The Family Estate Tax Reduction Strategy

Incredible Result: “We haven’t built all of this for Uncle Sam to take away or to deplete.”

Avoidable Train Wreck: Estate tax hit.

Main Play: The Estate Tax Reduction Strategy

What This Is:You have achieved control over potential government impact by reducing your projected estate taxes (or by pre-funding with life insurance) and assuring your Company does not need to be sold, liquidated or compromised in order to help your family pay your estate taxes.
 

 

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The role of Federal Estate Tax in family businesses has changed significantly over the past few decades. With the “permanent” increase in the Estate Tax lifetime exemption effective in 2012, and the “temporary” doubling in the exemption effective in 2018, the number of small family businesses impacted by the Estate Tax has been reduced. However, this tax remains in play for many family businesses under present law (all of which is dependent on future tax law developments).

The Estate Tax Reduction Strategy

Under the Federal Estate Tax law as it presently exists, you are subject to this tax if you die with an estate worth more than the sum of your marital deduction (if applicable) and your lifetime exemption. Under the Tax Cuts and Jobs Act of 2017, the Estate Tax lifetime exemption is presently about $14,000,000 (and is indexed to increase with inflation). This reverts back to $7,000,000 in 2026 (adjusted for inflation).

You have a taxable estate if the value of your Estate (less your marital deduction) exceeds your lifetime exemption amount.

Depending on the State in which you live or have assets, either or both a State Estate Tax and Inheritance Tax can also apply.

The following are some of the tools which Family Business Pioneers are using to reduce or eliminate their Federal Estate Taxes. These are based on specific provisions which have been established in the law to enable taxpayers to plan their affairs in a legal manner for reducing the estate taxes which would otherwise be due from their families.

• Annual exemption gifts. The present Estate Tax laws permit you to make gifts of up to $19,000 to as many persons as you would like free of federal gift tax. This is an annual exemption which is available to both spouses. It is typically used for annual exemption gifting to children, grandchildren, and/or children’s spouses. These gifts can include shares in your business or other investment assets. A gifting program should never be started until you’ve determined the coverage of your and your spouse’s lifetime needs.

•  Gifting Vehicle. Often, a parent or grandparent would prefer not to make their gifts directly to their children or grandchildren in the form of cash. A common technique to address this objective is to create a family limited partnership or a family limited liability company. These types of techniques can also be viewed as creating a bucket, into which you place a certain amount of cash or other investment assets. Then, just like giving shares of your Company, you can gift shares of ownership interest in the bucket to your children, grandchildren, and/or children’s spouses. Under this arrangement, you or certain family members might or might not retain some portion of the ownership.

Other Estate Tax reduction vehicles to be considered may include the grantor retained interest trust (known as a GRAT, GRUT or QPRT), the grantor trust (sometimes technically referred to as the “intentionally defective” grantor trust or IDGT), or a generation skipping trust. Details of these techniques are beyond the scope of our discussion and can be addressed further in the Fourth Quarter Planning process.

•  Lifetime Exemption Gifting. You can during your lifetime deploy up to $14,000,000 of your lifetime exemption to avoid payment of the gift tax, should you wish to gift more than the $19,000 annual exemption amounts. This can be done, for example, if you wish to have a means to move future growth out of your taxable estate. For example, if you owned an asset which today is worth $1 million, but which on the date of your death had grown to $2 million, then you would need $2 million of your lifetime exemption to avoid paying estate taxes on that portion of your estate. If instead, you gifted that asset today, using $1 million of your $14,000,000 lifetime amount, then the asset (and the future growth) has been removed from your estate using only $1 million of your lifetime exemption amount. The family limited partnership or the family limited liability company can be utilized for this type of lifetime exemption gifting as well. Note, however, that the tax basis of a gifted asset would not be “stepped up” to fair market value on your death, so this Estate Tax savings could be offset somewhat by an income tax cost.

•  Life Insurance Trust. If your combined estates (husband and wife) are presently valued at over your lifetime Estate Tax exemptions (including the value of your life insurance), then a commonly used Estate Tax reduction technique is the life insurance trust. This is a powerful Estate Tax planning technique for the following reason. Let’s assume, for example, that you and your spouse have estates consisting of at least $28 million in investment and business assets, along with $1.5 million in life insurance. This life insurance would be valued (and subjected to the 40% Estate Tax) at the full face amount of $1.5 million upon your death. However, during your lifetime, it’s valuation is relatively small (basically equal to the unearned portion of your last premium payment and any cash value).

Except where this has been designed to provide yourself with retirement benefits, this life insurance (designed in collaboration with a professional Insurance Advisor) is in place in order to provide funds for a spouse and for surviving minor or young adult children or for certain business purposes. Therefore, for that reason, it can be an ideal asset to gift to your children, since they will be the ultimate recipients of the proceeds anyway. It is particularly ideal because its present gift tax value is, as previously stated, extremely low in comparison to its future Estate Tax value, because the Estate Tax value literally blossoms into existence upon your death. Therefore, it is an asset which you can easily gift, typically using your annual exemptions (and/or part of your lifetime exemption).

Since, however, you may not wish to have the life insurance proceeds immediately available to your children upon your death, a trust can be used to hold the proceeds until that point in their lives at which you would like the proceeds to be distributed. A trustee can be appointed to make distributions as needed for their living, education, and health-related expenses. In addition, provisions can be included which provide that the funds can be used for your surviving spouse as needed for your surviving spouse’s support (without pulling the life insurance proceeds into your surviving spouse’s taxable estate). Since this technique constitutes a gift of an asset out of your taxable estate, the estate rules for “completed gifts” need to be met. For this reason, your gifting of life insurance into a trust typically needs to be an “irrevocable trust” which provides that you cannot revoke the gift at a later date.

•  Discount Planning. When you own less than a controlling percentage of a Company, the Estate Tax value is based on a discounted value method. In other words, if you own 49%, the value isn’t 49% of the whole. It is less, because the Estate Tax law recognizes that the market for a minority share should be discounted. This enables us to align family ownership between spouses, children and trusts to reduce Estate Taxes even if the family as a whole owns 100%.