Today's tax savings opportunities may not be available tomorrow
Estate planning is about much more than reducing taxes; it’s about ensuring your loved ones are provided for after you’re gone and that your assets are passed on according to your wishes. And because the Tax Cuts and Jobs Act (TCJA) has put estate, gift and generation-skipping transfer (GST) tax exemptions at record-high levels, far fewer taxpayers are worrying about these taxes. But under the TJCA, the high exemptions are available only through 2025. And Congress could pass legislation that reduces the limits sooner. So whether or not you’d be subject to estate taxes under the current exemptions, it’s a good idea to consider whether you can seize opportunities to potentially lock in tax savings today.
While the TCJA keeps the estate tax rate at 40%, it doubles the exemption base amount from $5 million to $10 million, and the inflation adjusted amount for 2023 is $12.92 million (up from from $12.06 million in 2022).
Be aware that although the doubled amount will continue to be adjusted annually for inflation, it expires after 2025. Without further legislation, the estate tax exemption will return to an inflation-adjusted $5 million in 2026.
So taxpayers with estates in roughly the $6 million to $12 million range (twice that for married couples), whose estates would escape estate taxes if they were to die while the doubled exemption is in effect, still need to keep potential post-2025 estate tax liability in mind in their estate planning. It's also important to keep in mind that reducing the exemption sooner — and increasing the estate tax rate — has been proposed.
To avoid unintended consequences, review your estate plan in light of the changing exemption. A review will allow you to make the most of available exemptions and ensure your assets will be distributed according to your wishes.
The gift tax continues to follow the estate tax, so the gift tax exemption also increases under the TCJA. Any gift tax exemption used during your lifetime reduces the estate tax exemption available at death. Making tax-free wealth transfers to take advantage of the higher exemption amount before it potentially “sunsets” could save substantial tax.
Under the annual exclusion, you also can exclude certain gifts of up to $17,000 per recipient in 2023 (up from $16,000 in 2022) — twice that per recipient if your spouse elects to split the gift with you or you’re giving community property without using up any of your gift and estate tax exemption.
Warning: You need to use your annual exclusion by December 31. The exclusion doesn’t carry over from year to year. For example, if you didn't make an annual exclusion gift to your granddaughter in 2022, you can’t add $16,000 to your 2023 exclusion to make a $33,000 tax-free gift to her this year. (See the Case Study “Why annual exclusion gifts can be a powerful tax-saver” for an example of just how powerful the annual exclusion can be.)
The GST tax generally applies to transfers (both during your lifetime and at death) made to people two generations or more below you, such as your grandchildren. This is in addition to any gift or estate tax due.
The GST tax continues to follow the estate tax, so the GST tax exemption also increases under the TCJA. The GST tax exemption can be a valuable tax-saving tool for taxpayers with large estates whose children also have — or may eventually have — large estates. With proper planning, they can use the exemption to make transfers to grandchildren and avoid any tax at their children’s generation.
Even before the TCJA, some states imposed estate tax at a lower threshold than the federal government did. Now the differences may be even more dramatic. To avoid unexpected tax liability or other unintended consequences, it’s critical to consider state law.
The nuances are many; be sure to consult a tax advisor with expertise regarding your particular state.
If one spouse dies and part (or all) of his or her estate tax exemption is unused at his or her death, the estate can elect to permit the surviving spouse to use the deceased spouse’s remaining estate tax exemption. Warning: Portability is available only for the most recently deceased spouse. It doesn’t apply to the GST tax exemption and isn’t recognized by many states. And it must be elected on an estate tax return for the deceased spouse — even if no tax is due. In fact, an estate tax return may need to be filed solely for this reason.
The portability election will provide flexibility if proper planning hasn’t been done before the first spouse’s death. But portability doesn’t protect future growth on assets from estate tax like applying the exemption to a credit shelter trust does. Trusts offer other benefits as well, such as creditor protection, remarriage protection, GST tax planning and state estate tax benefits.
So married couples with large estates should still consider marital and credit shelter trusts — and consider transferring assets to each other to the extent necessary to fully fund them at the first death. Transfers to a spouse (during life or at death) aren’t subject to gift or estate tax as long as the recipient spouse is a U.S. citizen.
Giving away assets now will help you reduce the size of your taxable estate.
Here are some strategies for tax-smart giving:
Choose gifts wisely. Consider both estate and income tax consequences and the economic aspects of any gifts you’d like to make:
- To minimize estate tax, gift property with the greatest future appreciation potential.
- To minimize your beneficiary’s income tax, gift property that hasn’t appreciated
significantly while you’ve owned it.
- To minimize your own income tax, don’t gift property that’s declined in value. Instead, consider selling the property so you can take the tax loss and then gifting the sale proceeds.
Plan gifts to grandchildren carefully. Annual exclusion gifts are generally exempt from the GST tax, so they also help you preserve your GST tax exemption for other transfers. For gifts that don’t qualify for the exclusion to be completely tax-free, you generally must apply both your GST tax exemption and your gift tax exemption.
So, for example, if you make an annual exclusion gift to your grandson and you want to give him an additional $30,000 in the same year to help him make a down payment on his first home, you’ll have to use $30,000 of your GST tax exemption plus $30,000 of your gift tax exemption to avoid any tax on the transfer.
Gift interests in your business or an FLP. If you own a business, you can leverage your gift tax exclusions and exemption by gifting ownership interests, which may be eligible for valuation discounts for lack of control and marketability. For example, you could gift an ownership interest worth up to $21,333 (on a controlling basis) tax-free, assuming a combined discount of 25%. That's because the discounted value of the gift wouldn't exceed the $16,000 annual exclusion. (For more on transferring interests in your business, see “Succession within the family.”)
Another way to benefit from valuation discounts is to set up a family limited partnership. You fund the FLP with assets such as public or private stock and real estate, and then gift limited partnership interests. Warning: The IRS may challenge valuation discounts; a professional, independent valuation is recommended. The IRS also scrutinizes FLPs, so be sure to set up and operate yours properly.
Pay tuition and medical expenses. You may pay these expenses for a loved one without the payment being treated as a taxable gift, as long as the payment is made directly to the provider.
Make gifts to charity. Donations to qualified charities aren’t subject to gift tax. They may also be eligible for an income tax deduction. (See the “Charitable Giving” section for more information.)
Consider “taxable” gifts. Making some gifts beyond annual exclusion gifts and using some or all of your lifetime exemption can make sense if you have a large estate. These “taxable” gifts can protect transfers from gift and estate tax, even if the exemption drops in the future. They also remove the future appreciation from your estate.
You do, however, need to keep in mind your beneficiaries’ income tax. Gifted assets don’t receive the “step-up” in basis that bequeathed assets do. This means that, if beneficiaries sell assets gifted to them, their taxable capital gains will be determined based on your basis in the assets. So their capital gains tax could be higher than if they inherited the same assets.
Trusts can provide significant tax savings while preserving some control over what happens to the transferred assets. Here are some trusts you may want to consider and the estate tax benefits they provide:
Credit shelter trust. Also referred to as a “bypass trust,” this is funded at the first spouse’s death to take advantage of his or her full estate tax exemption. The trust primarily benefits the children, but the surviving spouse can receive income, and perhaps a portion of principal, during his or her lifetime, and the trust provides some advantages over the exemption portability election.
QDOT. A qualified domestic trust can allow you and your non-U.S.-citizen spouse to take advantage of the unlimited marital deduction.
QTIP trust. A qualified terminable interest property trust passes trust income to your spouse for life, with the remainder of the trust assets passing as you’ve designated. The trust gives you (not your surviving spouse) control over the final disposition of your property and is often used to protect the interests of children from a previous marriage.
ILIT. An irrevocable life insurance trust owns one or more policies on your life, and it manages and distributes policy proceeds according to your wishes. An ILIT keeps insurance proceeds, which could otherwise be subject to estate tax, out of your estate (and possibly your spouse’s). You aren’t allowed to retain any powers over the policy, such as the right to change the beneficiary. The trust can be designed so that it can make a loan to your estate for liquidity needs, such as paying estate tax.
Crummey trust. This trust allows you to enjoy both the control of a trust that will transfer assets at a later date and the tax savings of an outright gift. ILITs are often structured as Crummey trusts so that annual exclusion gifts can fund the ILIT’s payment of insurance premiums.
GRAT and GRUT. Grantor-retained annuity trusts and grantor-retained unitrusts allow you to give assets to your children today — removing them from your taxable estate at a reduced value for gift tax purposes (provided you survive the trust’s term) — while you receive payments back from the trust for a specified term. At the end of the term, the principal may pass to the beneficiaries or remain in the trust. In a GRAT, the income you receive is an annuity based on the assets’ value on the date the trust is formed. In a GRUT, the payments are a set percentage of the assets’ value as redetermined each year. These trusts may be especially beneficial in a low-interest rate environment like we have today.
QPRT. A qualified personal residence trust works on the same principle as a GRAT except that, instead of holding assets, the trust holds your home — and, instead of receiving annuity payments, you enjoy the right to live in your home for a set number of years. At the end of the term, your beneficiaries own the home. You may continue to live there if the trustees or owners agree and you pay fair market rent.
Dynasty trust. The dynasty trust allows assets to skip several generations of taxation. You can fund the trust either during your lifetime by making gifts or at death in the form of bequests. It can be particularly powerful now as a way to potentially "lock in" today's very high exemption amounts. (See the Case Study “Now's the time to create a dynasty.”) The trust remains in existence from generation to generation. Because the beneficiaries have restrictions on their access to the trust funds, the trust is excluded from their estates. If any of the beneficiaries have a real need for funds, the trust can make distributions to them. If you live in a state that hasn’t abolished the rule against perpetuities, special planning is required.
Life insurance can replace income, offer a way to equalize assets among children active and inactive in a family business, provide cash to pay estate tax or be a vehicle for passing leveraged funds free of estate tax.
Life insurance proceeds generally aren’t subject to income tax. But, if you own the policy, the proceeds will be included in your estate:
- Ownership is determined by several factors, including who has the right to name the beneficiaries of the proceeds. Generally, to reap maximum tax benefits you must sacrifice some control and flexibility as well as some ease and cost of administration.
- Determining who should own insurance on your life is a complex task because there
are many possible owners, including you or your spouse, your children, your business, and an ILIT.
- To choose the best owner, consider why you want the insurance, such as to replace income, to provide liquidity or to transfer wealth to your heirs. You must also determine
the importance to you of tax implications, control, flexibility, and ease and cost of administration.