According to a recent Bloomberg article, $72.6 trillion will be transferred or inherited over the next 25 years. For the unwary taxpayer, the complex income, estate, and gift tax rules can be a tough minefield to navigate safely, and transferring wealth with no plan may result in significant costs that could have been avoided with proper planning. For 2022, a taxpayer can transfer up to $12.06 million ($24.12 million for a married couple) without incurring estate or gift tax. This amount is referred to as a taxpayer’s transfer tax exemption and can be utilized for transfers made during their life (gift tax exemption) and/or at their death (estate tax exemption). To the extent property is transferred in excess of the exemption, the excess is subject to a tax of 40%. Even though the same exemption applies to transfers made during life and/or death, utilizing a taxpayer’s gift tax exemption now will allow any future appreciation of the transferred asset to occur outside the taxpayer’s estate and thus reduce the taxpayer’s overall transfer taxes.
Additionally, the current gift and estate tax exemption is set to be reduced by half at the end of 2025. As a result, there is the added benefit of utilizing the currently available gift tax exemption before it decreases as failure to do so could cost a taxpayer (and his or her heirs) up to $2.4 million of transfer tax.
There are four methods of minimizing estate and gift taxes when transferring a taxpayer’s assets, such as ownership in their closely held business. These methods are gifting of assets prior to death, leveraged transactions, utilization of discounts, and freebie gifts.
Gifting of Assets
Assume the owner of Widget Enterprises gifts $12.06 million of Widget stock today to utilize his exemption and that this stock grows at average of 7% over the next 20 years. As a result of the growth of this stock after the gift, the owner has effectively transferred $34.6 million of appreciation that will be excluded from gift or estate tax. Assume instead that the owner did not gift his Widget stock and died 20 years later with the Widget stock included in his estate. After reducing for the $12.06 million exemption, the owner’s estate would owe tax of $13.8 million (40% of the $34.6 million of appreciation). As a result, and assuming all else equal, utilizing a taxpayer’s current exemption by making gifts now will generate tax savings as the growth of the transferred asset after the gift has been made will not be subject to additional gift or estate tax. If the current reduction in the tax law becomes effective the tax savings and growth outside of the taxpayer’s estate is even greater.
Some significant factors to consider when making gifts are the loss of benefits to the transferor from owning property (i.e., cash flow and control) and the potential loss of tax basis step-up for gifted property. Under current law, the tax basis of property included in a taxpayer’s estate is adjusted to its Fair Market Value (FMV) as of the date of death. As a result, retaining low basis property in a taxpayer’s estate can result in significant income tax savings due to this basis adjustment. This benefit lost means that gifted property must appreciate a certain amount to offset the tax savings lost from the lack of a basis adjustment before tax savings result. If the above concerns are significant, there are ways to plan around these issues while still reducing overall estate and gift taxes.
Utilizing a taxpayer’s gift tax exemption can generate significant transfer tax savings, but the benefit of this method is limited by the amount of the taxpayer’s available gift tax exemption. One method to avoid this limitation is using leveraged transactions which can amplify the amount transferred and increase the amount of future income and appreciation that occurs outside of a taxpayer’s estate during their lifetime. Examples of leveraged transactions include sales for promissory notes (either to an individual or properly structured trust), intra-family loans, and grantor retained annuity trusts (GRATs). If the taxpayer receives full value for the property transferred, then no gift exemption is utilized, and the transfer (and potential tax benefit) is not limited by the taxpayer’s available remaining gift or estate tax exemption. Furthermore, the taxpayer will generate tax savings to the extent the growth of the transferred property exceeds the minimum interest rate, known as the applicable federal rate (AFR), required on these transfers. In addition to tax savings on the future appreciation of the transferred property, leverage transactions can benefit the taxpayer by allowing them to receive cash flow from the assets transferred.
Another method that can have an immediate impact is by structuring ownership of assets in a manner that results in a discount on their valuation. If assets are owned outright or through a disregarded entity (i.e., single-member limited liability company), the value of these assets for gift and estate tax purposes is their full FMV. However, if these assets were contributed to a regarded entity (i.e., closely held corporation or family limited partnership) and a portion of the ownership is subsequently transferred, then the value of the ownership interest transferred for gift and estate tax purposes may be discounted to account for factors such as lack of control and lack of marketability. The discounts allow taxpayers to transfer assets out of their estate while using less of their transfer tax exemptions.
If we go back to our earlier example of Widget Enterprises and assume that the $12.06 million of stock was only 30% of the ownership of the company, then the owner could transfer the stock to a trust or family partnership and utilize these discounts. If we assume that the valuations determine that the appropriate discount is 20% then the taxpayer can gift the $12.06 million of stock while only using $9.65 million of their transfer tax exemptions. This leaves $2.41 million of exemption available for future gifts. The use of valuation discounts is frequently challenged by the IRS (Internal Revenue Service) and taxpayers should ensure assets transferred are valued by qualified appraisers and that these transactions are structured properly.
The last method available to minimize gift and estate taxes is using gifts that do not utilize a taxpayer’s gift tax exemption. These “freebies” include the annual exclusion amount ($16,000 per person for 2022) and qualified payments for health and education expenses. While these amounts may not generate significant tax savings in any given year, their use over time can result in significant tax savings. As an example, a 60-year-old grandfather with ten grandchildren can transfer $1.6 million over ten years solely by making annual exclusion gifts to his grandchildren each year without using any gift tax exemption or incurring gift tax. This amount also does not factor in the growth of the property transferred which would grow free of additional gift tax. Furthermore, the qualified payments for health or education expenses are not limited by the annual exclusion amount. As an example, assuming a $100,000 tuition cost for his grandchildren, the grandfather can transfer an additional $1 million from his estate by paying for his grandchildren’s tuition.
In nearly every situation, optimal gift and estate tax planning utilizes a combination of the above-mentioned methods. Due to the ever-changing tax landscape, unfortunately, it is not guaranteed that the aforementioned opportunities will be around forever. There is always a chance that they may expire or be removed by future legislation. Implementing a proper plan sooner rather than later for your assets can help ensure that you receive the most tax savings possible and shield them from the uncertainty of the future.
We can help
At Elliott Davis, our Closely Held Business and Family Wealth Services practices have experience working with customers to implement appropriate gift and estate planning solutions tailored to your unique situations. We also assist with periodic reviews of existing plans to ensure that they are still effective considering the ever-changing estate tax landscape. Contact either group at the link above to see how we can assist you.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.