By Jeff Chadwick, JD - Special guest author
This article is the second part of a two-part series that explores how to optimize lifetime gifting strategies. The first part focused on 99.8% of Americans without taxable estates. This part addresses transfer tax planning in light of legislative uncertainty. Although this article provides an overview of certain planning techniques, all such techniques are highly fact-specific, and clients should consult with legal and tax counsel prior to making any gifts.
Sunset of Increased Transfer Tax Exemptions
The Tax Cuts and Jobs Act of 2017 doubled the basic exclusion amount from federal gift and estate taxes (the BEA) and the generation-skipping transfer (GST) tax exemption amount (the GST Exemption). In 2020, the BEA and GST exemptions are each $11.58 million per person ($23.16 million per married couple).
If the double BEA and GST exemptions were permanent, it would be easier to plan for clients. The double exemptions are set to expire in 2026, however, and the tax laws could certainly change before then depending on the results of the next election cycle. In 2026, the BEA and GST exemption are both set to return to $5 million per person ($10 million per married couple), indexed for inflation with a base year of 2026. Factoring in inflation, it is estimated that the BEA and GST exemption in 2026 will be approximately $6.4 million per person ($12.8 million per married couple).
Three Groups of Clients
Explaining the current transfer tax laws to clients can be challenging, and it can be even more challenging to structure lifetime gifting strategies in the face of such uncertainty. The best place to start, however, is to gain a comprehensive understanding of the client's current net worth, appreciation potential, and remaining BEA and GST exemption. This information should enable the advisor to classify the client in one of three categories - "affluent" clients, "wealthy" clients, and "super wealthy" clients.
AFFLUENT CLIENTS. "Affluent" clients are unlikely to have a taxable estate, regardless of the exemption amounts. Affluent clients, therefore, are projected to have a net worth in 2026 of $6.4 million or less (or $12.8 million or less for married couples). Taxable gift planning for affluent clients is relatively straightforward. Because the client is unlikely to have a taxable estate, the client's gifts are not typically motivated by transfer tax savings. Rather, the client's non-tax objectives usually dictate the planning.
SUPER WEALTHY CLIENTS. At the other end of the spectrum, "super wealthy" clients currently have a taxable estate, and are likely to have a taxable estate as long as the estate tax exists. Super wealthy clients, therefore, have a net worth today in excess of $11.58 million (or in excess of $23.26 million for married couples). Planning for super wealthy clients is, in many respects, business as usual. Advisors should continue to recommend traditional lifetime gifting strategies, such as transfers of appreciating assets to grantor trusts, grantor retained annuity trusts, family limited partnerships, and others, but perhaps with more urgency given the scheduled expiration of the double BEA and GST exemption in 2026.
WEALTHY CLIENTS. "Wealthy" clients do not have a taxable estate under the current law, but are likely to have a taxable estate once the doubled exemptions expire in 2026 or if the tax laws change before then. Wealthy clients, therefore, have a net worth today between $6.4 million and $11.58 million (or between $12.8 million and $23.16 million for married couples), which means that they should have a net worth of $6.4 million or more (or $12.8 million or more for married couples).
Wealthy clients are the most difficult group of clients for which to plan. Unlike super wealthy clients, they generally cannot afford to make large taxable gifts and unlike affluent clients, they face a looming estate tax obligation if they die after 2025 without having engaged in active tax planning. Adding to the challenge, the doubled exemptions are "use it or lose it" amounts. For example, assuming the BEA drops to $6.4 million in 2026, if a taxpayer makes a $5.4 million gift in 2025, and has made no other taxable gifts in prior years, the taxpayer would only have $1 million of BEA remaining in 2026. Thus, the taxpayer would have to make gifts in excess of $6.4 million before 2026 to receive any benefit from the temporarily doubled exemptions. We call this the "wealthy client gifting threshold."
Creative Gifting Strategies for Spouses
For two reasons, more planning options are available for wealthy clients who are married, compared to a wealthy client who is single. First, a married couple has two BEAs and two GST exemptions at their disposal (instead of just one).
Second, and more importantly, many clients are comfortable naming spouses as beneficiaries of irrevocable trusts, with the hope (or, perhaps more accurately, the expectation) that if the client or the client's family has a financial need, the client's spouse will be able to receive a trust distribution to satisfy the need.
UTILIZE ONLY ONE SPOUSE'S BEA AND GST EXEMPTION. One simple solution for married couples is to have only one spouse make gifts, rather than both spouses. That way, the wealthy client gifting threshold is only $6.4 million, instead of $12.8 million.
Consider, for example, a husband and wife with a net worth of $20 million. The couple wishes to take advantage of the currently doubled exemptions, but they are only comfortable making a total gift of $10 million. If each spouse gifts $5 million, the spouses would not exceed the wealthy client gifting threshold. If the doubled exemptions expire in 2026, the spouses' combined BEA would total only $2.8 million.
In contrast, if the husband made a gift of $10 million, and his wife made no gifts, the husband's gift would exceed the wealthy client gifting threshold by $3.6 million. If doubled exemptions expire in 2026, the husband would have $0 of his BEA (and potentially GST exemption) remaining, but the wife would have her entire $6.4 million BEA and GST exemption. In this example, therefore, if only one spouse made gifts, the couple could make total tax-free transfers of $16.4 million, compared to the $12.8 million if the couple made gifts using the more traditional split gift method.
SPOUSAL LIFETIME ACCESS TRUSTS. A common planning technique for married couples involves at least one spouse creating an irrevocable trust for the primary benefit of the other spouse and possibly other beneficiaries, such as children and more remote descendants. These trusts are often referred to as Spousal Lifetime Access trusts, or "SLATs." By funding a SLAT during his lifetime, a client can take advantage of the doubled BEA and GST exemption amounts set to expire in 2026, while also removing appreciating assets from the transfer tax system. Moreover, if the donor spouse is concerned he may lack sufficient funds in the future, he may take some comfort that his spouse is the primary beneficiary of the SLAT and presumably could receive a discretionary distribution that is sufficient to support the client's family (and indirectly, as a result, the client himself).
Many married couples desire that each spouse create and fund a SLAT so that both spouses are permissible beneficiaries of transferred assets, instead of just one spouse. If each spouse creates and funds a trust for the benefit of the other spouse, the IRS may attempt to apply the "reciprocal trust doctrine." Where applicable, this doctrine allows the IRS to uncross each trust for his or her own benefit. Accordingly, if both spouses seek to create and fund a SLAT, the SLATs must be substantially different in their structure and funding to avoid application of the reciprocal trust doctrine.
Although SLATs have existed for many years, they became extremely popular in 2011 and 2012, when the $5 million BEA was set to be replaced in 2013 with a $1 million BEA and a 55% estate tax rate. With the same dynamic at play in the years leading up to 2026, many wealthy clients are likely to consider funding SLATs with gifts in excess of the wealthy client gifting threshold. Thankfully, through the issuance of Treas. Reg. §20.2010-1, the IRS has clarified that if a taxpayer makes gifts utilizing the doubled BEA, but later dies at a time when the BEA is less than the amount gifted, the taxpayer's prior gifts will not be "clawed back" into the estate to produce a higher estate tax liability.
Gifting Strategies for All Clients
Some wealthy clients do not have a spouse, or even if they do, a SLAT may not be appropriate planning vehicle. These clients should consider other planning techniques, all of which are designed to utilize the doubled BEA and GST exemption while providing the client with some opportunity to access the gifted property in the event of financial need. In other words, some wealthy clients may need to "eat their cake and have it too."
SIMPLE METHOD TO PRESERVE ACCESS TO FUNDS. Sometimes, providing a donor with access to funds may be relatively easy. For example, if a wealthy client wishes to fund an irrevocable trust for the benefit of his family members but wishes to retain some access to funds, the trust agreement could grant the client a swap power to reacquire trust assets for assets of an equivalent value, or an ability to borrow assets from a reliable source of liquidity during a time of financial need. Many wealthy clients may be comfortable relying on this borrowing power, with nothing more.
A wealthy client may also favor estate planning transactions that provide the client with a steady cash flow. The most common example is an installment sale to a grantor trust, in which the client sells assets to a trust in exchange for a promissory note (or in some cases, a private annuity). Interest and principal payments on the note (or annuity payments) should provide the client with liquidity, while any future appreciation in the transferred property should occur outside of the transfer tax system as to that client. Moreover, for wealthy clients who are not ready to consume their entire BEA and GST exemption now, but may wish to give more prior to 2026, a current installment sale would facilitate a quick and easy future gift through the client's forgiveness of all or a portion of the outstanding promissory note.
DOMESTIC ASSET PROTECTION TRUSTS. Some wealthy clients may consider funding an "asset protection trust," which, if it works as intended, consumes the client's expiring BEA and GST exemption, is protected from the client's creditors, is excluded from the client's taxable estate at death, and yet still permits the client to be a permissible beneficiary. Asset protection trusts can be formed offshore in jurisdictions such as the Bahamas, Bermuda, and the Cayman Islands, or in 1 of 19 states currently authorizing some form of "domestic" asset protection trust, or "DAPT."
A DAPT, in its purest form, permits an independent trustee to make discretionary distributions of income and principal to or for the benefit of the grantor. A more conservative approach, however, would be to create a DAPT that does not name the grantor as a beneficiary but authorizes an independent power-holder to add the grantor as a discretionary beneficiary at a later date. This approach should provide another layer of insulation between the grantor and the trust, which may help if the trust is challenged by a creditor or the IRS.
SPECIAL POWER OF APPOINTMENT TRUSTS. Some wealthy clients may believe DAPTs are too risky, despite their potential benefits. An alternative technique involves the creation of an irrevocable trust for the benefit of one or more beneficiaries, not including the grantor, in which a beneficiary or non-beneficiary is given a limited power to appoint the trust assets among a class of persons, including the grantor. Trusts with this feature are sometimes referred to as special power of appointment trusts, or "SPATs." SPATs offer considerable appeal for wealthy clients given the possibility that the trust assets could pass to a trust for the donor's benefit through a third party's exercise of a lifetime or testamentary limited power of appointment.
RETAINED INTEREST GIFTS. Under the estate tax "string provisions" contained in Sections 2035 - 2039, and 2042 of the Internal Revenue Code, a taxpayer can make a completed taxable gift during lifetime, but the gifted asset can still be included in the taxpayer's gross estate upon death. This basic concept, combined with the anti-clawback provision in the Treasury Regulations and the exception of assets included in the gross estate from adjusted taxable gifts, may enable wealthy clients to make use of the doubled BEA by making completed taxable gifts prior to 2026, while still enjoying the property during their lifetimes. While it exceeds the scope of this article to discuss specific techniques, wealthy clients may consider taking advantage of this interplay by engaging in more complex gifting strategies prior to 2026.
Designing a comprehensive gifting strategy has always been hard. It is even harder now in the face of legislative uncertainty and constantly changing exemption amounts. The right approach requires learning as much about the client as possible, including the client's tax and non-tax motivations for gifting, as well as the client's ongoing financial needs and cash flow. For most clients, it is more appropriate to plan for income tax savings, rather than transfer tax savings, and planners must learn to adapt to this new planning paradigm.
Clients and their advisors should be familiar with and take advantage of lifetime transfers that do not consume gift tax exemption. When considering a transfer that will consume gift tax exemption, advisors may group clients into three categories—affluent clients, wealthy clients, and super wealthy clients—in order to suggest techniques that are appropriate for each client group. Wealthy clients are the most challenging group to plan for because they are stuck in the middle of the expiring exemption amounts.
Transfer tax planning for wealthy clients may require creative solutions designed to utilize the client's increased BEA and GST exemption prior to 2026, while potentially permitting the client to access the gifted property directly or indirectly in the future.
Jeff Chadwick, JD,is a member of the Wealth Preservation Practice Group of Winstead, PC, with offices in Houston and The Woodlands, Texas. Jeff focuses his practice on trust and estate planning for business owners, corporate executives, professional athletes, and other high net worth individuals and families. He strives to provide innovative and practical solutions to a wide range of legal matters, including wealth transfer planning, trust and estate administration, business formation and succession, asset protection, charitable giving, and premarital planning.
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