Estate freezing and reduction strategies have been an increasingly relevant topic for high-net worth families as the countdown continues towards the sunset of the $13.61MM (double for married couples) estate tax exemption at the end of 2025.  You might recall that the estate tax is a flat 40% imposed on any amount over the lifetime exemption. Did you know that the generation skipping transfer tax (“GSTT”) levies another 40% tax, separate from and in addition to the estate tax? Even the most effective wealth transfer strategy designed to protect assets from estate taxation can be derailed if GSTT is left unaddressed – but much like the estate tax, the generation skipping transfer tax can be eliminated with the right plan in place. 

What is the Generation Skipping Transfer Tax?

As the name implies, GSTT was put in place to prevent families from dodging the estate tax by making gifts directly to their grandchildren or other descendants. Skipping the second generation would, in a perfect world, prevent an inheritance from being subject to estate taxation twice. GSTT was implemented to close this would-be loophole by acting as a backup to the estate tax. The GSTT is a flat tax equal to the maximum estate and gift tax rate of 40%. Consider GSTT as a separate tax system from the estate and gift tax, carrying its own separate exemption. The GSTT exemption is equal to the estate tax exemption of $13.61MM  – and like its estate tax counterpart, the GST tax exemption is scheduled to reduce by half at the end of 2025.

Consider a scenario where you’ve created a trust for the benefit of your descendants. When the trust was funded, you did not allocate your GSTT exemption and named your grandchildren as permissible beneficiaries. The trustee authorizes a distribution to your granddaughter to pay for college – and since GSTT exemption wasn’t allocated, that distribution is considered a taxable distribution to your granddaughter at a rate of 40%.

The bad news is that the GSTT doesn’t stop at your grandchildren. GSTT enters the equation when a transfer is made to someone defined in the tax code as a skip person. A skip person is anyone two or more generations below the transferor, most commonly a grandchild or great-grandchild, but it is not limited to family. A friend can also be a skip person if they are more than 37 ½ years younger than the transferor. A trust can even be treated as a skip person in specific circumstances, such as all beneficial interests being held by skip persons.

The good news is that the IRS has issued guidance that there will be no claw back of GST exemption for gifts made between 2018 and the 2025 sunset, which creates a unique opportunity to ensure this temporarily high exemption is properly utilized.

Anticipating the 2025 Sunset

Allocating your available exemption can protect certain transfers to your heirs from GSTT. There are various ways to utilize your exemption either during life or at death.

Allocation to a Trust

If GST exemption is allocated to a transfer to a trust, that exemption will shield not only the assets initially transferred, but also the future growth of those assets from GSTT.

Recall the example discussed above where a trust distribution to your granddaughter for college tuition is subject to 40% GSTT. In the same scenario, had you contributed $1 MM to the trust and allocated $1 MM of GST exemption, there would be no GSTT consequence to the amount distributed to your granddaughter. Further assume that the $1 MM you transferred to the trust grows to $10 MM. The trustee later makes a $5m distribution to your granddaughter to start a business. Because you allocated GST to the original transfer, the $5 MM distributed to your granddaughter does not trigger the taxable event that it otherwise would. The trust achieved $9 MM of GSTT-exempt growth for only $1 MM of exemption.

Correctly applying GSTT exemption to transfers to a trust can be both effective and complex. While there are automatic transfer rules that apply at death to act as a safeguard against unused exemption, those rules should not be relied upon alone to. Among many other caveats, one aspect that should be considered is the trust’s inclusion ratio which dictates how much of a trust can be subject to GSTT. Generally, it is desirable to have an inclusion ratio of either 0, meaning the trust is entirely exempt from GSTT, or 1, meaning the entire trust is subject to GSTT. It is critical to consult with a tax professional in conjunction with your estate attorney before any transfers are made to ensure the exemption is being correctly applied and confirm that any GSTT-exempt status of the trust is not inadvertently compromised.   

Reverse QTIP Election

Another way to apply GST is through a reverse QTIP (qualified terminable interest property) election. A notable trait of the GSTT exemption is that any portion left unused by a decedent does not pass to their surviving spouse, which the reverse QTIP helps remedy. A traditional QTIP election allows a decedent to leave assets to their spouse in trust under the unlimited marital deduction while controlling the final distribution of assets at the surviving spouse’s death. Since a normal QTIP election causes assets to be includable in the estate of the surviving spouse, the survivor is effectively the decedent for estate tax purposes. A surviving spouse could use their own GSTT exemption, but any GSTT exemption applied to the trust by the first decedent would be wasted because the survivor is now considered the transferor of assets. This is where the reverse QTIP election comes into play. This strategy would treat the surviving spouse as the original transferor for GSTT purposes, thereby allowing them to use their own GSTT exemption while keeping any exemption applied to the trust by the first spouse intact. Consultation with an estate tax professional is essential to property utilize this advanced strategy.

Take Action

The generation skipping transfer tax can apply across many circumstances beyond those discussed above. While GSTT is relatively straightforward, it quickly becomes complicated when unraveling the many ways the exemption can be used to curtail it. It is important to consult with an attorney and tax professional early in the estate planning process to discuss the various ways this tax could apply to you. Don’t allow this easily-overlooked tax to derail your wealth transfer plan.  

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Disclaimer

When creating an estate plan, many individuals contemplate their goals as limited to the transfer of wealth to family members, their charitable intentions, or succession planning for a closely-held business. Oftentimes these families work throughout their lives to reduce taxation at the individual level through meticulous tax planning, only for their heirs to be faced with a 40% reduction of their inheritance due to estate tax. While taxation at the individual level is impossible to entirely circumvent, the estate tax can be reduced or eliminated with some proactive planning. Estate tax mitigation should be top of mind for every high-net worth family before the federal lifetime exemption is reduced by half in tax year 2025.

Use it or Lose it

The 2022 federal lifetime gift and estate tax exemption is $12.92m per individual ($25.84m per married couple) and is scheduled to reduce by approximately half in 2025.  Accordingly, an individual taxpayer who dies this year with an estate worth 12.06m or less won’t be subject to any estate tax. Conversely, taxable estates in excess of the lifetime exemption are subject to estate tax at the flat rate of 40%. When the decrease in exemption occurs, known as the sunset, estate tax ramifications may be severe for those who do not utilize their lifetime exemption at its presently high level. Secure an efficient tax mitigation strategy for when – not if – the sunset arrives.      

Taxable Estate Reduction Strategies

Spousal Lifetime Access Trust

Usage of the Spousal Lifetime Access Trust (SLAT) has increased exponentially since 2017 when the Tax Cuts and Jobs Act (TCJA) doubled the lifetime estate tax exemption to what it is today. Many taxpayers want to reduce their taxable estate, but are hesitant to make an irrevocable gift in case they need access to those assets later in life. The SLAT allows an individual to use their lifetime exemption to make a tax-free, irrevocable gift to a trust for the benefit of their spouse. The assets gifted are permanently removed from the taxable estate, while still allowing backdoor access to the funds through the spouse. Married taxpayers who want to fully utilize their combined exemption may even create reciprocal SLATs. Each spouse would use the entirety of their exemption to create a trust for the benefit of the other. Under current law, over $25m of assets could be shielded from the estate tax system in this scenario. When drafted and executed properly, a SLAT is an effective method of transferring wealth tax-free to future generations. Among other caveats, a SLAT must be carefully executed to ensure one does not unintentionally disinherit themself from their own assets in the event of a divorce. It is important to consult with an estate attorney before making use of this compelling strategy.

Intentionally Defective Grantor Trust

The intentionally defective grantor trust (IDGT) allows an individual to make an irrevocable gift to a trust while continuing to pay income tax on the assets. An IDGT, when drafted as a grantor trust, is considered a disregarded tax entity. Therefore, the IRS does not differentiate between the individual taxpayer and the trust itself. The IDGT’s unique tax treatment allows the taxpayer to remove the trust from their estate while the assets remain taxable to them, thereby making it “defective” at the income tax level – but not at the estate tax level. This feature allows the assets to compound over time unencumbered by the comparatively higher trust tax brackets. An IDGT can also be used in conjunction with the succession plan of a family business. Similarly to gifting assets to the trust, one may gift business interests to grow tax-free outside of their taxable estate for eventual transfer to the next generation.   

 Irrevocable Life Insurance Trust

An irrevocable life insurance trust (ILIT) allows an individual to transfer ownership of an insurance policy to a trust to be held outside of the estate. Upon the death of the insured, the proceeds are paid to the trust for the benefit of the beneficiaries rather than being included in the insured’s taxable estate. The annual gift tax exclusion, not to be confused with the lifetime exemption, allows taxpayers to make tax-free gifts up to $16k (2022) per recipient each year. While lifetime additions to a trust would not generally fall under the annual gift tax exclusion, an exception to this rule is possible when drafted with the correct trust language. By including specific language allowing the beneficiaries the right to withdraw trust assets under limited scenarios, the insured can further reduce their taxable estate by making annual tax-free gifts to the trust under annual exclusion rules. These additions to the trust can be used to pay the premiums due on the insurance policy.  An ILIT is an especially unique estate planning tool because it allows estate tax to be avoided on assets passing to non-spouse beneficiaries even without the insured using their lifetime estate tax exemption to fund the trust. Individuals must work with a tax professional to avoid the pitfalls associated with this strategy, one such limitation being the “three-year rule.” If an individual does not live for a minimum of three years after the date of transferring an insurance policy to an ILIT, the policy will be included in their gross estate. Careful tax planning should be done to avoid inadvertently negating the benefits of this strategy.  

The Sunset is Imminent

The increased lifetime exemption set forth by the 2017 TCJA was never slated to be permanent. While much speculation has occurred in recent years on whether new legislation could cause the exemption to revert back to its pre-TCJA level early, the reduction will take effect in tax year 2025 as the law stands today. Families who may be impacted by the 2025 sunset should take action now to reduce the potential impact to their estate plan. Work with a legal professional today to discuss how to protect your family’s legacy from the inevitable – yet preventable – impact of estate taxation.

Important Disclosure Information

Please remember that past performance is no guarantee of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Waldron Private Wealth [“Waldron”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Waldron. Waldron is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Waldron’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request or at www.waldronprivatewealth.com.  Please Remember: If you are a Waldron client, please contact Waldron, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.  Unless, and until, you notify us, in writing, to the contrary, we shall continue to provide services as we do currently. Please Also Remember to advise us if you have not been receiving account statements (at least quarterly) from the account custodian.

Disclaimer

In recent months, investors have faced market volatility, depressed asset values, and rising interest rates. While unpleasant, these market conditions may present unique opportunities in the wealth planning arena. An intrafamily loan can be a useful tool for individuals who want to help a family member start a business or purchase a home without making an outright gift. This multipurpose strategy can even be used as part of a wealth transfer plan in conjunction with a trust.

WHAT IS AN INTRAFAMILY LOAN?

An intrafamily loan can be an effective tool to allow individuals to loan money to family members at a comparatively low rate without the loan being considered a gift. Highly attractive in a low interest rate environment, intrafamily loans may be especially timely given the potential for additional rate increases implemented by the Fed in the upcoming months.

INTRAFAMILY LOAN BENEFITS

Flexibility

Intrafamily loans often offer greater flexibility in contrast with their commercial counterparts. While the individual’s ability to repay the loan is important to ensure the loan is not deemed to be a gift by the IRS, the borrower does not need to have a perfect credit history or significant collateral. The loan can also be designed so the borrower has no limitations on how they may use the funds.

Loan repayment can be structured in virtually any way the lender chooses. An interest-only loan is an example of a repayment option that allows the borrower to pay interest annually and make a balloon payment at the end of the payment term. This may be especially attractive for those who would like to help their child start a business, but also allow the child adequate time to pay the loan off when the business is producing cashflow.

The lender has the ability to forgive all or part of the loan at any time. An important caveat of forgiving an intrafamily loan is that the forgone interest must be recognized as income by the lender. Notably, the loan must be structured so there could be no conclusion made by the IRS that the lender’s original intent was to forgive the borrower’s principal or interest payments. Among other considerations, the loan should be enforceable by the lender and loan forgiveness should be in their sole discretion.

Favorable Interest Rate

An intrafamily loan must charge a minimum interest rate in order to avoid being considered a gift for tax purposes. The interest rate must be greater than the Applicable Federal Rate, known as the AFR. The AFR, published monthly by the IRS, is the minimum interest rate allowed for private loans. The AFR rates include short-term (3 years or less), mid-term (3-9 year maturity), and long-term (9 years or longer). If the interest rate charged on an intrafamily loan is less than the AFR, the IRS can reclassify the loan as a gift and tax it as such. The AFR reached historic lows in recent years but has increased incrementally. It may be worthwhile for investors to consider the intrafamily loan strategy before further increase in the AFR.

ESTATE PLANNING USAGE

An intrafamily loan can be a useful estate planning tool. Rather than lending to a family member, one can instead loan funds to a trust. The same considerations for loan documentation and established repayment terms apply. In this method, a trust, commonly an Intentionally Defective Grantor Trust (IDGT), would first be funded with collateral. The loan would then be made to the trust in exchange for a promissory note. The assets would grow within the trust for the duration of the term and ultimately repay the loan. The remaining assets in the trust are shielded from estate tax and will pass according to the terms of the trust to the beneficiaries. An intrafamily loan to a trust may be a compelling wealth transfer strategy to reduce estate taxation while efficiently transferring assets to the next generation.

CAVEATS AND CONSIDERATIONS

While intrafamily loans carry many potential benefits, they must be structured carefully with the input of a tax or legal professional. Repayment documentation and establishment of a promissory note are among several critical steps to ensure the loan will not be reclassified as a taxable gift by the IRS. Should the lender choose to forgive all or part of the loan, the forgone interest will be taxable to them. Similarly, interest payments to the lender during the life of the loan will be considered taxable income.

Family dynamics must also be carefully considered. Intrafamily loans can be especially precarious in situations where the lender is dependent on the income stream from the loan payments if the borrower defaults on the loan. The cashflow needs of the lender and the likelihood of repayment must be taken into consideration. Of additional note is the potential for conflict within the family. A parent making an intrafamily loan to one child whose siblings may not need a loan or who have intentionally spent more conservatively can eventually lead to resentment towards the sibling or parents.

A VERSATILE PLANNING STRATEGY

Intrafamily loans have multiple purposes and can enable individuals to help family members accomplish goals which might otherwise prove difficult. The potential estate planning benefits can be highly appealing from a wealth transfer and tax mitigation standpoint. An improperly implemented intrafamily loan carries significant potential for adverse tax consequences. Careful tax planning must be done when executing this useful but complex strategy.

Disclaimer

Estate planning can be associated with topics we don’t like to think about – complicated family dynamics, the fear of becoming incapacitated, and the thought of our death. Estate plans don’t need to be complicated arrangements to serve an important purpose. In its simplest form, an effective estate plan ensures that your assets will pass to your chosen beneficiaries without undue cost or stress for the surviving family members upon your death. While there are many options to achieve this, a revocable trust is a versatile vehicle that can provide multiple benefits – even before you pass.

WHAT IS A REVOCABLE TRUST?

A revocable trust is a flexible document which can be used in conjunction with – or instead of – a will. An individual and their spouse can create individual trusts, a joint trust, or both. As the name implies, the terms can be changed or revoked at any time. The governing document outlines how any property held by the trust will pass upon death. As trust creator, or grantor, you retain full control over the assets during your lifetime. The trust then becomes irrevocable at your death and will distribute or remain in trust according to your wishes.

ADVANTAGES

Prevent Conservatorship

A revocable trust remains intact even in the event of your mental or physical incapacitation. The trust allows you to decide well in advance who would control your assets in the event of your incapacity. Absent this documentation, the court would instead name a conservator to make decisions on your behalf. This unfavorable position can be avoided by using a revocable trust to name a successor to seamlessly begin management of your financial affairs without any court intervention.

Avoid Probate

Unlike a will, a revocable trust does not undergo the probate process. Probate is the administrative court proceeding of carrying out the terms of a last will and testament. A personal representative is appointed and the distribution of assets is supervised by a judge. The process can be both lengthy and expensive. Since a revocable trust does not undergo probate, the assets are immediately available upon your death to pay administrative expenses and distribute according to the terms of the trust document.

Privacy

At death, a will becomes public record and is available to be viewed through the state court. Many families do not want outside parties, or even certain family members, to have the ability to learn the final disposition of their estate.  A revocable trust is not a public document and your assets will be distributed in private.

Flexibility

Among its other benefits, the revocable trust can also be used in conjunction with a will known as a pour-over will. A will of this type will simply direct remaining assets to “pour over” into your revocable trust at your death. A pour-over will allows for the same private distribution by the revocable trust’s terms for any assets that were not transferred to the trust during your lifetime.

WEALTH TRANSFER – SIMPLIFIED

A revocable trust affords the many benefits of a robust estate plan without its associated complexity or inflexibility. Consider an estate plan as a living, breathing entity that may need to change course alongside your shifting life circumstances. A revocable trust gives your estate plan the ability to change course at any time without the finality of an irrevocable wealth transfer arrangement.

Disclaimer