The 2017 Tax Cuts and Jobs Act (TCJA) temporarily increased the amount of gift and estate tax exemption to nearly double the amount available in 2017. Since the enactment of TCJA, we have seen record levels of wealth transfers; however, these higher exemption amounts are scheduled to sunset at the end of 2025, or earlier if legislation is enacted to revise the exemption amounts. For the unwary taxpayer, the complex income, estate, and gift tax rules can be a tough minefield to navigate, and transferring wealth with no plan may result in significant costs that could have been avoided with proper planning.
For 2024, a taxpayer can transfer up to $13.61 million ($27.22 million for a married couple) without incurring federal 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 lifetime (gift tax exemption) and/or at their death (estate tax exemption). To the extent property is transferred in excess of the exemption, most of the excess is subject to a tax of 40%. Even though the same exemption applies to transfers made during life and/or at 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.
Since the current gift and estate tax exemption is scheduled to return to pre-2018 levels after 2025, there is the added benefit of utilizing the currently available gift tax exemption before it decreases. Furthermore, the IRS has issued final regulations that ensure there will be no claw back after 2025 if a taxpayer makes gifts and claims the higher exemption amounts in effect from 2018 to 2025 and the exemption amount drops to pre-2018 levels as scheduled. Failure to utilize the full gift tax exemption now could cost a taxpayer (and his or her heirs) up to $2.64 million of transfer tax.
There are several popular techniques that can be utilized when transferring a taxpayer’s assets, such as ownership in a closely held business. These methods include gifting of assets prior to death, other non-gift transfers and leveraged transactions, utilization of discounts, and “freebie” gifts.
Lifetime gifting of assets
Assume the owner of Widget Enterprises gifts $13.61 million of Widget stock today to utilize his exemption and that the value of the stock grows an average of 7% annually over the next 20 years. As a result of the growth of this stock after the gift, the owner has effectively transferred $39 million of appreciation that will be excluded from gift or estate tax. Assume instead that the owner did not gift Widget stock and died 20 years later with a taxable estate including the Widget stock. Absent any legislative action, the exemption amounts would have returned in 2026 to a pre-TCJA level of $5 million, adjusted for inflation. Current estimates are that the exemption amount would be approximately $7 million ($14 million per married couple) in 2026. After reducing for the estimated exemption of approximately $7 million beginning in 2026, the owner’s estate would owe tax of $18.3 million (40% of the $45.6 million in excess of the $7 million exemption). As you can see from the example, utilizing a taxpayer’s current exemption by making gifts now can generate significant tax savings as the post-transfer growth of the gifted asset after the gift will generally not be subject to additional gift or estate tax.
There are significant nontax factors to also consider when making gifts, such as potential loss of control of a closely held business and reduced cash flow from the gifted asset, as well as potential income tax considerations. 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. When an asset is gifted, the recipient receives the same basis the donor had in the asset, so there is no step-up in basis. The benefit of gifting an asset now to maximize the available gift tax exemption and remove future appreciate from the taxpayer’s estate should be weighed against giving up a potential step up in basis at death of the owner since the basis step-up could reduce income tax liability on future sale of the asset. Careful consideration and planning around both estate and income tax implications can help to maximize overall tax saving opportunities.
Lifetime transfers other than gifts
Utilizing a taxpayer’s lifetime estate and 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. Other transfer techniques should be considered if the lifetime taxable gifts or estate are expected to exceed the available exemption amount. Techniques that can be used to amplify the amount transferred free of estate and gift tax during the taxpayer’s lifetime and increase the amounts of future income and appreciation that occur outside of a taxpayer’s estate include:
- Installment sales, either to an individual such as a family member or to a trust. Installment sales can be leveraged by utilizing promissory notes.
- Utilization of intrafamily loans.
- Transfer to a grantor retained annuity trust (GRAT) which allows the grantor to retain an annuity over a term of years while giving away the remainder interest with reduced gift tax liability.
If the taxpayer receives full value for the property transferred, then no gift tax 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 leveraged transfers. In addition to tax savings on the future appreciation of the transferred property, sale and leveraged transactions can benefit the taxpayer by allowing them to receive cash flow from the assets transferred.
Another technique that can reduce the gift tax cost of transferring assets is 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 (LLC)), the value of these assets for gift and estate tax purposes is their full FMV. However, if these assets were contributed to a properly structured legal entity (i.e., closely held corporation or family limited partnership or LLC) 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. These 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 $13.61 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 or LLC and potentially utilize valuation discounts. If we assume the valuations determine that the appropriate discount is 20%, then the taxpayer can gift the $13.61 million of stock while only using $10.89 million of his or her transfer tax exemption. This leaves $2.72 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 properly structured.
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 ($18,000 per person for 2024) 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 $1.8 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 nontaxable gift amount can be doubled if the grandmother and grandfather elect annually to split gifts, thereby each utilizing the annual “freebie” of $18,000 available to each of them for each grandchild. The assets transferred to the grandchildren can grow free of additional gift tax, further enhancing the tax savings of the annual gifts.
Qualified payments for medical care or tuition to a qualified educational organization 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 these 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 transfer of 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 they are still effective considering the ever-changing estate tax landscape as well as changes in your personal situation. 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.