Many estate planning concepts focus on how to completely reduce the gift or estate tax on transfers to $0. There is limited discussion on what happens after you have utilized all your exemption, and have already gifted to various vehicles like SLATs, GRATs, IDGTs, etc. If you still have assets that are going to be subject to estate tax after your passing, then what should you do?
There are still ways to use some of these more advanced techniques to reduce your taxable estate, for example using rolling GRATs to move the growth of the assets out of your estate. However, for these techniques to be effective, the assets’ appreciation needs to outpace the IRS §7520 Rate (“hurdle rate”). Which given the recent increase in interest rates currently sits at 4.40% for March 2023 and may reduce the effectiveness of these strategies. This means that the assets in a GRAT will need to increase at pace greater than 4.40% in order to effectively transfer appreciation of these assets to the ultimate beneficiaries. Another concern is that the donor of the assets to the GRAT will still receive the original gifted amounts back plus interest in the form of annuity payments, and those assets may still be includible in the donor’s estate and subject to estate tax.
There is, however, another technique that will ultimately allow a transfer of assets and will also reduce estate tax. This technique is to make taxable gifts during your lifetime. At this juncture, I’m guessing that most of the people reading this are wondering how this will reduce the amount of taxes being paid since they have the same tax rate. The answer lies in the difference of how these two taxes are calculated.
The major difference between the gift and estate tax is that the gift tax is tax-exclusive, where the estate tax is tax-inclusive. Meaning that for gift tax your tax is based on the amount that you are transferring to someone, where the estate tax calculated on the total amount of the assets in the estate including the tax that will be paid, and not just the amount being transferred to someone else. I believe that the best way to demonstrate this is to provide an example.
In order to provide an example, there are a couple of items that need to be assumed. First, the example will assume that there is an amount of $10,000,000 that is available to be gifted including tax, and if this amount isn’t gifted, then there will be a $10,000,000 estate. Additionally, we will assume that both the gift and estate tax rate is a flat 40%. Lastly, it will assume that the individual no longer has any gift/estate tax exemption available to them.
We will start our example with the gift tax and how the gift tax is calculated. Remember that the individual only has $10,000,000 of assets, which includes both the amount transferred, and any gift tax that needs to be paid. First, you need to determine how much will be transferred to someone else, and then calculate the resulting tax. Since the amount of tax is based on the amount of the assets transferred, we can’t just take the flat 40% and apply it to the $10,000,000 like we would for the estate tax, instead we need to determine the amount of the gift first, and then calculate the resulting tax that would get us to a combined $10,000,000.
There are two ways in which you can calculate the maximum gift amount, the first is trial and error to try and get as close to the amount of the total available amount of gift as possible. Using this method, we would likely end up with a gift of roughly $7,140,000. Apply the 40% tax rate ($7,140,000 X 40%), we end up with a total of $2,856,000 in gift tax. When combining the total amount transferred and total tax, the total amount of assets used is $9,996,000.
The second method is a more precise method, where we use an algebraic equation of (1+tax rate)X=Y. For this equation, Y is the total amount available for the gift including tax, and X is the amount that is being gifted prior to tax. Using the numbers in our example, the tax rate is 40% and Y is $10,000,000 our equation will look like the below:
Tax= $7,142,857.14 X 40% = $2,857,142.85
Total Assets Used= $9,999,999.99
Now moving to the easier of the two, we will calculate the estate tax. Again, the estate tax is inclusive meaning that the amount paid in tax is included within the calculation for the amount of total tax. If there is a total of $10,000,000 in the estate at the end of the individual’s life, and we apply a flat 40% tax, then the total amount of tax paid is $4,000,000, and the total amount of assets transferred to the beneficiaries is $6,000,000.
As a result of the difference of how these taxes are calculated, the individual would pay $2,856,000 in gift tax, and $4,000,000 in estate tax. Which means by gifting during the individual’s lifetime, they can transfer approximately an additional $1,144,000 to the next generation, while reducing their total tax by the same amount. In essence, although you must pay the tax now, you ultimately will save in total tax paid later.
Should you have any questions or would like to discuss this further, please do not hesitate to reach out to me. Prior to making any lifetime gifts, you should consult your CPA or estate planning attorney to discuss all alternatives available to you.
Jesse Livingston, J.D., LL.M Taxation, CTFA
Vice President/ Director of Trust Services
Phone: (702) 331-6089/ email: Jlivingston@nvf-trust.com
*The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only. FSTC does not offer tax, legal, or investment advice, professional counsel should be sought for tax or legal advice.