Not so long ago, paying federal estate tax was a much more common occurrence. In 2002, when the federal estate tax exemption amount was $1,000,000, 15,191 taxpayers filed a federal estate tax return. In 2020, only 3,441 returns were filed.
As of January 1, 2022, U.S. citizens and permanent residents enjoy a $12,060,000 exemption before federal estate tax impacts their estates, a married couple with proper advice and estate planning documents in place can typically shelter $24,120,000 with minimal estate planning. As such, we anticipate the number of federal estate return to remain low until the Tax Cuts and Jobs Act (TCJA) sunsets on December 31, 2025. At that time, federal exemptions will fall back to their pre-TCJA level at $5 million, indexed for inflation, exposing more estates to tax exposures. Now is the time for high-net-worth families to review their estates to ensure they are taking advantage of all the exemptions and ensure their plans factor in unforeseen changes in regulations.
Since the introduction of the TCJA, high-net-worth families and their advisors have been engaged in systematically transferring assets in advance of anticipated cuts to federal estate, gift, and generation skipping transfer tax (GST) exemptions. The most dramatic examples of significant multigenerational wealth transfers include clients with rapidly appreciating assets, clients with large estates who have not yet used their full exemption amount, and clients who are certain their tax burdens will increase going forward. There are useful estate planning vehicles that take advantage of current historically high federal exemptions while providing flexibility to adapt and modify those plans based upon future events or tax law changes. Some of these methods include disclaimer planning, making use of available powers of appointment, and implementation of the ubiquitous spousal lifetime access trust (SLAT).
Gifting: One Of The Most Useful Wealth Transfer Vehicles
Structured and leveraged gifting is one of the most useful wealth transfer vehicles by high-net-worth individuals and families. One may wish to utilize their GST and gift tax exemptions to make gifts to children, grandchildren and other family members prior to any potential tax law changes. To better illustrate the benefits of gifting while the exemption rate is at its current amount, consider the following scenario:
U.S. citizens and New York residents, John and Chrissy, are married, which currently allows them to make combined lifetime gifts of $24,120,000. They are also equal owners of a family business (Legends Only, LLP) which is worth $10 million. They have decided to transfer twenty-percent of their company to their children; however, this is a minority stake in the company and the minority owner doesn’t have the right to make all relevant business decisions and vote on important issues relevant to the company. Therefore, the 20% minority stake would be discounted and be worth $1.3 million as opposed to $2 million (20% of the $10 million value of Legends Only, LLP) for gift and estate tax purposes, allowing John and Chrissy to retain $700,000 more of their allotted exemption. For lifetime transfers, the valuation date is the date of the gifting, but for transfers at death, the valuation date is the date of death. By using this valuation discount while they were alive, John and Chrissy reduced the value of their company for estate tax purposes, while also giving their children a percentage of the company in a way that will cost less in terms of transfer tax.
By making these gifts in 2022, John and Chrissy would effectively remove $24,120,000 from their estates estate tax free. This also means that John and Chrissy have removed the appreciation on the assets which they have gifted away from their estates. However, if the gift is not made and the federal estate tax exemption rate is reduced to a hypothetical $6,000,000 per person prior to their deaths in 2040 then when the second of the married couple dies, their heirs or beneficiaries would receive significantly less than what they would have received had the gift been made prior to the reduction of the federal exemptions.
An obvious concern is what the tax outcome might be if a taxpayer makes large gifts now based on current law and the exemptions are subsequently reduced as scheduled or sooner. Thankfully this issue was addressed by IRS Treasury Decision 9884, which confirms that no claw back under these circumstances would occur.
Understandably, some high-net-worth individuals might be somewhat hesitant to make outright gifts to their chosen beneficiaries only to avoid estate tax. Beneficiaries are often too young, too immature, or uncomfortably vulnerable to potential creditors or predatory ex-spouses. In those cases, strategies can be used to allow the grantor to indirectly maintain some control and deny a child or grandchild’s creditors access to trust assets, all while locking in estate and gift tax advantages. Additionally, where desired, the Grantor can often execute a plan, which ensures that the donor receives an income stream from the transferred asset and/or maintains access to principal.
Are Changes Imminent?
In 2021, there was much talk but little action regarding an anticipated sea change in federal tax laws relating to large intra-family wealth transfers and available exemptions. Widely discussed proposals included increases in the estate tax rate, and a rapid reduction of the available gift and estate tax exemption to $3,500,000 per taxpayer. President Biden also publicly favored proposals which would have required realization of capital gains at death rather than receiving the unlimited step-up in cost basis which we have all become accustomed to, as well as an intent to reduce or eliminate several wealth transfer and estate planning techniques, such as the use of short-term zeroed-out GRATs, grantor trust planning, and valuation discounts on transfers of partial interest in family owned entities.
Applicable Federal Rates (AFR) are considered “safe harbor” rates used to confirm there is no imputed additional interest for income or gift tax purposes. These rates are critical components of many popular estate planning strategies, and transfers of wealth which involve use of these interest rates perform significantly better in low interest rate environments. Unfortunately, these rates have begun to increase recently, and it is widely believed that rates will continuously increase to combat inflation for the foreseeable future.
Despite the ominous clouds on the horizon of estate planning, all of the current wealth transfer techniques and entities discussed in this article are still viable options for those looking to take full advantage of the generous current estate tax exemption and increase gift and estate tax savings. All of the proposed changes to the current tax laws will continue to be reviewed and debated in Congress, which is why it may be prudent to act now. Even if it is decided there shall be no estate tax changes for now, they will occur by default on January 1, 2026, less than four years away. Additionally, it is also critical to review one’s estate planning documents on a regular basis to ensure such documents express your present intent; this will refresh yourself on which tax saving provisions your documents invoke and if those provisions still make sense based upon evolving law.
Jordan Linn is a partner in the T&E practice of Tannenbaum Helpern Syracuse & Hirschtritt, and Jordana Balsam is an associate in the practice.