(USA Today) - If former President Donald Trump's tax cuts expire as scheduled at the end of 2025, one of the most significant changes will be the reduction in federal estate and gift tax exemptions.
Under the Tax Cuts and Jobs Act of 2017, the exemptions were effectively doubled. The exemption in 2025 is $13.99 million per person, up from $13.61 million in 2024. These increased exemptions, however, are set to revert to about $7 million ($5 million when adjusted for inflation) after 2025 unless Congress extends the provision.
The Tax Policy Center estimates that just over 7,000 returns will pay estate taxes in 2024, while nearly triple that number (about 19,000 returns) will pay estate taxes when thresholds drop after 2025.
That’s not a large percentage of Americans, but many who are in that group are taking the time now to plan, experts said.
How much is at stake?
The estate tax rate ranges from 18% to 40%, depending on the amount above the exemption amount. For each tax tier, you pay a base tax charge and an additional marginal rate.
Some states also levy an estate tax, but exemption levels and the top tax rates are usually much lower than the federal government’s.
Is it too early to plan without knowing the election outcome?
“There’s no downside to doing planning now,” said Brian Large, partner at financial planning firm Lenox Advisors.
The tax cut act was the largest overhaul of the tax code in 30 years. It included widespread tax reductions for businesses and individuals that will expire at the end of 2025. With so many tax changes coming, many accountants, lawyers and financial planners are expecting to be booked, they said. Proper planning may require legal documents, moving large sums of money and more – all of which take time, they said.
“The next year and a half will be one hell of a ride for all of us,” said Miklos Ringbauer, founder of accounting and tax strategy firm MiklosCPA. “Every taxpayer should be proactive (about) what’s going to happen.”
How are wealthy people using trusts before TCJA expires?
The wealthy are maxing out the higher gift and estate exemption limits with substantial gifts to heirs and trusts to help reduce the size of their estate and minimize potential tax liabilities.
Irrevocable trust assets aren’t counted in your estate, but you lose control over them. The best way to use them is to fund them with appreciable assets. That way, you’re passing on the initial asset and all the additional gains tax-free.
There are different types of irrevocable trusts, including:
Grantor-Retained Annuity Trust (GRAT) which allows the grantor, or person who sets up the trust, to receive an annuity, or regular fixed payments over a specified period and pay taxes on income generated by the trust. The annuity, based on a percentage of the trust asset plus interest, can attract older adults looking for steady income. At the end of the term, the beneficiary keeps the remaining assets in the trust tax-free.
GRATs usually hold high-yielding or appreciating assets because ideally they’ll outperform the IRS's Section 7520 rate, or hurdle rate − which is the minimum rate the investment is expected to return. The beneficiary receives any appreciation above the hurdle rate tax-free at the end of the GRAT’s term. In October, that rate was 4.4%, the lowest since June 2023, and it probably will continue to fall as the Federal Reserve continues to lower interest rates, advisers said.
In that case, people can set up rolling short-term GRATs with their annuity payments, said Karen Fierro, tax partner at advisory firm Wiss.
“It has the advantage that the principal remains in the trust for a longer period of time (for growth) but not in the same trust,” she said. Plus, you can capture the expected decline in interest rates. Each Fed rate cut likely means a lower hurdle rate, or larger appreciation to pass on tax-free.
If the GRAT doesn’t outperform the hurdle rate, the GRAT fails, and the asset is returned to the grantor, so there’s little downside. If the grantor passes before the GRAT ends, the assets return to the estate and may get taxed.
Spousal Lifetime Access Trust (SLAT) allows spouses to separate some of their assets and “gift” them to each other in irrevocable trusts to remove them from their estate. Basically, a spouse gifts cash, life insurance, marketable securities, real estate or other assets of which they are the sole owner to a SLAT and pays taxes on the trust’s income. The beneficiary spouse can request distributions from the SLAT to live on, and when the beneficiary spouse dies, the SLAT terminates. Remaining beneficiaries receive the remaining assets at termination tax-free.
What are some non-trust strategies?
Intra-family loans can be used to transfer wealth between generations without tapping into the lifetime gift exemption. The loan can be used to buy a house or fund a business that’s expected to be profitable, for example, and can be made with more flexible terms and a better rate than can be had commercially, Fierro said.
Intra-family loan rates are determined by the IRS's applicable federal rates (AFR) for various loan lengths. November AFR was 3.64% for a 3-to 9-year loan, compared with 5% or more for a commercial loan depending on credit worthiness and other factors. If rates continue to fall, as expected, intra-family loans can be refinanced, too.
Because you’re getting repaid with interest, you’re not shrinking your estate for taxes. Instead, you’re transferring a portion of the growth on the loaned funds to the borrower without using any estate tax exemption. The lower the interest rate on the loan, the better chances the asset will grow more than the interest, Fierro said.
- Example: A parent loans their child a 12-year interest-only loan of $1 million at a 2.25% AFR. The child invests in appreciating assets, producing a 10% after-tax return. At the end of year 12, the child’s investment has grown to $3,138,428, and the amount due on the loan is $1,306,050. The remaining $1,832,378 is a tax-free transfer of wealth to the next generation.
Gifting nonpublicly traded assets takes advantage of potential valuation discounts and growth. By giving away an asset for which it's difficult to assess the “fair market value," the law allows it to be valued at a discount to account for factors like lack of marketability, no ready market to sell it, or lack of control because it’s a nonvoting or noncontrolling stake in some entity. Discounts can range between 10% and 50%, but the asset needs to be professionally appraised.
People can combine this with a trust to gain even more benefits, some experts said.
Could politicians just extend the tax cuts?
Yes, but it may not be easy.
Trump has promised to keep most of the tax cuts, including the estate tax. Vice President Kamala Harris has vowed to raise taxes on high net wealth people but hasn’t specifically discussed estate taxes.
Complicating matters: Congress needs to pass tax legislation, and who will control Congress is anyone’s guess, experts said.
By Medora Lee
October 24, 2024
