High-net worth individuals have an opportunity to take advantage of high transfer tax exemptions if they act fast. Set to expire in 2026, if not before, the time is now to implement strategies that make the most of the current “death tax” exemptions.
There has been a lot of talk since September 2021 about the Build Back Better Act, which included some major tax increases. According to U.S. Senator Joe Manchin of West Virginia, this Act is dead—and I think that is the most likely case. But as is the case with most things involving Congress, we shall see.
Regardless of the fate of Build Back Better Act, the contents of the Act are telling as to areas in which Congress is likely to act with respect to taxes that are commonly referred to as “death taxes.” As with most hot topics, there is a lot of confusion as to death taxes so today I would like to provide some clarity on Death Taxes related to what we know, what we do not know and how we can plan for certainties and uncertainties.
Starting with terminology, the “death tax” is a form of “transfer tax” and is formally referred to as the estate tax. Everyone is familiar with income taxes. If you receive a salary, that salary is subject to ordinary income tax. If you sell appreciated property, the gain is subject to capital gains tax. Ordinary income tax and capital gains tax are both types of income tax, and the tax on receiving money in exchange for something.
Transfer taxes, on the other hand, are taxes (at a rate of 40 percent) on the right to transfer something without receiving anything in exchange. When would you transfer something without receiving anything in exchange? In two circumstances: first, if you make a gift to someone; and, second after you die and someone receives an inheritance from your estate.
There are three types of transfer taxes:
While managing all these potential taxes is part of estate planning, this discussion focuses on the first two, the gift tax and the estate tax.
Lawmakers do not tax every gift an individual makes, nor do they tax every estate. Rather, Congress sets a dollar cap for gifts that a person can make during life or bequests after death before a transfer tax will apply. This dollar cap is often referred to as the “exemption amount.”
Under current law, an individual has an exemption amount of $12.06 million dollars, and married couples together have a combined exemption amount of $24.12 million dollars. However, these exemption amounts will be decreased by half on January 1, 2026 (unless Congress acts sooner as it tried to do in the fall of 2021), so the time is now to implement strategies that make the most of the current death tax exemptions.
A hypothetical may better explain what all this means. Assume we have a single individual whose net worth in $20 million dollars. That individual can either gift during their lifetime or leave as an inheritance at their death the sum total of $12 million dollars.
If the individual does not make any taxable gifts during their lifetime, then at death the individual could pass approximately $12 million dollars transfer tax free. The remainder of the individual’s estate ($8 million) would be taxed at 40 percent, so approximately $3.2 million would be paid to the IRS and the remaining $4.8 million would be available for the individual’s beneficiaries.
Now, what if the individual had made taxable gifts of $10 million during their lifetime? Based on the net worth of $20 million, an individual who gifts $10 million during their lifetime uses up $10 million of their $12 million exemption. So, $2 million of exemption remains and the individual’s net worth is now revalued at $10 million.
Assume the individual dies with that $10 million net worth and the $2 million exemption remaining. In this case, the $2 million passes to the beneficiaries free of the estate tax. The remaining $8 million gets taxed at 40 percent, resulting in $3.2 million being paid to the IRS and the remaining $4.8 million available for the individual’s beneficiaries.
Using today’s law, an individual can give up to $12.06 million away free of transfer tax either during their life or after their death. But we can never predict the future of tax law.
We do have one certainty that is approaching on January 1, 2026, and that is, the $12.06 million ($24.12 million for married couples) exemption amount is going to be cut in half unless Congress acts to keep the exemption at its current amount. While not a certainty, the Democrats have made it clear that they would like to try to reduce the exemption amount sooner. If the Build Back Better Act had passed, the exemption would have already been reduced. Therefore, one thing to plan for is the possible decrease in the exemption amount.
There are many strategies, approved by courts and the IRS, to take advantage of current exemption amounts. First and foremost, the IRS has confirmed that people who make gifts prior to a decrease in the exemption amount will not be adversely impacted when the exclusion amount is cut in half in 2026. An individual can gift $12 million dollars today, and if the exemption amount reverts back to roughly $6 million, they will have sheltered an additional $6 million from the transfer taxes. One strategy for those who can afford to do so is to fully utilize the exemption amount before the amount gets reduce.
Second, when a gift is made the amount of the exemption used is the value of the gift the day it was made. If someone gifts an asset that will appreciate in value and that asset is currently worth $12 million dollars today, then essentially the appreciation is removed from the estate of the person who made the gift. This creates wonderful opportunities for business owners who are seeking to remove appreciation from their estate and leave more money to their family as opposed to the IRS.
This discussion of death taxes is just scratching the surface of a large iceberg. Individuals with a net worth of $6 million or more should review their current situation with an attorney who is experienced in transfer tax matters. Waiting until 2025, or to see if Congress acts prior to that time, may be too late. Families and their advisors may remember a similar situation in 2013 and those who waited until 2013 often had difficulty finding a qualified attorney who had capacity to assist with last minute planning.
Dylan Metzner counsels individuals and families throughout the United States and internationally with their tax, estate and private wealth planning needs, guiding them through the maze of laws and practical considerations in moving each client closer to achieving goals and resolving outstanding issues. Reach out to Dylan at email@example.com for private wealth management guidance.
This information is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the matters addressed above.