Uncle Sam: Your Business Partner in Estate Tax Planning
Learn tax strategies for transferring wealth to descendants smoothly and efficiently. Generating substantial wealth has always been challenging, full of risk and a good measure of luck, but for the few who accomplish it, a gauntlet awaits.
The US estate tax rules exact a heavy toll when passing wealth to children and future generations. The federal estate tax currently sits at 40 percent, which is actually a bargain considering it has been as high as 77 percent in the past. The tax applies to worldwide assets above your lifetime exemption, currently set at $12.9 million or more per person. That means a married couple can pass nearly $26 million without paying any federal estate tax, though that exemption is scheduled to be reduced by roughly half in 2025. Each additional dollar above the exemption costs forty cents in gift and estate tax. For a family with $100 million in assets, without proper planning, roughly $30 million goes directly to federal estate tax. On top of that, some states impose their own estate taxes as well.
When you factor in income tax, capital gains tax, and estate tax together, families with significant wealth may end up paying as much as 70 percent or more of their wealth to Uncle Sam, making him effectively your largest business partner. It is essential to have a well thought out plan in place to minimize the impact of these taxes.
There are several strategies worth considering, broadly categorized as time focused versus value focused.
Time Focused Tax Strategies
Using your lifetime exemption early allows family assets to grow over an extended period outside your taxable estate. Typically, these assets are transferred into a protected vehicle, such as a Generation Skipping Trust. This specialized trust allows you to transfer assets to your children and grandchildren, and sometimes future generations beyond that, while skipping the estate tax each time assets pass to the next generation. You not only avoid the 40 percent estate tax on the trust assets, regardless of their value at your death, but your children also avoid estate tax when those trust assets eventually pass to their own kids, and so on. When properly structured, assets held in a Generation Skipping Trust can grow estate tax free for the benefit of many future generations.
You also have the ability to make an annual gift of up to $17,000 to as many people as you like without triggering any gift tax, or $34,000 for a married couple. Over time, these annual gifts can accumulate impressively for family members through a vehicle known as an annual exclusion trust, or Crummey trust, named after the taxpayer who first pioneered the technique. Imagine gifting $34,000 annually for twenty years to five children and grandchildren. That adds up to $3.4 million, without accounting for compounding or any increase in the annual exclusion over time. At the current 40 percent estate and gift tax rate, that represents a tax savings of $1.36 million. This technique can be further enhanced by purchasing a life insurance policy on yourself inside the Crummey trust. Insurance proceeds are not subject to income tax, capital gains tax, or estate tax. In cases I’ve worked on, the tax adjusted death benefit can end up being ten to fifteen times the total premiums paid. This is a technique wealthy families should seriously consider.
Value Focused Tax Strategies
Some value focused techniques involve passing assets that qualify for valuation discounts due to elected restrictions like lack of control or lack of liquidity. For example, a $50 million business held within a Family Limited Partnership or Family Limited Liability Company can sometimes carry heavy restrictions on control and liquidity. These restrictions can drive down the value of interests in the business, thereby lowering the value used for gift and estate tax purposes. Family run businesses are often particularly well suited for this technique. A patriarch or matriarch can choose to gift a portion of the business into a well designed trust for the benefit of children and future generations. Attorneys and valuation specialists can help craft these complex structures and generate significant estate tax savings.
Why the Right Guidance Makes All the Difference
Other value focused strategies work by transferring assets out of your estate that carry a relatively low current value but strong appreciation potential. A common vehicle for this approach is the Grantor Retained Annuity Trust, or GRAT, which allows you to shift the future growth of assets to your children in trust while retaining the original value for yourself. Success depends on outperforming a government assumed rate of appreciation, currently 4.4 percent at the time of writing. Any appreciation beyond that rate passes to your children free of estate and gift tax, while the original value of the asset is returned to you in annual installments, along with the government assumed rate of return. In a volatile market, this may be one of the most effective tools available in a family’s planning arsenal. If assets appreciate faster than the government assumed rate, the GRAT succeeds and that appreciation passes to the children. If the assets depreciate or fail to beat the rate, the GRAT technically fails, but the only real consequence is that the assets simply return to you, allowing you to try again. We’ve recommended and administered dozens of GRATs, collectively passing hundreds of millions of dollars into trusts for the next generation. In the right hands, this technique carries remarkably little downside.
There are many more strategies that take advantage of time and value, some designed to freeze an estate so that all future appreciation passes directly to beneficiaries, and others built around specific assets like personal residences. But nearly all of them play with either time, value, or both.
Conclusion
Using these strategies to transfer wealth effectively to future generations can be complex and challenging. It is essential to work with a team of qualified financial advisors, estate attorneys, and tax planners to evaluate the full extent of your tax liability and implement a tailored plan. An ultimately successful strategy will likely draw on several techniques together, since no single approach can accomplish the whole task on its own. But with the right team and consistent effort, much of the tax expense involved can be meaningfully mitigated.
I’ve often counseled clients to differentiate between net worth and net keep, since it’s not what you make that ultimately matters, it’s what you keep.
Ash Chopra, CPWA, is the CEO of San Francisco based Syon Capital, LLC, a wealth management firm that advises a select number of families, executives, and entrepreneurs. The firm specializes in building thoughtfully curated, holistic financial strategies designed to help optimize clients’ capital and enhance both their lives and their legacies.
