U.S. Federal Transfer Taxes – An Introduction
The U.S. utilizes an integrated transfer tax system commonly referred to as the federal estate and gift tax regime. In short, the federal estate and gift tax regime is structured and intended to impose tax on the gratuitous transfer of wealth between individuals regardless of whether such transfer happens during the life of the donor (i.e., a gift tax) or following the death of the donor (i.e., an estate tax). The federal estate tax and the federal gift tax are integrated in that each tax system utilizes a single “unified credit” or “exemption” for determining the value of assets that an individual may gratuitously transfer, cumulatively, during their lifetime or upon their passing. For example, if the applicable “exemption” were $5 million, and an individual made gifts equal to $3 million (at the time of the gift(s)) during their lifetime, then such individual would only have $2 million of exemption remaining to shelter any assets that would pass upon such individual’s death. If an individual cumulatively made lifetime gifts and at-death transfers in excess of their available exemption, then such excess would be taxed at the then-prevailing tax rates (currently 40%).
While the maximum available exemption is often thought of in the “single-person” context, it is important to keep in mind when planning for married couples the availability of “portability.” In short, “portability” refers to the ability for one spouse, upon their death, to transfer any unused portion of such deceased spouse’s then available exemption to the surviving spouse. Because of this portability feature, married couples are often viewed as a “double exemption,” both because of their separate individual tax exemptions, as well as through the sharing feature of portability.
Overview of the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (TCJA) took effect on January 1, 2018, resulting in substantial and widespread changes to the United States Tax Code for individuals and corporations. However, while most of the changes impacting taxation of corporations were made “permanent,” most of the changes impacting taxation of individuals were limited to exist for a set period of time before “sunsetting” (i.e., reverting) back to pre-TCJA levels. Specifically, most tax benefits created by the TCJA for individuals will expire effective December 31, 2025.
Among the temporary changes made for individual taxpayers was a significant increase in the maximum available federal gift and estate tax exemption. Specifically, the maximum exemption essentially doubled from $5.49 million per individual in 2017 to $11.2 million in 2018, which was followed by annual increases each successive year to adjust for inflation. As of 2024, the current federal gift and estate tax exemption is at an all-time high of $13.61 million per individual under current law. The maximum available exemption is expected to receive one final increase on January 1, 2025 to $13.99 million, before reverting effective January 1, 2026, to pre-TCJA levels, indexed for inflation.[1]
From a planning perspective, this means that HNW and UHNW individuals currently have a limited opportunity to take advantage of a temporary tax benefit that could substantially reduce and/or mitigate, if not eliminate, future estate tax liability for themselves and their families. Opportunities to take advantage of such tax benefits are often presented through strategic lifetime gifting and advanced wealth planning strategies, often utilizing specialized vehicles such as irrevocable trusts, life insurance, and/or family limited partnerships / limited liability companies. While widely applicable to HNW and UHNW individuals in any asset classification, these planning strategies may be especially useful for owners and operators of closely-held businesses that may otherwise be faced with substantial financial hardship upon the death of a principal as the need for liquidity to satisfy federal estate tax obligations arise. However, given the impending “sunset,” HNW and UHNW U.S. citizens who have not yet taken advantage of the historically-high current maximum available exemption amounts are likely quickly running out of time to do so.
Who Should Consider Engaging in Wealth Transfer Planning?
As used in this article, “wealth transfer planning” broadly refers to generational asset protection planning with a focus on federal estate and gift tax mitigation. Notably, because of the relatively high available exemption levels, the pool for ideal “candidates” for wealth transfer planning is substantially smaller than the population at-large. While practitioners’ opinions may vary regarding what “level” of wealth warrants implementing “complex” planning strategies, a basic rule of thumb is that if an individual has a net worth that is currently above the current maximum available exemption, or is reasonably expected to grow to such level in the future, then such individual should be considering some sort of wealth transfer planning. Looking ahead to expected post-TCJA exemption levels in 2026, any individual with a net worth in excess of $7 million and/or married couple with a net worth in excess of $14 million should consider exploring one or more advanced wealth transfer planning strategies before the end of 2025. As described above, individuals with relatively illiquid assets such as real estate assets in and outside the U.S.[2] and/or closely-held business interests, as well as individuals who have rapidly appreciating assets, would likely realize substantial benefit from taking advantage of some of the current benefits under the TCJA in their tax planning strategies.
One such example and application of the foregoing relates to a material portion of our clientele which are generational agricultural families with substantial agricultural holdings such as land, equipment, machinery, and livestock; these types of families often times will find this planning strategy to be particularly beneficial. Such operations tend to be “land rich / cash poor” businesses, meaning that the majority of their wealth is held in real estate and other illiquid assets. Accordingly, the occurrence of a major impending expense, such as a substantial estate tax liability occurring upon the death of an owner and due shortly thereafter, can compromise, and potentially entirely prevent, the ability of an operation to continue as a going concern. Traditional planning tools for these types of circumstances may include acquiring life insurance to ensure some form of liquidity at death to offset all or a portion of such estate tax liabilities; however, as a practical concern, payment of premiums on such policies, which are often substantial, may not be feasible for the already cash-strapped operator. While Congress has attempted to provide limited relief for families in such situations, such as through the use of “2032A Special Use Valuations” or “6166 Installment Payments,” the relief offered by these tools are often still accompanied by further expense and hardship for a family, especially when compared to the use of other “current planning” opportunities that may be available, such as through the temporary increased available exemption provided under the TCJA.
Practical Planning Strategies Using the TCJA
So, how does one take advantage of the temporary estate and gift tax benefits afforded under the TCJA? For starters, as set forth above, the federal estate tax and federal gift tax systems are integrated through a single unified credit, thereby allowing an individual to decide whether to make the “taxable transfer” during their lifetime as opposed to waiting until death. In this context, gifting can have a much stronger impact than passing assets upon death. First, if an individual believes that their assets will appreciate over time, then utilizing a lifetime gifting strategy would allow such individual to transfer assets at a lower current value rather than retaining such asset and transferring it (as appreciated) upon such individual’s death. Second, the IRS has already acknowledged through regulations[3] that it will not attempt to “claw back” most gifts made during the expanded exemption period, meaning that gifts made prior to the expiration of the TCJA will not be subject to inclusion in an individual’s taxable estate solely because the maximum exemption level at date of death is lower than the then-current maximum exemption level at the time the gift was made. Both of these factors strongly support implementing a lifetime gifting strategy at the present for purposes of mitigating federal estate tax.
So, if substantial gifts should be made prior to January 1, 2026, that begs the question: In what manner should those gifts be made? While the simplest method may just be for an individual to directly transfer and/or assign valuable assets to their intended heirs, this method is riddled with its own fatal flaws. Instead, Practitioners may consider implementing specialized vehicles which are intended to effectively utilize the increased federal gift tax exemption to mitigate and even eliminate estate tax liability such as an Intentionally Defective Grantor Trust (IDGT). IDGTs are a type of irrevocable trust that are treated as separate from its grantor in every regard with the exception of with regards to income taxes. This means that a grantor may transfer legal ownership of an asset to an IDGT, and such asset will no longer be viewed as belonging to the grantor for federal estate tax purposes as well as for other general creditor purposes. The transfer from the grantor to the IDGT is a “taxable gift” which must be reported for federal tax purposes on a Form 709 in the year following the year of the transfer. The tax “due” on the gift is satisfied through application of the grantor’s available gift tax exemption. If properly structured and administered, the asset(s) transferred from the grantor to the IDGT will not be included in the grantor’s taxable estate upon their death. Through the effective use of this structure, an individual can “freeze” the value of the asset(s) transferred to the date of the gift, which allows any growth on the asset(s) inside the IDGT between the date of the gift and the date of grantor’s death to pass to grantor’s heirs free of estate tax.
As stated above, an IDGT is treated as separate from in its grantor in every regard with the exception of income taxes. By intentionally triggering certain provisions of the Tax Code, the IDGT will be disregarded for income tax purposes, resulting in the grantor remaining liable for the payment of income taxes generated by the assets held by the IDGT; in this regard, the irrevocable nature of trust and the corresponding transfers are viewed as “defective” for income tax purposes.
IDGTs may be funded by gift, sale, or a combination of the two. Note that, because of the “defective” nature of the trust, there are no income tax consequences associated with the sale of assets between an IDGT and its grantor. Because the grantor of an IDGT cannot also be a beneficiary from such trust, the sale of assets to an IDGT on a secured promissory note can be an excellent tool to provide sustaining cash flow to the grantor.
Illustrations
The following illustrations are designed to provide a simplified overview of the IDGT strategy.
A.
Assume Frasier is a single, unmarried man with a $10 million net worth. If he were to die after January 1, 2026, estate tax would be assessed on the $3 million of assets he owns in excess of an assumed $7 million exemption. Prior to January 1, 2026 Frasier creates an IDGT for the benefit of his son, Freddy. In order to keep the assets out of his control, and therefore out of his taxable estate, Frasier appoints his brother as the trustee. Frasier funds the IDGT by transferring, via gift, real estate located within the U.S. and Mexico cumulatively valued at $8 million – well within his current lifetime gift tax exemption. Because Frasier has no control over the IDGT and is not a beneficiary of it, all the assets he gifted will be excluded from his taxable estate. Ten years later, Frasier dies; the value of the real estate previously gifted is now approximately $16 million. While the IDGT’s assets have substantially appreciated, his gross estate only includes the then-current value of those assets not previously transferred to the IDGT (i.e., the $2 million of net worth remaining after transferring the real estate), and therefore tax could only be assessed on such retained assets; the value of the retained assets is likely to be substantially less than the $16 million of assets then-held in the IDGT. Because Frasier structured his IDGT as a dynasty trust, the IDGT assets will now flow into a new separate irrevocable trust controlled by and held for the benefit of Freddy; the generation-skipping transfer tax features of which will prevent the value of such assets from being includible in Freddy’s taxable estate upon his subsequent death.
B.
Assume that Niles and Daphne are a married couple who collectively hold an interest in DukesCo which is estimated to be worth approximately $50 million. Assume further that each of Niles and Daphne create IDGTs for the benefit of the other, with their son as a contingent beneficiary. Each of Niles and Daphne attempt to transfer their entire interest in DukesCo (which is represented by non-voting equity interests) to their respective IDGTs via gift, with plans to utilize the entirety of their 2024 gift tax exemptions. In determining the value of the non-voting equity in DukesCo attempted to be transferred by each of Niles and Daphne, a discount may be applied due to inherent qualities of such non-voting equity, such as lack of control and lack of marketability. For purposes of this illustration, assume that the cumulative effective valuation discount is twenty-five percent (25%); in this case, the cumulative value of the transferred non-voting equity would be approximately $37.5 million.
Note that, even though, for transfer tax purposes, the value of the non-voting equity in DukesCo has been discounted from approximately $50 million to approximately $37.5 million, such value is still in excess of the combined $27.22 million asset value that Niles and Daphne can collectively transfer via gift in 2024. So, what becomes of the “excess” $10.28 million (or $5.14 million per person) that could not be transferred via gift in 2024? Without more, this “excess” value, plus the value of any appreciation incurred between the present and date of death, would be includible in the taxable estates of the survivor of Niles and Daphne.
To further minimize estate tax liability exposure, Niles and Daphne each could sell the remaining $5.14 million (or $10.28 million collectively) of non-voting equity in DukesCo to their IDGTs in exchange for interest-bearing promissory notes. Each IDGT would now own $25 million in non-discounted assets while Niles and Daphne would each own $5.14 million in their own names with respect to the outstanding promissory notes.
Niles and Daphne can pay down these promissory notes over the years to provide liquidity for income taxes and lifestyle needs. With diligent planning, Niles and Daphne may be able to retire the full balance of the promissory notes, thereby eliminating the inclusion of even the “excess” value in DukesCo being includible in their respective taxable estates.
How We Can Help
Dvorak Law Group has extensive experience working with HNW and UHNW families throughout the United States. While we have substantial experience and expertise working with owners of closely-held businesses in the agricultural, construction, transportation and logistics, medical, financial services, real estate sectors, our team is capable of working with clients operating closely-held businesses in almost any industry. We can assist with creating uniquely-tailored plans that will permit seamless transitions of the family business from one generation to the next while maximizing tax efficiency. In addition to our estate planning services, we also offer comprehensive corporate services designed to work hand-in-hand with your planning efforts.
Authors
David M. Dvorak • Dvorak Law Group, LLC | ddvorak@ddlawgroup.com
David R. Mayer • Dvorak Law Group, LLC | dmayer@ddlawgroup.com
[1] While the exact figure will not be known until 4Q2025, most practitioners expect the reduced federal estate and gift tax exemption to be between $7 million and $8 million per person.
[2] Foreign assets, including real estate and financial accounts, are includible in a U.S. decedent’s gross estate for estate tax purposes under 26 U.S.C. § 2031(a). Additionally, non-citizens who own any assets in the U.S. are subject to the estate tax under 26 U.S.C. § 2103.
[3] Treas. Reg. § 20.2010-1(c).