How to efficiently transfer wealth to successive generations

Estate planning is a crucial aspect of wealth management and enables an efficient transfer of wealth to subsequent generations and other beneficiaries. The taxation of estate planning is tricky; hence, expert help is needed to carry out this task in a manner which can ensure that the beneficiaries are able to access their inheritance with the least possible tax liabilities.

Estate or wealth planning is a critical component of wealth management. It details the inheritances and bequests that an individual leaves behind on death. An effective plan minimizes the chances of family conflict, lowers estate costs and taxes, and aids in transferring the wealth efficiently. For wealthy individuals, it is especially an essential arrangement as the process helps them plan the distribution of their wealth in an efficient manner after their passing.

There can be three recipients of assets that are divided posthumously: family, charity, and the government. Effective tax planning within estate planning can enable tax-efficient wealth distribution. Wealth transfer is subject to three type of taxes: gift tax, estate tax, and generation skipping transfer tax (GSTT).

Estate and Gift Tax
Estate tax is generally levied on the fair market value of all assets included in the estate at the time of death of the owner. This includes the value of taxable gifts made during the owner’s lifetime. However, certain reductions are permitted on taxable estate include: (i) debts; (ii) administration expenses; and (iii) the value of assets passing to qualified charities, assets passing to a spouse and the applicable exclusion amount at the date of death.

Any one-way transfer of either cash or property (in which the giver does not receive something of equal value in return) is considered a gift. US citizens and domiciliaries are subject to gift tax on all lifetime gifts, regardless of where the property is located.

Currently, the estate and gift tax rate in the US stands at 18–40%. This rate is applicable to US citizens, US domiciliaries, and non-US domiciliaries.

Generation Skipping Transfer Tax
GSTT is levied in addition to the estate/gift taxes when property is transferred through a gift or inheritance to beneficiaries (other than a spouse) who are two or more generations younger (related beneficiaries), or are younger than the donor by at least 37½ years (unrelated beneficiaries). Currently, the GSTT rate in the US is a flat 40%. This tax is applicable only when the value transferred exceeds $11.58 million per individual donor (as per the revision in 2020).

Estate Transfer Planning Tools
Transfers to the next generation are often implemented in way that leads to either the maximization of tax benefits, production of a non-tax benefit, or both. Following are some of tools that can be used to plan estate transfers effectively.

Tax-free gifts
Using the exemption provided under gift tax, one can reduce overall tax liability on the wealth transfer. Gift tax provides the following exemptions:

• Annual gift tax exclusion: In a year, an individual can give a gift worth less than $15,000 per recipient without attracting a liability. By spreading the gifting over a longer period, one can use the annual gift tax exclusion more efficiently. The annual gift of up to $15,000 would not be considered in the calculation of the lifetime gift exclusion limit. Furthermore, if the donor is married, this threshold can be effectively increased to $30,000 using gift-splitting provisions. However, it is to be noted that gift-splitting may not be permitted if either of the spouses is a non-US domiciliary.
• Lifetime gift tax exclusion: Gift and estate tax is applied only on the value of the estate and gifts made throughout the lifetime if it exceeds the lifetime gift exclusion limit. In 2020, this limit was revised upward to $11.58 million per individual. This means a married couple would be able to transfer $23.16 million to the next generation without attracting a tax liability.
• Payments made towards education and medical expenses are also exempt from the gift and estate tax. Therefore, paying these expenses for family members would be of greater benefit to them than gifting them the amount to cover these expenses.
• Gifts to spouse: Unlimited assets can be transferred to the spouse, without paying tax, if the spouse is a US citizen. An annual limit of $155,000 is applicable if the spouse is not a US citizen.

The advantage of the gifting strategy is that future appreciation in the value of gifted assets is transferred to the receiver without attracting the gift or estate tax. Whether the assets are transferred to a beneficiary or they remain in the donor’s estate, the appreciation accrued on the gifted asset could still be subject to tax on investment returns (such as dividends and capital gain). However, if the asset had remained in the estate (if the tax-free gift had not been made), the appreciation on the asset attracts the estate or inheritance tax, depending on the state in which the inheritor lives.

Irrevocable Trusts
When bequeathers wish to control the use of assets they are leaving behind, they can form a trust with a specific mandate on the release of assets to beneficiaries. Additional tax benefits apply if such a trust is irrevocable.

An irrevocable trust is an extremely useful instrument for large estates to minimize the estate tax liability. When a grantor transfers asset to an irrevocable trust, these assets are removed from the estate, effectively reducing the estate tax liability. Furthermore, the grantor is not responsible for taxes on the income accrued on the assets held in an irrevocable trust. Additionally, assets in an irrevocable trust are projected against credit claims on the grantor.

After transferring assets to an irrevocable trust, the grantor loses all ownership rights; they cannot then make any changes to the trust. The trustee manages the transferred assets and releases funds to the beneficiaries according to the trust deed.

Foundations
Apart from providing for the deceased’s family, estate planning can have other aims, such as contributing to society. Establishing a private foundation is an effective way to maximize the post-tax funds available for charity. Income generated by assets inside the foundation are subject to substantially low taxes, which also reduces the amount of assets that a donor has to set aside to meet charitable goals. Due to the lower contribution required to meet charitable goals, more assets become available to meet other objectives of wealth transfer.

Discounts Applied on the Value of Shares of Privately Held Businesses
The value of an asset (such as shares of a publicly traded company) can be ascertained based on its recent trading price. However, determining the value of a stake in a private company is a complex process. This complexity also makes room to reduce the estate tax liability. As the stocks of private companies are not traded in public markets, the fair market value of such securities is lower than the traded securities of a similar business. Furthermore, if the minority stake held is that in a private company, an additional discount for lack of control can be applied to the value of the shares. These discounts are judgment-based; an experienced business appraiser can help defend a bigger discount on the holdings in a private company.

Aranca is a reputed business valuation firm with vast experience in preparing valuations for compliance with the Internal Revenue Code. If you plan to bequeath your estate or wish to gift your interest in a private company, Aranca will help you reduce your tax liabilities.

Please connect with Manish Goyal (Manish.Goyal@aranca.com) to know how Aranca can help you.