Election Day is around the corner and sometimes policy changes follow. When it comes to estate planning, current policies have never been more favorable than today.
The current estate tax law allows each individual to transfer up to $11.58 million to others free of transfer tax either at death through inheritance or by gifting during his/her lifetime. Why is this important? If your assets at the time of your death exceed the lifetime estate tax exemption amount, a tax that can go as high as 40% will be owed to the government. More importantly, depending on the outcome of the 2020 election, the $11.58 million exemption may be cut in half (or more)! Let’s discuss a few strategies to maximize today’s favorable estate policies.
First, you must define your purpose and intention for wealth transition. There are different strategies available and the most appropriate will depend on whether you intend to give to charity, transfer business ownership to family, or have tax efficiency while maintaining some control. For the sake of time and article space, we will focus on strategies intended for transferring assets and appreciation to the next generation. More specifically, we will start by highlighting a strategy that works best during low interest rate environments, like we have today.
Grantor Retained Annuity Trust (GRAT):
A GRAT will allow you to freeze the current value of an asset you believe may appreciate over time, as long as you are willing to give up control of said asset for the benefit of the next generation. This irrevocable trust removes future asset growth from your estate calculation. The strategy works best during low interest rate environments because projected future growth by the IRS is calculated using today’s interest rates.
For example, Tom has business holdings valued at $10M and believes it will grow significantly over the next ten years. Tom places his business holdings in a GRAT with a ten-year term, naming his children as beneficiaries. The IRS projects that Tom’s business will be worth $14M ten years from now based on today’s interest rates. The GRAT requires that Tom receive $14M over the next 10 years via an annuity payment from the trust. At the end of ten years, his children as beneficiaries of the GRAT receive the business holdings. If his business value has actually grown to $20 million, the additional growth of $6 million is transferred to his children tax-free.
Gifting Interest of a Family Limited Partnership (FLP):
Family Limited Partnerships allow the first generation to retain control while transferring assets that they believe will appreciate in the future to the next generation today. This transfer occurs through the gift of partnership interests. These units of ownership have the opportunity to be transferred at a discount to net asset value, which can reduce gift and estate tax liability.
For example, Jane owns a business worth $20 million and desires to one day pass it on to her children. Today, Jane sets up an FLP naming herself as a general partner and gifts limited partnership interests to her children. Jane can retain full control of the business while allowing the children to share in any distribution of business profits.
Since the children are not general partners and are restricted in power due to limited partner status, their value is discounted for gift tax purposes when the limited partner ownership is transferred.
Let’s assume that Jane gifts 40% of her $20 million business to her children. The limited partnership discount only requires Jane to use $6 million of her lifetime gift exemption versus the true net asset value of $8 million (40% of $20 million). All future appreciation on that portion of her business is now out of her estate. This is a method of maximizing the value of the estate and gift tax exemption.
Charitable Lead Trust (CLT):
If you have charitable intentions and would like to transfer assets to the next generation, a Non-Grantor Charitable Lead Trust may be your preferred strategy. Similar to a GRAT, these irrevocable trusts are structured for a set term and are intended to hold appreciable assets. In this case, instead of the Grantor receiving an annual annuity payout, the charity receives the income stream throughout the term. Again, given historically low interest rates, the charity’s payout percentage will be lower at today’s rates, allowing a potentially higher remaining balance for your beneficiaries.
With this type of CLT, the donor enjoys a gift or estate tax deduction on the value of the total estimated benefit to the charity. After the charity’s income stream period ends, the remaining assets are distributed to the next generation. If the assets appreciate more than calculated, that growth in value is not taxed, allowing the next generation to receive the CLT assets free of any estate tax.
For example, Sally sets up a ten year CLT and funds it with $5M. A level annuity income stream is paid to XYZ charity over the ten years based on expected investment return that is tied to today’s interest rates. Over the ten years, a total expected payout to XYZ charity is calculated to be $7M. Today, the donor receives a charitable income tax deduction. At the end of year ten, if the investment growth was more than expected, leaving a balance of $3M. Jane’s children receive $3M tax-free with no gift or estate tax.
Future estate tax policies are unknown; however, today’s lifetime exemption is as favorable as it has ever been. Similarly, future interest rates are unknown; however, we do know today’s rates are at historical lows. The combination of these two knowns can result in advantageous and creative generational wealth transfer strategies.
Everyone’s goals and intentions for wealth transfer are different, so customizing a strategy that fits your needs is the most important first step. It is recommended that you seek the advice of a knowledgeable estate or financial planning advisor as you look for ways to take advantage of the current environment.
Evan Bedel is the Director of Finance and Strategy with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Evan at email@example.com.