7 Tools to Prefund Inheritances and Reasons to Exploit Them Now

The current lifetime estate and gift tax exemption is scheduled to be slashed in half after midnight on December 31, 2025. It’s time to put together your plan for that potential reduction in the exemption.

A lot could happen between now and 2026. A majority in Congress might agree to continue the current exempt amount. Or Congress might fail to make a deal on time, so the exemption automatically is cut in half, at least temporarily.

It is also possible that before 2026 a deal is made to reduce the exemption but by less than half. Or the 2024 congressional election might give a solid majority to those who in 2021 almost had the votes to slash the exemption by more than half.

Keep in mind the tax rate on estates and gifts also is likely to change if the exemption changes. A tax rate of 50% or higher might be applied to estates above the exempt amount.

On the other hand, there are those who say the exemption amount never has decreased, and it’s foolish to assume it will happen this time.

Many estate owners and estate planners are spending a lot of time trying to forecast which of these or other scenarios most likely will happen.

It is better to recognize we can’t forecast what Congress will or won’t do.

If your estate might be taxed under any of the probable changes, don’t wait to find out what Congress will do. Develop a plan now. Decide the actions you’ll take under different scenarios, and when you’ll implement them. There probably are actions you should take well before the end of 2025.

The lifetime estate and gift exemption is $12.92 million for an individual in 2023, or $25.84 million between a married couple, but it is a use-itor-lose-it asset. If you don’t use the exemption to make gifts before 2026 and the amount is reduced to, say, $7 million, you’ve lost forever that extra $5.92 million exemption.

The first step is to determine how much of your estate is needed to ensure your financial independence for life. If you’re likely to need all the estate to feel secure, stay with your current plan.

Then, consider prefunding part of the inheritance for your loved ones now to ensure that less of the estate will be siphoned away by taxes after 2025. There are a wide range of ways to prefund an inheritance while reducing or eliminating gift taxes.

You could transfer money and property directly to loved ones now, giving them full control of the assets. You’ll want to minimize gift taxes, so review the tax-free ways to give away assets described in our March 2023 issue.

You might not be ready to turn over full control of assets yet. Or you might want to maximize the after-tax value of gifts by reducing the value placed on the assets for gift tax purposes. There are multiple ways to accomplish these goals. Go through the playbook with an estate planner to determine the strategies that are best for you.

Irrevocable trusts are and probably the most-used strategy.

You draft a trust agreement that names the beneficiaries and also states when income and principal will be distributed to them. Or the agreement gives the trustee discretion to make distributions as the trustee determines they are in the best interests of the beneficiaries.

After executing the trust agreement and lining up a trustee, you make gifts of money or property to the trust.

The trustee decides how trust assets are invested, consistent with any guidelines in the trust agreement.

Irrevocable trusts often are used because trust creators are concerned the beneficiaries aren’t ready to make wise spending and investment decisions. An irrevocable trust also protects the assets from creditors of both the trust creator and beneficiaries in most states.

Keep in mind that when appreciated property is transferred to the trust (or any other type of gift is made), the trust (or donee) takes the same tax basis in the property that you had. When the trust sells the property, it pays capital gains taxes on the appreciation that occurred while you owned it.

If you hold the property for the rest of your life, under current law the beneficiaries who inherit it will be able to increase the tax basis to its then-current fair market value and sell it without incurring capital gains taxes. So, you might not want to give property in which you have substantial capital gains, unless they are assets you expect to remain in the family, such as a vacation home or business.

Irrevocable trusts are very flexible, and there are many variations of the trusts. A popular irrevocable trust these days is the spousal lifetime access trust (SLAT).

One spouse sets up the trust and transfers property to it. The other spouse is the initial trust beneficiary. When the SLAT is created properly, its assets are out of the estate of the spouse who created it. But the spouse who created the trust essentially benefits from the assets, because the other spouse is the trust beneficiary. For details, see the November 2020 issue of Retirement Watch.

Another widely-used and effective gift-giving strategy is the family limited partnership (FLP).

You (or you and your spouse) create a limited partnership and are the general partners and the initial limited partners. You contribute money and property to the FLP.

Then, you give the limited partnership interests to your children, either all at once or over time.

Like the irrevocable trust, the FLP is flexible. In the standard FLP, the general partners end up with a 1% ownership interest and the limited partners own the other 99%. But the general partners control the FLP’s asset management and distributions. Most of the FLP’s assets now are out of the parents’ estates, but they still have control over how the assets are managed and the distributions made to the children.

Because the limited partners have little control and their ownership interests aren’t marketable, when the limited partnership interests are given to the children, the assets are valued for gift tax purposes at less than the value of the underlying assets. Valuation discounts often are 20% or more.

With the FLP, in addition to taking advantage of today’s high lifetime gift tax exemption, you give away more assets tax free than you could have through direct gifts or an irrevocable trust. You could give $1,000,000 worth of assets but have them valued at $800,000 or less for gift tax purposes.

Don’t forget to integrate charitable giving into your estate plan. Some strategies provide benefits for you or your loved ones in addition to supporting charity. Plus, the taxable amount of your estate is reduced.

For example, you can create a charitable remainder trust (CRT) and transfer appreciated property to it. The trust sells the property and owes no taxes because the CRT is tax exempt.

You don’t owe any taxes on the gain that accrued in the property’s value while you owned it. You also are eligible for an income tax deduction equal to part of the value of the money or property that is transferred to the CRT. The amount of the income tax deduction depends on current interest rates and your age.

The CRT invests the sales proceeds and pays income to you or other beneficiaries you name. The income continues for life or a period of years, whichever one you select.

After the income period ends, whatever remains in the CRT goes to charities you named. The CRT property isn’t included in your estate.

A charitable lead trust (CLT) is sort of the reverse of the CRT. The trust pays income to a charity for a period of years. Then, the property remaining in the trust is paid to you or beneficiaries you name. The remaining property is included in your estate.

You receive an income tax deduction when setting up a CLT.

There are more sophisticated strategies that might be appropriate for you, such as private annuity trusts, grantor retained annuity trusts, qualified personal residence trust, installment sales to trust or family members, low interest loans and more. Some of these are targeted by either the IRS or Congress. Take advantage of them while they’re still available and be sure to work closely with an estate planner to ensure you comply with all the rules.

To learn details about these and other estate planning strategies, read “The New Rules of Estate Planning.” A PDF file of my book is available free on the members’ section of the website. After logging in, go to the “Special Reports” section and search the pages for the book.