For taxable gifts made after 2017 and for estates of decedents dying after 2017, the exclusion from the U.S. gift and estate tax has been increased to $10 million (adjusted for inflation, $11.4 million in 2019).1 However, this increased exemption will expire at the end of 2025 when, commencing in 2026, the exclusion from the U.S. gift and estate tax will revert to the exemption that was in effect in 2017 (approximately $5 million, adjusted for inflation).2 In November 2018, the Internal Revenue Service issued proposed regulations addressing various concerns that professional advisors, including financial advisors, accountants and attorneys, had raised regarding the effect of the increase in the exemption from the U.S. gift and estate tax and its sunset.3 The clarity afforded professional advisors by reason of the IRS proposed regulations has caused many of us to consider how we might encourage our high-net-worth (HNW) clients to take advantage of the increase in the exemption from the U.S. gift and estate tax by making large taxable gifts now, well before the end of 2025.
We’ll start by analyzing the estimated value of a large taxable gift (that is, a gift having a value of $10 million) from an HNW client to his beneficiaries under various estate tax regimes, such as from a client residing in a state with no state gift or estate tax or from a client residing in a state with a gift and estate tax regime similar to that of New York’s. In addition, we’ll analyze the estimated benefit to the HNW client making the taxable gift to a trust that’s treated as a grantor trust for U.S. income tax purposes. Next, we’ll compute the estimated loss of benefit to the HNW client’s beneficiaries of waiting a year to make the taxable gift and the compounding of that loss over a period of 30 years. Finally, for HNW clients, we’ll compare the expected benefit of making a large taxable gift during life with the expected benefit of funding a credit shelter trust (CST) in the estate of the first spouse to die. In each case, we conclude that for an HNW client having the capacity to give, making a gift today adds significant wealth to his beneficiaries.
We’ll then move to identifying many of the issues a professional advisor must resolve when structuring the HNW client’s gift, including determining his gifting capacity, addressing the risk of over-gifting and planning with gifts of specific assets.
Assumptions
To undertake our quantitative analysis, we’ve made certain assumptions about the client’s net worth, expected rates of return and tax rates (including estate, capital gains and dividend tax rates). See “Key Assumptions,” p. 21.
Gift of $10 Million
For an HNW client residing in a state that doesn’t impose a gift or estate tax, a gift of $10 million, made today, produces a benefit of approximately $16 million (or $8.8 million adjusted for inflation) by 2049, 30 years from now.4 If the HNW client makes this gift to a trust that’s treated as a grantor trust for U.S. income tax purposes,5 the benefit of this gift increases to $26.5 million (or $14.6 million adjusted for inflation) by 2049.
If the HNW client resides in a state with a gift and estate tax regime similar to New York’s, the benefit of a $10 million gift today is $24 million (or $13.2 million adjusted for inflation) by 2049. Under this state gift and estate tax regime, if the HNW client makes this gift to a trust that’s treated as a grantor trust for U.S. income tax purposes, the benefit of the original gift of $10 million is approximately $38.7 million (or $21.3 million adjusted for inflation) by 2049.
Thus, for an HNW client with the capacity to use the incremental exemption through 2025, for every one dollar he gives, he may create almost four dollars in additional wealth for beneficiaries. (See “Benefit of $10 Million Gift,” p. 22.)
The Cost of Waiting
It’s human nature for clients to wait until just prior to a deadline to take action. (We all remember December 2012!) Therefore, it’s also important for the professional advisor to explain to his HNW client the disadvantage of waiting to make such a gift. As “One-Year Wait,” p. 23, illustrates, the cost of waiting one year to make the taxable gift will reduce its value to the client’s beneficiaries by between $1 million and $2.7 million over a 30-year period depending on the gift and estate tax regime in which the HNW client resides and the use of a grantor trust. That sounds unreasonable, but here’s how it happens. Suppose an HNW client makes a $10 million gift, and the assets given appreciate 7% in the next year. The appreciation creates an additional $700,000 that’s outside of the HNW client’s estate. Thereafter, the beneficiaries will receive the compound growth on that $700,000 for the next 30 years.
Furthermore, there’s always the possibility of a legislative change to federal gift and estate tax law prior to 2025. If the HNW client has the capacity to make a gift and desires to maximize the wealth transferred to beneficiaries, why wait?
$10 Million Gift vs. CST
Many married HNW clients would prefer to make their large taxable gift to a CST (created under their estate-planning documents) at the death of the first spouse to die. However, the expected benefit of making a large taxable gift during life compared to the expected benefit of funding a CST in the estate of the first spouse to die can be significant, especially if the death of the first spouse to die occurs after 2025 when the current law that increased the exemption from U.S. gift and estate tax to its current increased amount has sunset. The cost of waiting to use the exclusion at the death of the first spouse to die also can be high because, until the spouse’s death, the property that would have been the subject of the gift is appreciating in the spouse’s estate, and that appreciation will be subject to estate tax. Finally, for HNW clients residing in states that impose an estate tax but don’t impose a gift tax, that property, and the appreciation in its value until the death of the first spouse to die, remains subject to state estate taxation.
Armed with our quantitative analysis as set forth in the charts, the professional advisor may use the proverbial carrot (the estimated value to the beneficiaries) or stick (the estimated cost of waiting to make the gift) or a combination of both, to motivate his HNW client to make a large taxable gift prior to the sunset of the current increased exemption from the U.S. gift and estate tax.
Implementation
Not only should the professional advisor strongly encourage an HNW client to make a large taxable gift in the near term to take advantage of the temporary increase in the exemption from the U.S. estate and gift tax, but also he must properly structure those gifts to address the client’s concerns and achieve the client’s overall objectives. Below, we’ve identified the recurring issues applicable to most client circumstances and suggested ways to resolve those issues.
Determining gifting capacity: rules of thumb. The initial and most important issue for the HNW client is whether he has the financial capacity to make a large taxable gift. Put differently, after such a gift is made, will the client possess sufficient assets to fund the life he wishes to live? There are many ways to determine a client’s gifting capacity, but all of them include a robust analysis of the client’s anticipated spending and earnings. While each client’s situation is unique, several rules of thumb provide guidance on this issue.
Under today’s market conditions, a balanced stock and bond portfolio may have an expected annual rate of return of about 5%. If we assume that inflation is 2% (which has been the long-term average and is the current break-even inflation projected by inflation-linked Treasury bonds), then we can rewrite that rate of return as inflation + 3%. Thus, to endow a client’s lifestyle, grown with inflation, he can spend 3% of his initial capital and sustain that spending on an inflation-adjusted basis. If we invert 3% spending (1/.03), we get 33, meaning that a client should set aside capital equal to at least 33x his spending amount. Accordingly, a client who wants to endow a lifestyle spending $500,000 per year should set aside at least $16.5 million (33 x $500,000) for that purpose. The client should add to that amount a cushion for lifetime enhancements or charitable planning. Then, to the extent the client has significant additional capital beyond these guidelines, he may feel comfortable making an irrevocable gift of the excess capital. In the example used above, a client with $50 million and spending $500,000 per year likely has enough flexibility to make a $10 million (or $20 million for a married couple) gift.
Addressing risk of over-gifting. Many clients would prefer to hedge their bets by using structures for their taxable gifts that would enable them to benefit from, or have access to, the transferred property if, in the future, they have a compelling, but presently unanticipated, financial need.
Two structures address this client preference and minimize the financial risks of making large taxable gifts. Both of these structures involve gifts in trust. If the client is married, the client could make his large taxable gift in trust for the benefit of his spouse and other members of his family (such a trust is commonly referred to as a “spousal lifetime access trust” (SLAT)). If the client ever needed (or wanted) access to the property held in the SLAT, the trustee could distribute it to the client’s spouse. Such a distribution could be used by the beneficiary spouse to benefit the donor client, with minimal tax risk. Of course, for this structure to address the client’s need or desire for funds at the time it arises, the beneficiary spouse must be living and married to the client at such time.
Alternatively, the client could make a large taxable gift to a trust the governing instrument of which grants to an independent third-party trust protector the right to add one or more individuals as beneficiaries of the trust. If the client ever needed (or wanted) access to the property held in this trust, the trust protector could exercise the power to add the client’s spouse (or perhaps even the client) as a beneficiary of the trust. Thereafter, the trustee could distribute the property to the client’s spouse (or the client).
Both of these structures have a U.S. income tax consequence to the donor client: The SLAT trustee’s power to distribute trust property to the spouse of the donor client without the consent of an adverse party, and the independent third-party trust protector’s power to add beneficiaries to a trust, will cause the trust to be a grantor trust for U.S. income tax purposes.6 As a wholly owned grantor trust, the donor client must report on his U.S. income tax returns all items of income, deduction and credit arising from the trust property.7 As mentioned above, the economic outcome of a client making a large taxable gift to a grantor trust and, each year, paying the associated income tax liability, is significantly better than the economic outcome of a client making such a gift either outright to family members or to a non-grantor trust, where the family members or the trust would pay the tax on income earned by the transferred property. Accordingly, the client should view this income tax consequence favorably, and the professional advisor shouldn’t hesitate to recommend these structures to a client seeking to hedge his bets when making large taxable gifts.
Asset composition and subject of gift. As mentioned above, one factor in determining a client’s gifting capacity is his asset composition or the amount of the client’s overall wealth that’s composed of income-producing and liquid assets (such as a portfolio of marketable securities) versus non-income-producing and illiquid assets (such as personal residences, works of art or interests in closely held business entities). When a client wishes to retain his income-producing and liquid assets and give away the others as the subject of a large taxable gift, the professional advisor must address specific concerns of the client and the risks attendant thereto. The nature of the asset being gifted can dramatically affect the benefit that we’ve calculated in this article because income (or maintenance costs), timing of taxation of the income and the appreciation rate drive the financial analysis.
Risk associated with embedded capital gains. Assets that have significant embedded capital gains, irrespective of whether those assets are liquid or illiquid, may be better off staying in the client’s estate to benefit from the step-up in basis at the client’s death. In some cases, the 40% U.S. estate tax owed on death might be very close to the capital gains tax owed on an appreciated asset given away during life. For example, a California resident in the top tax bracket has a capital gains tax rate of 37.1% (20% federal capital gains tax + 3.8% Medicare surcharge + 13.3% state income tax), thus offsetting the U.S. estate tax savings if the beneficiary were to sell the asset.
Risk associated with continued use, enjoyment and control. In many instances, a client will want to continue using and enjoying the property he’s given away. This desire frequently is expressed by a client who’s giving a family vacation home or a work of art to members of his family. The client will want to use the vacation home or display the work of art in his home, notwithstanding the fact that, after completion of the transfer, the client will no longer own the vacation home or work of art.
The professional advisor must address the estate tax risk in these situations. The client’s continued use and enjoyment of the property that’s the subject of the client’s large taxable gift may cause the value of such property, at the client’s death, to be included in the client’s gross estate for U.S. estate tax purposes.8 In these circumstances, and to mitigate the estate tax risk, the professional advisor, at a minimum, should recommend that the client enter into a lease agreement with the new owners of the vacation home or work of art and pay fair market rent to them for the use of such property. The rent payments pursuant to the lease agreement have other benefits. First, they work to reduce further the HNW client’s taxable estate. Second, they provide the new owner with cash to pay the expenses of the property (such as insurance and maintenance expenses). In addition, if the donee of the gift is a grantor trust for U.S. income tax purposes, the donee needn’t recognize income or pay income tax on the rent payments it receives.
The professional advisor also must address this concern when his HNW client wishes to give interests in a closely held business. The HNW client’s retention of control over the transferred business interests (such as by retaining the right to vote the interests or continuing to serve as the manager of the business entity with the authority to direct distributions to entity members) at the client’s later death can cause the unintended inclusion of the value of those business interests in the client’s estate for U.S. estate tax purposes.9 Such an estate tax inclusion would eliminate the estate tax benefits of making the gift during the client’s lifetime.
Valuation risk associated with gift of certain assets. Another concern associated with a client using certain assets, such as interests in closely held business entities, as the subject of the large taxable gift is that the value of these illiquid assets for U.S. gift tax purposes often is determined by applying discounts for lack of control and lack of marketability. If the client and professional advisor fail to consider these discounts and the effect they have on the value of the interests being transferred, the portion of the business entity the client ultimately gives away could be too large. This risk is particularly acute when the client uses a defined value clause to make his gift of interests in a closely held business and needs to retain a specified portion of the business to maintain his cashflow and address other financial considerations. The following clause makes the point: “I give that number of shares of XYZ, Inc. having a value as close to but not exceeding $11.4 million, as finally determined by a qualified appraisal.” If the combined discount for lack of control and lack of marketability for the shares in XYZ, Inc. is 25%, then the client will have given away 33% more shares in XYZ, Inc. by reason of the combined discount than had that discount not been applied in determining the value of those shares.
Value in Acting Now
We all face the challenge of inertia. Estate planning is complex and cumbersome, and clients are hesitant to take action. However, for a client who has the capacity to make a large taxable gift, there’s tremendous value in taking action now. Every year, there are compound wealth transfer benefits from the growth of the client’s gift outside his estate. In addition, there are the potential incremental wealth transfer benefits of the client paying income taxes on the income earned by the assets given to a grantor trust. Finally, there are wealth transfer benefits to avoiding a state estate tax on the gift and subsequent appreciation. The client’s delay of just one year to make a $10 million gift may cost his beneficiaries at least $1 million in wealth. And, if the current federal gift and estate tax law sunsets in 2026 as scheduled, waiting could cost the client’s beneficiaries significant wealth. Furthermore, placing the right assets in an appropriate trust structure may create the flexibility needed to help make the client comfortable with making a large taxable gift.
Endnotes
1. See Tax Cuts and Jobs Act, Pub. L. No. 115-97.
2. Ibid. See also American Taxpayer Relief Act of 2012.
3. See REG 106706-18.
4. All scenarios are hypothetical results based on the assumptions in “Key Assumptions,” p. 21. These are for illustrative purposes only and not intended to portray an actual investment.
5. See generally Internal Revenue Code Sections 671 through 679.
6. See IRC Sections 677 and 674.
7. Supra note 3 and note 4.
8. See IRC Section 2036.
9. Ibid.