This is the second installment of a two-part blog briefly exploring available federal transfer and income tax planning considerations.
Using Estate and Gift Tax Exemption
Welcome back! If you recall, in my previous blog, I summarized the application of federal gift and estate tax, as well as possible changes in the current tax laws, and attempted to identify taxpayers who may benefit most from proactive planning, whether before the end of 2020 or thereafter. This installment goes into a bit more detail and touches on some strategies many planners are discussing as we approach the end of the year and as we move forward.
Married Couples – One exemption, or two?
Transfer tax exemption amounts are at such historically high levels that many married taxpayers simply cannot afford to make a gift large enough to use all available exemptions. If, however, they can afford to make a gift equal to one exemption amount ($11,580,000 in 2020), they can “lock in” at least one spouse’s full exemption, and the other non-transferor spouse can preserve his or her remaining exemption for future transfers, subject to the risk that exemption amounts may be reduced by a change in tax laws. There are several fact-specific considerations that need to be examined in each case to confirm the advisability of this planning technique, but for a married couple considering a large gift, this presents one possible option.
If a taxpayer determines that a transfer of some kind is appropriate (one exemption or two), the next step is to evaluate which assets and what approach is best suited to meet the taxpayer’s overall objectives.
The easy gifts to give
The most basic gift transaction would be a simple transfer of cash, outright, to one or more donees. Once delivered, the gift is complete. For all gifts, however, it is important to memorialize the date the gift was. Although easy to implement, outright gifts can have significant downsides compared to gifts in trust, which are discussed more below.
But, not all gifts are created equal!
Non-cash gifts have the potential of surprising the donee with income tax when he or she later disposes of property if the fair market value of the property exceeds its basis. The basis of gifted property is the same in the hands of the transferee as it was in the hands of the transferor. So, a gift of property with income tax liability built-in has the economic effect of reducing the after-tax value of the gift in the hands of the donee, although this gift will still use exemption amounts equal to the fair market value of the property transferred. The same is not true, however, if the property’s basis exceeds its fair market value at the time of a gift. In that situation, the tax benefit of the existing loss can be, well, lost. Other assets, like annuities and depreciable property, can cause even less-desirable results. Bottom line…to the extent possible, a property’s basis for income tax purposes should be considered when developing a gifting plan to avoid an unintended income tax consequence.
Get More Out of Your Gift
For transfer tax purposes, the fair market value of the asset transferred determines the amount of exemption used by the transferor taxpayer. The good news is that the IRS’s definition of “fair market value” honors the application of certain discounts generally seen in arm’s length transactions (such as for lack control or marketability). For example, the fair market value of a one-half interest in real property is likely something less one-half of the property’s total value. In corporate structures, the value of an equity interest can be discounted for restrictions on transfers, limitations on participation in management, or lack of voting control. Therefore, being thoughtful about how the asset transferred will be valued for transfer tax purposes can potentially yield a much better gift tax and/or future estate tax result.
Try a transfer to trust – it’s protected!
Although outright transfers (transfers from a taxpayer directly to a donee) can be relatively uncomplicated transactions, such transfers can create unforeseen issues for the donee. Many of these issues can be avoided with a transfer to one or more trusts established to benefit the donee. For example, an outright gift to the donee exposes that gift to the donee’s creditors and will include the appreciated value of that gift in the donee’s estate for future transfer tax purposes. A transfer by gift to a properly drafted gift trust, however, permits the donor to set aside the same assets in trust for a beneficiary, free from the reach of most of the beneficiary’s creditors. Further, gifts to trust can serve to shelter trust assets (and appreciation of such assets) from future transfer taxes. If drafted properly, these trust assets can be excluded from the taxable estates of trust beneficiaries for generations (in Florida, up to 360 years!).
A gift that avoids income tax!
It may be counter-intuitive, but sometimes paying tax is a good thing. Where the donor has assets that will likely eventually be subject to a federal estate tax, that donor may want to transfer as much wealth as is comfortable to his or her descendants all while minimizing any use of available exemption. Current law allows the grantor of a specifically designed “grantor trust”, to pick up the tab and pay all of the income tax liability of that grantor trust, allowing the trust assets to grow tax free! Grantor trusts also allows for the flexibility to conduct tax-free transactions (such as sales and exchanges) between the grantor and the grantor trust, which can be used to help facilitate further tax planning. Finally, the trust provisions creating the grantor trust status can usually be terminated if the structure is no longer optimal (at which point the trust will become a distinct tax entity, separately taxed from the grantor).
Have your gift and keep it too…
Because it is difficult for any taxpayer to know for sure what assets they may need to support their lifestyle in the distant future, and maybe even more difficult to speculate how federal taxes may affect that need, married taxpayers may find that a spousal lifetime access trust (“SLAT”) stands out as a comfortable way to complete a gift, but maintain a degree of access to funds should they be needed. A SLAT is similar to other irrevocable gift trusts for descendants, except that the SLAT includes the non-donor spouse as one of its permissible beneficiaries. So, practically speaking, this can provide some assurances to the married couple that, if needed at some point in the future, the non-donor spouse can access the trust assets as one of its permitted beneficiaries. However, that element of comfort has its limitations. For example, the death of the non-donor spouse, or a divorce, would limit the donor spouse’s ability to access trust assets from that point forward (although there may be ways to at least partially address those contingencies). Even more complexity presents itself in blended family situations. Although it may not be relevant or desirable to all married taxpayers, a SLAT is a flexible option worth considering for many married couples, especially those with marginally taxable estates under current law.
What is a Taxpayer to Do?
Like a delicious fruitcake, there is a lot to digest here. Individuals or couples seeking to reduce future estate taxes through current gifts might be loosely divided into three groups. The first are those whose current assets do not permit the use of a full exemption amount (i.e., $11,580,000 per individual). For this first group, use of annual exclusion gifts, life insurance trusts, payment of qualified tuition and medical expenses for beneficiaries, planning for “step-up” in basis at death, utilizing other traditional estate “freeze” techniques, and transferring assets with discounted values, may provide income and transfer tax efficiencies that can be achieved without pulling the trigger on a gift of $11+ million. The second group might be those married taxpayers whose assets may permit a gift of at least one exemption amount. In addition to the techniques mentioned for the first group, this second group will likely want to seriously evaluate using at least one available exemption, either outright or in trust (perhaps including spousal access) and “locking-in” one of their current exemption amounts. Finally, the third group are those taxpayers who can afford to transfer assets in the amount of all available exemptions. This third group should aggressively pursue transfer and income tax planning – they will likely look to the techniques outlined above, but this group should also focus on maximizing the ability to leverage these historically high exemption amounts to the greatest extent possible before the laws change.
There is clearly no “one size fits all” approach to transfer tax and income tax planning. Effective estate planning can have both simple and highly complex elements. Each taxpayer is unique, and each taxpayer’s circumstances may present or limit possible planning opportunities. Therefore, before moving forward it is important to match the family’s objectives with the available tools presented by qualified estate planning and tax advisors to find the path that works best for the family. Happiest of Holidays and see you next year!