All Good Things May Come to an End

 

The Tax Cuts and Jobs Act of 2017 (TCJA) received a great deal of attention for providing significant income tax savings to many taxpayers. Getting less attention were the changes to the estate and gift tax laws that, for wealthier individuals and couples, were even more significant.

 

Prior to the passing of the TCJA in December 2017, the lifetime individual estate and gift tax exemption was $5.45 million while the annual gift exclusion was $14,000. That allowed a married couple to transfer up to $10.9 million to their heirs without any Federal estate tax due and gift up to $28,000 annually to an individual without the need to file a gift tax return. Under the TCJA, the individual estate tax exemption more than doubled in 2018 to $11.18 million ($22.36 million for married couples) while the individual annual gift exclusion increased to $15,000 ($30,000 for married couples). And, because the TCJA permits annual inflation adjustment increases, the federal estate and gift exemptions have since grown to $12.92 million ($25.84 million for married couples) and $17,000 ($34,000 for married couples), respectively in 2023.¹

Sunset Is Coming

Chaucer is credited with saying, “All good things must come to an end,” and the TCJA is no exception. The TCJA was established with sunset language that will cause many income and estate tax provisions to expire at the end of 2025. Absent new legislation, income tax rates will increase, and the current estate and gift tax exemptions will revert to pre-TCJA levels. Even with adjustments for inflation, the exemptions will be cut by half to approximately $6.5 million for individuals or $13 million for married couples if the TCJA sunset occurs.

 

How Congress will respond to the upcoming sunset of the TCJA is unknown. But now is the time to begin planning for the coming sunset or other changes that may occur. How would a sunset of TCJA affect you and your family? It depends on the size of your net worth. To explain further, let’s consider the following scenarios:

 

1. You have an estate that is currently above the lifetime exemption amount, making it subject to estate tax at your death.
2. You have an estate that will be above the lifetime exemption amount if that amount reverts back to pre-TCJA levels.
3. You will not have a taxable estate immediately after sunset of the TCJA, but your net worth is rapidly growing.

Estate & Gift Tax Planning Ideas

People with a taxable estate typically have the following planning concerns:

 

• They want to protect their heirs and be thoughtful about how they distribute their estate.
• They wish to preserve their legacy for their family and their community.
• They prefer to minimize or eliminate estate and gift taxes.

 

If you share these concerns, the following are several planning ideas to consider.

Leveraging Your Lifetime Exemption

While the estate tax exclusion amount is credited to the estate at death, it can also be allocated during your lifetime. A common example is using part of your lifetime exemption to transfer partial ownership of an appreciating family business to the next generation to reduce potential estate taxes.

 

The primary idea behind using the estate exemption to gift assets today is to shift future asset appreciation out of the estate from the owner (i.e., grantor) to the future heirs or beneficiaries of the estate. Benefits of this approach may include the following:

 

1. Reduction of the grantor’s estate taxes.
2. Favorable positioning of heirs or charities to receive benefits from a future sale of assets.
3. Asset protection for trust beneficiaries from creditors.

 

Estate planners employ a wide variety of trust planning strategies, from those that are straightforward to others that are complex. A comprehensive discussion of all strategies is beyond the scope of this article, but here are three trust strategies that are commonly used by planners to provide some or all of the benefits listed above.

 

Spousal Lifetime Access Trust (SLAT)

 

A Spousal Lifetime Access Trust (SLAT) is an irrevocable trust funded for the benefit of the current spouse. The grantor uses their lifetime exemption to gift individually owned assets (joint assets are not permitted) to a trust with their spouse as the current income or principal beneficiary. The main benefit of this strategy is the removal of the assets gifted to the trust and the future appreciation of those assets from the estate of the grantor and their spouse for the ultimate benefit of heirs.

 

A SLAT is usually treated as a grantor trust, which means that the grantor pays taxes on the trust’s income. This is a benefit from an estate tax perspective because it allows the trust’s assets to grow outside of the grantor’s estate more quickly than if income taxes were withdrawn. A further benefit is that the IRS does not count the grantor’s payment of the trust’s income taxes as a gift to the trust.²

 

Although a SLAT is frequently funded with financial assets such as stocks and bonds, other assets such as life insurance, closely held businesses, and real estate can also be contributed. The strategy is most effective, however, when using assets with high appreciation potential.

 

A SLAT’s provisions can be customized to allow for planning flexibility. A common example is a substitution power that allows a grantor to exchange cash for an asset in the trust. Because irrevocable trusts do not allow for a stepped-up cost basis at the grantor’s death, the grantor could exercise this power to substitute cash for a highly appreciated asset, thereby making the asset eligible for a stepped-up basis. The substitution would have the added benefit of locking in appreciation inside the trust.

 

It is important to note that the primary objective of this strategy is to reduce estate taxes on the transfer of wealth to heirs. An added benefit is that it allows the spouse to access funds during their lifetime. Any amounts paid from the trust to the spouse are brought back into the estate, which may reduce the effectiveness of the strategy.

 

At the death of the spouse, the assets within the SLAT are distributed to heirs either outright or in trust.

 

Grantor Retained Annuity Trust (GRAT)

 

A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust specifically designed to transfer the appreciation of assets to beneficiaries. The grantor of the trust contributes assets with appreciation potential to the GRAT in exchange for an annuity payment over a set term—usually 2 to 10 years.

 

The annuity payment is based on three factors: 1) the fair-market value of the assets gifted; 2) the set term of the trust; and, 3) the IRS 7520 rate in effect when the trust is funded. The grantor uses part of their lifetime exclusion based on the value of the remainder interest calculated at the time of the gift.

 

For the strategy to be effective, the overall appreciation and income generated by the gifted assets must exceed the initial IRS 7520 rate (5.0% as of August 2023) and satisfy all annuity payments back to the grantor.³ At the end of the term, any remaining assets in the trust are distributed to the beneficiaries outright or in trust with no additional gift or estate tax.

 

One example of an ideal asset to use in a GRAT is a high-performing, closely held business intended to be transferred to family members. The combination of a proper GRAT strategy, a low IRC 7520 rate, significant appreciation or cash flow from the business, and the ability to use a valuation discount can lead to the successful transfer of a business interest to the next generation without additional gift or estate tax.

 

There are a variety of GRAT strategies available, such as Rolling GRATs, Zeroed Out (a/k/a Walton) GRATs, Single Asset GRATs, and Long-Term GRATs that can be used to transfer assets to heirs. Additional trust provisions, such as substitution powers, can be included to provide flexibility and enhance the performance of the strategy.

 

Intentionally Defective Grantor Trust (IDGT)

 

An Intentionally Defective Grantor Trust (IDGT) is a complex strategy typically employed to transfer appreciating assets, such as business interests, real estate, or marketable securities, to the next generation. Before delving further into the strategy, an explanation of why the trust is called “intentionally defective” is in order.

 

For most irrevocable trusts, the trust is responsible for any income tax obligations generated on income and capital gains that are retained. An “intentionally defective” trust is deliberately drafted to define the trust as a grantor trust under IRC Sections 671-678, causing the income and capital gains generated by the trust to be taxable to the grantor.⁴ Some features that make the trust defective include the power to vote or to direct the vote of the stock held by the trust, the power to borrow from the trust without adequate security, and the power to substitute assets of equal value from the trust.

 

Grantors wanting to make larger gifts can use a gift and sale combination strategy to fund the trust. Under this strategy, the grantor uses all or a portion of her lifetime exemption to gift cash or marketable securities to the trust—typically 10% of the final funding amount. Once the gift is complete, the trust purchases assets at fair-market value from the grantor in exchange for a promissory note with a legitimate interest rate set by IRC Section 1274.⁵ Because the trust is classified as a grantor trust under IRS rules, the sale of the assets to the trust is not recognized as capital gain to the grantor.⁶ This has the added benefit of preserving the remaining exclusion amounts available to the grantor and providing an income stream to the grantor in the form of interest on the promissory note.

 

From an estate tax perspective, the transferred assets and the future income and appreciation on them have been removed from the grantor’s estate. While the promissory note is still included in the estate of the grantor, the power of the strategy is realized over the long term if the assets provide a return that is higher than the interest rate charged on the promissory note.

 

The IDGT strategy is complex, with multiple legal and tax consequences that should be discussed with your legal and tax professionals before proceeding.

Other Reasons to Review Your Estate Plan Before the Sunset of TCJA

Even if the scenarios above do not apply to your situation, there are good reasons to look over your estate plan before the sunset of TCJA. Whether you have a taxable estate today or not, you should periodically review if your estate plan still reflects your wishes. Ask yourself these questions:

 

• Have my family circumstances changed?
• Have the market values of my assets changed significantly?
• Are the people named in my estate documents still able and willing to serve in the roles I have assigned to them?
• Will I have a taxable estate in the future?

Concluding Thoughts

Change is the one constant in life. Estate plans are based on the circumstances and laws in place at the time they were written. Just as Congress changes laws, life circumstances and priorities change as well.

 

The potential sunset of TCJA at the end of calendar year 2025 has placed a target date by which to complete the review of your current estate plan or to implement a new estate plan. The more complex your financial situation, the greater the need to begin this process now. Once the sun sets on these provisions, it may be too late to use these effective tax-and-estate-planning strategies to the same degree.

 

Contact your Goelzer wealth planning professional if you have questions about how the sunset of TCJA may affect your overall financial plan.

 

¹ Roger Wohlner, The Estate and Gift Tax Exclusion Shrinks in 2026. What’s an Advisor to Do?, ThinkAdvisor.com, December 7, 2022, https://www.thinkadvisor.com/2022/12/07/the-estate-and-gift-tax-exclusion-shrinks-in-2026-whats-an-advisor-to-do/.

 

² Section 7520 Interest Rates, Internal Revenue Service, July 18, 2023, https://www.irs.gov/businesses/small-businesses-self-employed/section-7520-interest-rates.

 

³ Luke Harriman, Just What Is a “SLAT,” Anyway?, WealthManagement.com, October 27, 2020, https://www.wealthmanagement.com/high-net-worth/just-what-slat-anyway.

 

⁴ Michael Kitces, How the IDGT Strategy Turns Business Stock into a Bond for Estate Tax Purposes, October 12, 2016, https://www.kitces.com/blog/idgt-installment-sale-to-intentionally-defective-grantor-trust-rules/.

 

⁵ Paul Sundin, Intentionally Defective Grantor Trusts (IDGT): Top 3 Strategies, Estate CPA, June 26, 2021, https://estatecpa.com/intentionally-defective-grantor-trusts-idgt/.

 

⁶ See n. 4.

 

 

DISCLAIMER: The information provided in this piece should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.

 

ABOUT GOELZER: With over 50 years of experience and more than $2.7 billion in assets under advisement, Goelzer Investment Management is an investment advisory firm that leverages our proprietary investment and financial planning strategies to help successful families and institutions Dream, Invest, and Live.