Managing assets and values for clients whose net worth is close to the federal estate tax exemption can be a challenge. Fortunately, there are practical ideas that you can implement to manage volatility and plan for estate tax.
The challenge for these individuals is that the current high federal estate tax exemption (now $12.92 million per person) is scheduled to drop by half in 2026. So, is there anything to be done for someone who is just below or even just over the current or 2026 levels? The answer, of course, is not black and white. It should go without saying that each idea is particular to the specific facts and circumstances of the individual. There is no true one-size-fits-all option. So, do your due diligence and consult appropriate legal and tax counsel. But, in some cases, due to the nature of the assets, the longevity of the clients, and the family succession goals, it makes sense to take action now to keep those folks at or below the federal estate tax exemption levels.
In this blog post, I will discuss some of the ideas that I have used and considered in for different clients. Here’s what I will cover:
- Make gifts
- Loan liquid assets to family
- Sell property to intentionally defective grantor trusts (IDGTs)
- Reorganize company equity to freeze values
- Fund Charitable Remainder Unitrusts (CRUTs)
- Grantor Retained Annuity Trusts (GRATs)
- Irrevocable Life Insurance Trusts (ILITs)
- Equalize spouses
- Convert separate property to community property
- Use Clayton QTIPs in Wills or revocable trusts
One way to manage assets is to make gifts. While some people may hesitate to make gifts, they can be an effective way to manage volatility. Assets tend to appreciate faster than inflation, so gifting now can lock in the value of the assets and provide some certainty. Additionally, adjusted taxable gifts can be locked in under IRC Sec. 2001(b)(1)(B). While the use of the lifetime exclusion amount against gift tax reduces available basic exclusion for federal estate tax, should the federal estate tax become an issue, the already gifted assets are outside of the gross estate of the donor. Plus, all appreciation on those assets. This can be good planning. There is an inherent trade off: assets that were gifted away do not receive a basis adjustment when the donor dies, if there was a completed gift and the donor did not retain any string powers over the assets (see IRC Sec. 2036-38, 2042). Thus, you are swapping potential federal capital gains tax savings for potential federal estate tax savings.
Make Liquid Assets to Family
Another option is to loan liquid assets to family members. Loaning liquid assets can help freeze the values at the face amount of the note plus interest or the rental rate. This strategy can be implemented best to an irrevocable grantor trust. Some keys are that the loans would need to be genuine debt and subject to at least the applicable federal rate of interest found under IRC Sec. 1274.
Sell Property to Intentionally Defective Grantor Trusts (IDGTs)
Selling property to IDGTs can also be a good option. This swaps the value of the asset, which is variable, with the value of a note, which is set. The transaction needs careful structuring and planning. Do not assume it is simple. Adequate deference to IRC. Sec. 2036 and 2038 issues, at minimum, is required. But, if properly done, this can be a powerful tool.
Reorganize Company Equity to Freeze Values
Reorganizing company equity to freeze values, such as through preferred units or shares, can also be effective. This locks the future appreciation of the company into the common units or shares, assuming the company can produce enough income to cover the preferred return that must be paid to the preferred units. The rules of IRC Sec. 2701 are paramount to this technique and are quite technical. So, do not dabble. But, if properly structured there can be great results that are blessed by the Internal Revenue Code and that are flexible enough to fit many circumstances.
Fund Charitable Remainder Unitrusts (CRUTs)
For charitably inclined clients, one option is to fund CRUTs with appreciated assets. These trusts can be structured to have 90/10 actuarial valuations (unitrust/remainder interests). That means, at least actuarially, the donor receives back 90% of the value of the property contributed to the trust. Of course, depending on the investment performance of the trust that could be more or less than 90%. And, if the donor wants a larger charitable income tax deduction for the remainder gift to charity, they have the flexibility to reducing their payout percentage. At death, the property of the trust is then not subject to federal estate tax (assuming it qualifies as a CRUT).
Grantor Retained Annuity Trusts (GRATs)
GRATs can also be used to swap variable values for certain values. GRATs work best for liquid assets, but they can also be used with illiquid assets if carefully layered with leverage. It is important to run the numbers to determine if this is the right option for you. And, you need someone who understands the detailed rules of IRC Sec. 2702 that govern GRATs. The nice thing about GRATs is that they are, other than the administrative costs, a no-lose transaction in that if the GRAT over performs (meaning its investments exceed the IRC Sec. 7520 rate), property passes to family at the end of the GRAT with little or no federal gift tax exemption used and if the assets under perform or the donor dies during the GRAT term, generally the assets of the trust just revert back to the donor or the donor’s estate as if nothing ever happened.
Irrevocable Life Insurance Trusts (ILITs)
ILITs can be useful for clients with potential federal estate tax issues. The key word here is potential, because insurance is really a hedge against risk. Back in the day (10 years ago) when the federal estate tax exemptions were quite low, ILITs were all the rage. For people now caught between the current federal estate tax exemption and the possible 2026 exemption, the old risk is the same. So, ILITs make sense for that group. Plus, for people who are close to the current federal estate tax limit, moving life insurance out of their hands and into an ILIT makes sense because there is an oversized estate tax hit if they die with the life insurance and the gift tax value of the policy is often much lower than the death benefit. The oversized estate tax is due to the fact that the estate tax value of the policy is the death benefit, while the thing the person owns during lifetime is only the cash value of the policy, which is often much lower. There is also no real income tax benefit of collecting the insurance proceeds outside or inside of a trust, so usually, with proper planning, adding the life insurance to the ILIT does not change the income tax picture.
For married clients, equalizing spouses can be an effective strategy. Gifting to the poorer spouse can bring down the wealthier spouse’s estate. Then, other techniques can be used with both spouses. The idea is that if one spouse does not, or cannot, ultimately use their entire exemption, it is lost. To a degree, the portability rules solve a lot of issues in this regard, but they do not apply until someone dies and planning might need to happen sooner. Also, gift splitting can resolve some issues, but it is also a bit clunky and imposes some limitations on the planning, especially between spouses. So, in the right circumstance, equalizing can make sense.
Convert Separate Property to Community Property
Additionally, converting separate property to community property can provide two bites at the IRC Sec. 1014 basis adjustment apple if the married clients die without federal estate tax issues. And, to be fair, you can still get both bites even if there is a federal estate tax issues, though it is limited to the assets exposed to federal estate tax. Not every jurisdiction allows for community property, so for large parts of the country this is not an option. However, where married folks are moving to a community property state (like California, Washington, Texas, Arizona) from a common law state (like Oregon, New York, Illinois, Minnesota), there is a planning opportunity available that did not exist as readily before the move. Anything dealing this changes in property among spouses, of course, has to take into account the potential for divorce and loss of ownership of a portion of the property by the richer spouse. Where the spouses are planning to remain married, though, this can be a neat option with high federal income tax value.
Use Clayton QTIPs in Wills or Revocable Trusts
Finally, Clayton QTIPs in Wills or revocable trusts can be used for married spouses where federal estate tax could apply. The name of the game is flexibility. And, the Clayton QTIP gives you the broadest postmortem flexibility to plan how property can pass from one spouse to a surviving spouse with the appropriate amount of tax planning. If you want to learn more about this, see my article here https://www.americanbar.org/groups/real_property_trust_estate/publications/probate-property-magazine/2021/september-october/revocable-trusts-changing-times/.
Managing assets and values for clients whose net worth is close to the federal estate tax exemption requires careful planning and implementation. The strategies outlined above can be effective ways to manage volatility and plan for federal estate tax.
To learn more about these and other strategies, you can check out the Wealth and Law Podcast at wealthandlaw.com, where I discuss these things and host guests who have expertise on these topics.
Photo by Karolina Grabowska: https://www.pexels.com/photo/crop-man-counting-dollar-banknotes-4386431/