A window of opportunity opened in 2018 when the Tax Cuts and Jobs Act (TCJA) doubled the lifetime gift, estate and generation-skipping tax exemptions to $11.18 million from $5.6 million. Adjusting for inflation, the current exemption this year is $11.58 million — the highest it has ever been.
While the change provides a major opportunity to pass on a substantial part of your wealth tax-free, there is a catch: It is a limited-time offer. This increase in the estate tax exemption is set to sunset at the end of 2025, meaning the exemption will likely drop back to what it was prior to 2018. Additionally, the upcoming U.S. presidential election could accelerate the rollback as the challenger candidate has proposed significant changes, increasing taxes for the wealthy.
While many states have eliminated their state estate taxes — only 17 states and the District of Columbia still have them — the estate planning landscape has changed significantly over the last decade. Additionally, the higher exemption presents a unique use-it-or-lose-it opportunity, and affluent families should avoid taking a set-it-and-forget-it approach. This is especially true for assets that may appreciate over time and helps ensure that the appreciation is not part of their taxable estate. But remember: This area of wealth planning can be very complex, so we recommend speaking with your financial adviser or tax professional prior to making any decisions.
Consider Gifting Away Assets to Reduce Estate Taxes While You Still Can
While the increased estate tax and gift tax exemption is set to expire, the Internal Revenue Service has decided there will be no clawback on lifetime gifts. This means that any gifts made under the current exemption will not be subject to estate taxes in the future, even if the exemption is reduced. Additionally, if you’ve already gifted away $5 million, consider gifting up to an additional $6 million to preserve the $11.58 million exemption for your children and future generations.
Keep in mind that when you gift assets, to make a gift complete for tax purposes, you relinquish ownership, control and use of those assets. If loss of ownership and control is a concern, married couples may want to consider a Spousal Lifetime Access Trust, or SLAT. A SLAT is an irrevocable trust created by one spouse for the benefit of the other. The grantor may indirectly benefit from this type of trust through their spouse’s lifetime access to the trust funds.
When funding irrevocable trusts, beware of gifting low cost-basis assets. If the trust holds assets that appreciate while in the trust for long periods of time, the beneficiaries could be saddled with substantial tax burdens. You can potentially avoid these issues by using substitution power provisions in the trust. With these power provisions, the grantor may substitute or swap out of the trust low cost-basis assets that have appreciated over time with assets of equal value, such as cash or high cost-basis assets. This allows the value to remain the same in both the grantor’s trust and estate. An additional benefit of using this technique is that those appreciated assets, now outside of the trust, are in the estate and will qualify for a step-up in basis at death. This substitution of assets can also save the grantor’s beneficiaries capital gains taxes, if applicable, making this a prudent step for income tax planning as well.
Take Advantage of Lower Valuations and Low Interest Rates
As a result of the COVID-19 pandemic and current market volatility, the valuations of many securities and businesses have been impacted, making now an opportune time to consider gifting or transferring assets out of your estate when interest rates and asset values are low.
Lower valuations allow you to transfer a greater portion of your assets out of your estate using the annual gift tax exclusion or the lifetime exemption, thus reducing your taxable estate. The hope is that those assets will grow back to their original value and any appreciation will be removed from the taxable estate.
In addition to low valuations, interest rates are at historical lows. Low interest rate environments may be particularly advantageous for intra-family loans. These loans can be an effective wealth-transfer strategy, allowing family members to make loans to one another without triggering gift taxes. These loans use the IRS Applicable Federal Rate — which is currently at record lows of between 0.14% to 1.12% — depending on the length of the loan. Intra-family loans work best when the borrowed funds are invested, and the rate of return earned on the invested loan proceeds exceeds the loan interest rate. This enables the appreciation in excess of the interest rates to pass to the borrower free of estate and gift taxes.
Consider Acting Now to Avoid the Last-Minute Rush
Additionally, another reason to get started now is that wealth planning using sophisticated techniques takes time. If you have more time to carefully plan today, you’re less likely to run into hurdles and challenges that might come up if you wait and end up rushing through the process. When estate tax laws change, trusts and estates attorneys often get backlogged with cases, causing delays. Creating a thoughtful estate plan now may also help prevent planning mistakes, including triggering the reciprocal trust doctrine or the step transaction doctrine.
In addition to estate planning, affluent families should also focus on asset protection and distribution preparation, which complement tax planning. Asset protection and distribution planning allow you to protect your assets now and for future generations, giving you control of your money long after you have passed your legacy on to your family.
Chuck Cavanaugh is the Head of Financial Planning for Citi U.S. Consumer Wealth Management, where he is responsible for leading the financial planning team. The team works with clients to develop and implement financial plans, including estate & trust planning, charitable giving, intergenerational planning, business succession, secured retirement income, risk mitigation and wealth protection.
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