As most advisors are aware, the lifetime exemption from federal gift, estate and generation-skipping transfer tax will rise to $13.61 million in 2024. Practitioners should educate clients about the benefits of planning before the exemption is cut in half by operation of law in 2026, or earlier, depending on the outcome of the 2024 federal elections.
Wealth advisors, accountants and tax preparers must play a prominent role because they’re often in the best position to have the initial client conversations about planning and guide clients to reach out to their estate-planning attorney. Attorneys should discuss with clients the multiple benefits of planning now to achieve significant benefits. The following is an overview of some of the many reasons planning sooner rather than later may be advantageous.
Asset Protection
Clients are naturally concerned about risks to their assets from litigation as borne by grim statistics: “Nearly half of physicians 55 and older report having been sued compared with just 8 percent of doctors younger than 40;”1 and “. . . 50% of all civil lawsuits target small businesses annually. And 75% fear being targeted by a frivolous lawsuit.”2
To achieve asset protection, clients should consider:
Settling irrevocable trusts and making transfers to them before claims arise and perhaps before any particular claim is even anticipated.3 Assets transferred after a claim might be anticipated or, after a claim is known, may not be protected from the claimant.
Planning for creditors who may claim they’re entitled to assets from a trust if protecting assets had been a motivating factor for setting up or transferring assets to a trust, even when the claim was unknown at the time of the transfer. The looming change to the lifetime exemption may deflect a later challenge that the transfer was a fraudulent conveyance.4
Accomplishing asset protection transfers over time rather than all at once. By making annual gifts to a trust so that no one gift transfer is a very significant portion of the client’s net worth, each transfer might be less susceptible to attack as being a fraudulent conveyance. Any such “creeping” plan necessarily requires additional time to be fully effectuated.
Strategic Distributions
Non-grantor trusts pay federal income taxes on income earned at the highest tax rates for net income over $14,450 in 2023. The distributing non-grantor trust will realize a deduction up to distributable net income (DNI)5 distributed to the beneficiary who will pick up the income distributed. By making strategic distributions to beneficiaries in lower tax brackets, a trustee might be able to achieve income tax savings for the family as a whole.6
Before making distributions, the trustee should evaluate the risks:
Funds distributed to a beneficiary may be reached by that beneficiary’s creditors.
Certain government aid programs might disqualify a beneficiary who receives distributions from a trust.
When the trust has no accounting income, a distribution may not reduce the trust’s tax liability, particularly when the trust owns an interest in a pass-through entity. The trust’s tax advisor should calculate DNI and confirm the benefits of a distribution.
If any beneficiary is a foreign domiciliary, there could be foreign tax implications that may outweigh the U.S. tax benefits of making a distribution.
State Income Taxes
Carefully planned transfers to a non-grantor trust may also facilitate state income tax savings. A client living in a high tax state, such as California or New York, could form a trust in a low tax jurisdiction, like Nevada, Delaware or Alaska, to mitigate state income tax.
A settlor’s spouse might be a beneficiary of a non-grantor trust so long as the trust instrument requires spousal distributions to be approved in advance by an adverse party, defined as “any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust . . .”7 Thus, a trust might be able to hold assets that are exempt from high state income taxes but are still within the reach of the settlor’s spouse. Those state tax savings can be realized now. Why should the client defer such planning? If the trust is a completed gift non-grantor trust, pre-2026 planning now can add state tax savings.
Enhanced Charitable Deductions
Unlike individuals, trusts aren’t limited by percentage limitations when deducting charitable contributions. Under Internal Revenue Code Section 642(c), trusts can deduct gross income paid for a charitable purpose. Additionally, trusts can make an election to treat charitable contributions of gross income made during the taxable year as if made in the preceding taxable year. Properly planned charitable distributions from trusts can provide income tax advantages so long as:
The trust instrument requires that contributions are paid from income;
Charitable distributions aren’t made to discharge a legal obligation (for example, binding pledge) of the settlor (as in some trusts that might create an issue of estate inclusion); and
The charitable purpose is specified in the trust instrument. The Internal Revenue Service has taken the position that a charitable beneficiary can’t be added later through non-judicial modification or make any other change that isn’t in the original instrument.
Even when the trust instrument doesn’t satisfy the requirements to permit direct charitable contribution deductions, a trust may still be able to take charitable contribution deductions made by an underlying pass-through entity owned by the trust. This pre-2026 planning may provide immediate income tax benefits.
Basis Step-Up
Any completed gift trust, whether characterized as grantor or non-grantor, might give a senior family member with a modest estate a general power of appointment (GPOA) over a trust holding appreciated property.8 On the death of that senior family member, the basis of assets subject to the GPOA may be stepped up to the date-of-death value, creating an opportunity for substantial income tax savings. Creating the trust in advance can permit distributions from the trust to the elderly relative to support an argument that the power wasn’t a mere naked power with no economic substance to such relative’s interests in the trust.
A trust with such a GPOA should:
Prevent unintended use by the powerholder that would diminish the trust value;
Include automatic adjustment in case the exemption amount declines before the power holder dies.; and
Consider whether trust assets could be subject to the claims of the powerholder’s creditors. If the potential powerholder is a credit risk, it might be safer to grant the power to a different family member.
Step Transaction Doctrine
The step transaction doctrine gives advantage to planning earlier. In the simplest of terms, the IRS could apply the step transaction doctrine to collapse separate steps of a plan to create a devastating result for the client. The Tax Court decision in Smaldino v. Commissioner provides an illustrative and cautionary tale about how the step transaction doctrine might unravel an estate plan.9 In Smaldino, the husband gave his wife interests in a family limited liability company, which she purportedly transferred the next day to a trust benefiting the husband’s children from a prior marriage. The court found that it was really the husband that made the transfer to the trust and imposed a gift tax on the transfer.
Smaldino is perhaps an egregious bad facts example of how timing between steps might facilitate the IRS’ application of the step transaction doctrine to recharacterize transfers. However, it illustrates the point that timing can be a crucial factor in protecting the plan from creditor claims and IRS challenges.
When practitioners are working with a married couple interested in shifting assets between them to accomplish estate planning, the recipient spouse should:
Treat gifted funds as their own in many ways by reallocating investments, withdrawing funds and commingling funds with an old account of their own;
Engage their own investment advisor;
Invest a cash gift in a new investment portfolio;
Rather than re-gift the funds received from the donor spouse, have an independent analysis completed to determine how much to contribute to a trust for the donor spouse;
Allow several months to pass (the more the better, there’s no definitive time period that assures escape from the step transaction doctrine), possibly into a separate tax year, before making a gift of assets received; and
Adhere to legal and tax formalities. For example, when interests in a closely held business are transferred, the entity should have an amended operating or shareholder’s agreement confirming the new owner. The entity should issue a Schedule K-1 to the recipient spouse for the period of ownership.
The longer the time between each phase of a plan, the more likely that each planning step may stand independently on its own. Ideally, there should be some economic implications to each step of the plan. To the extent feasible, each step should be able to serve as the final step. There should be no requirement or even need to proceed to later steps.
Reciprocal Trust Doctrine
The reciprocal trust doctrine can “un-cross” two trusts, deemed to be too similar, such as spousal lifetime access trusts (SLATs). To prevent application of the reciprocal trust doctrine, practitioners often try to differentiate SLATs:
Create SLATs at different times, with different assets and trustees. That requires time, so encourage clients to start planning before the end of 2023;
Establish each SLAT in a different state. Consult local counsel;
In one trust, the beneficiary spouse can be entitled to distributions each year, have a lifetime broad special POA, can change trustees (within the Revenue Ruling 95-58 safe harbor)and withdraw under an ascertainable standard (for example, health, education, maintenance and support). In the other trust, the beneficiary spouse would have no entitlement to current distributions, no power to change trustees and no POA, but could become eligible to receive distributions only on exercise by an adult child with the power to add beneficiaries;
Give one spouse a noncumulative “5 and 5” power, but not the other; or
Give one spouse a special POA, but not the other, recognizing that the absence of a POA reduces the flexibility of the trust.
While it’s crucial for the spouses to be in a different economic position following the establishment of the SLATs, the practitioner should conduct a cash flow analysis to ensure that planning doesn’t excessively restrict either spouse’s access to assets.
Focused Planning
The exemption is high, and it probably won’t be reduced in 2023 or 2024. It may seem reasonable for clients to consider waiting to incur the costs and hassle of planning now if the game rules may be changed. However, members of a professional advisory team need to educate clients as to the advantages of more focused, deliberate planning over a longer period.
Endnotes
1. www.ama-assn.org/practice-management/sustainability/1-3-physicians-has-been-sued-age-55-1-2-hit-suit.
2. www.simplybusiness.com/simply-u/articles/2022/07/how-to-protect-your-small-business-from-lawsuits/.
3. See Yegiazaryan v. Smagin, 143 S. Ct. 645 (2023).
4. Jackson v. Calone, No. 2:16-cv-00891-TLN-KJN (E.D. Cal. Sept. 30, 2019).
5. Defined in Internal Revenue Code Section 643(a).
6. The deduction for a distribution of distributable net income is allowed under IRC Section 651 or 661.
7. IRC Section 672(a).
8. IRC Section 2041.
9. Smaldino v. Commissioner, T.C. Memo. 2021-127 (Nov. 10, 2021).