What are potential next steps in your estate plan after you have fully exhausted your available federal lifetime gift tax exemption?

For individuals and couples who have fully used up their entire federal lifetime gift tax exemptions, strategic planning for federal transfer tax mitigation remains essential.

“Freeze it” strategies: How can you lock in current assets values for gift and estate tax purposes?

While making gifts in excess of your lifetime gift tax exemption amount can be tax effective, it's not always practical. Thankfully there are planning techniques that let you give away just the future appreciation of an asset — effectively “freezing” its value for estate tax purposes at today's fair market value.

Grantor Retained Annuity Trusts (GRATs)

In a GRAT you create and fund an irrevocable trust while retaining the right to receive annuity payments for a certain period of time. Therefore, the value of your gift for tax purposes is reduced by the value of these retained annuities. GRATs are typically structured to be “zeroed out”, meaning that the total value of the Grantor’s retained annuities is equal to the fair market value of the assets being contributed to the GRAT. Therefore, there is no gift when the GRAT is funded.

However, when assets in the GRAT grow faster than the IRS-assumed rate of return (the “7520 rate”¹), the excess passes to beneficiaries gift-tax free. For example, a $10 million GRAT with a two-year term and assets growing at an 8% annual rate of return instead of the IRS’s assumed rate of 5.40% would pass over $400,000 to the GRAT’s beneficiaries tax-free after just two years.

Installment sales to grantor trusts

For long-term planning, consider selling assets to a grantor trust in exchange for an interest-bearing promissory note.² Transactions between the grantor and a grantor trust (a trust considered to be owned by the grantor for income tax purposes) are disregarded for federal income tax purposes, and therefore, there are no capital gains recognized when appreciated assets are sold to the trust and interest payments on the promissory note do not generate taxable income.

Any appreciation of the sold assets beyond the interest rate on the note remains in the trust without incurring additional gift or estate taxes. This strategy works especially well if you already have an existing grantor trust that can function as the purchasing trust.

“Split it” strategies: How can you create tax-advantaged ownership structures?

Another approach involves dividing assets among different interest holders in order to reduce the value of each different interest for federal gift and estate tax purposes.

Qualified Personal Residence Trusts (QPRTs)

A QPRT splits the value of your personal residence into:

1. A right to live in the home for a retained term of years (which you keep); and
2. A right to receive the home after this period ends.
    

The gift's value for gift tax purposes is only the value of the right to receive the home after your retained term of years has ended. This is calculated based on the home's fair market value at the time the QPRT is created reduced by the actuarial value of your retained term. A QPRT created by a donor aged 72, for a $5 million residence with a 10-year retained term and a section 7520 rate of 5.40%, might generate a taxable gift of only $2.02 million — a discount of nearly 60%. Note that if after the retained term you wish to continue living in the personal residence, you must pay rent to the beneficiaries of the QPRT.

Other splitting techniques

• Grantor Retained Income Trusts (GRITs) work similar to QPRTs but, unlike a QPRT, the GRIT may be funded with any type of asset. They are particularly valuable for transfers to unmarried partners, nieces, nephews or friends, since IRS rules strictly limit the use of GRITs when immediate family members are the beneficiaries of the GRIT.
• Split-purchase trusts allow a senior family member to purchase a life estate in a residence while an existing trust simultaneously purchases the right to receive the residence upon the passing of the senior family member. This provides lifetime enjoyment of the property and multigenerational planning benefits. However, its use is generally limited to instances where a home is being acquired and it may not be used to split a home that the senior family member already owns.
• Family LLCs and partnerships can create valuation discounts if the fractional membership or limited partnership interests lack control or marketability. For example, a gift of a 10% non-managing membership interest in an LLC worth $10 million might be worth significantly less than $1 million for federal gift tax purposes. Any such discount depends on many factors and must be established by a qualified appraisal of the LLC or partnership.
• Remainder Purchase Marital Trusts (RPMTs) combine estate freezing with a statutory valuation discount based on the life expectancy of the spouse holding the income interest and the applicable 7520 rate. The strategy involves creating a lifetime trust for the exclusive benefit of a spouse that qualifies for the marital deduction alongside a separate trust for descendants that purchases the right to receive any assets remaining upon the passing of the spouse. The value of the remainder trust is significantly discounted because of the spouse’s lifetime interest. If all technical requirements are met, then upon the passing of the spouse, the assets will pass to the remainder trust without any additional federal estate or gift taxes.

Finding your strategy

The estate planning landscape offers numerous techniques for those who have exhausted their federal exemptions or have wealth substantially exceeding these thresholds. These strategies — whether focused on giving, freezing, or splitting — can be combined to provide potential optimal wealth transfer results while minimizing federal transfer taxes.

Implementing these plans requires time, expertise, and ongoing compliance with specific requirements. We encourage you to speak with your Merrill Private Wealth Advisor, who, working in conjunction with your tax advisor and estate attorney, can provide information on these strategic approaches to help you determine which might work best for your family's unique circumstances.