During the last several years, the federal government has audited approximately 30 percent of the estate tax returns filed by estates with a gross value of at least $10 million. The audit rate for estates with a gross value of $5 to $10 million is less (about 20 percent) but still significant. The hassle and expense of dealing with an IRS audit after the loss of a loved one is undoubtedly one of the reasons polling consistently shows the American public as having a strongly negative view of the estate tax.
While the exemption from the estate tax has increased substantially in recent years, the tax can still snare many business owners and reduce the property the owner’s heirs inherit. Unfortunately, despite continued calls for its repeal, the estate tax remains a fixture in the Tax Code. The estate tax is actually just one of three taxes under the transfer tax system, with the others being the gift tax and the generation-skipping transfer tax (GSTT). These three taxes work together to subject a person’s transfers of wealth (whether made during life or upon death) over a certain dollar amount to a tax rate as high as 40 percent.
Fortunately, sound tax planning, particularly when begun well before the end of a client’s life, can greatly reduce transfer taxes. Planning involves the use of several tools. First, proper use of the lifetime exclusion amount and the annual exclusion from transfer tax: every U.S. citizen is granted an exemption from transfer tax; under current law, a person can transfer $5.45 million without incurring any transfer tax. In addition, a person can give away a certain amount of property each year to each of an unlimited number of donees that is exempt from transfer tax (currently, $14,000 to each donee). Here is a simple example illustrating the benefit of the annual gift exclusion: a married couple with four children and eight grandchildren can gift a total of $336,000 every year without incurring any transfer tax. If they do that the last 20 years of their lives, they can transfer $6.72 million to their descendants and save almost $2.7 million in transfer taxes.
Second, transfer tax planning relies heavily on the concept of an “estate freeze.” An estate freeze involves the disposition of property in a way that ensures that all or part of the appreciation in the property after the date of the disposition avoids transfer tax. An irrevocable transfer (such as a gift) can accomplish the same goal, but estate freezes do not necessarily use up any of the client’s life exclusion amount. Sophisticated techniques like a grantor retained annuity trust (GRAT), a sale to an intentionally defective grantor trust (IDGT), a qualified personal residence trust, a private annuity, and a self-cancelling installment note are all versions of an estate freeze. Estate freezes work especially well with property that is expected to appreciate rapidly- an interest in a growing family business is an excellent candidate for an estate freeze.
Third, because transfer tax depends on the value of the property transferred, valuation of assets plays a critical role in transfer tax planning. Some assets, such as publicly traded stocks, have a clear value, but many items (a family business, real estate, artwork, etc.) have a value that is uncertain. An expert planner will look for evidence that the value of an asset is less than the IRS thinks it is. For example, a taxpayer without sound advice might report that a 10% limited partner interest in a limited partnership worth $1 million is worth $100,000; however, the true value of that interest is considerably less than $100,000. The explanation for this is that the limited partner interest is almost certainly subject to very significant limitations on voting and transfer rights; as a result, of these limitations, the “superficial” value of $100,000 can be discounted by a significant percentage. The discount that can be successfully defended varies depending on a client’s specific circumstances, but 30% is not uncommon.
Fourth, trusts can be used in tax planning to define the ownership rights of the creator and beneficiaries of the trust in a way that leads to optimal tax results. A good example of this is the irrevocable life insurance trust (ILIT). Suppose a high-net worth, unmarried man with a successful business owns a life insurance policy of $3 million and passes away with a $10 million estate. The life insurance proceeds will be included in his estate and subject to estate tax; the $3 million proceeds will be reduced by $1.2 million in federal estate tax. However, if the policy had been purchased by an ILIT, the proceeds would be excluded from the business owner’s estate and the owner’s heirs would receive the $3 million in proceeds free of tax.
Given the high tax on transfers, the frequency with which estate tax returns are audited, and the outstanding results that a qualified estate planner can achieve, transfer tax planning should be a priority of every high net-worth person.