Navigating the Waters of Wealth Transfer

Understanding Gift, Estate, and GST Taxes for Effective Legacy Planning

The transfer of wealth refers to the process of assets, property, and financial resources passing from you or your estate to another, during your lifetime as a gift or after your death through an inheritance. The wealth transfer process is important, as it may ensure financial security of heirs and beneficiaries, preserve your legacy, encourage entrepreneurship, and contribute to economic growth as transferred assets are put to use.

Careful planning is necessary, as the wealth transfer process is subject to various federal taxes that aim to regulate the transfer of assets, such as cash and non-cash gifts, real estate, stocks, and ownership interests in closely held businesses. The three significant taxes that impact this process are the gift, estate, and generation-skipping transfer (GST) taxes.

In this discussion, we will delve into the details of each tax and its purpose, differences between the taxes, and relevant valuation considerations and potential sunsetting provisions affecting estate and gift tax laws. Proper understanding, careful planning, and consultation with qualified professionals are essential to navigate the complexities of the wealth transfer landscape and ensure effective wealth preservation for future generations.

Three Types of Wealth Transfer Taxes

The three federal taxes we’ve mentioned impact the wealth transfer process and apply to different situations: The gift tax applies to transfers during your lifetime; the estate tax applies to transfers at the time of your death; and the GST tax can apply to transfers made during your lifetime and at or after your death.

Gift and estate taxes, known as “unified” taxes, share a single rate schedule and have a unified exemption amount, which means that you can transfer a certain value of assets during your lifetime or upon your death without paying gift or estate taxes. The GST tax is an additional tax imposed on specific transfers made to individuals more than one generation younger than you. It’s important to mention that the IRS permits tax-free gifts up to a specific annual limit for each beneficiary, known as the gift tax exclusion. This exclusion does not affect the unified lifetime exemption. Additionally, there are exemptions and exclusions applicable to the GST tax.

Each tax has its unique application and rules, targeting different scenarios of wealth transfer. Understanding these taxes and their implications is essential for individuals and families involved in estate planning and wealth preservation. It’s important to note that certain states have their own estate or inheritance tax laws, which may have different exemption amounts and tax rates. These state-level laws are unaffected by federal changes and may vary from state to state.

Here’s a breakdown of each federal tax and their properties:

• The estate tax, also known as the inheritance tax or death tax, is a tax imposed on the transfer of assets from a deceased person’s estate to their heirs or beneficiaries. The tax is based on the total value of the deceased person’s estate and is typically paid by the estate before the assets are distributed to the heirs. Estate tax laws and exemptions may vary between states. 
• The gift tax is a tax imposed on transfers of property or assets from one person to another during their lifetime. The purpose of the gift tax is to prevent individuals from avoiding the estate tax by giving away their assets before death. The person making the gift (the donor) is responsible for paying the gift tax, although certain exemptions and exclusions may apply, allowing for tax-free gifts up to a certain limit.
• The GST tax is a federal tax that applies when a person transfers assets to a “skip person,” typically a beneficiary at least two generations younger than the donor, such as grandchildren or great-grandchildren. The tax is imposed in addition to any estate or gift tax that may already apply to the transfer.

Not all transfers of wealth are subject to gift tax, estate tax, and GST tax. The GST tax exemption serves as a critical component of the tax code, allowing you to transfer a certain amount of wealth to subsequent generations without incurring additional taxes. In addition, valuation discounts can also mitigate GST tax liability. In certain instances, valuation discounts could be applied to reduce the taxable value of assets subject to the GST tax.

GST Tax Exemption

The primary purpose of the GST tax exemption is to strike a balance between wealth preservation and tax revenue generation. It recognizes the importance of intergenerational wealth transfer while ensuring that the tax system remains fair and equitable. By providing an exemption, the law allows families to transfer a certain amount of wealth to subsequent generations, thereby enabling them to preserve their financial legacy.

Utilizing the GST tax exemption requires careful planning and understanding of the rules governing its application.  There are several key considerations to bear in mind:

• Allocation of the Exemption: The GST tax exemption can be allocated to various transfers, including trusts, outright gifts, and bequests. Understanding how to allocate the exemption optimally is crucial to minimizing tax liability and maximizing the preservation of wealth. The GST tax comes into effect when you transfer assets to a skip person. This type of transfer skips one or more younger generations and involves individuals related to you through blood, marriage, or adoption. Typically, grandchildren and great-grandchildren are considered common skip persons. However, there is an exception known as the deceased parent rule (IRC § 2651(e)), where descendants are elevated to their parent’s level if the parent passes away before the transfer occurs. Consequently, a grandchild who would have been considered a skip person to you will no longer be classified as such if the grandchild’s parent dies before you and the grandchild die. On the other hand, an unrelated person becomes a skip person if they are more than 37½ years younger than you.
• Generation-Skipping Trusts: Generation-skipping trusts are effective for utilizing the GST tax exemption. These trusts allow assets to be held for the benefit of multiple generations, providing income and support while minimizing tax consequences. Proper drafting and administration of these trusts are vital to ensure compliance with applicable regulations. A trust can be categorized as a skip person under two circumstances: (a) when all the beneficial interests in the trust are held by skip persons, or (b) when no current beneficial interests are held by skip persons (but note: distributions cannot be made to individuals who are not skip persons, commonly referred to as “non-skip persons”). An individual holds a beneficial interest in a trust when (a) they have a present entitlement to income or principal, or (b) they are a potential recipient of income or principal (for instance, when there are no mandatory income or principal beneficiaries presently, and the trustee has the authority to distribute income or principal to a group that includes the individual in question).

Several types of trusts can be used to address the GST tax. It’s important to note that each trust has its own unique features and considerations, and consulting with a qualified estate planning attorney or financial advisor is crucial to determine the most suitable trust structure for your specific circumstances and objectives. Here are a few common examples:

• Dynasty Trust: A dynasty trust is specifically structured to last for multiple generations. By transferring assets into this irrevocable trust, individuals can bypass the GST tax and preserve wealth for their descendants. The key feature of a dynasty trust is its perpetuity; keeping the assets within the trust so the trust can continue to grow and provide ongoing financial benefits to future beneficiaries without triggering additional GST taxes with each generational transfer.
• Irrevocable Life Insurance Trust (ILIT): An ILIT is a trust specifically designed to hold life insurance policies outside of the estate of the insured individual. By using an ILIT, individuals can avoid estate taxes and potentially reduce the impact of the GST tax on the proceeds paid out to the trust beneficiaries.
• Qualified Personal Residence Trust (QPRT): A QPRT allows individuals to transfer their primary residence or vacation home to the trust while retaining the right to use it for a specified period. This type of trust can reduce the property’s taxable value and mitigate GST tax implications when passing it on to future generations.
• Grantor Retained Annuity Trust (GRAT): A GRAT allows individuals to transfer assets to an irrevocable trust while retaining an annuity payment for a predetermined period. Any remaining assets pass to the trust beneficiaries at the end of the term. Utilizing a GRAT can minimize the GST tax impact on the transferred assets.
• Charitable Lead Trust (CLT): A CLT allows you to provide income to a charitable organization for a set period while passing the remaining assets to non-charitable beneficiaries, such as your family members. By incorporating a CLT, you can reduce the value of your assets subject to the GST tax.

Considering the interaction between the GST tax exemption and the annual gift tax exclusion is essential. The annual exclusion allows you to gift a certain amount per year to each recipient without incurring gift tax. However, transfers utilizing the GST tax exemption will consume a portion of your lifetime gift tax exemption.  When the GST tax exemption is utilized, you’ll need to file a generation-skipping transfer tax return with the IRS. Failure to file the return may result in penalties and interest. Complying with the reporting requirements is crucial to avoid unnecessary complications.

Valuation Considerations

Fair market value (FMV) is a crucial concept in the taxation of gift and estate transfers. And one of the primary challenges in gift and estate taxation is determining the FMV of various assets being transferred. Valuing assets with established market values, such as publicly traded stocks are relatively straightforward. However, when it comes to unique or illiquid assets like closely held businesses, determining FMV becomes significantly more challenging.

Valuing business interests, especially in closely held companies, presents additional complexities. Factors such as the company’s financial performance, market conditions, and future prospects must be carefully considered to arrive at an accurate FMV. Furthermore, specific FMV issues for qualifying estates and gifts add further complexity to the taxation process.

The IRS may require a qualified appraisal for certain assets to substantiate the FMV reported on the gift or estate tax return. A qualified appraiser, knowledgeable in the specific asset type, must perform the appraisal to ensure compliance with IRS regulations.

Professional appraisals may be necessary to ascertain accurate FMVs for these assets and will consider critical factors such as the date of value, discounts, and premiums.

The valuation date is critical, as it impacts the FMV calculation. For gift transfers, FMV is usually determined as of the date of the gift. However, for estate transfers, the FMV is typically determined as of the date of the decedent’s death or an alternate valuation date. Fluctuations in market conditions between the date of the decedent’s death and the alternative date can affect the accuracy of FMV assessments.

Certain assets in gift or estate transfers may be eligible for discounts or subject to premiums, which influence their FMV. Examples include discounts for lack of marketability (when an asset cannot be easily sold on the open market) or minority interest (when the ownership stake does not grant significant control). Conversely, closely held businesses may have a control premium applied to reflect the increased value or less of a discount for marketability associated with owning a controlling interest.

Valuation Discounts

Valuation discounts are based on the concept that certain characteristics of a business or business interest, such as the inherent rights, privileges, conditions, restrictions, and limitations governing asset ownership and transferability, contribute to a diminished overall value. It’s important to highlight that the IRS recognizes and sanctions these discounts in gift and estate tax valuations, in accordance with provisions outlined in the Internal Revenue Code (IRC) and relevant regulations. Thus, valuation discounts may reduce the taxable value of the assets transferred, consequently lowering the tax liability. Several valuation discounts could be warranted in this context:

• Lack of Control/Minority Interest Discount: A lack of control discount recognizes that certain ownership interests lack control over decision-making processes and are, therefore, less valuable. Similarly, a minority interest discount reflects that a minority interest in a closely held business or partnership lacks control and marketability and, thus, is less valuable than a controlling interest. Transferring assets with limited control to skip persons can reduce the taxable value.
• Lack of Marketability Discount: This discount accounts for the illiquid nature of certain assets, such as closely held businesses, real estate, and restricted stocks. Since these assets may take time and effort to convert into cash, their value might be decreased.

For instance, minority shareholders, such as those with only a 1% interest in a business, typically have limited or no control over the company’s decision-making processes. This lack of control can deter potential buyers and result in a discount. Even if a 1% shareholder has some voting rights, they may not be sufficient to influence significant corporate decisions. This lack of meaningful voting power can contribute to the discount. In addition, restrictions on the transfer of a 1% interest, as specified in the company’s operating agreements or bylaws, can deter potential buyers. These restrictions can include rights of first refusal, buy-sell agreements, and limitations on selling to external parties that make the asset less liquid and therefore less attractive to potential buyers.

It’s important to note that the IRS closely scrutinizes the use of valuation discounts and may challenge them if they are deemed excessive or unsupported by appropriate documentation or business reasons. Working with qualified appraisers and tax professionals is crucial to ensure compliance with applicable regulations and substantiate the claimed discounts. Furthermore, it’s worth mentioning that valuation discounts may be subject to changes in tax laws or regulations. Staying informed about any updates or amendments to the tax code is essential to ensure the continued effectiveness of these strategies. To navigate these intricacies successfully, consulting with qualified professionals, such as estate planners, tax advisors, and appraisers, is essential to ensure compliance with applicable tax laws and regulations.

TCJA Changes

The Tax Cuts and Jobs Act (TCJA), enacted in 2017, made several significant changes to the estate tax, gift tax, and GST tax (set to expire on December 31, 2025, unless extended by future legislation). One of the notable changes under the TCJA was a substantial increase in the “unified” gift and estate tax exemption, which approximately doubled for tax years 2018 through 2025 compared to previous levels.

Specifically in 2018, the estate tax exemption amount was set at $11.18 million per individual (or $22.36 million for a married couple), adjusted for inflation in subsequent years, compared to $5.6 million in 2017. For the 2023 tax year, the federal estate and gift tax exemption in the United States is $12.92 million per individual (or $25.84 million for a married couple). This means you can make tax-free wealth transfers up to the exemption amount during your lifetime or upon your death without incurring tax. Transfers exceeding the exemption amount are subject to tax. Any amounts above the exemption are generally subject to a flat rate of 40% for estate and gift taxes.

Additionally, an annual exclusion allows you to gift a certain amount to each recipient each year without counting toward the lifetime exemption. In 2023, the annual exclusion amount for an individual making a gift is $17,000 per recipient (or $34,000 per recipient for married couples making a gift). This means you can make GSTs up to the exemption amount without incurring the GST tax. Transfers exceeding the exemption amount may be subject to the gift tax.

Further, the TCJA retained the portability provision and maintained the unification of the estate and gift tax exemption, which allows your surviving spouse to use any unused portion of your estate and gift tax exemption, and the same exemption amount applies to estate tax and lifetime gifts, allowing you to utilize your exemption during your lifetime, upon your death, or a combination of both. If you take advantage of the increased gift tax exclusion or unified exemption in effect from 2018 to 2025, you will not be adversely impacted after 2025 when these amounts are scheduled to drop to pre-2018 levels.

Sunsetting Provisions

It’s important to note that the increased estate and gift tax exemptions introduced by the TCJA are temporary and are set to revert to pre-TCJA levels (adjusted for inflation) unless new legislation is enacted. In terms of the sunsetting provisions, several potential changes are being discussed:

• Reduction of Estate and Gift Tax Exemption: One potential change being discussed is a reduction in the estate and gift tax exemption amount. Some proposals suggest lowering the exemption amount. A lower exemption amount would subject more estates and gifts to taxation.
• Increase in Estate and Gift Tax Rates: Another potential change is an increase in estate and gift tax rates. Higher tax rates on estates and gifts could be proposed to generate additional revenue or address perceived inequalities in the tax system.
• Elimination of Step-Up in Basis at Death: The step-up in basis allows assets to be revalued at their fair market value at the time of the owner’s death. This can minimize capital gains taxes for heirs when they sell inherited assets. There were discussions about potential changes to the step-up in basis, such as its elimination or modification. These changes would likely result in increased capital gains taxes for heirs upon selling inherited assets.
• Modifications to Generation-Skipping Tax: Changes to the GST tax are also being considered. These changes could include modifications to the GST exemption amount or adjustments to the tax rate applied to GSTs.

Conclusion

Navigating the complex landscape of wealth transfer taxes requires careful planning, knowledge of the available exemptions and strategies, and consultation with qualified professionals to ensure wealth preservation for future generations. Proper planning and understanding of these tax rules are crucial to preserving wealth. Utilizing the GST tax exemption, employing valuation discounts, and utilizing various types of trusts, such as dynasty trusts, irrevocable life insurance trusts, qualified personal residence trusts, grantor retained annuity trusts, and charitable lead trusts, can be effective strategies for maximizing your tax savings.

Staying informed and working with qualified professionals is essential to ensure compliance and effectiveness of wealth transfer strategies. It’s important to note that valuation discounts and changes to the estate and gift tax laws, including a reduction in the exemption amount, an increase in tax rates, modifications to the generation-skipping tax, and potential elimination or modification of the step-up in basis at death, may occur. Monitoring these developments and adjusting wealth transfer plans accordingly will be crucial in the future.