Gifting Strategies Today And Why There Is No Better Time In History
By: Randall A. Denha, J.D., LL.M.
As Albert Einstein famously said, “in the middle of difficulty lies opportunity”, and those words resonate loudly in today’s current estate planning marketplace. In the world of estate planning (which is not routinely very action-packed) there are few times when it makes perfect sense to look at gift giving. This current market may be the most perfect time to consider gifting assets due to the following reasons: historically low interest rates, depressed asset values, generous transfer tax exemptions (discussed below), ever-evolving news around coronavirus and the uncertainty of the political outcomes in November. This piece is intended to share a few ideas and strategies to take advantage of the current environment’s low interest rates and depressed asset values.
As the law currently stands, believe it or not, it is tilted in the taxpayer’s favor.
• In 2018, the federal tax law changed to allow individuals to transfer double the amount of assets they were previously able to gift or transfer tax free. Currently, individuals can transfer $11.58 million or couples can transfer more than $23,160,000. This is a temporary law that will sunset in December 2025.
• After December 2025, unless new laws are passed, the exemption will drop to only $5.49 million (or $10.98 million for couples) as indexed for inflation.
Down markets are a prime opportunity for tax planning for many families. In the few years following the 2008 recession, wealthy families took advantage of gifting options to transfer wealth and reduce taxes. This was done at a feverish pace and in a short period of time, once again, in 2020, we have yet another down market. For those taxpayers with a taxable estate, you should consider taking advantage of this opportunity to transfer wealth by leveraging gifts in current the down market, so your loved ones will pay less estate taxes upon your death.
For perspective, the federal lifetime estate tax exemption was $600,000 in the 1990s and gradually increased over the years to a whopping $11,580,000 in 2020. The current law is set to sunset in 2025, which means that in 2026, it will revert to the law that was in place when it was enacted, $5.6 million, with a slight increase for inflation. At this time, the Generation Skipping Transfer tax (GST), or transfer tax imposed when a gift is made to someone two or more generations below you (think grandchild or “skip person”) equals the same amounts as the lifetime exemption amount. This has not always been the case. So, if your estate exceeds the exemption amount, the federal estate tax rate is a 40% tax on the excess, and if you gift to a skip person, then the GST is yet another 40% tax. Ouch!
The lifetime exemption amount may be gifted during lifetime or transferred at death, or you could gift a portion during your life with the remainder of your exemption available at your death. From a pure tax efficiency standpoint, there is far greater wealth transfer when a gift is made than leaving the same asset to a loved one at death. This is because of the way the tax is calculated and the fact that the asset can grow on the balance sheet of another taxpayer who is younger and with a longer life expectancy.
When you file the gift tax return, if you gift to a skip person or to a trust, you may allocate a portion of your available GST exemption to the gift. In recent tax pronouncements, the IRS has indicated that for those taxpayers who make gifts now, while the exemption is high, it will not count against you when the exemption decreases later. By gifting a portion of your exemption amount during your lifetime, the asset and any appreciation on the asset (from the time of the gift until your death) would not be in your countable estate for estate tax purposes because it would be owned by the person receiving the gift.
You can generally make two types of gifts to leverage the transfer of wealth in a down market:
• Making Annual Gifts of the Gift Tax Exemption Amount ($15,000 per person in 2020) by gifting marketable securities, real estate, private equity investments and anything else of value instead of gifting cash to loved ones.
• Making Lifetime Gifts that Utilize All or a Portion of your Lifetime Estate Tax Exemption Amount, by gifting marketable securities, real estate holdings, and/or business interests, instead of cash, to your loved ones directly, or even better, to an irrevocable trust where you may allocate your GST, to be held for the benefit of your loved ones, in generations.
For example, assuming your estate is greater than the federal estate tax exemption amount, and you own stock, real estate, or a business with a value in May 2020 of $10,000,000 and the market value decreased by 30%, the current market value is $7,000,000. You could gift that stock or real estate to an irrevocable trust for the benefit of your descendants. If you have a family limited liability company, with that irrevocable trust as a member of the LLC, using a business appraisal, you may qualify for a discount on the gift for a minority interest and/or lack of control, which may reduce the currently valued gift of $7,000,000 another 30%, which means that the gift is valued at $4,900,000 for the gift tax return. Thus, in this down market, you may be able to transfer assets worth approximately $10,000,000 (assuming the value of the transferred assets will increase again over time) to your descendants by utilizing only $4,900,000 of your lifetime estate tax exemption amount and allocating your GST exemption amount to the gift, which could be a tax savings of approximately $2,040,000 (which is the 40% estate tax that you would otherwise have paid on the transfer of the $5,100,000 value not counted in this gift). In addition, if that gift was made to skip person, then you may save an additional 40% GST, totaling $4,080,000 in estate and GST tax savings on the value not counted in this gift.
Side note and a word of caution regarding gifting that is often forgotten: the general rule is that a person who receives the gift will receive your cost basis in it (carryover basis). This means that if you bought a stock for $1, it was valued at $50 at the time of your gift, and valued at $100 at the time of your death, then the person receiving the gift decides to sell it after your death, the sale is $100 – $1 carryover basis = $99 x the capital gain rate due for income taxes. You would count the gift as valued at $50 against your lifetime estate tax exemption amount.
Alternatively, if you held that same stock until your death, the person inheriting stock would generally receive the stock with a step-up in basis equal to the fair market value on the date of your death, so if the same person sells it after your death for $100 – $100 step up basis = $0 capital gain means 0 income tax due. However, depending on the size of your gross estate and your remaining lifetime estate tax exemption amount, the stock may incur an estate tax due at your death.
Therefore, we usually look for assets that have a high cost basis when making a gift, and a low-cost basis when keeping assets in your estate.
A few additional strategies to consider are the following:
Intra-Family Loans. Selling assets to family members is an effective planning tool. In practice, you sell an asset, and, in return, you are paid via the delivery of a Promissory Note (a “Note”). Typically, the terms of the Note include payment of interest only for several years with a balloon payment due at maturity of the Note’s term. To keep your estate from growing, you typically sell appreciating assets and charge as low an interest rate as possible. The federal government offers guidance as to these rates by issuing Applicable Federal Rates (“AFR”) monthly.
The Note can be modified at any time (e.g., to take advantage of lower interest rates or to extend the term if expiration is near). The appreciation in the asset’s value is charged to the buyer as the seller now only owns a Note. For estate tax purposes, the seller “freezes” the value of the asset at its sales price. The current interest rate to be imposed is remarkably low. AFRs are calculated based on the term of the loan. Short-term rates are for loans which are less than 3 years; mid-term rates are for loans of 3 years but less than 9 years long and long-term rates are for loans of 9 years or more. The May mid-term AFR is only .58%.
Making a loan to a trust for a child (if the trust is set up as a grantor trust) is advantageous for income tax purposes. Ordinarily, the interest payments on the note must be included in your taxable income, but not if the trust is a grantor trust.
Modifying Existing Notes. If you have an existing loan and do not need the annual income it presently supplies, now is a great time to modify your Note to take advantage of the extremely low interest rates. There is no tax consequence to such a modification.
Impact of Coronavirus on Retirement Accounts. For certain individuals, it may be prudent to consider converting IRAs or 401ks to Roth IRAs or Roth 401ks. A “Roth conversion” triggers immediate income tax. However, Roth accounts do not require mandatory distributions during the owner’s lifetime and any distributions from a Roth account are free of income tax. Under the SECURE ACT, most beneficiaries eligible are now required to draw down accounts by the end of the 10th calendar year following the account owner’s death. Certain beneficiaries still can take advantage of the “stretch rule”. These include a surviving spouse, minor children (until such child attains the age of majority), disabled or chronically ill beneficiaries and beneficiaries less than 10 years younger than the account owner (e.g., a brother, sister, nephew or niece depending on age difference).The cost of converting (i.e., paying income taxes now) should be weighed against the benefit of having future distributions escape income taxes. If the account value has significantly decreased, the income tax effect of conversion may be palatable considering the future benefit.
While we cannot say what will happen if President Trump wins re-election and while it is way too early to predict what will happen; it seems that the election of a Democratic President would likely alter the present estate and gift tax landscape. In either event, costs of coronavirus will undoubtedly lead to large federal and state budget deficits. Accordingly, it is not unreasonable to believe that the wealthier citizens will be taxed at a higher rate than the present. We urge everyone who can take advantage of the current laws to minimize the impact on future tax increases by acting now rather than later.
