There are three key aspects to estate planning. First, your objectives for your assets and legacy at your passing need to be documented appropriately. Second, the titling and beneficiary designations of all of your assets need to be correct to ensure efficient administration of your estate and avoidance of the hassle, time delays and costs of probate Third, attention needs to be given to make sure that the estate planning is tax efficient and results in zero or minimal tax for both federal and state purposes.
Currently, most estates are not subject to any estate tax, because the current lifetime estate and gift tax exemption of $11.58 million means a couple with $23 million or less of assets has no federal estate tax. And, only 15 states, including Illinois, and D.C. currently assess a state estate tax. However, this may change.
The current federal exemption is scheduled to be cut in half on January 1, 2026. And, if there’s a change in the White House this November, estate and gift tax exemptions could be reduced or repealed and the current 40% estate tax rate increased.
It’s critically important for many people to look at their assets, both now and when they might pass, and reevaluate the question: “Could estate taxes be in your future?” If so, strategic planning and implementation in 2020 could potentially save millions of estate tax dollars for your family in the future.
For example, let’s look at a widow with a current estate of $10 million dollars which currently results in no federal estate tax. However, if the exemption was reduced to $2 million in 2021 and the tax rate remained at 40%, the federal estate tax would be $3.2 million. If that hypothetical estate was growing because the projected earnings and retirement income exceeded future expenses and income taxes, then the estate and tax could be larger. For example, a hypothetical annual net increase of 2% in the assets would produce an estate in 25 years of $16.4 million and a tax of $5.7 million, using a $2 million exemption and a 40% tax rate.
Fortunately, there are a number of strategies and techniques that estate attorneys, CPAs and wealth managers know that you can use to help reduce that tax. The general concept is to make transfers now that will freeze or diminish the value of certain assets over time and, at the same time, transfer a portion of current assets to vehicles that will grow for the benefit of beneficiaries and not be part of the eventual estate.
Today, let’s look at two very important techniques that are used to accomplish this. First let’s look at the irrevocable trust. An irrevocable trust is a type of trust which cannot be modified, amended or terminated without the permission of the grantor’s beneficiaries. Once the trust is established, the grantor transfers all ownership of certain assets into the trust and legally removes all of her or his rights of ownership to those assets. This removes those assets along with any future appreciation of those assets from the grantor’s estate and also provides creditor protection relative to claims against the grantor.
The transfer of assets to the irrevocable trust is often done as a gift, using some of the grantor’s lifetime exemption. Assets held in the trust typically include business interests, investment assets, cash, or life insurance policies.
So let’s go back to our example of the widow with $10 million that might live for another 25 years. Let’s say this individual establishes an irrevocable trust for the benefit of her only child and makes a $4 million gift to the trust. The gift, minus the annual exclusion amount, will count as a gift towards the current $11.58 million estate and gift exemption. Income taxes will be paid by the irrevocable trust or the beneficiary on the income of the irrevocable trust. Let’s say that, after tax, the irrevocable trust earns 4% per year. In 25 years, the value of the irrevocable trust would be $10.7 million. The grantor’s remaining assets of $6 million, will have diminished slightly to $5.7 million. There will be no estate tax on the assets in the irrevocable trust. The grantor’s estate, assuming a $2 million exemption and 40% estate tax, would be subject to a $1.5 million federal estate tax, a savings of over $4 million in estate tax without this strategy.
Now, let’s look at a second example, a Limited Liability Company or LLC. The LLC needs to provide for two classes of ownership; one, a general or preferred class which has control and, two, a limited class, without control. This allows the grantor to give assets to the LLC which will be classified as partly general units and partly limited units, let’s say 2% general and 98% limited. The next step is that the grantor may also establish an “intentionally defective grantor trust” (“IDGT”). An IDGT is called “defective” because the earnings of the IDGT are taxed to the grantor, thereby further reducing the grantor’s estate. The grantor now gifts or sells all or some of the Limited units in the LLC to the IDGT. Similar to our earlier example, the grantor gifts the 98% LP units of $4 million LLC to the IDGT. That would be a $3.9 million gift. Because the limited partners do not have control of these units and because the units are not marketable, the grantor does not have to use the full $3.9 million as a gift. There are discounts which might reduce the value of the gift. A 25% reduction, for example, would reduce a $3.9 million transfer to a $2.9 million taxable gift. Furthermore, because the owner of these LP units is an IDGT, the grantor pays the income tax on the earnings of the IDGT. This might increase the return on the IDGT to 5%, assuming a 20% income tax. If so, the $3.9 million IDGT, with the sole child as beneficiary, could grow to $13 million in 25 years. The grantor, because she has paid taxes on all of the income in the LLC, including the LP units has a lower estate now of $3 million. Hypothetically, the estate tax would be $400,000, using the 40% tax rate and $2 million exemption in 25 years. A savings of over $5 million in estate taxes.
The LLC coupled with an IDGT allowed the grantor to pay all income taxes which increased the growth of the transferred assets and reduced the grantor’s retained assets and estate taxes. In addition, the LLC allowed the grantor to retain control of the 2% general partner units during her lifetime.
There are many other techniques used to reduce estate taxes in addition to irrevocable trusts and LLCs and IDGTs. it’s important to look at all of the possible techniques with your estate attorney, your CPA and your wealth manager to determine which strategy or strategies are most appropriate and what would be the best plan of implementation. And, then, get it done.
There’s no time like the present to look at this planning and do things in 2020 that can help you in the future. That’s an additional advantage for some brought on by COVID-19. There has been a significant decrease in certain assets and current interest rates are low. This helps with minimizing valuations and, in the case of leveraged sales, smaller installment payments required by an IDGT. At DWM, we’ve been collaborating with estate attorneys and CPAs for decades in the design and implementation of plans to reduce estate taxes. If estate taxes are in your future, there could be great savings ahead for you and your family if you take action in 2020. Give us a call.