Estate Tax Planning for Large Company Stock Holdings: Four Tips for Using Record-High Lifetime Exemptions

September 23, 2020 Articles

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Key Points

  1. Annual inflation-indexing continues to increase the historically high lifetime exemption amount for gift, estate, and generation-skipping transfer taxes. Those of considerable wealth who have not yet made gifts, such as company shares, may wish to think about lifetime gift strategies to execute this year.
  2. By making gifts of company shares in trust you can retain some degree of control over the gifted assets and allow for flexibility to adapt to changed circumstances.
  3. Give assets that will remain in the family. Consider selling assets to a grantor trust for a promissory note, which may be forgiven. However, do not make gifts beyond your comfort zone.

Due to annual inflation-indexing, the historically high lifetime exemption amount for gift, estate, and generation-skipping transfer taxes increased in 2020 from $11.4 million to $11.58 million per person ($23.16 million for married couples). Individuals who had used up their lifetime exemption as of last year may choose to make "topping up" gifts of $180,000 ($360,000 for married couples).

Those of considerable means who have not yet made gifts, including company shares, to use their lifetime exemption may wish to think about lifetime gift strategies to execute this year. We are in a low-interest-rate environment and starting to see lower valuations of private and public company stock, both of which magnify the benefit of the available wealth transfer tools.

In addition, by making gifts now, a person can lock in the current amount of the exemption, which may shrink in 2026 or sooner under new law, perhaps depending on the results of the 2020 general election. Treasury regulations issued last year confirm that gifts made on or before December 31, 2025 will not be “clawed back” into a person’s taxable estate at death, regardless of whether the lifetime exemption amount subsequently decreases. Absent new legislation, the lifetime exemption will revert to the prior $5,000,000 level, adjusted for inflation, on January 1, 2026.

This article presents four estate planning ideas for high-net-worth individuals who want to capitalize on the record-high lifetime exemptions in what may be a "use it or lose it" scenario.

1. Make Gifts In Trust

By making gifts, such as gifts of company shares, to your loved ones in trust you can retain some degree of control over the gifted assets and allow for flexibility to adapt to changed circumstances. If properly drafted, you can serve as trustee of trusts that you create, meaning that you remain in a position to determine trust investments and distributions. A beneficiary can be granted the power to change the disposition of trust assets remaining at the beneficiary’s death (within any constraints provided by the grantor) or to redirect assets to charity during life. For added flexibility, you might name a "protector" to carry out enumerated administrative and strategic purposes generally not reserved to the trustee, grantor, or beneficiaries. An independent trust protector can be authorized to add or remove beneficiaries, for example.

The trust structure can offer beneficiaries some protection from creditors, including by way of keeping assets clearly separate from a divorcing spouse. Trusts also enable potential avoidance of estate and generation-skipping transfer taxes when the assets pass to the next generation.

If you make gifts to a grantor-type trust, you remain responsible for the payment of income taxes associated with the gifted assets, unless or until you choose to "turn off" the grantor trust status. The payment of income tax on behalf of the trust enables you to make further tax-free "gifts" to the trust (of the income tax) without using any additional lifetime gift tax exemption.

Substituting Low Basis Stock

Another benefit of using grantor trusts is that you are permitted to substitute assets of equivalent value in exchange for the trust assets without recognition of gain, which enhances flexibility and can be a useful tool in terms of managing income tax basis. If a trust holds low basis assets, such as company stock, you might substitute in cash or other high basis assets prior to death, taking the stock back in your own name. If you own the appreciated stock at your death, rather than the trust, you can take advantage of the step-up in income tax basis, and the beneficiaries of your estate will receive the stock without any built-in gain.

QSBS Strategy

On the other hand, non-grantor trusts can be advantageous for certain sophisticated planning such as avoidance or deferral of state income taxes, or multiplication of the capped excludable gain for qualified small business stock (QSBS). A qualified small business is an active domestic C corporation whose gross assets, valued at the original cost, do not exceed $50 million on and immediately after its stock issuance. QSBS can be eligible for a capital gains exclusion of up to 100% after being held for five years, subject to a per taxpayer cap of $10 million or 10 times the adjusted basis of the stock, whichever is greater. If you spread your QSBS among several non-grantor trusts, the capped excludable amount of gains would apply on a per trust basis, multiplying the benefits.

2. Give Assets That Will Remain In The Family

With lifetime gifts, you forgo a step-up in basis of appreciated assets that would otherwise occur upon your death. The step-up would reduce or eliminate capital gains exposure on a subsequent sale of those assets. This is not of consequence, however, if the transferred assets are not intended to be sold and will instead remain in the family. For this reason, it may make sense to give shares of a business that is intended to remain family-owned. Beware the unintentional transfer of built-in gain to your beneficiaries if you give securities with low basis that will be promptly sold rather than held.

By transferring a portion of a family business during life, you can ensure that your estate includes less than a 100% interest in those assets at your death, which is advantageous from a valuation perspective, especially if you decrease your position below 50%. When fractional interests in a private company are valued, they are typically eligible for generous discounts for lack of control and lack of marketability.

Lifetime gifts have the additional advantage of being valued on a per beneficiary basis, rather than based on the grantor’s aggregate ownership.

Example: (a) You die owning all 1,000 shares of a business with fair market value of $4 million, passing to your four children (taxable estate includes $4 million) versus (b) you give each of your four children 250 shares in the business (each valued at $750,000, or $3 million total, using a 25% discount).

3. Consider Selling Assets To A Grantor Trust For A Promissory Note, Which May Be Forgiven

One wealth transfer strategy is selling assets to a grantor trust ("intentionally defective grantor trust" or IDGT) in exchange for a promissory note. In the usual case, the grantor sells an asset at its fair market value to the trust in exchange for a note, typically with a 9- to 30-year term, which note is either self-amortizing or, if the cash flow is not sufficient to amortize, interest only and a balloon payment of principal due at the end of the term.

Assets that are either depressed in value or are expected to appreciate substantially, such as company stock, should be selected for this purpose. The goal is to remove future asset appreciation, above the mandated interest rate, from the grantor’s estate. The required interest rate is a mere 1.0% for a long-term loan made in September 2020.

A seed gift to the IDGT is generally recommended (minimum 10% of the purchase price) to give the transaction commercial viability, which uses some lifetime gift and GST tax exemption. Given the record-high exemption amount, a twist on the typical sale to an IDGT planning is that additional lifetime exemption can be used to forgive a portion or all of the promissory note if it later looks like the exemption amount will decrease.

Given the particularly low current interest rates, sales to grantor trusts are a well-timed strategy even without the forgiveness of indebtedness gift component.

4. Don't Make Gifts Beyond Your Comfort Zone

To fully lock in the increased lifetime exemption, you must use the entire $11.58 million amount per person. If you were to make a gift of $6 million, for example, and the exemption amount subsequently decreases to that amount, you would be deemed to have used all of your exemption. Put differently, use of exemption is, unfortunately, not treated as coming "off the top" of the current amount. Before making gifts of great magnitude, however, it is best to consider carefully your cash flow needs and how the gift could impact you going forward.

If a married couple falls short of wanting to make a $23.16 million gift, one spouse could use up the record-high gift tax exemption as an alternative to both spouses doing so. Safety values can be inserted into planning to help ensure that if your estate tax planning goes really well (i.e. you have substantially depleted your estate), you can, say, still draw a salary from your business for your services (while you are still working), stop paying the income taxes associated with gifted assets, and the like.

That said, the best approach from the outset is to take care to refrain from making gifts that might jeopardize your lifestyle, especially in light of the unusual circumstances we currently face. Tax savings is merely a part of a larger discussion to be had around wealth transfer strategies.

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