In recent years, the Internal Revenue Code (IRC) has endured some drastic changes resulting from legislative action. Such changes have altered the recommended strategies and methods employed for the transfer of wealth from one generation to the next. As planning options divert from past options that are no longer suitable, the necessity of reviewing and maintaining estate plans becomes important, if not urgent. However, not all clients are keyed into the sufficiency of their existing estate plans and whether updates to the IRC have fundamentally altered their planning needs.
The expectation that clients will be vigilant about routinely reviewing and updating their estate plans may be an unrealistic and dangerous approach to planning, and anticipatory planning can be equally dangerous if it is based on politically dependent expectations of future legislative outcomes that would impact a client's estate plan.
Frequently, legislative proposals that, if passed, would present estate planning issues for clients prompt some planners to try to get ahead of those changes by suggesting action in anticipation of those bills becoming laws. However, despite being bombarded with countless articles and webinars on the planning implications of these proposals and the urgent actions needed to be taken, many of these proposals often never translate to becoming law.
To account for the multitude of legislative proposals that arise from a constantly changing political landscape, it is imperative that clients' estate plans contain flexible provisions to ensure that changes in the law do not result in disastrous results within their estate plans.
We often take for granted how susceptible the Internal Revenue Code is to the whims of Congress and that the only thing we can count on is that the tax laws are not going to stay static for long periods of time. But the reality is that Congress is only part of the story, as when Congress passes a bill and the president signs the bill into law, it is often the regulatory agencies entrusted to enforce the law that impose dynamic rules based on their subjective interpretation of the laws passed by Congress.
Influence of the IRS on tax law
In the case of tax legislation, the IRS stands in a powerful position to interpret laws and implement rules in accordance with their interpretation. Once the IRS determines that a given set of provisions within the Internal Revenue Code is failing to achieve its intended objective, it alerts the legislative and executive arms of the government and directs their attention to altering the law to shut off the availability of such strategies.
For instance, in 1980, Congress intended to incentivize the conservation of certain land (e.g., historically significant, scenic, natural ecosystems, etc.) and codified
A Syndicated Conservation Easement transaction involves an investor purchasing previously worthless or low-value land and then obtaining an appraisal showing a significantly higher value of the land due to its potential development opportunities that had not previously been considered. The investor then donates the land through a pass-through entity to receive a large charitable deduction.
The IRS fought these deductions for years with little success, as those promoting and profiting from the strategy were able to show a basis in law for the legitimacy of the transaction and resulting deduction. Out of regulatory arrows in its quiver, the IRS was saved by Congress coming to the rescue with its passage of
Few are particularly sympathetic to investors unable to continue to use this type of strategy, given that artificially inflating charitable deductions seems reasonable for Congress to legislate out. However, this series of events shows Congress' willingness to eliminate or limit the benefit of certain tax strategies at the behest of the IRS.
The English 'window tax': A 17th century case study
As long as taxes have existed, people have determined clever ways to try to avoid them. It is not, however, the case that the best estate planning strategies typically emerge from anticipating and taking affirmative action. More commonly, laws are implemented, and citizens adapt in crafty ways.
In the late 17th century, King William III of England had a great idea to increase revenue for the crown.
Now, did the citizens of this country read online that there were rumblings of a window tax being imposed and then affirmatively brick up their windows? Unlikely. What is more likely is that once the law was imposed, citizens adapted. And this is how it has gone throughout the history of civilized government — a tax is imposed, the citizens determine a crafty way to avoid it and the government catches up and closes the loophole.
In the case of the window tax, it was replaced 50 years after its adoption by an
Moving and shaking, that's what's always happening. The government imposes a tax, savvy financial planners find a loophole, Congress attempts to close the loophole, and the beat goes on and on.
Modern-day example of rules under government scrutiny
Modern-day grantor trust rules provide a more contemporary example of savvy adaptation to existing law. The
Of course, the tax structure changed, the rates essentially flipped and now people are using the grantor trust laws (initially designed to disincentivize grantor trusts) to take advantage of the tax laws and cause the trust to be taxed to the trust grantor, individually. Hence the use of
And, of course, now we have seen in various recent proposed bills (e.g., the original iterations of the
While these past legislative actions resulted in formulating strategies to combat laws already on the books, there have also been recent proposals that may have resulted in unnecessary (or premature) financial planning measures.
For example,
- Immediate recognition of unrealized capital gain on the non-spousal and non-charitable transfer of an appreciated asset by gift or at death in excess of $1 million; and
- Elimination of the ability to take a valuation discount on the gift of a minority interest in a business entity.
Later in 2021, the House Ways and Means Committee released legislative proposals in a draft of the Build Back Better bill expanding estate planning limitations by proposing to:
- Accelerate a provision of the Tax Cuts and Jobs Act (TCJA) scheduled to sunset in 2026, reducing the estate tax exemption back to $5 million (adjusted for inflation); and
- Include grantor trusts in the estate of the decedent.
These proposals resulted in planners trying to determine the best ways to proactively assist their clients in avoiding the negative implications of the forthcoming laws on their estates. Such strategies included making massive gifts to make sure their wealth transfers to Intentionally Defective Grantor Trusts (IDGTs) were grandfathered in, as well as prepaying years worth of life insurance premiums in existing Irrevocable Life Insurance Trusts (ILITs) to try to ensure the value of future premium payments were not includible in their taxable estates.
However, the above-referenced proposals were eliminated in the legislative process and never came to fruition. And while it is unlikely that the past proposals will be enacted into law anytime soon, those who took drastic action in anticipation of the passage of those provisions are left to assess whether their plans remain viable or need to be unwound, if possible.
Because of the ever-changing allegiances and priorities in Congress, most legislative proposals should be considered only as food for thought to raise financial planners' antennas for potential tax-saving strategies that the government may identify as detrimental to their goal of collecting tax revenue.
The dramatic increase of the estate tax exemption that came with the passage of the
Estate-tax exemption changes can impact the efficacy of credit shelter trusts
Let's take the example of a married couple with a trust stating that, upon the death of the first spouse there is an estate tax funding formula directing assets into a Marital Trust and a Family Trust, commonly known as
The Family Trust serves as a credit shelter trust so that when the second spouse dies, any assets in the Family Trust, including any growth since the death of the first spouse, would not be in the surviving spouse's estate. Therefore, estate taxes are not a concern regardless of the size of the credit shelter trust at the surviving spouse's death.
What's the problem, then?
In this example, the trust was drafted in 2006, when the Federal estate tax exemption was only $2 million per person. Fast forward to today, their estate is nowhere close to the current estate tax threshold of $12.92 million per person (doubled for a married couple).
So, if one spouse were to die, then all of the assets in the deceased spouse's trust would go into the credit shelter Family Trust needlessly. If, instead, the assets were included in the surviving spouse's estate, then the assets would get a stepped-up basis at the surviving spouse's death. By sending the assets to a credit shelter trust that provides no offsetting estate tax relief benefit, all that could be accomplished by this trust strategy would be to increase administrative costs and cause a potentially large capital gains tax liability upon liquidation by the heirs.
While it seems illogical to formulate an estate plan with such disadvantageous results, in the decades prior to the Tax Cuts and Jobs Act, A/B trusts had become ubiquitous — and, at the time, perfectly appropriate — for spousal estate tax planning. However, changes in the law, including the advent of
Changing tax laws can jeopardize the utility of irrevocable trusts
While revocable trusts containing rigid estate-tax funding formulas may result in irritating legal fees to amend the document to add flexibility, even worse may be when an irreversible transaction is done without an appreciation of how often the law may change. Many irrevocable trusts were funded at a time when individuals were motivated to remove assets from their taxable estate with the expectation that, should the assets grow inside the estate until their death, there would be an estate tax issue.
However, many of the individuals who utilized a strategy, such as a
To further complicate the matter, the threat of the impending reversion —or "sunset" — of the estate tax exemption to the Pre Tax Cuts and Jobs Act level of $5 million per individual (indexed for inflation) in 2026 has added an additional layer of confusion as to whether to keep an existing irrevocable trust structure.
Why proactive planning in anticipation of legislative changes can sometimes backfire
In light of the TCJA's sunset provisions, individuals and families with sizable estates may consider now to be a good time to explore options for gifting assets from the estate while the exemption is still at an unprecedented level. The
This development has many estate planning professionals becoming proponents of wealth-transfer strategies that involve
This type of strategy is not without risk, though, as not only would the donor lose substantial control over the assets, but the assets would also no longer be eligible for a step-up in basis. Additionally, this proposed strategy is only beneficial if a person is going to make very large "taxable" gifts in excess of the future exemption amount because if they were to gift an amount of assets less than the future threshold, it would not offer any appreciable benefit as they would still be subject to the same exemption threshold.
For example, there are various ways in which gifting prior to sunset can impact an estate. A gift of $5 million, which, while substantial, would yield no estate tax relief as compared to making the same gift in 2026 after sunset. This is because after deducting the gift from the estate, the $7 million estate would still be valued higher than the post-sunset exemption amount of $6.46 million. Therefore, after sunset, the taxpayer would have used up almost all of their exemption amount and most of the remaining value of the estate in excess of the gift would be subject to federal estate taxes.
Alternatively, gifts of $10 million or $12 million would be in excess of the post-sunset exemption and, therefore, would yield significant estate tax savings because, though the entire exemption has been used up, any previously gifted amounts in excess of the exemption amount would escape consideration for taxation.
Many individuals may be reliving the reality of 2010 when it seemed as though there was similar urgency to gift from the estate, only to be in the position of revisiting the plan years later to potentially undo what they originally did due to the increased estate tax threshold that followed.
These risks make proactive planning for TCJA's sunsetting provisions difficult, if not impossible. No one can know what the political landscape will be like in 2025 and whether the sunset will actually occur or whether an entirely different set of laws may be enacted.
By adopting flexible estate planning strategies, clients need not worry about the whims of Congress. Obviously, routine reviews of the estate plan are still essential, and both the current and anticipated future needs of the client should be considered during drafting (rather than a pure wait-and-see approach), but there are many ways to build flexibility into an estate plan while still planning effectively for the "now."
Disclaimer trusts planning can adapt to changes in estate tax laws
Going back to our example of the couple that adopted an A/B trust structure with mandatory funding, what could have been done to ensure flexibility so that, regardless of the estate tax exemption amount at death, their plan would work just fine?
Instead of mandating funding of the credit shelter trust, they could create a "Disclaimer Trust" where all assets are directed to fund the Marital Trust while giving the surviving spouse the discretionary option to "disclaim" assets to fund the credit shelter family trust, which may result in an estate tax to the credit shelter trust. This would put the surviving spouse in the driver's seat to direct what, if any, assets fund the credit shelter trust.
This Disclaimer Trust structure provides for maximum flexibility, not only because the surviving spouse can select what assets to disclaim but also because it is flexible enough to adapt to the ever-changing estate tax laws. Under this type of trust arrangement, the surviving spouse must be vigilant to effectuate a qualified disclaimer within the requirements of
The requirements of a qualified disclaimer are as follows:
- The disclaimer must be irrevocable and unqualified;
- The disclaimer must be in
writing ; - The
writing must be delivered to the transferor of theinterest , the transferor's legal representative, theholder of the legal title to the property to which theinterest relates, or theperson in possession of such property; - The disclaimant must not have accepted the
interest disclaimed or any of its benefits; and - The
interest disclaimed must pass either to the spouse of the decedent or to aperson other than the disclaimant without any direction on the part of theperson making the disclaimer.
These conditions are relatively easy to satisfy, provided the surviving spouse is counseled ahead of time not to take action with any assets titled in the name of the trust prior to confirming the appropriate post-death trust funding strategy.
If, for example, the surviving spouse liquidated certain positions and withdrew from a brokerage account in the name of the trust in order to fund a personal vacation, they may be hard-pressed to later disclaim that account to the credit shelter trust as they had already likely exercised impermissible dominion and control over the asset in violation of item 4 above.
As for the writing requirement, there is no formal IRS process or filing requirement related to the disclaimer. As described above, the disclaimer must be in writing and delivered to the trustee (which usually refers to themselves). This means that it is important to document that the surviving spouse (or trustee if it is someone other than the surviving spouse) technically made the disclaimer in the event of a later IRS audit contesting or questioning whether a valid qualified disclaimer had been made.
Interestingly, the surviving spouse may still act as trustee and discretionary beneficiary of the credit shelter trust provided that the trust is drafted to limit the spouse's access to the principal of the trust to an "ascertainable standard" — which typically means that discretionary distributions are limited to Health, Education, Maintenance, and Support (HEMS) of the beneficiary — and that the surviving spouse does not possess control over the disposition of the credit shelter trust that could cause inclusion in the surviving spouse's estate under
Failure to create a qualified disclaimer trust could result in assets passing through the surviving spouse's estate, and the only way to remove those assets from the estate thereafter would be through gifting methods that would potentially eat into the surviving spouse's estate and gift tax exemption amount — the very thing the strategy seeks to avoid.
Clayton Trusts provide more grantor control
The flexible Disclaimer Trust approach is not a one-size-fits-all strategy because this structure only works in a family dynamic where the grantor is comfortable permitting the surviving spouse to have this level of control over the estate. For example, in a blended family where the grantor wants to ensure there is something left over for their own kids, giving the surviving spouse maximum discretion may not be ideal. Accordingly, a disclaimer trust strategy where the surviving spouse has the complete flexibility to determine what assets, if any, are set aside into the credit shelter trust may not be palatable.
This doesn't mean that these types of clients are left without a flexible option. For those wanting a similar (but slightly more administratively burdensome) approach, there is the "Clayton Trust," a trust permitting the trustee to make a Clayton QTIP election. The Clayton Trust structure would work similarly to a rigid A/B trust structure where assets are directed to two separate A and B subtrusts for the benefit of the surviving spouse. However, rather than the A trust acting as a marital deduction trust (in the surviving spouse's estate) and the B trust as a credit shelter trust (outside of the surviving spouse's estate), what would otherwise be the credit shelter trust would instead be a trust that is available for a Qualified Terminable Interest Property (QTIP) election.
A Clayton Trust allows for an election to be made on the decedent spouse's estate tax return to treat the assets in the B trust as a QTIP and, therefore, a part of the taxable estate of the surviving spouse upon the death of the first spouse (which would ensure a step-up in basis). Failure to make this QTIP election would mean that the B trust would be outside of the estate of the surviving spouse, which could be beneficial if there are estate tax concerns — just like the disclaimer trust strategy.
For a QTIP election to be valid under
The addition of an independent third party (i.e., someone who is not a beneficiary of the trust or a close family member of the surviving spouse) into the equation is usually not a concern, as one of the reasons to use the Clayton-QTIP structure may be to ensure that the surviving spouse does not have the ability to alter who will ultimately benefit from the remaining trust assets at death.
An additional benefit of the Clayton trust is that the time frame to make the QTIP election is more lenient and must be made on the Form 706 Federal estate tax return within 15 months of death (or
Trust protectors and decanting provisions offer flexibility with irrevocable trust planning
The term "irrevocable" certainly does not seem to offer much wiggle room to alter the terms of a trust. However, even if, under current law and circumstances, an irrevocable trust accomplishes a person's stated goals, it is important to try to soften the irrevocable nature of the trust as much as possible. This flexibility could come in many forms to make the otherwise irrevocable trust somewhat changeable.
One method would be creating a
Often, the Trust Protector's powers are limited to the ability to alter administrative provisions of the trust, but many trusts will also allow a Trust Protector to change the beneficial interests within the trust. The Trust Protector role offers a potential "do-over" option for trusts that were validly created but rendered obsolete due to unforeseen legislative or personal circumstances. In states that have adopted the Uniform Trust Code (UTC), the Trust Protector role is an authorized role. Additional states that have not adopted the UTC may or may not have statutes recognizing the role, and, therefore, individuals seeking to include this flexible role within their trust document should be vigilant to determine if such a role has any basis of authority as determined by state law.
A decanting provision is another popular method of providing some flexibility in an irrevocable trust. This allows assets to be "poured" into a new irrevocable trust if the original is no longer suitable. Like the Trust Protector role discussed above, the ability to decant is dependent on state law.
State statutes define the permissible variance in provisions between the delivering and receiving trust, but if done correctly, a trust containing obsolete or inadvisable provisions could be disregarded in favor of a new, "better" trust without pulling the assets into the grantor's estate or otherwise disturbing the protection offered by the original trust when initially funded.
'Escape hatch' provisions that provide discretionary power to trustees
Absent altering the provisions of the irrevocable trust to update it to put it in line with the current legislative framework and/or beneficiaries' circumstances, some individuals may feel that completely unwinding the trust is the most desirable approach.
If these irrevocable trusts lack an "escape hatch," the grantor may be stuck, unable to effectively remove assets from the trust without Court approval. Typically, such an escape hatch would come in the form of a discretionary beneficiary of the trust capable of receiving the assets of the trust without strings attached. The ability to do so is dependent on whether the trust itself permits complete discretion for distributions rather than limiting distributions to an ascertainable standard, i.e., allowing distributions to be made only for the beneficiary's Health, Education, Maintenance or Support (HEMS). If the trustee is limited to such a standard, they may be hard-pressed to justify the full distribution of the trust assets to a single beneficiary while maintaining their fiduciary duty to current and future beneficiaries.
Of course, issues of control are ever present in determining whether an individual would want the trustee to have that vast discretionary power and whether a given beneficiary is an appropriate recipient. Whenever property is given to an individual without the intent of their full enjoyment of such property, there is the risk that the beneficiary will not do the right thing and use such property to fulfill the desires of the grantor or that the property will be put at risk of dissipation or relinquishment as a result of the individual beneficiary's creditors, divorce, etc.
As always, the effectiveness and suitability of any potential estate planning solution will depend on the unique circumstances of the client and their individual planning goals and needs. Even more important than the specific potential solutions, though, is a mindset that focuses on flexibility to adapt to a constantly changing political landscape. Ensuring that a client's estate plan meets their current needs but is also designed to withstand unexpected changes in the law —as well as personal circumstances — will provide a client with an indispensable planning experience.
