A recent WSJ Intelligence study revealed the top two priorities of ultra-high-net-worth individual respondents (UHNWI’s) are growing their assets and limiting tax liabilities.
Despite this, a separate survey of affluent Americans found that fully 52% of respondents lack even the basic elements of a proper estate plan. Given the complexityof the issues involved, it’s little wonder that the phrase “estate planning fatigue” has entered the financial lexicon.
How, then, can UHNWI’s and their families make their hard-earned money work for them in the most tax efficient manner, and also help ensure their philanthropic efforts have maximum strategic impact?
We spoke with Laura Williams, Geller Tax Director, to learn more.
Let’s dive into the fundamentals of Trust & Estates, which enable UHNW families to optimize wealth distribution and shape their legacy. This is a crucial element of prudent financial planning, yet research shows that only 27% of ultra-wealthy Americans say they understand trusts and their benefits very well.
Recent decades have seen legally binding trust agreements, a concept which dates to ancient Rome, evolve to become increasingly complex. Two types we hear a lot about are ‘revocable trust’ and ‘irrevocable trust.’ What’s the difference, exactly?
A revocable trust is established while the grantor is still living and can be amended or revoked as circumstance change. A revocable trust doesn’t shield income or estate taxes, it simply allows your assets to pass to family members while avoiding probate.
Probate is a time-consuming and administratively burdensome process, during which years can pass before the beneficiary actually receives the funds. However, if the assets are already in a revocable trust, they should all transfer quite quickly.
Individuals mainly establish revocable trusts for privacy purposes and ease of estate administration. If you have a will, but all of your assets are titled in your name personally, your estate, instead, goes through the probate court process and the disposition of assets is part of the public record.
Importantly, a revocable trust doesn’t actually transfer any assets out of your estate. Should an individual have a sizeable taxable estate (in excess of the current lifetime estate and gift tax exemption of $13.61 million) then the assets in a revocable trust remain subject to estate tax.
Therefore—to the extent you expect a taxable estate—you may also want to consider an irrevocable trust in order to move the assets out of your taxable estate. As its name implies, irrevocable trusts generally can’t be changed though you are able to bake in some flexibility.
For example, say you have a life expectancy of 30 more years. Should you be in a position to put $13.61 million in an irrevocable trust now, it would grow outside of your estate for the next three decades. If, when you eventually pass away, the value has compounded to $40 million, your estate won’t bear an estate tax burden on the appreciation. The earlier you move assets outside of your taxable estate, the more it will grow estate tax free for future generations.
How does one decide what assets should go into an irrevocable trust?
Expected appreciation in the asset’s value is a significant consideration. As mentioned earlier, after an asset is transferred to an irrevocable trust, the asset continues to grow outside of your estate, shielding the appreciation from estate tax.
Valuation discounts are another consideration. Discounts are available when transferring an interest in structures like family limited partnerships, hedge funds, and private equity funds. Fair market value is the sale price that would be agreed to by a hypothetical buyer and seller. Common discounts available are from lack of marketability, lack of control, or minority share.
Discounts allow you to maximize the use of your lifetime exemption. Let’s say, for instance, you own 49% of a family limited partnership and your share of the assets are valued at $15,000,000. Assuming a 35% discount based on lack of marketability and control, the transfer may use $9,750,000 of your lifetime exemption. Discounts are also available for an estate so shouldn’t be the only consideration given to transfers during life.
An irrevocable trust can also be an effective mechanism in maximizing annual giving to children, other family members, and friends. You may make annual exclusion gifts to as many individuals as you wish, without using your lifetime exemption. This year’s annual exclusion is $18,000, indexed for inflation, so a married couple can gift up to $36,000 in 2024 to each individual and not exhaust their lifetime exemptions. These gifts may also be made directly to those individuals you wish to benefit.
Drilling down further, what’s the difference between a grantor and non-grantor trust?
An irrevocable trust can be constructed in two ways: as either a grantor or non-grantor trust. The primary difference is that the income tax burden of a grantor trust continues to be paid by the grantor, whereas the income tax burden of a non-grantor trust is paid by the trust which depletes trust assets.
For example, suppose you transfer income-generating assets (like a publicly traded security or XYZ stock) into a grantor trust. Whenever that stock pays dividends you personally owe the tax, but the dividend and appreciation stays within the trust. Essentially, every time you pay tax, it represents an estate tax-free gift to the trust allowing you to continue to grow assets outside of your taxable estate.
In the above example, if XYZ stock is placed into a non-grantor trust, the trust now needs to pay its own income tax liability related to the dividend. So, when XYZ stock pays a dividend and the non-grantor trust owes tax, trust assets will be used to cover the tax. To the extent that the grantor can continue bearing the tax burden, doing so personally provides substantial estate tax savings. Continuing to bear the tax burden personally, allows the trust assets to keep appreciating outside of your taxable estate.
Any additional advice here?
Yes. Depending on the trust terms, making a change can be fairly flexible in order to keep the option open to convert a grantor trust to a non-grantor trust at a later date. This is known as ‘turning grantor status off.’
To the extent you are comfortable personally paying the income tax burden, this approach keeps more money outside of your taxable estate. Depending on your cash flow needs, it may make sense to turn grantor status off at some point so the trust assets are used for its tax liability. Another option when drafting, is to allow the trust to reimburse for income tax liabilities which would alleviate the need to turn grantor status off when you may just want the trust to bear its tax burden in a certain high-income year.
An irrevocable life insurance trust (ILIT) is another option. Who could benefit from these?
An ILIT may hold life insurance policies excludable from the settler’s taxable estate. Gifts to the trust in order to pay premiums use the grantor’s annual exclusion and, possibly, lifetime exemption, depending on the premium amount and number of beneficiaries. If you personally own a life insurance policy, the value of that policy is included in your taxable estate. If the policy is owned by the ILIT, when you pass away, the insurance proceeds go directly to the trust and its beneficiaries estate tax free.
Regarding Trusts & Estates, clients often ask whether trust and estate (T&E) documents established years earlier by the family matriarch or patriarch should ever be revisited. Generally speaking, what do you recommend in such situations?
Reviewing your estate plan at least every five to ten years to account for any major life changes is a good rule of thumb. It’s also vital to carefully choose the correct candidate for the roles of executor and trustee.
These positions are often akin to a full or part-time job and involve an important fiduciary duty to act in the best interests of the beneficiaries. The trustee should be someone who you view as having both the time and capacity to complete the task professionally.
All mandatory distributions must be made timely. If trust terms allow discretionary distributions, it’s also the trustee’s responsibility to determine whether such distribution requests are reasonable. Other important trustee obligations may include ensuring applicable taxes are paid promptly and issuing any relevant letters or notices to beneficiaries. You might also identify a trust protector, which comes with additional administrative duties to ensure the trust terms are correctly carried out, like a trust accounting when there are multiple beneficiaries.
There are several options available when choosing trustees. Assuming the trustee fee isn’t an issue, I would recommend selecting both a family member and a trust company so the trust company is responsible for the administrative procedures while allowing the family member you trust to weigh in on reasonableness of distribution requests.
“Think of giving not only as a duty but a privilege.” So said John D. Rockefeller in the Gilded Age. Philanthropy is equally important to many of today’s UHNWI’s and their families. Two particularly popular charitable vehicles are private family foundations and Donor Advised Funds (DAFs). Can you talk us through each one, and how they can help benefactors achieve their philanthropic goals?
Private foundations are an excellent way to ensure your legacy and impact lives on for future generations. Private foundations require abundantoperational infrastructure, are required to grant out 5% of assets annually (based on the average of the prior five years) and must file tax returns. These tax returns are posted online and part of the public domain. Donations to a private foundation are only income tax deductible up to 30% of your adjusted gross income (AGI), 20% when using appreciated securities rather than cash. Net investment income earned by a private foundation is subject to 1.39% net investment income tax.
Donor advised funds (DAF), by contrast, provide greater discretion as one can opt to contribute anonymously. They are also relatively easy to establish and typically involve little to no administrative upkeep compared to a private foundation. You can deduct DAF donations up to 50% of your AGI, 30% when using appreciated securities rather than cash. DAFs are especially well-suited for those who wish to exert a philanthropic influence but are not yet sure about which exact organization(s) to support.
Are there any tax-advantaged strategies clients can utilize to get more ‘bang for their philanthropic buck’?
If you are able, it’s always advantageous to use appreciated securities for your charitable donation instead of cash. By doing so, the donor avoids having to pay income tax on the capital gain while still receiving a FMV deduction.
Additionally, for estate planning purposes, designating certain retirement accounts to charity rather than family saves both estate and income tax. Often individuals leave IRA accounts to family members and other assets to charity, while switching those designations around may result in substantial tax savings.
Summing up, anything else worth emphasizing?
Ideally, you want a team of tax, legal and investment professionals that will work together. It’s important a client can call on seasoned professionals for an analysis of complex tax considerations. These include opining upon which specific assets are best suited for selling or gifting to a trust or donating to charity. Such an integrated approach can aid proactive estate planning and maximize the impact of your wealth strategy, while working to reduce future estate tax.
Glossary of Terms
Beneficiary: In the context of a trust, a beneficiary can be either an individual or organization and is the recipient for whom the trust was established.
Capital Gain (or Loss): The amount of profit (or loss) that is realized when one sells a financial asset whose value has increased (or decreased) from the original purchase price.
Donor Advised Fund: A private investment vehicle that acts under the operational jurisdiction of a public 501(c)(3) charity. As such, it is fully tax-exempt. The National Philanthropic Trust is an example of a DAF.
Estate Planning: The process of arranging for the management and transfer of assets in anticipation of death or incapacitation.
Grantor: The person or organization that creates a trust, typically the initial owner of the assets that are put into the trust.
Grantor Trust: A revocable trust created during an individual’s life that becomes irrevocable at death; or a type of irrevocable trust created during lifetime. Such a structure allows the grantor to bear the income tax burden during life, allowing trust assets to appreciate outside of your taxable estate.
Irrevocable Life Insurance Trust: A trust that contains life insurance policies. Generally, it cannot be amended, and it ultimately reduces the estate tax burden borne by beneficiaries.
Irrevocable Trust: A trust that allows the grantor to transfer certain assets away from their taxable estate, in exchange for giving up control of the assets and designating a trustee who manages the assets in the trust. The trust terms typically cannot be altered.
Non-grantor Trust: An irrevocable trust in which the grantor gives up control of the trust assets after it’s established. This type of trust pays the tax on the income earned. Non-grantor trusts can be used for estate planning, asset protection, and income tax planning.
Private Foundation: An independent charitable organization established by a family or individual, which may be run by their family members or others beyond their lifetimes to achieve philanthropic goals. The Bill & Melinda Gates Foundation is one well-known example.
Revocable Trust: A trust that may be revoked or revised during life, and stipulates how assets will be distributed upon the grantor’s passing. Estate taxes still apply to the assets held in a revocable trust.
Trust: A legal contract that allows a person—the grantor or trustor—to transfer assets to a third party, also known as a trustee, to hold and manage for the benefit of another person(s) or organization, called the beneficiary.
Trustee: A person or organization that manages assets or property in a trust, for the benefit of the receiving party, called the beneficiary.
