Use It or Lose It: Preparing for the Estate Tax Exemption Sunset

Introduction

The Tax Cuts and Jobs Act of 2017 brought about significant changes to tax laws, including a temporary increase in estate and gift tax exemptions. However, this favorable increase is scheduled to sunset at the end of 2025 and revert back to pre-2018 levels (inflation-adjusted), unless new legislation is enacted. This upcoming change presents both challenges and opportunities for families wishing to pass on wealth.

What is the Estate Tax Exemption?

As of 2024, each individual has an exemption of $13.61 million, while married couples have a combined exemption of $27.22 million. However, on January 1, 2026, the exemption will be cut in half (approximately $7 million per individual), drastically reducing the amount of wealth that can be transferred gift and estate tax-free.

This has significant implications for families wishing to pass on their wealth in a tax-efficient manner. Without proper and timely planning, a larger portion of your estate may be exposed to federal estate taxes if the increased exemptions aren’t made permanent. Therefore, taking proactive steps now can save you and your heirs from a hefty tax bill later.

Considerations for Married Couples

One effective strategy for married couples is the creation of dual spousal trusts, known as a Spousal Lifetime Access Trust (SLAT). A SLAT is an irrevocable trust where one spouse is the grantor and names the other spouse as the beneficiary (typically along with descendants or other beneficiaries). This allows assets to be excluded from the grantor spouse’s estate while still providing some level of access for the beneficiary spouse (and marital community).

Each spouse creates a SLAT for the other spouse, effectively leveraging the ability to use each spouse’s exemption while providing “access” to trust assets if needed. For example, if you and your spouse have combined assets of $50 million, you could each transfer $13.61 million into a SLAT (in 2024). All $27.22 million, plus any future appreciation and income, will be outside of your taxable estates.

However, it’s crucial to ensure that the SLATs are not too similar, as this could trigger the “reciprocal trust doctrine,” which the IRS may argue to void the SLATs for estate and gift tax purposes. That’s why it’s highly recommended to work with an estate planning attorney to avoid the pitfalls.

Understanding the Generation-Skipping Transfer Tax

Another consideration for married couples and families is the Generation-Skipping Transfer (GST) tax. The GST tax applies when a transfer is made to someone who is two (or more) generations below the donor, such as grandchildren. The GST tax exemption is currently aligned with the estate tax exemption, making today an opportune time to make such transfers.

By allocating your GST tax exemption to a gift transfer to an irrevocable trust (“GST Trust”), it allows trust assets to grow GST tax-free and avoid both estate and GST tax when transfers are made to future generations. This strategy is highly effective for transferring wealth across multiple generations.

Family-Held Entities

Family Limited Partnerships (FLP) and Family Limited Liability Companies (FLLC) offer unique opportunities for transferring family assets. These structures may allow parents to transfer ownership interests while retaining some control.

In an FLP, family members can serve as general and limited partners. For instance, a married couple could each retain 1% control as GP while transferring 49% LP interests to each of their two children. A FLLC operates similarly. Once established, parents can transfer non-managing member interests in the FLLC to children, or to trusts for their benefit, while keeping the Managing Member interest (or act as a non-member Manager). By serving as the GP or Manager, parents may maintain control over investment and management decisions. These family-held entities not only serve to facilitate the transfer of family assets but also offer the added benefit of asset protection.

Valuation Discounts

Both FLPs and FLLCs have the potential to utilize discounts to reduce the value of a gift. For instance, assume parents created an FLP and funded it with $25 million. Parents later transfer a 95% LP interest worth $23,750,000 to an irrevocable trust for descendants. Assume further that an appraisal supported a 15% discount to the value of the LP interest gifted. This means parents have transferred a 95% LP interest worth $20,187,500 for gift tax purposes.

Strategic Gifting

Strategic gifting can reduce your estate’s value, thus minimizing future tax liabilities. With the currently higher exemption amounts, gifting assets to loved ones today offers an advantage of future appreciation growing outside of your taxable estate.

For example, if your estate is valued at $25 million you can transfer up to $13.61 million in 2024 without being subject to gift tax. Under current law, beginning in 2026, the same exemption amount will be approximately $7 million. Consequently, you would lose the ability to gift almost double the amount tax-free.

Charitable Giving as an Estate Planning Tool

Charitable giving can also play a crucial role in estate planning. By donating to qualified tax-exempt charitable organizations, you can reduce the size of your taxable estate while supporting causes that are important to you. Split-interest trusts such as Charitable Remainder Trusts (CRTs) and Charitable Lead Trusts (CLTs) may accomplish charitable giving goals while also providing additional income tax benefits (if structured properly).

In general, a CRT allows you to receive an income stream from the trust for a specified term, after which the remaining assets pass to the charity. This may provide both tax benefits and a source of income.

Conversely, a CLT provides an income stream to the charity for a set period, with the remaining assets, if any, transferred to heirs. There are highly technical rules for each strategy and working with a well-versed estate planning attorney is imperative.

The Importance of Regular Reviews and Updates

Estate planning is not a one-and-done event. It’s essential to regularly review and update your plan to reflect changes in your financial situation, family circumstances, and tax laws. Regular reviews ensure that your plan remains aligned with your goals and takes advantage of current opportunities.

Work with your estate planning advisor to conduct periodic reviews and make adjustments as needed. This proactive approach helps to avoid potential pitfalls and ensures that your estate plan continues to achieve your objectives.

Wrapping It Up

The upcoming sunset of the estate tax exemption presents both challenges and opportunities for families wishing to pass on their wealth. By understanding the implications and taking proactive steps now, you can optimize your estate plan to minimize tax liabilities and maximize the benefits for your heirs.

Remember, estate planning is a dynamic process that requires regular attention and adjustments. Stay informed, seek expert advice, and take action to secure your family’s wealth legacy. If you’re ready to explore these strategies further, don’t hesitate to reach out to an estate planning specialist.