When it comes to gifting assets to rising generations, many families of wealth are rightfully concerned about the potential tax impact. How and when should they pass down wealth to ensure that the greatest amount possible gets transferred to their heirs? Here are some underused and often misunderstood strategies for gifting assets and potentially reducing the tax consequences.
Outright Gifts and Transfers
Gifting assets can be tax-free up to a certain point. As of 2019, that amount is $11.4 million for an individual or $22.8 million for a married couple. These thresholds are available to make gifts to rising generations (either outright or through a trust), and many families can make these gifts without the need for more-complicated strategies.
However, the challenge with this option is choosing the appropriate asset to gift—ideally an asset likely to increase in value after transferring. For example, with a pre-initial public offering (IPO), stock is typically priced lower before the IPO and can rise following the IPO. That type of gift potentially provides benefits to both the person giving (that is, lower taxes today and the potential removal from a taxable estate), as well as the individual receiving (that is, an asset potentially increasing in value over time). Given the high exemption amounts today, outright gifts can be an attractive, simple and effective method for moving assets to beneficiaries.
Estate and Gift Taxes: Now or Later?
The current estate and gift tax rates are some of the most advantageous in history for families of wealth. To add some perspective, the highest marginal rates for estate and gift taxes were 77% (roughly between 1941-1976) and 70% (roughly between 1977-1981). Today’s highest marginal rate for both estate and gift taxes is a mere 40% by comparison. Of course, wealth transfer is enhanced when taxed at the lowest possible rate. There are compelling circumstances in which gifting assets today could avoid substantial estate taxes in the future that would otherwise reduce the amount of wealth a family wants to pass down to the next generation. Namely, the confluence of several circumstances that exist today—a relatively low rate for the gift tax, an all-time high on the lifetime exemption amount and the possibility that the rate may increase and the exemption amount could decline—causes many wealthy families to seriously consider making outright gifts now.
Another factor to consider is that the gift tax is “tax exclusive,” meaning the funds used to pay the tax aren’t subject to the tax. However, the same isn’t true for estate tax, which is “tax inclusive,” meaning the funds used to pay the tax are subject to the estate tax.
Net Gifts and Bargain Sales
A net gift is a gift of assets given under the condition that the individual receiving the gift pays the applicable gift tax. It’s called a “net gift” because the final amount received is equal to the value of the asset transferred, minus the amount the recipient agrees to pay in gift tax.
The individual making the gift is ultimately responsible for paying the gift tax. As a result, the recipient reimburses the individual making the gift, which is why it’s sometimes referred to as a “bargain sale.” This strategy can be helpful when a large gift is contemplated but the one giving lacks the liquidity to pay the tax or is unwilling to pay the tax.
It’s important to note that the beneficiary of a gift will receive the same tax basis in the asset as the person giving the gift. That is, gifting an appreciated asset creates an income tax liability for the recipient that may be recognized if the recipient later sells or transfers the asset. Regardless, net gifts or bargain sales can be more tax efficient in certain scenarios, such as when a donor lacks liquidity to pay the applicable gift tax and/or the beneficiary is willing to pay the tax for the benefit of receiving the asset and its potential future appreciation.
Paying Income Taxes on Behalf of Beneficiaries
Grantor trusts are a core component of many estate planning strategies. Grantor retained annuity trusts, intentionally defective grantor trusts and spousal limited access trusts are a few examples of grantor trusts. A grantor trust is considered a “disregarded entity” for income tax purposes, which means that any taxable income or tax deduction produced by the trust is taxable and reportable on the grantor’s tax return. In contrast, when a grantor makes a transfer of assets to an irrevocable trust, that trust is held outside the grantor’s taxable estate.
These trust structures can provide a grantor with a powerful method to move wealth to the next generation tax efficiently. For example, a grantor can sell assets to a grantor trust and not recognize any capital gains on the transfer. A grantor can loan money to the grantor trust and not incur any taxable interest (however, the trust must pay the grantor at least a minimum interest rate on the debt). Finally, a grantor trust’s income tax, paid by the grantor, isn’t considered an additional gift to the grantor trust.
Effectively, grantor trust assets may increase in value without the trust having to pay income tax. Instead, that’s paid by the grantor. Essentially, the grantor is able to make a tax-free gift to the grantor trust and thereby to the trust beneficiaries.
Valuation Considerations
All gifts involving assets require a determination of the value of the gift, and taxes are based on that valuation. However, there are strategies to influence valuations that can benefit families of wealth.
For example, if there’s real estate to be transferred, a family can move the real estate into a family limited partnership and then transfer the partnership interests to the rising generation. This technique allows the value of what’s transferred (in this case, the partnership interests) to potentially receive valuation discounts.
A valuation discount strategy can also be applied to minority interests in closely held businesses, fractional interests in real estate, interests in private equity funds or other investment entities, and even interests in family-owned investment entities.
Given how effective valuation discounts can be at enhancing gifting strategies, great care and consideration should be provided in how these principles affect transfers to the rising generation.
Tony McEahern is a senior managing director/head of wealth strategy at Cresset in Chicago.