Over the last couple of years, as there was concern that the gift and estate tax exemption (along with the related generation-skipping transfer tax exemption) would be reduced back to pre-2017 levels, many individuals made gifts or other transfers to utilize their remaining gift and estate tax exemption. By utilizing their remaining exemption, these individuals have protected themselves against any future reductions in the estate and gift tax exemption because they have “locked-in” the higher exemption amount, so-to-speak. However, even if you have utilized your full exemption, there are several planning opportunities available to further reduce your taxable estate or otherwise protect your assets from potential creditors.
The remaining planning opportunities range from fairly simple opportunities that everyone should consider taking advantage of, to more complex structures that are only appropriate for certain individuals and families. Several of these ideas are discussed in this blog post. This discussion, however, is based on the current tax laws. As our tax laws are not static, it is important that you discuss any of these opportunities with your estate planning counsel to ensure that these strategies are still viable and to ensure that you choose a strategy that best compliments your overall estate plan.
Simple Strategies Before delving into more complex strategies, there are a couple of simple strategies that you can take advantage of annually: 1) ensure that you are taking advantage of annual exclusion gifts each year, and 2) utilizing the annual inflation adjustment made to the gift and estate tax exemption.
In 2022, the annual exclusion is $16,000 per person. This means that you can gift $16,000 worth of assets to friends, family members, and certain trusts each year without utilizing any portion of your gift and estate tax exemption. Furthermore, this $16,000 limit is per donee, meaning that you can gift $16,000 to each of your children annually, each of your parents, etc. Thus, while individual $16,000 gifts may not appear to be significant, if you make annual exclusion gifts to a fairly large class of persons, and do so every year, you can move significant value out of your taxable estate. However, not all transfers qualify for the annual exclusion, so you will want to work with your estate planning counsel to ensure that any annual exclusion gifts that you make do, in fact, qualify for the annual exclusion to ensure that you do not inadvertently trigger a gift tax.
Additionally, the estate and gift tax exemption is increased each year to adjust for annual inflation. For example, in 2021 the gift and estate tax exemption was $11,700,000, but was increased for 2022 to $12,060,000. This means that, even if you utilized your entire exemption in 2021, you now have additional exemption that you can utilize in 2022. Thus, you can make additional gifts in 2022 to ensure that you lock in the highest exemption possible. To be clear, the annual increases in the estate and gift tax exemption are not always significant, but, like with the annual exclusion, over time taking advantage of these annual increases can move significant assets out of your taxable estate.
Grantor Retained Annuity Trusts (GRATs) GRATs can be a good tool to move future asset appreciation out of your estate. When you create a GRAT, you transfer assets to a trust and retain an annual annuity that will be paid to you over the life of the GRAT, with all remaining assets held in the GRAT after the final annuity payment transferred to the remainder beneficiaries, oftentimes your children or trusts for your children’s benefit. Due to the way the annuity is calculated, this results in a gift amount of near zero dollars (typically gifts to GRATs are from $0-$1,500 depending on various factors). Thus, even if you used up your entire exemption amount in 2021, the inflation increase for 2022 more than covers any gift to a GRAT that you make this year.
The total amount of a GRAT’s annuity payments will be equal to an amount slightly above the value of the assets transferred to the GRAT (the actual annuity calculation will vary based on current interest rates). All asset appreciation above the annuity amount will be transferred to the remainder beneficiaries and removed from your taxable estate. Thus, for example, if you transfer $1,000,000 to a GRAT with total annuity payments equal to $1,050,000 and the assets at the end of the annuity period would equal $1,200,000, you have removed $150,000 from your taxable estate while using little to no estate and gift tax exemption.
GRATs are not right for everyone, however. If you do not live through the entire annuity term, the entire GRAT will be included in your taxable estate. Additionally, if the assets you transfer do not appreciate above the annuity payment, or decrease in value, no value is moved to the remainder beneficiaries. The best assets to transfer to GRATs are assets that have significant growth potential, such as investments in start-up companies. If you have assets that have significant growth potential, a GRAT may be right for you and you should speak to your estate planner about potentially creating a GRAT.
Basis Planning If you have already used up your exemption amount, you may want to turn your attention to some income tax planning, particularly ways to reduce the overall capital gains tax that your heirs will eventually pay when your assets are sold after your death. Typically, assets that are included in your taxable estate will receive a step-up in basis to such assets’ fair market value on the date of your death. Assets you gift during your lifetime, however, will not receive a step-up in basis and will instead retain the basis such assets had at the time you acquired the assets. As many of the assets you have gifted, especially if gifted several years ago, have likely experienced significant appreciation, significant capital gains taxes may be due upon the sale of such assets.
If your gifted assets are held by a grantor trust, there are several options to reduce overall capital gains taxes that may eventually be due. First off, if you retained a swap power over the assets of the grantor trust allowing you to swap trust assets for assets of equal value, you can swap high basis assets (i.e., assets whose tax basis is equal to or almost equal to the assets’ fair market value) held by you personally for low basis assets (i.e., assets whose tax basis is significantly lower than the assets’ fair market value) held by the trust. Since these low basis assets will now receive a step-up in basis on your death, the overall capital gains taxes realized upon the eventual sale of your assets will be minimized. Alternatively, you can also buy assets from and sell assets to a grantor trust without realizing any income tax to move assets around for basis planning purposes.
Charitable Planning Charitable planning can also help significantly reduce any estate taxes that may be owed on your death, and can have the added benefit of reducing income taxes while you are alive as well. Charitable planning can be accomplished in many ways, including setting up charitable trusts, making charitable contributions during your life, making charitable contributions upon your death, etc. You will need to work closely with your advisors to determine the right structure for you, but this discussion will focus on comparing lifetime charitable contributions to charitable contributions made upon your death.
Making charitable contributions during your life can have numerous tax benefits. A lifetime charitable contribution will give you an immediate income tax charitable deduction that can reduce your income taxes in any given year. Moreover, any assets gifted to charities during your lifetime are also removed from your taxable estate without any gift tax implications because charitable contributions are typically exempt from gift taxes. Thus, lifetime charitable contributions allow you to reduce your current income taxes while also reducing potential estate taxes on your death. Conversely, charitable contributions made upon your death will reduce any estate taxes you may owe, but will not provide you with any income tax benefit.
In addition to the tax benefits described above, charitable contributions allow you to control who receives your assets and how such assets are ultimately used. Any estate taxes that are paid to the federal government will be used as the federal government determines, regardless of whether you would have approved of such uses. Thus, charitable planning, even without taking into account its tax benefits, can be used to control how your assets are used and ensure that causes important to you are being benefited.
General Probate Avoidance Depending on which state you live in at the time of your death, the probate process can either be relatively simple or fairly complex. In all events, however, the probate process will result in delays. Thus, if you have not done so already, you should consider ways to minimize or otherwise eliminate the need to probate your estate. Typically, this is done through the use of payable-on-death accounts, beneficiary designations for insurance policies and retirement plans, pre-funding your revocable trust, etc. Accordingly, if you have already used up your exemption, you should ensure that your overall estate is structured in a manner that will ensure the smoothest and cheapest transfer of your estate after your death.
Asset Protection Planning If you already utilized your exemption amount, any assets gifted by you are likely in a structure that is safe from your creditors. However, any assets that you personally own will be subject to any creditor claims against you. The goal of estate planning is not merely to reduce your overall taxes, but to ensure that your assets are ultimately distributed according to your wishes. As transfers to creditors will conflict with this goal, asset protection should always be considered when designing your overall estate plan.
Asset protection can be accomplished through many different means. For example, a simple asset protection plan can ensure that family businesses are properly structured and that all necessary formalities of that structure are followed. Some families take this a step further to structure their personal assets through entities, such as limited liability companies, to add an additional layer of asset protection for their personal assets. Finally, some individuals and families like to use self-settled spendthrift trusts, either in a state like Nevada or in an offshore jurisdiction, to provide yet an additional layer of asset protection. As all of these structures require that you follow some relatively strict formalities to ensure that the structure operates as intended, which structure is best, or whether any structure is necessary at all, will be determined on a case-by-case basis. However, even if you have used all of your exemption amount, you can still maximize the amount of assets passing to your friends and family upon your death by engaging in some asset protection planning.
Conclusion Many families believe that once they have utilized their full gift and estate tax exemption, their estate planning, especially with regards to estate taxes, is essentially complete. However, as detailed in this blog post, there are still many planning opportunities available to further reduce estate, reduce potential income taxes, provide additional asset protection, etc. We would be happy to discuss any of these planning opportunities with you to determine if any of these opportunities are right for you and your family. Contact [email protected]
By: Andrew Bechel, Esq.
