The Internal Revenue Service recently issued Revenue Procedure 2021-45 providing calendar year 2022 inflation adjustments for more than sixty tax provisions. Two of these adjustments are of particular interest to estate planners: the increase to the basic exclusion amount (the “BEA”) to $12,060,000 and the increase to the gift tax annual exclusion amount to $16,000. These adjustments come in the wake of Congress’ decision not to decrease the BEA by half to pre-2018 levels starting in 2022.
Increased Basic Exclusion Amount
The basic exclusion amount is the total amount an individual can transfer during lifetime and at death without incurring federal gift tax or federal estate tax. When the cumulative amount of transfers made by an individual exceeds the individual’s available BEA, after considering deductions and exclusions, a tax is due. Prior to 2018, the BEA was $5,000,000, adjusted annually for inflation. The Tax Cuts and Jobs Act (“TCJA”) doubled the BEA starting in 2018 to $10,000,000, adjusted annually for inflation. In 2021, the BEA is $11,700,000. The BEA will be $12,060,000 for 2022. Portability, which allows a surviving spouse to use their predeceased spouse’s unused BEA, effectively doubles the BEA for married couples to $24,120,000 in 2022. Absent Congressional action, the TCJA will expire and the BEA will revert to $5,000,000, indexed for inflation, as of January 1, 2026.
This annual increase is beneficial for tax planning purposes, but perhaps the more significant news is it no longer appears the BEA will be reduced to the pre-TCJA levels as the House Ways and Means Committee had proposed in September. Reduction of the BEA prior to its expiration in 2026 has been a concern for, and the planning focus of, high net worth estate planning advisors and their clients who have been working to use up as much BEA as possible before a reduction. This planning takes advantage of final IRS regulations issued in 2019 clarifying there will be no “clawback” of the BEA upon reduction: a taxpayer’s BEA at death will be the greater of the BEA in effect on their date of death or the amount of basic exclusion properly used during their lifetime. While this creates planning flexibility, it also means the doubled BEA is “use it or lose it.”
It is important to note that New York state (“NYS”) has different rules when it comes to estate and gift taxes. NYS’ estate tax exemption is tied to the pre-TCJA federal BEA and is $5,930,000 in 2021 (NYS has not yet released inflation adjustments for 2022). NYS does not impose an independent gift tax, but taxable gifts made within three years of death are included in the taxable estate for NYS estate tax purposes. Also, unlike the federal estate tax regime, NYS does not allow portability between spouses, so if either spouse dies without using their entire NYS exemption, the unused amount is lost forever.
Increased Gift Tax Annual Exclusion
The gift tax annual exclusion is the amount an individual donor can give to any donee without the obligation to file a gift tax return and without using any of the donor’s BEA. Any gift in excess of the annual exclusion is a taxable gift, reducing the donor’s BEA by that excess or, if the donor has used all of their BEA, subjecting the gift to current gift tax. The annual exclusion amount has been $15,000 since 2018 and will be $16,000 for 2022.
The annual exclusion amount is an oft-used tool in the estate planner’s toolkit because it allows the donor to make gifts up to the annual exclusion amount to an unlimited number of donees. For example, an individual donor with ten grandchildren can give each grandchild $16,000 in 2022, for a total of $160,000 without making a taxable gift and using any BEA. Further, married donors may elect “gift splitting” to combine their annual exclusion with their spouse, allowing them to gift each of their ten grandchildren $32,000 for a total of $320,000 in non-taxable gifts.
The annual exclusion is also relied upon by many implementing irrevocable life insurance trusts (“ILITs”) in their estate planning. Provided certain conditions are met, a donor’s payment of premiums on life insurance policies owned by an ILIT are eligible for the annual exclusion. This is due to the ILIT’s beneficiaries having a present right to a portion of the premium payment or the trust corpus, often referred to as a “Crummey” power.
In addition, the annual exclusion can be used to frontload tax-favored education planning. Section 529 plans allow an individual to deposit funds in an account which may be used only for another individual’s educational expenses. The donor may qualify for a NYS income tax deduction of up to $5,000 for an individual and $10,000 for taxpayers married filing jointly, investments in the account are not taxable, and no tax is due upon withdrawal for qualified educational expenses, provided certain requirements are met. Individuals may make a frontloaded gift of up to five times the annual exclusion to fund a Section 529 account. So, provided they elect to do so on a gift tax return, a grandparent can fund a grandchild’s Section 529 account with $80,000 in 2022, take immediate advantage of the tax-free growth potential, and the entire $80,000 will qualify for the annual exclusion, allocated ratably over five years.
Notably, the gift tax does not apply to direct transfers made for another individual’s qualifying educational and medical expenses. Internal Revenue Code Sec. 2503(c) provides that any amount paid on behalf of an individual either to a qualifying educational organization—including primary, secondary, preparatory, high school, college, and university—as tuition for that individual’s education or training, or to any medical care provider for that individual’s medical care, is not treated as a gift. In the educational context, this exception does not cover items such as room and board, books, or supplies. To qualify, the payment must be made directly to the educational organization or medical provider. It cannot be a reimbursement to the student or to a Section 529 account. The primary purpose of the exclusion is to allow parents and grandparents to pay for their children’s educational and health care needs without a tax impediment.
The major focus of planning for intergenerational wealth transfer is accomplishing the individual’s non-tax goals while minimizing overall exposure to estate, gift, income, and generation-skipping transfer taxes. Efficiently using an individual’s available basic exclusion amount is the centerpiece from which all such planning is derived. Myriad planning strategies are available, including outright gifting; certain grantor and non-grantor trusts including irrevocable life insurance trusts, spousal lifetime access trusts, and grantor retained annuity trusts; note-sale transactions; and various charitable planning options; among others.
While taxpayers and planners alike spent much of 2021 planning for the potential decrease in the BEA amid strong returns in the financial markets, Congressional abandonment of such a decrease (as of the time of this writing) is welcome news. Many well-established strategies exist to aid taxpayers in leveraging the BEA and gift tax annual exclusion to minimize their tax burden while maintaining the integrity of their overall wealth transfer plan.
This alert does not purport to be a substitute for advice of counsel on specific matters.
Harris Beach has offices throughout New York State, including Albany, Buffalo, Ithaca, New York City, Rochester, Saratoga Springs, Syracuse, Uniondale and White Plains, as well as New Haven, Connecticut and Newark, New Jersey.