New Tax Laws are Coming! Planning to Consider for Transfers of Wealth
President Biden has made tax proposals which effect estate and gift tax. Currently, there is a unified exemption for after death estates and lifetime gifts in the amount of $11.7 million. This means a person may leave $11.7 million in inheritance; make lifetime gifts up to $11.7 million; or a combination of inheritance and gifts up to $11.7 million without being subject to estate or gift tax. Transfers which exceed this amount are subject to a tax at 40%.
Biden is in favor of reducing the estate tax exemption to $3.5 million, the lifetime gift tax exemption to $1 million, and increasing the tax rate to 45%. Biden is also in favor of eliminating step-up in basis for inherited assets. If you expect your estate will be valued more than the estate tax exemption when you die, it is wise to explore options to reduce tax.
Current law allows an Annual Gift Tax Exclusion of $15,000 for each gift recipient per year without using tax credits. If you expect your estate will be subject to estate tax, you should take advantage of the Annual Gift Tax Exclusion. You can leverage these gifts by making contributions to an Irrevocable Life Insurance Trust (ILIT). The $15,000 exclusion is multiplied by the number of beneficiaries of the trust. For example, if an ILIT was created for two children and four grandchildren, $90,000 ($180,000 if married) per year can be contributed to the trust under the Annual Gift Tax Exclusion. If these gifts are used to pay premiums on life insurance, the death benefit payable to the trust and ultimately the beneficiaries of the trust can be substantial.
What about making gifts in excess of the Annual Gift Tax Exclusion amount? Under current law, you can give $11.7 million ($23.4 million if married) without gift tax. Unified estate and gift tax credits would be used to avoid recognizing tax on the gift. Future appreciation of the assets given are not in your estate and avoid estate tax at your death. Making gifts before new laws are enacted could provide substantial tax savings.
Is there a smarter way to make life time gifts? All wealth transfer strategies have trade-offs. There is a cornucopia of strategies known by an “alphabet soup” of names which can be explored including SLATs, FLPs, CLATs, GRATs, and IDGTs. Two of the most powerful strategies to transfer significant amounts of wealth with the use of minimal amounts of tax credits are a Grantor Retained Annuity Trust (GRAT) and sale to an Intentionally Defective Grantor Trust (IDGT).
A GRAT requires the trustee to pay an annuity to the trust creator. The difference between the present value of the annuity and the value of the property transferred to the GRAT is the amount of the gift for gift tax purposes. Because the trust creator can determine the amount and term of the annuity, a GRAT can be designed to have a low gift value. To the extent the assets in the GRAT appreciate more than the current interest rate (7520 rate; which is 0.8% as of March 2021), the GRAT will be successful and pass on the amount remaining in the trust after the annuity payments are made to its beneficiaries. An ideal asset to fund in a GRAT is an asset expected to have significant appreciation in value during the GRAT term such as pre-exit or pre-IPO privately held stock or a portfolio of publicly traded stock designed for high appreciation.
IDGTs are designed for the trust creator (Grantor) to be the income taxpayer of the trust but assets held in the trust are excluded from the Grantor’s estate for estate tax purposes. With this design, a sale for fair market value of assets by the Grantor to the trust is not an income tax recognition event because both parties to the transaction are deemed to be the same person under the tax laws. So, an appreciated asset could be sold to the trust without triggering income tax. Sales to IDGTs are typically structured by use of a down payment and seller financing for the balance. The source of the down payment is typically a gift by the Grantor to the trust. This strategy provides a stream of payments to the Grantor from the seller financing and removes the asset from the estate of the Grantor. All future appreciation of the asset avoids estate tax. IDGTs are generally used to transfer already appreciated assets which are expected to appreciate more such as pre-exit or pre-IPO privately held stock, real estate portfolios, and oil, gas, and mineral rights.
It should be noted, courts have determined certain retroactive tax laws are constitutional. Such laws can become effective retroactive to a date prior to it becoming law. Although such laws are subject to scrutiny to determine if constitutional, depending on the facts and circumstances, it is possible new tax laws enacted later this year will be retroactive to the first day of January. Many pundits, however, believe there would be significant political pressure and litigation should a retroactive tax law cause additional tax to taxpayers for events which occurred prior to enacting the law. But be warned, actions taken now may not have the intended result if retroactive tax laws are enacted.
Edward P. Schlesier, Esq. is a certified specialist in estate planning, trust, and probate law and a shareholder with Blanchard, Krasner & French, a law firm with offices in La Jolla, California and Reno, Nevada.