For US citizens and domiciliaries, the lifetime estate and gift tax exemption for 2023 is $12.9M ($25.8M for married couples). Estate in excess of the exemption amount would be subject to 40% tax upon transfer. After 2025, the exemption will fall back to $5M ($10M for married couples), adjusted for inflation, unless Congress enacts to extend the higher amount. The odds of any extension depend on which party controls the White House and Congress after the 2024 election.
Rather than banking on these uncertain chances, numerous affluent individuals are currently taking advantage of the existing lifetime estate and gift tax exemption. Moreover, some strategies employed by these individuals enable them to remove the assets from their estate without relinquishing control, utility, or the income to be generated by these assets. Additionally, many of these strategies involve setting up a separate entity, a vehicle used to hold and transfer assets, which provides asset protection from potential creditors. Let's introduce some of the strategies that the wealthy individuals use to preserve and safeguard their legacy.
Family Limited Partnership (FLP)
A Family Limited Partnership (FLP) is a legal entity used by families to manage and control their assets, including businesses, real estate, and investments. The structure involves the creation of general and limited partnership interests. One of the primary benefits of using an FLP for estate tax planning is the ability to take advantage of valuation discounts. When transferring limited partnership interests to heirs, the value of those interests can often be discounted for lack of marketability and lack of control. This means that the assets inside the FLP might be worth, say, $1 million, but when transferred as a limited partnership interest, they might be valued for estate tax purposes at a discounted value, such as $700,000. This can significantly reduce the taxable estate. Yet the grantors, as general partners of the FLP, retain the control over the assets in the FLP.
Grantor Retained Annuity Trust (GRAT)
A Grantor Retained Annuity Trust (GRAT) is an advanced estate planning tool designed to transfer appreciating assets to beneficiaries while minimizing estate or gift tax impact. The grantor transfers assets into the GRAT and retains the right to receive an annuity payment for a fixed term of years. At the end of the term, any remaining assets in the GRAT pass to the beneficiaries (usually family members) tax-free, as long as the grantor survives the term.
The present value of the remainder interest (what is expected to be left for beneficiaries) is subject to gift tax. However, by setting the annuity payments appropriately, the present value of the remainder interest can be minimized or even "zeroed out." This means the grantor can transfer a potentially significant future value without utilizing any of their lifetime gift tax exemption.
Grantor Retained Unitrust (GRUT)
A Grantor Retained Unitrust (GRUT) is another sophisticated estate planning tool similar in some respects to the Grantor Retained Annuity Trust (GRAT) discussed previously. However, while the GRAT provides for a fixed annuity payment, the GRUT provides for a payment that varies based on a fixed percentage of the trust's annually recalculated value.
When a grantor establishes a GRUT, they transfer assets to the trust and retain the right to receive an annual payment, which is a fixed percentage of the trust's current value. This payment is recalculated each year based on the new value of the trust assets. At the end of the trust term, any remaining assets are transferred to the named beneficiaries, typically the grantor's heirs.
When the GRUT is established, the IRS calculates the present value of the remainder interest (what's expected to be left for the beneficiaries). This amount might be subject to gift tax. However, like with the GRAT, the value of the remainder interest can be reduced by increasing the retained payment, possibly reducing the taxable gift when the GRUT is established.
Qualified Personal Residence Trust (QPRT)
A Qualified Personal Residence Trust (QPRT) is an advanced estate planning tool that can offer significant estate tax savings. When a residence is transferred into a QPRT, the value of the gift for tax purposes is discounted based on the term during which the grantor retains the right to live in the home. This can reduce the taxable size of the grantor's estate. Additionally, any appreciation of the residence's value after the transfer is locked into the QPRT, ensuring that future appreciation remains outside of the grantor's taxable estate. If the transfer value is below the grantor's available lifetime gift tax exemption, no gift tax may be due, and by the end of the QPRT term, if the grantor is still alive, the residence will be entirely excluded from their estate for estate tax purposes.
Grantor trusts are a type of irrevocable trust where the grantor retains certain powers or rights that cause the trust's income and/or principal to be taxable to the grantor, not the trust. The primary mechanism through which grantor trusts achieve estate tax savings revolves around the separation of income tax responsibility from the transfer of assets out of the grantor's estate. Here's how grantor trusts can help save on estate taxes:
When assets are transferred to a grantor trust, their value for gift or estate tax purposes is "frozen" at the time of transfer. Any appreciation in the value of those assets after the transfer will occur outside of the grantor's estate. If the assets are expected to appreciate significantly, this can result in substantial estate tax savings.
Qualified Terminable Interest Property Trust (QTIP)
The Qualified Terminable Interest Property Trust (QTIP) serves as a strategic tool for married individuals, particularly those in second or subsequent marriages, who want to ensure that their assets are eventually passed on to their own descendants (like children from a previous marriage) while still providing for their current spouse. Here's how the QTIP achieves estate tax savings and ensures the intended beneficiaries are the grantor's descendants:
The primary advantage of a QTIP trust is its ability to use the unlimited marital deduction. When one spouse dies and leaves assets to the QTIP trust, these assets qualify for the marital deduction, meaning that they can be transferred to the trust free of estate taxes. This allows the estate to defer estate taxes that would have been due on those assets until the surviving spouse's death.
The QTIP trust provides the surviving spouse with a "life estate" interest, meaning the surviving spouse receives income from the trust assets (and under some conditions, may also receive principal). Crucially, however, the surviving spouse does not have the power to determine the final beneficiaries of the trust. The deceased spouse, when establishing the QTIP trust, dictates who the remainder beneficiaries will be after the surviving spouse's death. This design ensures that, after the surviving spouse's passing, the remaining trust assets will go to the beneficiaries specified by the first spouse (e.g., the grantor's children from a previous marriage).
In situations where there's concern that a surviving spouse might remarry and potentially divert assets away from the deceased spouse's children or other intended beneficiaries, a QTIP trust provides assurance. The trust ensures that the final beneficiaries (e.g., the grantor's descendants) will receive the assets regardless of any subsequent marriages or changes in the surviving spouse's circumstances.
Many might recall that due to the Economic Growth and Tax Relief Reconciliation Act of 2001, the estate tax was temporarily eliminated in 2010. This led to a humorous quip among professionals, labeling it the "prime year to pass away." Alas, neither the timing of our demise nor the intricacies of governmental fiscal policies, such as estate and gift taxes, can be dictated by us. As highlighted earlier, in 2023, U.S. citizens and domiciliaries have a lifetime exemption for estate and gift taxes set at $12.9M, and $25.8M for couples. Should an estate surpass this amount, a 40% tax rate applies. Notably, after 2025, the exemption is projected to reduce to $5M ($10M for married couples), adjusted for inflation, unless the higher limit is sustained by Congress. The fate of this potential revision heavily hinges on the political landscape post the 2024 elections. Given the intricate nature of estate tax, forward-thinking strategies are essential to protect one's accumulated wealth and legacy. Collaborating with well-versed experts in estate tax, like attorneys and CPAs, can guide you in distributing your assets in alignment with your intentions and making the most of the legal advantages available.