At the beginning of 2023, the Internal Revenue Service (IRS) increased the amounts individuals can gift free of federal gift and generation-skipping transfer (GST) tax. The amounts now stand at $12,920,000 for individuals and $25,840,000 for married couples. The lifetime gift tax exclusion and the GST tax exemption levels create extraordinary multigenerational estate planning opportunities for affluent individuals and families. Significant recent stock market volatility and depressed valuations have increased the likely effectiveness of lifetime gifts as well as of many other estate planning techniques.
The window of opportunity presented by the elevated gift tax exclusion and GST tax exemption—and the currently available estate planning techniques—is limited. The exclusion and exemption amounts are scheduled to be cut in half by the end of 2025. If Congress enacts legislation proposed by President Biden, the reduction will occur even earlier, and a number of effective estate planning techniques will no longer be available.
This article describes some of the more effective estate planning techniques we think you should consider implementing today.
EXPANDED GIFTING OPPORTUNITIES
The Tax Cuts and Jobs Act of 2017 (TCJA) doubled the federal estate and gift tax exclusion amounts and the GST tax exemption. In October 2022, the IRS announced revised figures adjusted for inflation for 2023 that expanded these exemptions even more.
- In 2023, individuals can transfer $12,920,000 free of estate, gift and GST tax during their lives or at death; married couples can transfer $25,840,000 during their lives or at death. Based on current inflation rates, the exclusion and exemption amounts that the IRS will announce in October 2023 may increase by $520,000 to $13,440,000.
- Individuals who exhausted their gift tax exclusion amount and GST tax exemption prior to 2023 can gift an additional $860,000 in 2023 free of gift and GST tax. Similarly, married couples who previously exhausted their exclusion amounts can gift another $1,720,000 in 2023.
- Because of the portability provisions made permanent in 2013 by the American Taxpayer Relief Act of 2012, the surviving spouse may use the deceased spouse’s unused federal estate tax exclusion (but not GST tax exemption) for lifetime gifting or at death.
- The annual per donee gift tax exclusion amount also increased in 2023 from $16,000 in 2022 to $17,000 per donee (or $34,000 per donee if spouses elect to split gifts). This amount is subject to indexing in future years. Gifts in any amount for tuition or medical expenses (including health insurance) paid directly to the educational institution, medical provider or insurance company continue to remain exempt from gift tax.
The federal legislation that doubled the federal estate and gift tax exclusion amounts and the GST tax exemption sunsets at the end of 2025. On January 1, 2026, the exclusions and exemption revert to their pre-2018 exemption levels, as indexed for inflation. If you secure the use of the increased exclusion by making a completed gift between now and January 1, 2026, the IRS has confirmed that there will be no “clawback” of the benefit of the enhanced exclusion if you die after 2025. Your pre-2026 gifts will be grandfathered and will not be subject to additional estate tax.
SPECIAL CONSIDERATIONS FOR NEW YORK, NEW JERSEY AND CONNECTICUT RESIDENTS
New York Residents:
For New Yorkers, significant market volatility, depressed values for certain asset classes (e.g., residential and commercial real estate) and soaring inflation-related federal exclusion amounts all aid powerful gifting and other leveraged transfer opportunities in 2023. Explore our related article to learn how the expanded federal exemptions give New Yorkers a greater opportunity to plan to permanently reduce their New York taxable estates and avoid the New York Estate Tax Cliff.
New Jersey Residents:
New Jersey has neither a gift tax nor an estate tax. It does, however, have an inheritance tax that applies to property passing at a decedent’s death and to gifts made within three years of death to persons other than the decedent’s spouse, parents, children or more remote descendants. The tax is imposed at rates as high as 16%. New Jersey residents who want to benefit other family members should consider making lifetime gifts to those individuals or to trusts for their benefit using the temporarily high exclusion amounts to protect their gifts from federal gift tax.
Connecticut is the only state that imposes a gift tax. In recent years, the Connecticut exclusion amount was well below the federal exclusion amount. As a result, Connecticut residents who utilized their entire federal exclusion amount incurred a substantial Connecticut gift tax. As of January 1, 2023, the Connecticut exclusion amount increased from $9,100,000 to meet the federal exclusion amount, increasing the Connecticut exclusion amount by an extraordinary $3,820,000 to $12,920,000.
The increase presents a valuable opportunity for Connecticut residents who previously made gifts up to the Connecticut exclusion amount. Residents may now gift an additional $3,820,000 per individual and $7,640,000 per married couple (potentially to already existing trusts) without incurring any federal or Connecticut gift tax.
POPULAR WEALTH-TRANSFER TECHNIQUES
Here are some planning techniques to consider while they are still available and while the exclusion and exemption amounts are at an all-time high:
- Topping off prior planning by making additional gifts to existing or new family trusts.
- Gifting residences or other assets to existing or new trusts that include spouses as discretionary beneficiaries, commonly referred to as spousal lifetime access trusts (SLATs).
- Funding grantor-retained annuity trusts (GRATs) to take advantage of current stock market volatility and depressed asset values.
- Selling assets to grantor trusts or, where appropriate, making cash gifts to facilitate the prepayment of existing loans from senior family members.
- Making new intrafamily loans.
- Allocating increased GST tax exemption to existing family trusts that are not exempt from GST tax.
- Securing the use of younger family members’ exclusion amounts and exemptions with gifting to family trusts for siblings and future descendants.
Additional detail on these popular techniques is provided below.
Dynasty (Generation-Skipping) Trusts
Through coordinated use of your federal gift exclusion and GST tax exemption, you may create trusts with an aggregate value of up to $12,920,000 ($25,840,000 per married couple) with no gift or GST tax. These trusts may benefit several generations of your descendants while insulating the assets from gift, estate and GST taxes. Transfer tax-protected multigeneration trusts are sometimes referred to as “dynasty trusts,” particularly if they are situated in jurisdictions such as Delaware and New Jersey that permit trusts to last indefinitely.
The creator of a dynasty trust allocates GST tax exemption to the trust and funds it with assets likely to appreciate. Those assets and all post-funding income and appreciation are removed from the taxable estate of the creator of the trust and would not be included in the estate of his or her children and grandchildren, allowing the trust to grow free of transfer taxes for multiple generations. In addition to mitigating the impact of transfer taxes, a dynasty trust can help shield a family’s assets from creditors, claims in the event of divorce and poor decisions of future beneficiaries. If structured correctly, in most cases, the trust income can be protected from state income tax.
Spousal Lifetime Access Trusts (SLATs)
Trusts, including dynasty trusts, may be structured to give your spouse, as well as your children and more remote descendants, access to the trust as discretionary beneficiaries. SLATs appeal to individuals who want the comfort of knowing that transferred wealth could still be available for family needs through distributions to the spouse. The trust assets can serve as a “rainy day fund” while allowing the grantor to take maximum advantage of the current levels of exclusion and exemption.
It is possible for each spouse to create a trust that includes the other as a beneficiary. So long as the two trusts are not interrelated, and do not leave each spouse in approximately the same economic position as he or she would have been in if he or she had named himself or herself as a beneficiary of the trust he or she created, neither trust should be included in either spouse’s taxable estate. One way of satisfying this test is to create the trusts at different times (preferably in different years) and to provide each spouse with different types of beneficial interests.
Grantor-Retained Annuity Trusts (GRATs)
Grantor-retained annuity trusts are a popular technique that you can use to transfer a portion of the appreciation on your assets to family members without the imposition of any gift or estate tax (assuming you survive the initial term, which can be as short as two years). GRATs are particularly useful in a time of extreme market turbulence. Turbulence creates an opportunity to fund a GRAT when there is a downswing in values that is expected to be temporary. GRATs are also particularly attractive gifting vehicles for hard-to-value assets.
The grantor of a GRAT transfers assets to a trust while retaining the right to receive a fixed annuity for a specified term. The retained annuity is paid with any cash on hand, or if there is no cash, with in-kind distributions of assets held in the trust. At the end of the term, the remaining trust assets pass to the ultimate beneficiaries of the GRAT (for example, a trust for the benefit of the grantor’s spouse and children), free of any estate or gift tax.
Some of the key features of a GRAT include the following:
- GRATs are structured so that the transfers they receive produce little or no taxable gifts. A GRAT that provides its grantor with an annuity stream equal to the value of the property transferred to it is known as a “zeroed-out” GRAT. A grantor’s gift to a zeroed-out GRAT is not subject to any gift tax.
- Grantors can fund GRATs with any type of property, such as interests in closely held businesses; venture, hedge and private equity funds; and marketable securities. The best assets to transfer to GRATs are those that are likely to appreciate during the GRAT term at a rate that exceeds the IRS hurdle rate (an interest rate published by the IRS every month). The rate in August 2023 is 5%. The value of the grantor’s retained annuity is calculated based on the IRS hurdle rate—the lower the IRS hurdle rate, the lower the annuity that is required to produce an annuity stream with a value equal to the value of the property transferred to the GRAT.
- The grantor of a GRAT runs no gift tax risk if he or she undervalues the transferred assets. If an asset for which there is no readily ascertainable market value is transferred to a GRAT and the IRS later challenges the value reported for gift tax purposes, the GRAT annuity automatically increases to produce a near-zero gift.
- The downside of planning with GRATs is the difficulty of protecting the value of the assets that move to trusts for family members at the end of the annuity term from the GST tax.
Younger Generation Planning
The younger members of wealthy families have exclusions and exemptions that are likely to be cut back before they establish trusts for their future children. If they are adults, they should consider using their exemptions by creating trusts for the benefit of their unborn descendants and other family members. Senior generations can also be included as discretionary beneficiaries if warranted.
If a young family member lacks funds to use to make gifts, the trustees of non-GST tax-protected trusts held for their benefit could consider making distributions to them to enable them to make gifts before 2026.
Income Tax Considerations
GRATs and SLATs enjoy an income tax advantage that further enhances their appeal. GRATs and SLATs are both grantor trusts. Dynasty trusts can also be structured to be grantor trusts. When a trust is a grantor trust, its assets are treated as owned by the grantor and the grantor must pick up all items of income, credit and deduction attributable to the trust on the grantor’s personal income tax return. Because the trust’s grantor pays income tax on all trust income, the trust property will be able to grow free of income tax. Under current law, the payment by the grantor of the income tax on income earned by his or her grantor trust is not considered a taxable gift.
Because the grantor of a grantor trust is treated as owning the trust’s assets, transactions between the trust and its grantor are ignored for income tax purposes. This permits the grantor to exchange assets owned by the grantor with assets of equal value owned by the trust. Exchanges can be a very valuable technique for income tax basis planning. If, for example, a grantor trust owns an asset worth $10 million with a tax basis of $5 million, the grantor could acquire that asset from the trust for a cash payment of $10 million. No tax would be imposed on the sale. If the grantor retains that asset until death, the asset will receive a new tax basis equal to its value on the date of the grantor’s death.
The IRS publishes interest rate tables each month that establish the lowest rate that, if properly documented, can be safely used by you for loans to family members without producing taxable gifts. The growth rate of your funds that are lent to children, or to trusts for their benefit, will be limited to that interest rate. Those funds, in turn, can be used by the junior family members to be invested in a manner that hopefully will achieve a rate of return in excess of the interest rate charged on the loans.
Making a loan to a trust for your children may be even more advantageous than making a loan outright if the borrowing trust is a grantor trust for income tax purposes. Ordinarily, the interest payments on a note must be included in the taxable income of the lender, but if the payments are made by a grantor trust, they will be free of income tax.
Alternatively, it may be more advantageous for senior family members to put some of their expanded federal gift exclusions and GST tax exemptions to work by making cash gifts to facilitate the prepayment of existing loans to family members and to trusts established for the benefit of family members.
Sales to Grantor Trusts
A sale to a grantor trust for cash or a note can be an extremely effective planning strategy. In the case of a sale of a minority interest in an entity or a fractional interest in real property, valuation discounts can apply to limit the amount of purchase price necessary to avoid a taxable gift. As is the case with gifts, the income and appreciation generated by the sold property after the sale will be protected from future estate taxes. If you don’t already have a grantor trust in existence, consider using your current gift tax exclusion to create one.
A grantor trust provides you with two independent planning opportunities. First, as discussed above, you will pay the income tax on the income generated by the trust, including tax on capital gains, thereby allowing the trust to grow tax-free while reducing your future estate taxes. In addition, you may engage in transactions with your grantor trust without any income tax consequences.
If you have previously exhausted your exclusion and exemption amounts through prior gifting to grantor trusts, you may want to leverage the value of your prior gifts through new sales to grantor trusts or, where appropriate, by making cash gifts to facilitate the prepayment of existing installment obligations owed to you by your grantor trusts from prior sales.
The temporary increase in the lifetime gift tax exclusion and GST exemption offers a time-sensitive opportunity to leverage gifting and preserve wealth for multiple generations. Thoughtful planning and careful implementation are essential to a successful estate plan that preserves wealth in the most tax-efficient manner and fulfills the family’s personal objectives.