While income tax planning focuses on the short term, transfer tax planning takes a long-term view of preserving your family wealth for generations to come.
Whatever your age, health, or net worth, you should look to the future, keeping an up-to-date will and planning the disposition of your estate.
If you plan properly, you can provide security for your family and potentially reduce the gift and estate taxes you or your estate must pay.
The TCJA did not make a lot of changes in the transfer tax area, but it did enhance your ability to minimize transfer tax by doubling the lifetime exemption amount.
Temporarily Increased Lifetime Exemption Amount
Federal law provides a lifetime exemption that allows you to gift or bequeath a certain amount of wealth without having to pay transfer tax. Under the TCJA, from 2018 through 2025, the exemption is doubled to $10,000,000 from its prior base amount of $5,000,000.
This amount is adjusted annually for inflation. This means that you may give up to the threshold amount of assets over the course of your life or at your death without incurring a gift or estate tax. The generation-skipping transfer (GST) tax exemption is the same. After 2025, barring further changes in the law, the exemption will revert to $5,000,000 (adjusted for inflation).
Overview of Federal Transfer Tax System
Broadly speaking, when you transfer an asset to someone and get back less than the Fair Market Value of what you transferred (often referred to as “full and adequate consideration”), you have made a gift that may be subject to transfer tax. Such transfers can be made during life or at death.
Transfers made during life may be subject to gift tax. Transfers made at death may be subject to estate tax. Transfers made to much younger individuals (skip persons) (such as grandchildren) may be subject to Generation Skipping Tax.
Various exclusions and deductions are available, in addition to the lifetime exemption discussed above, to reduce your transfer tax liability.
For example, each year, you can make a gift of up to $15,000 (for 2021—this amount changes based on inflation) to as many people as you choose without making a taxable gift. This benefit is called the “annual exclusion.” If you are married, it is possible with your spouse’s consent to double that amount to $30,000 per recipient.
You are also allowed to pay for someone’s tuition or medical expenses without those being subject to gift tax—but those have to be paid directly to the service provider to qualify for that exclusion.
To ensure that your year-end gifts qualify for the annual gift tax exclusion, make certain that the transfers are completed in time. A gift by check is not considered a completed gift until it is cashed. If you think the donee might not cash the check by year-end, consider using a cashier’s or certified check, since the funds will be irrevocably removed from your account when the check is issued.
In addition, assuming you are both U.S. citizens, you can gift an unlimited amount to your spouse without those transfers being subject to gift tax.
Transfers to charities will generally qualify for the unlimited gift tax charitable deduction. Certain requirements must be met in connection with each of these exclusions and deductions.
For example, annual exclusion gifts must be enjoyable by the individual currently rather than only at some future time, also referred to as a present interest gift. Thus, speaking with your tax adviser prior to embarking on a gifting program is advised to help you avoid any pitfalls. If your gifts exceed these excludable and deductible amounts, the excess will be subject to tax at a rate of 40 percent. If you are the one making the gift, you are responsible for paying the tax and filing Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
The gift and estate tax systems are unified; this means that if you fully utilized your lifetime exemption by making gifts during life, then at your death, you will not have any exemption remaining and any assets included in your estate will be subject to estate tax at a rate of 40 percent. At your death, Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, must be filed if your gross estate (plus any taxable gifts made during life) exceeds the lifetime exemption of $11,700,000 (as adjusted for inflation). Deductions for spousal transfers and charitable transfers are also available for estate tax purposes.
Although the gift and estate tax regimes form a unified system, transfers may still have different tax consequences depending on when they occur. For instance, if you make a gift of appreciated property, the recipient will generally have “carryover” basis—the same basis as you did in the asset. Alternatively, if the transfer is made from your estate, then the tax basis in the asset will generally be “stepped up” to the FMV of the asset at your date of death. This is true whether or not your estate has to pay estate tax.
Given today’s higher exemption amount and historically low transfer tax rate compared to the combined federal and state income tax rate, you may want to consider postponing the transfer of high-value, low-basis assets (especially when they are not appreciating rapidly) until your death. That way, your heir would be able to sell the asset and incur a lower capital gains tax due to the resulting step-up in basis at your death.
In addition to any potential gift or estate tax, if a transfer is made to a “skip” person (such as a grandchild or an unrelated person more than 37½ years younger than you), the transfer may also be subject to Generation Skipping Transfer (GST) tax. As mentioned above, there is a similar exemption of $11,700,000 from this tax that can be used during your life or at death. Any GST tax due is generally reported on Form 709 or Form 706 (depending on whether the GST tax is incurred during life or at death) and paid along with any gift or estate tax due.
Unlimited Marital Deduction
As mentioned earlier, transfers to your U.S. citizen spouse will not be subject to the gift or estate tax because of an unlimited marital deduction. The marital deduction is available for outright transfers to your spouse and transfers to certain types of trusts. A common trust setup for the spouse that qualifies for the marital deduction is a qualified terminable interest property (QTIP) trust.
Among other requirements, a QTIP trust must pay all net income to the spouse at least annually, cannot be used to benefit anyone other than the spouse during the spouse’s lifetime, and will be included in the spouse’s estate at the spouse’s death. A QTIP trust can be set up during your lifetime (as an inter vivos trust) or set up at your death (as a testamentary trust). The reasons for using a QTIP trust instead of transferring assets outright to your spouse are generally not tax-related; they include maintaining financial control for a spouse who may need assistance in managing money and making sure the assets pass to your descendants when your spouse dies. This may be particularly important to you if this is not your first marriage and you have children from another marriage whom you wish to benefit while still making the assets available for your surviving spouse should they be needed.
Portability
The traditional approach to estate planning involved the creation of a bypass (or credit shelter) trust to hold the amount of the decedent’s unused lifetime exemption for the benefit of the children and the spouse and a QTIP trust to hold the balance of the decedent’s assets for the benefit of the surviving spouse. This approach created a nontaxable estate at the death of the first spouse to die by virtue of the lifetime exemption and marital deduction and also enabled the couple to transfer assets equal in value to both spouses’ exemption amounts to their heirs without paying gift or estate tax. In contrast, if the assets of the first spouse to die were transferred outright to the survivor, although no tax would be due at that time by virtue of the marital deduction, only the surviving spouse’s lifetime exemption would be available to protect the remaining assets from estate tax when the second spouse died.
Legislation allowing for the portability (or transferability) of the lifetime exemption to the surviving spouse has made this planning less critical in some cases. Now, a decedent leaving everything to the surviving spouse (either outright or in trust) can pass on his or her unused exemption amount to the surviving spouse so that both spouses’ exemption amounts can be utilized at the second spouse’s death without using the two-trust structure described above. In order to transfer the unused exemption amount, the executor of the first deceased spouse’s estate must make an election by filing Form 706 (even if it is not otherwise required).
Although portability was meant to simplify estate planning (particularly for those with estates with a total value between one and two times the lifetime exemption amount), it adds another variable in determining the most appropriate estate plan.
Creating a bypass trust instead of relying on portability has the added advantage of shielding the additional appreciation on those assets that takes place between the first and second deaths from the estate tax; however, for income tax purposes, assets in a bypass trust would be inherited with only a carryover basis at the death of the second spouse instead of a step-up (assuming appreciation) to their FMV at that later date. In addition, to the extent that you want to utilize both spouses’ GST exemptions, the GST exemption is not portable.
Finally, there may be nontax benefits to creating one or more trusts—asset protection, protecting someone who is not financially savvy, and making sure assets are preserved for later generations, to name a few. You must carefully consider the benefits and burdens of relying on portability versus employing a more traditional estate plan and determine which approach would best meet your personal objectives.
Income in Respect of a Decedent
Some property owned by a decedent, such as individual retirement accounts and bonuses paid after death, may be subject to both estate tax and income tax. Such assets are referred to as income in respect of a decedent (IRD) property. A beneficiary who inherits such an asset is entitled to an income tax deduction for the amount of estate tax paid on the asset.
While the income tax deduction is beneficial, if you are planning to make charitable contributions at death, it is more tax advantageous to give IRD assets to a charity that will not have to pay taxes on the amount in any event. In other words, if you have two items, one that involves IRD and another one that does not have a built-in income tax liability, it would be advisable to give the item without the income tax liability to a noncharitable beneficiary and the IRD item to a charity, which will not have to pay income tax on it. To do this, specify in your will that the charity is to receive the IRD items so that neither income tax nor estate tax will be due on those items.
Importance of Your Will
One basic building block of a proper estate plan is your last will and testament. In drafting your will with legal counsel, you should provide for the disposition of your property, name an executor, and designate guardians for your minor children. If you fail to take care of these items in your will, the state will do it for you, distributing property in accordance with state law and appointing an executor and guardians for your children. Although the court acts in good faith, the outcome may not match your intentions. You may also want to have other basic but often essential documents, such as a medical directive and a financial power of attorney, drafted at the same time.
Estate planning requires a comprehensive approach, including succession planning for your business and determining the appropriate beneficiaries for life insurance and compensation plans. At the heart of the process, however, is your will. Not only is it the primary instrument for determining the distribution and management of your property but it may also help you manage estate and GST taxes.
Some people may prefer to use what is typically called a “revocable living trust” (RLT), along with a shorter pour over will, to dispose of assets. The advantages of an RLT include avoidance of probate, confidentiality, and an easier transition in the case of disability.
Once your documents are properly drafted, it is important to keep them up to date. Certain events should trigger a reexamination of your documents to ensure that they still fulfill your intentions. For example, you should revisit your documents when there is a marriage, divorce, birth of a child or grandchild, death of someone named in your documents, purchase or sale of major assets, change in state of domicile, or change in the tax law.
Choosing the Right Executor
One of the important issues you should address in your will is the identity of your executor (or personal representative)—the person responsible for managing your estate and distributing assets as directed in your will. This individual will have various responsibilities, including conserving the assets, preparing them for distribution to beneficiaries, and making required government filings.
Choose your executor carefully. You may designate a family member, trusted friend, or associate. If your estate is particularly complex, you may prefer to name a professional adviser or an organization such as a financial institution as executor or coexecutor. As you contemplate the choices, consider the responsibilities, the required time commitment, and the capabilities of the individual. Also remember that your executor will be working with your family during a time of stress and grief. An ability to navigate family personalities and issues may be an important factor in your decision. Also, consider indicating a second choice, in case the person you name is not in a position to serve when it becomes necessary.
Shifting Assets to Heirs
Shifting assets to your heirs (or trusts for their benefit) during your life offers both long-term and short-term financial benefits. First, by transferring income-producing assets, you can possibly reduce total family income tax liability associated with the property (although this advantage may be diminished by the “kiddie tax” and compressed trust tax brackets). Second, you can help your children build wealth of their own. Finally, you can reduce the size of your estate and therefore, ultimately, the tax on your estate. If properly planned, shifting assets can accomplish your objectives and ensure that the rewards of a lifetime of work pass to your heirs.
Consideration should be given to gifting assets with the most appreciation potential. This allows you to maximize the benefits associated with using your lifetime exemption and the payment of any gift tax. Gifting such assets today allows the anticipated future increase in value to escape transfer tax.
Establishing Trusts
A trust is a legal entity that is established for a given period. It separates legal title (the powers of ownership) from equitable title (the benefits of ownership). The trustee has legal title to the trust property but holds it for the benefit of the beneficiaries who have equitable title to the trust property.
Federal income tax rates on trust income parallel individual tax rates but with more compressed brackets.
While an unmarried individual will not reach the top tax rate of 37 percent for 2022 until he or she has over $539,000 of income, a trust will reach that rate with just $13,450 of income. In addition, the 3.8 percent Medicare tax and capital gains and qualified dividend rates, now 20 percent for those in the 37 percent bracket, may also apply. The combined effect could be severe for those trusts and estates that do not distribute all of their income each year.
Trusts can be utilized to achieve both tax and non-tax goals of the creator of the trust. For example, a trust might be established to:
- Avoid the cost and administrative effort associated with probate
- Minimize gift, estate, and GST tax on the transfer of wealth to your descendants
- Arrange for proper management of assets until children or grandchildren reach a certain age
- Provide income and ease of management for your surviving spouse
- Maintain income for your surviving spouse while naming children as ultimate beneficiaries
- Contribute current income to a charity with yourself or others named as beneficiaries after a given period
- Provide current income for yourself or others with the remainder going to a charity when the trust terminates
- Retain income from assets for a period of years and then pass on remainder interest to others
- Ensure professional management of assets
- Prevent creditors or former spouses of your children and grandchildren from reaching assets held for their future benefit.
Recovable Living Trust
One of the most popular trusts is the Revocable Living Trust (RLT), which can be established to manage assets and avoid the difficulties and costs associated with the probate process for the assets transferred to the trust before death. Because it is revocable, you can change the terms and beneficiaries as needed.
You can be as involved or uninvolved as desired in managing the assets, serving as trustee personally or naming another trustee. Upon your death, the assets that have been titled in the name of the RLT pass to your beneficiaries as designated in the trust agreement without going through probate.
An RLT thus allows you to retain control of the trust assets during your life and allows your trustee to access funds immediately at your death instead of being tied up in probate. But keep in mind that the assets held in the RLT are still included as part of your estate for estate tax purposes.
Other trusts are irrevocable and involve a permanent transfer of assets. Although you relinquish all control and may have to pay gift tax on the transfer, the trust assets, as well as the income and appreciation attributable to the transferred assets, are owned by the trust and are not subject to estate tax upon your death, unless you retain a beneficial interest in the trust.
Irrevocable Trusts
The term irrevocable trust refers to a type of trust where its terms cannot be modified, amended, or terminated without the permission of the grantor's beneficiaries. The grantor, having effectively transferred all ownership of assets into the trust, legally removes all of their rights of ownership to the assets and the trust.
Irrevocable trusts are generally set up to minimize estate taxes, access government benefits, and protect assets.
Irrevocable Life Insurance Trusts
Life insurance proceeds can be used to pay estate taxes or otherwise enhance your wealth. You should determine the amount of insurance you need, and then decide on the type of policy that is best for you.
Although the death benefit from a life insurance policy is not taxable to the beneficiary for income tax purposes, the value of the death benefit will be subject to estate tax in the estate of the insured if the insured owns the policy at death or within the three years preceding death. This will occur unless you relinquish, more than three years before death, all incidents of ownership.
In some instances, the inclusion of a life insurance policy could cause the value of the estate to exceed the exemption amount. If this were to occur, the beneficiary of the policy could be forced to use life insurance proceeds to pay an estate tax caused by the presence of that very policy. As a result, it generally is more beneficial to have someone else (such as an irrevocable life insurance trust [ILIT]) own the policy.
Intentionally Defective Grantor Trust
The tax rules regarding what qualifies as a completed transfer for income tax purposes and for estate tax purposes are not identical. Because of these differences, an irrevocable trust can be structured so its assets are excluded from the grantor’s estate (and considered completed gifts) but its income is taxed to the grantor (as if the gift had not been made). An IDGT takes advantage of these differences, allowing the trust assets to grow undiminished by income tax (because the tax liability associated with such growth is paid by the grantor of the trust rather than the trust itself) for the benefit of future generations while also removing growth on assets gifted or sold to the trust from your estate for estate tax purposes.
A trust that is treated as not separate from the grantor for income tax purposes has another advantage: Sales of appreciated assets by the grantor to the trust are ignored for income tax purposes and generate no capital gain. Nor does a sale to the trust result in gift tax liability, as the transfer of additional assets to the trust is for full and adequate consideration.
Grantor Retained Annuity Trusts
For those who have already utilized or wish to minimize use of their lifetime gift tax exemption, a grantor retained annuity trust (GRAT) may be a way to shift additional assets to children without generating a gift tax. The GRAT pays you back an annuity amount each year, and any remaining assets in the trust at the end of the annuity term pass to the remainder beneficiaries (typically, the creator’s children).
If the grantor retains a sufficiently large annuity payment during the term—equal in value to the assets originally transferred to the GRAT plus an assumed rate of return— the value of the remainder gift can be “zeroed out,” such that no taxable gift is made.
If the assets in the trust outperform the assumed rate of return (which has ranged from .4 percent to 1.2 percent over the past year) the excess passes to the beneficiaries free of gift tax.
Qualified Personal Residence Trusts
A qualified personal residence trust (QPRT) involves the transfer of ownership of your residence or vacation home to a trust but the retention of the right to live in that home for a term of years. The remainder interest generally passes to your children.
The benefit of this type of trust is that the gift amount is reduced by the value of your retained income interest. Therefore, you are able to leverage your gift tax exemption and exclude a valuable asset from your estate. The longer the term of years, the greater the reduction in the value of the gift. However, if you do not survive the term of years, the entire value of the property is includable in your estate. So it is in your interest to choose a term that you think you will survive.
Charitable Remainder Trusts
By using a properly structured CRT to transfer highly appreciated, long-term gain property, you can improve your own financial situation in addition to benefiting a charity.
A CRT allows you to transfer assets to a trust with the stipulation that you receive distributions for a specified period. Property in the trust is transferred to the charity at the end of the trust term. You can choose generally one of two options (although there are variations on both of these types): (1) a charitable remainder annuity trust that provides a fixed amount of annual income irrespective of fluctuations in value within the trust from year to year or (2) a charitable remainder unitrust that remits an amount based on a fixed percentage of trust assets valued annually.
With either option, the trust term can last for your lifetime, for beneficiaries’ lifetimes, or for a designated period not to exceed 20 years. You also can name more than one income beneficiary in either type of trust.
Charitable Lead Trusts
A charitable lead trust (CLT) is an arrangement whereby the donor gives an annuity or unitrust interest to a charity for a term of years (or for the donor’s lifetime), after which the remaining value is paid to the donor or some other remainderman. This type of trust is the reverse of a CRT since the charity is the first party to enjoy an interest in the trust. It is generally preferable that the assets transferred to a CLT produce sufficient income to pay the annuity due to the charity.
Business Succession Planning
Passing on the family business to your successors involves many issues: transferring responsibility for running the business to the next generation, guaranteeing future income and financial resources, and minimizing income and estate taxes.
