfers between unrelated parties if the gift giver is more than 37.5 years older than the gift recipient. The GST tax applies to both lifetime gifts and bequests.
An important concept related to the federal estate tax is portability. Because the BEA changes annually, portability can be an important estate planning tool for married couples. Portability is the ability of a surviving spouse to “port” (or pocket) a deceased spouse’s unused exclusion amount (DSUE) to add it to the exclusion available when the survivor later dies. This effectively increases the AEA available to the survivor’s estate because AEA equals BEA plus DSUE. Thus, if a spouse dies while the BEA is high, electing portability allows the survivor to potentially avoid estate tax liability by pocketing and saving for later any DSUE, which can then be used to augment the BEA available in the survivor’s year of death.
Historical Context
The Sixteenth Amendment to the Constitution, ratified in 1913, gives Congress the right to “lay and collect taxes on incomes, from whatever source derived.” Three years later, the Revenue Act of 1916 marked the inception of estate taxation. In the 1920s, the government created and instituted gift taxes to tax gifts made during life. This tax was repealed, modified, and reinstated in the 1930s. In 1976, the estate and gift taxes were unified, and GST taxation was implemented. The GST tax was modified in 1988, and since 2010, the GST tax exemption and the BEA have been equal in amount—although they are entirely separate taxes. In 2010, the estate tax briefly expired; otherwise, the gift tax annual exclusion, the BEA, and GST exemption amounts have increased (or remained stable) since 1976. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 fixed the estate tax, gift tax, and GST tax exemptions at $5 million (adjusted annually for inflation). The TCJA doubled the estate tax, gift tax, and GST tax exemptions, which continue to be adjusted for inflation. However the increase in these exemptions is scheduled to sunset at the end of 2025. The impacts are summarized in the table below, which shows selected metrics from this century.
Given the uncertainty about whether the high exemption amount will sunset as scheduled, estate planners and clients alike may be wondering what (if anything) they should do now to take advantage of the historically high exemptions and prepare for the sunset. The following discussion presents some options.
Portability Elections
If a spouse dies while exemptions are high and they have not used their full exemption, the surviving spouse would be well advised to consider electing portability, because this effectively preserves for the survivor the benefit of the inflated DSUE left behind. Portability elections must be made on a timely filed Form 706. Under Revenue Procedure 2022-32, estates that are not otherwise required to file an estate tax return (i.e., because the estate is not above the taxable thresholds) may have as long as five years after a death to file for portability. The survivor can have the benefit of the DSUE of their most recent spouse to die, so survivors who intend to remarry should be reminded about the possible loss of a ported DSUE if their new spouse dies first.
Lifetime Gifting
The lifetime gift and estate tax unified exemption amount applies both to gifts made during life and transfers upon death. When lifetime gifts are made in excess of annual gift tax exclusion amounts, they must be reported to the Internal Revenue Service (IRS); however, such gifts are not actually subject to taxation when the gift is made unless the gift giver has already used up all of their available exemption. Taxable gifts are reported on a Form 709, and they eat into the remaining BEA available at death (which, as discussed above, is an unknown, moving target that changes annually).
The simplest way to use lifetime gifting to take advantage of the historically high exemptions is to make outright gifts before 2026. The obvious disadvantage of lifetime gifting is that the gift giver becomes permanently divested of ownership and control over the gifted asset—they have given the asset away, and they may regret it. Another disadvantage is that the recipient of the gift gets the gift giver’s carryover basis rather than receiving the gift at a basis adjusted to fair market value, as they would if they received the asset at death. This may mean that the recipient would be subject to capital gains taxation if the recipient decided to sell the gifted asset. However, capital gains tax rates are lower than estate tax rates, so removal of the assets from the gift giver’s estate via lifetime gifting may still result in a net benefit from a taxation perspective.
Estate-Freezing Techniques
Practitioners are likely to find many and varied recommendations about planning for the sunset in practical and academic literature; many of these recommendations refer to estate-freezing techniques. Estate-freezing techniques freeze the value of assets for gift and estate tax purposes as of the time of a transfer, allowing any subsequent appreciation to pass to beneficiaries without creating any additional gift or estate tax liability. The ability to allocate the GST tax exemption when utilizing estate-freezing techniques varies somewhat depending on the technique used, so careful attention should be paid when beneficiaries may include skip people.
The process of using an estate-freezing technique might go as follows:
Trustmaker transfers assets to an irrevocable trust for the benefit of the trustmaker’s children.
Trustmaker’s gift tax liability for the gift that funds the trust is fixed at the time of the transfer (and a gift to an irrevocable trust is generally treated as a gift made to the beneficiaries of that trust).
Trustmaker must report gifts in excess of annual gift tax exclusion amounts.
Although such gifts are reportable, they do not create any actual tax liability if they do not exceed available exemptions (which is one way to make use of the historically high exemption amounts).
By making gifts to an irrevocable trust, the trustmaker removes gifted assets from the trustmaker’s estate for estate tax purposes. Doing so eliminates or mitigates the estate taxes the trustmaker’s estate is likely to owe upon the trustmaker’s death at a later date when exemptions may be lower and allows any subsequent appreciation in value to pass to the beneficiaries without creating any additional gift or estate tax liability.
A number of estate-freezing techniques are discussed below.
Grantor Retained Annuity Trusts
A grantor retained annuity trust (GRAT) allows a trustmaker to create and fund an irrevocable trust while reserving to the trustmaker the right to receive an annuity for a specified period of time. The specified period of time can vary, but the annuity is a fixed annual payment, and the cumulative total of annuity payments received is generally equal to the value of the assets transferred. For a GRAT to be successful, the assets in the GRAT must appreciate faster than the I.R.C. § 7520 rate of return. This requirement essentially allows the GRAT assets to appreciate on a transfer tax-free basis and pass a larger benefit to the remainder beneficiaries than the trustmaker had to pay transfer taxes on when the trustmaker funded the GRAT. However, if the trustmaker dies during the GRAT term, the GRAT assets will be included in the trustmaker’s estate for estate tax purposes.
Intentionally Defective Grantor Trusts
The primary objective of an intentionally defective grantor trust (IDGT) is to create a trust that is effective for estate tax purposes (i.e., it removes assets from the estate of the trustmaker) but defective for income tax purposes (i.e., it is a grantor trust, and the trustmaker continues to be responsible for the payment of income taxes on the transferred assets). In order to achieve this result, certain provisions are included in the trust that will result in the grantor being considered the owner of the trust for income tax purposes pursuant to I.R.C. § 671 but will not cause the assets to be included in the estate of the trustmaker at the time of their death. Of course, when an asset is excluded from the estate of a decedent at death, it is generally not eligible for a basis adjustment, and in Revenue Ruling 2023-2, the IRS signaled that it would challenge basis adjustments for assets held in an IDGT.
Irrevocable Life Insurance Trust
When a client has incidents of ownership over a life insurance policy, the value of that life insurance policy is included in their estate upon death. The primary purpose of an irrevocable life insurance trust (ILIT) is to make the proceeds of life insurance available to beneficiaries in a way that does not subject the proceeds to estate tax upon the death of the insured. Put differently, the primary goal of an ILIT is to exclude the value of a life insurance policy from the estate of the insured. Once created, the ILIT owns a life insurance policy on the life of the trustmaker—either because the trustmaker gave an existing policy to the ILIT (i.e., funded the ILIT by gift, which may be a taxable gift) or because the ILIT purchased a new policy. The ILIT names any number of Crummey beneficiaries, who have the right to withdraw certain amounts annually, but if they do not withdraw within a specified period, the gift lapses and becomes part of the ILIT. The trustmaker can make gifts to the ILIT for each Crummey beneficiary up to the annual gift tax exclusion amount, which can be used to pay for insurance premiums. This may be necessary when the ILIT buys a policy or when the existing policy continues to have premiums.
Spousal Lifetime Access Trust
A spousal lifetime access trust (SLAT) is an irrevocable trust designed specifically for married couples that allows the donor spouse to create and fund the trust for the benefit of the beneficiary spouse and possibly others. In so doing, the donor spouse relies on their available exemption amounts to shelter from taxation the gift that funds the trust. The transferred assets are then excluded from the estates of both the donor spouse and the beneficiary spouse for estate tax purposes, the beneficiary spouse (and sometimes other beneficiaries) retain access to the assets, and any appreciation in the assets is also excluded from the estates of both the donor spouse and the beneficiary spouse. One shortcoming of a SLAT is that, if the couple divorces or the beneficiary spouse dies first, the donor spouse will likely lose all access to the assets in the SLAT.
Conclusion
It remains to be seen what will happen at the TCJA sunset, and hasty planning can lead to regrets. On the other hand, transfer taxes can always be changed by an act of Congress, and historically, there have been many such acts and changes. However, we have every reason to believe that the sunset is coming. Estate planning for the vast majority of Americans will not be impacted if the exemptions revert to pre-2017 levels of $5 million adjusted for inflation (likely $5–7 million in 2026), because the vast majority of Americans do not have such wealth. However, estate planning for the wealthiest minority will certainly be impacted, and wealthy clients and their advisors may wish to act now to take advantage of historically high exemption.