Estate Taxes – Are You Safe?

For years, the trend in Washington was to decrease estate tax. In 1997, the exemption from federal estate tax was $600,000 and the top federal estate tax 55%. The Taxpayer Relief Act of 1997 provided a phased tax deceased. That law increased the exemption from federal estate tax to $1 million by 2006. Congress did not stop there. President Obama and President Trump both oversaw substantial congressional increases in the estate tax exemption and reductions in the top rate. The exemption is now indexed for inflation and for 2024 the exemption is $13,610,000 per person with a tax rate of 40% on the excess.

The historical takeaway is that both Democrats and Republicans like larger estate tax exemptions and lower estate taxes. The presumption by this writer is both parties appreciate donations from folks who appreciate the more liberal tax break. As a result, it seems to have been exempt from governmental attack for almost 40 years.

There are currently concerns over possible change in congressional attitude. One of the most concerning is the position of the current administration to increase the tax rate and reduce the exemption. A Bill introduced in the Senate would reduce the exemption to $3.5 million and increase the maximum tax rate to 65%. Many feel it is unlikely the current President will be re-elected and are optimistic attacks on the estate tax exemption will fail. However, there is another time bomb lurking in the existing tax laws that may be more concerning.

The current large estate tax exemption sunsets at the end of 2025 and reverts to the previous exemption which, although indexed for inflation, is estimated to be between $6.5 million and $7 million. High net worth individuals and couples might want to start planning for the possibility of change in the estate tax structure. What follows are some of the options being considered.

Cornerstone of those considering changes to their estate planning is the fact that the current estate tax exemption is combined with the current gift tax exemption. Annual gifts greater than the current $17,000 per year per person that can be given free of tax consequences accumulate and use up part or all of a person’s estate tax exemption.

That annual exemption is a popular tool. Each person can give up to $17,000 per year, per recipient free of estate tax, gift tax and tax filing requirement. Each parent can give $17,000 to each child. And, in congenial families, that can be doubled by including gifts to a spouse. Gift of an asset that is likely to appreciate substantially can magnify the impact since those assets will be worth a lot more when someone dies and the increased value could be taxed at 40%. But, even if rapidly appreciating assets are gifted, those gifts are only a drop in the bucket at $17,000. What more could be done?

A taxpayer can leverage educational and medical exclusions. A taxpayer does not use any exemptions when payments are made directly to a university for educational expenses or to a hospital for medical expenses to aid a beneficiary. 

A bigger opportunity requires understanding a person could give away $13,610,000 this year, free from gift and estate tax, but if the large exemption sunsets at the end of 2025 and the person dies thereafter… only half that amount could be given free of estate tax at death. If the tax rate stays at 40%, gifting the maximum tax-free amount before the exemption sunsets could save almost $2.5 million in taxes. 

What’s the drawback? The drawback is gifting is generally irrevocable and if the estate tax exemption does not sunset or is increased there may be much gnashing of teeth. Nevertheless, the desire to maximize potential for estate tax savings has many pursuing options.

Perhaps the easiest one is to establish what is known as a Qualified Personal Residence Trust (QPRT). In a QPRT, the taxpayer transfers a residence to a trust under which the taxpayer is the trustee. The taxpayer is obligated to pay all property expenses during the term of the trust, but at the end of the term (in most QPRTs the taxpayer’s children) get the property. In addition to getting assets out of the taxpayer’s estate, the assets get out at reduced value. The property is valued using a formula that determines what someone would pay for property they will not own for a term of years. The longer the term of years, the lower valuation of the property. Most common term is 10 years.

If the taxpayer does not outlive the term, the asset remains part of the taxpayer’s estate for estate tax purposes. Is the taxpayer unhappy when the taxpayer’s children get the residence, and the taxpayer still wants to live there? Usually no, because the taxpayer arranges a lease with the kids under which the taxpayer pays fair market rent. That gets even more money out of the taxpayer’s estate, which is taxed as income to the children. Maximum income tax rate is still lower than 40%. 

QPRTs are relatively simple to set up and operate, with the biggest problem being at end of the term. The taxpayer forgets that the property is supposed to be deeded to the kids. A secondary problem is that if the estate tax exemption has increased, the taxpayer may no longer need a QPRT, and the taxpayer may be unhappy that the kids own the residence. But for many, those problems pale in comparison to a 40% tax.

Giving away minority interests in a family business is another popular option. Many do not have a business but can create one by acquiring or operating rental property or an entity to own and operate investments. These arrangements often involve a family limited partnership or a limited liability company under which the parents may continue to own a controlling interest, but the children receive minority ownership. Gifting a minority ownership is done at a discounted rate because value of less than a controlling interest is discounted would pay for an interest in an entity that does not control. The IRS is particularly unhappy with these entities, but if properly established and operated they can save a lot of estate taxes.

There are also options involving charities under which a charity can benefit immediately with a stream of income or in the future with the taxpayer retaining or assigning right to income to someone else. These gifts take advantage of the exemption from estate and gift tax for charitable donations and are increasingly attractive with rising interest rates. These options are of particular interest to those who want to help a charity.

All of these options require giving up some degree of control and ownership. That can be stressful to a taxpayer and the discomfort associated with maximum effort to save taxes may make these options a poor choice. For many, keeping control of one’s money and letting Uncle Sam take a bigger bite is the more attractive option, especially when there is no guarantee the estate tax exemption or rate will change. Nobody’s crystal ball can predict tomorrow’s taxes.

William G. Morris is the principal of William G. Morris, P.A. William G. Morris and his firm have represented clients in Collier County for over 30 years. His practice includes litigation and divorce, business law, estate planning, associations, and real estate. The information in this column is general in nature and not intended as legal advice.