Exemption Increases So Now What?

By: Randall A. Denha, J.D., LL.M.

Many investors are aware that a limit exists on the amount of money that may be given by a single individual both in a single year and throughout their lifetime. Specifically, I am referring to the annual gift exclusion and the estate and lifetime gift tax exemption (aka the unified credit against estate tax). These two amounts (three if you include the generation-skipping transfer tax that is interwoven within these wealth taxes) have long been established through Congressional acts, and then codified by the IRS. These amounts are subject to constant change both in legislation and as adjusted for inflation.

Throughout the history of our modern estate tax, the amounts of both the lifetime exemption and annual gift exclusion have continued to increase.

$860,000 – that is the amount of the increase in the gift, estate, and generation-skipping transfer (“GST”) tax exclusion that came into effect on January 1st when the exclusion increased from $12.06 million for 2022 to $12.92 million in 2023. This one-year increase is unprecedented and is more than the entire exclusion in 2001. For a U.S. married couple, the total increase is $1.72 million.

The large increase is due to inflation. Although inflation is generally nothing to be pleased about, the IRS recently announced inflation-adjusted changes to the annual gift tax and estate tax exclusions for 2023. If you are considering wealth transfer tax planning, these are welcome increases. The lifetime exclusion and the annual gift tax exclusion (which was $16,000 in 2022 and increased to $17,000 in 2023) are both adjusted annually for inflation.

Effective January 1, 2023, the combined gift and estate tax exclusion increase went into effect which now permits a transfer of $12.92 million ($25.84 million for a married couple). The combined gift and estate tax exemption is the total amount of gifts a person may make during their lifetime, including transfers made at death, before being on the hook for gift or estate tax. For those who used up all of their gift tax exemption as of December 31, 2022, you will now be able to gift another $860,000 tax-free starting January 1, 2023. Married couples in this situation may make additional gifts of $1.72 million. Truly a windfall for many and when this occurs, it is best to optimize the reward!

Here are some strategies which can be used to take advantage of the increased exemption:

1. Topping-off Gift Trusts. Making additions to existing gift trusts and applying available exclusion to the gift is a simple way to utilize the additional exclusion amount. The question is how to leverage the additional exclusion. Transfers of minority/non-controlling interests in entities are customarily valued at a discount due to lack of control and marketability. And transfers of assets with appreciation potential optimize the long-term benefit of a gift. If you have not already made gifts that use some or all of your annual or lifetime exemption, now may be a good time to do so, as many investment assets have suffered a 25%-35% decline in value since the beginning of the year, but are expected to recover their value in the medium to long term. Making a gift of these discounted investments that are then held by or for your beneficiaries, means that you are leveraging the increased exemption by gifting investments at a discount.
   
   
2. Intra-family Loans. Loans to family members for home purchases and business start-ups and financed asset sales to irrevocable grantor trusts are common. The loans can, however, become a bit of a nuisance to maintain. Consider making a gift to an individual family borrower to repay a family loan and canceling loans to irrevocable grantor trusts in amounts covered by the additional exclusion. While debt forgiveness is typically subject to income tax, neither repayment of a debt nor cancellation of debt between a grantor and a grantor trust triggers income tax.
   
   The use of a note can do three very positive things. It can create the needed cash flow in the form of note payments back to the selling generation. It can create liquidity for the purchasing generation to make the necessary note payments, and it will set a value for the asset being sold, meaning no additional appreciation in the business or partnership is created in the estate of the sellers—further increasing their taxable estate. It is very important that any business or partnership interest be appraised prior to a gift or a sale via note. Another prudent use of intrafamily loans is the funding of a mortgage for children or grandchildren. Lower payments can typically be accomplished via an intrafamily loan as opposed to a conventional lender, based on their financial situation.
   
   
3. Funding an Irrevocable Life Insurance Trust. Owning life insurance in an irrevocable life insurance trust (“ILIT”) removes the insurance proceeds from the insured’s taxable estate, but the policy must be maintained in the trust. Typically, annual contributions within the annual gift tax exclusion amount are made to the trust, and the trustee then provides notices of the contributions to beneficiaries and subsequently pays the annual policy premium. The contribution, notice, and payment cycle repeats, and repeats, and repeats. Sometimes there are time crunches and record of ILIT contributions and beneficiary notices are not always maintained. If a larger contribution is made to the trust in an amount to cover projected premium payments and available exclusion is applied to the contribution, the gift is tax-free and annual contributions and notices are no longer required. The trustee can simply pay the annual premium each year from the liquid assets in the trust.
   
   
4. Generation-Skipping Trust Refresh. The objective of a multi-generational dynasty trust is to apply GST tax exclusion to the trust when it is established so it is fully exempt from the GST tax for the entire duration of the trust. Occasionally the available exclusion is insufficient to fully exempt the trust. Fortunately, with the recent increase in the exclusion amount, part or all of the increase can be applied to an existing trust to wholly exempt the trust from the GST tax.

Each strategy will require filing a Gift Tax Return (Form 709) to report allocation of exclusion, but no tax will be due provided the value of the gifts does not exceed the available exclusion. Which strategy to use depends on each individual’s prior gifting and current goals.