What Investors Need to Know About The Federal Estate Tax Sunset

The estate tax, also called the death tax, is a tax on transferring assets from a deceased person to their heirs or beneficiaries. One significant component of our current estate tax law is the sunset provision, which implies that specific policies within the law have a set expiration date after which they cease to exist. The impending estate tax sunset on December 31^st. 2025, may significantly impact high-net-worth individuals transferring their estate to heirs and those who inherit these assets.

In this article, we review the current estate tax exemption, the step-up basis rule, and how proactive estate planning and the implementation of strategies may help lighten the tax burden on heirs.

Today’s Federal estate tax exemption

Currently, the estate tax exemption limit in the U.S. is $13.61 million per benefactor, implying that any estate valued less than this amount will most likely not be subjected to federal estate tax. Nonetheless, these parameters are subject to change following the sunset provision, which will expire at the end of 2025.

As the sunset date approaches, the federal estate tax exemption could be decreased by nearly half. This reduction would mean more estates fall into the taxable category, substantially impacting heirs. Investors who initially thought their estate or heirs would not be liable to pay the estate tax due to the value under the exemption threshold may need to reevaluate their estate plan due to the lower limit.

Though the exact changes following the sunset provision are subject to legislative decisions, being prepared for different scenarios may help investors better preserve their investments and their heirs’ inheritances from adverse tax consequences.

The stepped-up basis rule

Another aspect of the estate tax sunset that could impact investors relates to the step-up basis rule. Under the current law, when an investor inherits an asset, its cost basis is adjusted (stepped up) to the market value at the time of the previous owner's death. It allows the inheriting investor to sell the asset immediately without incurring capital gains taxes or to hold onto the asset with a managed potential future tax liability.

Eliminating or modifying the stepped-up basis rule could result in higher capital gains taxes for heirs inheriting assets. In such cases, the inherited assets' cost basis would remain the same as when initially purchased by the original owner, leading to higher capital gains when these assets are sold.

Proactive estate planning needed

The uncertainty surrounding these impending changes urges investors to consider proactive estate planning strategies; some examples include:

·        Intervivos gifts—Intervivos gifts are the transfers of assets made during the giver's lifetime. Such gifts can strategically help manage an estate's value to fall within the exemption limit.

·        Life Insurance Trusts (LITs)— A life insurance trust (LIT) is a legal agreement that allows a third party to manage a life insurance policy's death benefit and help mitigate the tax liability to heirs on assets held in the trust. Trusts can help control how and when assets are distributed to beneficiaries, offering protection against future estate tax changes.

The sunset of the estate tax may also impact investment strategies. If the estate tax reverts to its old rules, more estates may be subject to the tax, encouraging investors to consider tax-efficient investing more seriously. This could lead to increased investments in assets such as dividend-paying stocks, municipal bonds, and real estate properties that provide rental income.

It is essential to remember that the sunset of the Federal estate tax is not a certainty. Future Congresses could decide to extend the increased exemptions or even make them permanent. Alternatively, there could be further restrictions or increases to the estate tax. Given the fluctuating nature of this scenario, it is recommended that investors continually revisit their estate plan with their financial, legal, and tax professionals to ensure it still aligns with their financial goals and wishes.