By Stephen G. Vogelsang
Pressly, Pressly, Randolph & Pressly
The Trump tax cuts dramatically reduced the number of estates subject to the federal estate tax by doubling the estate tax exclusion amount from a base of $5 million to a projected $11.58 million in 2020. The Tax Policy Center estimates that only 1,700 estates were subject to estate tax in 2018 compared to almost 5,000 taxable estates in 2013 when the exemption was $5 million and more than 50,000 taxable estates in 2000 when the exemption was only $675,000. The larger exemption afforded by the Trump tax cuts are scheduled to sunset at the end of 2025 and return to the former inflation-adjusted $5 million base. Many wealthy families are actively pursuing lifetime strategies to reduce their exposure to estate tax before the window closes on the current $11.58 million exclusion. This article will briefly describe three strategies commonly employed by families seeking to whittle away at their estates prior to the sunset of the Trump tax cuts in 2025.
1. Gifts to Intentionally Defective Grantor Trust (“IDGT”):
Intentionally defective grantor trusts – commonly referred to as “IDGTs” are one of the most powerful tools for reducing exposure to federal estate taxes. An IDGT is considered “defective” because gifts to these trusts are ignored for federal income tax purposes so that the settlor of the IDGT continues to pay income tax on income generated by trust assets. The continued payment of income tax by the settlor allows for assets contributed to the trust to continue to grow tax-free while depleting the settlor’s taxable estate.
IDGTs provide a number of additional benefits when compared to outright gifts. First, assets held in an IDGT can remain in a creditor-protected trust for the benefit of children, grandchildren and more distant descendants free from federal gift, estate and generation-skipping tax. Florida trusts may be settled for as long as 360 years, allowing for many generations of transfer tax-free distributions to descendants. Second, IDGTs serve as a platform for more sophisticated planning to significantly reduce even the largest estates – typically through sales of discounted interests in closely held business entities such as family-controlled partnerships, or limited liability companies. While these more sophisticated techniques can provide extraordinary results for families, they are also a minefield for potential tax controversy and should only be considered after a thoughtful examination of each family’s unique circumstances.
2. Lifetime Gifts: “Use It or Lose It:
The current increased exemptions are scheduled to expire in 2025. Families that can afford to utilize their full exclusion amounts – $23.16 million for married couples – should consider doing so prior to the scheduled sunset of the Trump tax cuts. Families might even consider making taxable gifts; that is, gifts beyond the $11.58 million exclusion amount because the gift tax, even though imposed at the same forty-percent rate as the estate tax, is computed in a manner which is more favorable to taxpayers. Suppose, for example, Mrs. Taxpayer owns assets valued at $140 million. If Mrs. Taxpayer has used her entire exclusion amount and makes gifts of $100 million to her children, she will pay a gift tax of $40 million reducing her taxable estate to zero. If alternatively, Mrs. Taxpayer continues to hold assets worth $140 million when she dies, her estate would pay federal estate taxes of $56 million leaving “only” $84 million for her heirs – a whopping $16 million less than had she given her assets to her children during her life.
3. Grantor Retained Annuity Trusts:
Grantor retained annuity trusts (“GRATs”) are trusts which effectively “freeze” the value of a taxpayer’s estate by passing future appreciation to younger generations at little or no transfer tax cost. If Mr. Taxpayer transfers $1 million to a two-year GRAT which pays him an annual annuity of $500,000 on each of the first two anniversaries of the funding of the GRAT, he will have received back from the GRAT an amount equal to what he initially contributed, $1 million. Assets remaining in the GRAT after the second $500,000 annuity payment will be distributed to Mr. Taxpayer’s children. Because the aggregate annual annuity payments to Mr. Taxpayer are equal to the amount he initially contributed to the GRAT, the only taxable gift is the present value of the remainder interest in the GRAT at inception, which is zero or near zero. If the GRAT is funded with volatile assets which produce outsized returns during the two-year GRAT term, the taxpayer’s children may receive a considerable sum without the imposition of gift tax.
While death and taxes may indeed be a certainty, taxpayers are not under an obligation to maximize the taxes their estates ultimately owe at death. Proactive families can utilize the foregoing strategies and many others to manage exposure to the federal estate tax.
Stephen G. Vogelsang is a Board Certified Tax Lawyer with the Palm Beach law firm of Pressly, Pressly, Randolph & Pressly. Mr. Vogelsang practices in the areas of Estate Planning and Administration for high net worth families, Trust Planning and Administration, and Gift and Estate Tax controversies with the Internal Revenue Service.