United States: How To Maximize The Increased Transfer Tax Exemptions

On December 22, 2017, President Trump signed into law the most sweeping changes to federal tax law in decades, including nearly doubling the basic exclusion amount (hereinafter referred to as the "exemption amount") for gift, estate, and generation skipping transfer (GST) tax for the next 8 years. To put it in dollar terms, the exemption amount increased from what would have been $5.6 million per person in 2018 before the law changed, to an estimated $11.18 million in 2018 ($22.36 million for married couples), adjusted for inflation. The increase is only available from January 1, 2018 through December 31, 2025, and, for the most part, taxpayers are in a use it or lose it window. As under the prior law, the unused federal estate and gift tax exemption, but not the unused GST tax exemption, can be "ported" to a surviving spouse, meaning if it is not used it is lost but only if one spouse dies before the exemption is set to revert to pre-2018 levels on January 1, 2026.

Grantor Trust Planning

For ultra-high net worth individuals, the increased exemption provides an obvious opportunity to top off prior gifting. For those with substantial assets, the increased gifting power when coupled with the power of leveraging and the use of "grantor trusts" can create explosive growth opportunities for multi-generational trusts. A "grantor trust" in this context is a trust created in a way that results in the grantor of the trust being considered the owner of trust assets for federal income tax purposes but not estate tax purposes. This means that the grantor must report, on his or her individual income tax return, all of the income, deductions, and credits of the trust, just as if trust assets were owned directly, and pay the associated tax on the trust's earnings. As a result, the trust grows effectively income tax free.

Once a grantor trust is funded with a gift, the equity can be leveraged by the grantor selling additional assets (or loaning money) to the trust in exchange for a promissory note. For example, with $22.36 million of equity, assuming a 9:1 debt to equity ratio, the trust could conceivably purchase up to $200 million worth of assets on credit. Neither the sale nor the interest payments on the note create taxable income because transactions between the grantor and a grantor trust are disregarded. Any growth above the interest rate is retained by the trust. With interest rates still reasonably low at 2.88% for a long term note issued in March 2018, the trust could grow exponentially if the assets perform well, and remember that the income and growth are tax free to the trust as the grantor picks up the tax liability, further reducing his or her estate and accelerating the growth of the trust.

There are few who can take advantage of the magnitude of planning described above. On the larger end of the spectrum are families who want to use their increased exemption and have the ability to do so, but are concerned about making a substantial gift of assets that they might need later in life. There is a natural tension of not wanting to lose the exemption (in theory paying millions in estate tax that could have been avoided) and having security and comfort late in life regardless of what the market does and what expenses arise including long-term health care needs. For those clients who are married, spousal lifetime access trusts (SLATs) are a good option. A SLAT is a trust that one spouse creates for the benefit of the other spouse and their descendants. With a SLAT, the beneficiary-spouse would be eligible to receive a distribution from the trust if an unexpected need did arise.

Using Exemption to Optimize Existing Trusts

The increased exemption amounts also present opportunities for individuals or married couples who do not have enough assets to fully utilize their gift, estate, and GST tax exemptions, but who are themselves grantors or beneficiaries of existing trusts. If such a trust (i) is not exempt from GST tax, (ii) is required to terminate earlier than would be permitted under current law, (iii) has low basis assets, or (iv) has provisions that are not sufficiently flexible for changing circumstance or are otherwise undesirable and cannot be easily changed, then the increased exemption may provide a chance to make that trust more tax efficient or optimal.

For those taxpayers who funded trusts without allocating their GST exemption, including trusts with an estate tax inclusion period that precluded GST allocation at the outset such as qualified personal residence trusts (QPRTs) or grantor retained annuity trusts (GRATs), there is still time to allocate GST exemption through a late allocation based on the current value.

There are also options to use a beneficiary's available exemption. The simplest approach is to distribute assets from the inefficient trust outright to the beneficiary who can use the funds to create a new GST exempt (perhaps perpetual, depending on the jurisdiction) trust for his or her descendants. If the beneficiary wants to continue to benefit from the assets, he or she could be given a testamentary general power of appointment ("GPOA") to use the beneficiary's exemption by causing the assets to be included in the beneficiary's estate for estate tax purposes, though this only works to use the increased exemption if the beneficiary dies prior to 2026. For beneficiaries with creditor concerns or where there are income tax considerations that suggest against making an outright distribution to a beneficiary or giving the beneficiary a GPOA, a third option is to affirmatively use the "Delaware tax trap" to trigger gift or estate tax inclusion through the use of a specially crafted limited power of appointment ("LPOA") without actually giving the beneficiary the trust property.

Higher transfer tax exemption amounts also provide an opportunity for income tax planning. If a beneficiary with exemption to spare is likely to die before the exemption reduces in 2026, a distribution or a testamentary GPOA specifically over the low basis assets could be used so that the assets are included in the beneficiary's estate for estate tax purposes to get a step up in basis to fair market value as of the beneficiary's death.

Integrate Trust Planning with Income Tax Planning

Trust planning can also be used to mitigate the loss the state and local tax (SALT) deduction. Because of unique rules applicable to where a trust is resident, it may be possible to structure a non-grantor trust (i.e. a trust that is responsible for its own tax liability) to avoid state and local income tax. The rules vary by state but in many cases, it is possible to have a trust that does not pay income tax in any state as a resident. State income tax planning with trusts should be considered for individuals as part of their gifting but also for beneficiaries of existing trusts or where there is an expected inheritance so that a trust can be structured with these rules in mind. For example, a New York City couple with well-off parents in Florida who would otherwise plan to invest an inheritance would be better off if the inheritance is left in trust because the income on the trust's investments would not be subject to New York City or State tax, a huge savings in all cases but especially with the loss of the SALT deduction.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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