Some tactics can reduce liabilities for passing wealth
Gifts to future generations aided with efficient plans
Michael MaehlMarch 16th, 2023
When it comes to gifting assets to future generations, many families are rightfully concerned about the potential tax effect. In other words, how and when should they pass down their assets to ensure that the greatest amount possible actually gets to their heirs?
Here are some underused strategies for gifting assets and potentially reducing the tax consequences.
Gifts and Transfers
Assets can be tax-free up to a certain point. As of 2023, the annual individual gift tax exclusion amount has increased to $17,000. That is the amount you can gift to any one person—each year—free of any tax implications. The annual joint gift tax exclusion, for married couples, is $34,000. Further, the lifetime gift tax limit is $12.92 million, per individual donor, or $25.8 million for a married couple, the same as the annual estate tax exemption. These thresholds are available to make gifts to generations, either outright or through a trust, and many families can make these gifts without having the need for more complicated strategies.
By the way, the lifetime gift tax exclusion is scheduled be cut in half in 2026. Current estimates put the 2026 lifetime limit at around $6.8 million. Congress could permanently adopt the current amount, but I wouldn’t want to count on that.
The challenge with this option is choosing the appropriate asset to gift. Ideally, it would be an asset likely to increase in value after transferring. For example, consider using a high-quality growth stock. This type of gift potentially can provide benefits to both the person giving, by lower taxes today and the potential removal from your taxable estate, as well as the individual recipient, meaning acquiring an asset that potentially can increase in value over time. Given the high exemption amounts today, outright gifts can be an attractive, simple, and effective method for moving assets to your beneficiaries.
Estate and Gift Taxes
The current estate and gift tax rates are quite advantageous. To add perspective, the highest marginal rates for estate and gift taxes were 77% roughly between 1941 and 1976, and 70% roughly between 1977-1981. Today’s highest marginal rate for both estate and gift taxes is a mere 40% by comparison. And, for the record, a small percentage of people are subject to these rates.
Of course, wealth transfer is improved when taxed at the lowest possible rate. There are circumstances in which gifting assets today could avoid substantial estate taxes in the future that would otherwise reduce the amount of wealth a family wants to pass down to the next generation.
Namely, the confluence of several circumstances that exist today—a relatively low rate for the gift tax, an all-time high on the lifetime exemption amount, along with the possibility that the rate may increase and the exemption amount could decline—causes many families to seriously consider making outright gifts now.
Net Gifts and Bargain Sales
A net gift is a gift of assets given under the condition that the individual recipient pays the applicable gift tax. It’s called a net gift because the final amount received is equal to the value of the asset transferred minus the amount the recipient agrees to pay in gift tax. The individual making the gift is ultimately responsible for paying the gift tax.
As a result, the recipient will reimburse the individual making the gift, which is why it’s sometimes referred to as a “bargain sale.” This strategy can be helpful when a large gift is contemplated but the donor lacks the liquidity to pay the tax or is unwilling to pay the tax. It’s important to note that gifting an appreciated asset creates an income tax liability for the recipient that may be recognized if and when the recipient later sells or transfers the asset.
Regardless, net gifts or bargain sales can be more tax efficient in certain situations, such as when the beneficiary is willing to pay the tax for the benefit of receiving the asset and its potential future appreciation.
Paying Taxes for Beneficiaries
Grantor trusts can be a core component of many estate planning strategies. Grantor retained annuity trusts, intentionally defective grantor trusts, and spousal limited access trusts are a few examples of grantor trusts.
A grantor trust is considered a “disregarded entity” for income tax purposes. That means that any taxable income or tax deduction produced by the trust is taxable and reportable on the grantor’s tax return. In contrast, when a grantor makes a transfer of assets to an irrevocable trust, that trust is held outside the grantor’s taxable estate.
These trust structures can provide a grantor with a powerful method to move assets efficiently to the next generations. For example, a grantor can sell assets to a grantor trust and not recognize any capital gains on the transfer. Or a grantor can loan money to the grantor trust and not incur any taxable interest. However, the trust must pay the grantor at least a minimum interest rate on the debt. And, finally, a grantor trust’s income tax, paid by the grantor, isn’t considered an additional gift to the grantor trust.
Effectively, grantor trust assets may increase in value without the trust having to pay income tax. Instead, that’s paid by the grantor. In effect, the grantor can make a tax-free gift to the grantor trust and thereby to the trust beneficiaries.
All gifts involving assets require a determination of the value of the gift, with taxes based on that valuation. However, there are strategies to influence valuations that can benefit families.
For example, if there’s real estate to be transferred, a family can move the real estate into a family limited partnership and then transfer the partnership interests to the rising generation. This technique allows the value of what’s transferred—in this case, the partnership interests—to potentially receive valuation discounts. A valuation discount strategy can also be applied to minority interests in closely held businesses, fractional interests in real estate, interests in private equity funds or other investment entities, and even interests in family-owned investment entities.
Given how effective valuation discounts can be at enhancing gifting strategies, great care and consideration should be provided in how these principles affect transfers to the next generations.
I’m neither an estate attorney nor a certified public accountant, so please check with those folks who help you ensure any strategies you choose or gifting you do are structured properly and using the assets you want to include.