Anyone paying attention knows that stock markets have been volatile. As a simple example, the Dow Jones Industrial Average saw an increase of over 600 points (1.56%) on April 11 after dropping over 1,000 points (2.5%) on April 10. Similarly, the S&P 500 gained 9.5% on April 9, but dropped 3.5% on April 10. Generally, most investors dislike this volatility. However, regardless of the cause of market volatility, these market conditions can create opportunities. Some of those opportunities relate to estate planning.
In the way of background, each individual currently has a $13.99 million gift and estate tax exemption amount,[1] being the amount which may pass free of gift or estate tax. Any value in excess of this exemption passing during lifetime or at death, will be subjected to a 40% gift or estate tax. Therefore, a married couple can transfer $27.98 million to their intended beneficiaries (not considering deductible gifts such as those benefitting from the marital or charitable deduction) without subjecting those transfers to wealth transfer tax. This is the largest transfer tax exemption in history. Although not the point of this writing, the pre-inflation adjusted exemption amount is scheduled to be reduced in half after 2025. Legislation to avoid that reduction is a priority for many members of Congress, but that legislation has not yet passed. Beyond the items discussed here, planning to avoid losing the current increased exemption may be valuable if this legislation does not pass or merely delays the date that exemptions drop.
Many estate planning strategies seek to transfer appreciating assets to lock in currently low values in order to ultimately transfer more than these amounts at death. If, for example, I buy stock that is worth $1,000,000 today but I anticipate it being valued at $5,000,000 at my death, then I save $1,600,000 in estate tax by making a current gift as long as that value change occurs as anticipated and the transfer would be fully taxable.[2] As a result, making gifts of assets at depressed value provides an opportunity for transfer tax savings. With this background, some of the estate planning opportunities which make sense in a volatile market environment are described below.
Planning Opportunities
Gifts
As discussed above, gifting assets at low value can be tax efficient. This is because transfer tax cost (use of exemption or tax) is based on fair market value at the time of the gift. Further, each individual has an annual exclusion amount of $19,000 currently which is the amount which may be gifted without using exemption or paying gift tax (assuming the requirements are met). This may not sound substantial. However, consider a married couple with two children and four grandchildren. By both spouses making gifts to their children and grandchildren, they can gift $228,000 each year without using exemption or paying gift tax. This represents $99,200 in gift or estate tax before considering any appreciation on the gift. When asset values are depressed, more eventual value may be gifted, whether via an individual’s annual exclusion or otherwise, than uses annual exclusion, uses gift tax exemption, or is subjected to gift tax.
Gifts to irrevocable grantor trusts[3] are common. In addition to other benefits, this allows the trust assets to grow income tax free inside of the trust while reducing the taxable estate of the grantor by the income tax paid on behalf of the trust. This income tax payment is not a gift for gift tax purposes. Therefore, assuming asset values return after a market downturn, not only was the grantor able to benefit from reduced transfer tax costs of the gift, but also pays the income tax when the gifted asset is later sold without being considered to have made a gift, thereby increasing the assets effectively transferred free of gift or estate tax.
Sales
In addition to gifts, a number of individuals sell assets in the estate planning context. This may be for a variety of reasons such as having previously used all of the individual’s gift tax exemption or having a need to retain positive cash flow from the asset transferred. In these and other situations, assets may be sold rather than gifted. These sales may be to individuals, such as a child, or trusts. When asset values decline, there can be a double planning benefit. First, sales to individuals (as opposed to grantor trusts) can cause the seller to recognize taxable gain.[4] The lower the value of the asset sold, the less gain that may be recognized. Second, similar to gifts, more ultimate value can pass to the intended recipient free of wealth transfer tax. This is because, assuming the asset returns to higher value after the sale, the seller takes back less in purchase price while still passing the higher value asset to the buyer. The lower sales price therefore reduces the amount eventually subject to estate tax for the seller’s estate.[5] Sales to grantor trusts do not result in gain recognition. They also experience combined benefits both to gifts to grantor trusts and sales to related parties.
Exercise Powers of Substitution
Many irrevocable grantor trusts contain a provision allowing the grantor to exchange trust assets for other assets of equivalent value. Even outside of volatile market conditions, the power of substitution can be valuable. Because assets in the irrevocable trust do not obtain a cost basis adjustment at the death of the grantor,[6] swapping low basis trust assets for higher basis assets in the hands of the grantor allows for greater gain elimination while still passing the same amount of wealth to beneficiaries. When asset values decline, this provides other opportunities. Currently low value assets held by the grantor can be exchanged with the trust in exchange for trust assets that may not be expected to experience significant further appreciation.
GRAT Strategies
A GRAT is an irrevocable trust into which the grantor makes gifts, retaining the right to an annuity for a term of years. After the expiration of the term, any remaining assets pass to the remainder beneficiary or beneficiaries. The value of the gift in a GRAT is a calculation based on the value of the asset gifted to the GRAT, the term of the GRAT, the retained annuity amount, and an IRS discount rate. Often, a GRAT is “zeroed out” by calculating the value of the annuity to equal 100% of the value of the asset contributed plus the IRS discount rate. To the extent the GRAT outperforms that discount rate, the excess will pass to the beneficiary gift tax free. As such, the lower the value of the asset gifted to the GRAT versus its expected appreciation over the term, the more wealth that may be passed to the beneficiary free of gift tax. As such, gifts to a GRAT of depressed value assets can produce valuable tax free wealth transfers.
Similar to other irrevocable grantor trusts, GRATs often contain a provision allowing the grantor to swap assets in the GRAT for other assets of equivalent value. If GRAT assets drop in value, they may be exchanged for other assets with more appreciation potential on a leveraged basis due to the drop in value. Also, the assets removed from the GRAT in that swap may be contributed to a new GRAT with the gift tax calculations being based on the depressed asset value. Even if cash is exchanged with the original GRAT, this provides a benefit. The original GRAT will “fail” meaning all assets are paid back to the grantor. However, the new GRAT has much more opportunity to pass wealth because of the low value on contribution relative to expected value upon GRAT termination.
Further, locking in GRAT gains can be valuable. When assets originally contributed to a GRAT have substantially appreciated such that there is expected to be a meaningful gift tax free wealth transfer, locking in that appreciation can be powerful. Were the GRAT assets to decline, the amount of wealth transferred would be reduced or eliminated. As such, substituting those appreciated assets with more stable assets, or even cash, allows that preexisting appreciation to be “locked in” at a high point. By doing so, the success of the GRAT can be reasonably assured.
Conclusion
While most people look at a decline in the value of their investments as a negative, that does not necessarily have to be the case. If asset values recover, those investors ultimately do not experience that loss. In the meantime, depressed asset values can present planning opportunities for those willing to “turn lemons into lemonade.” There are a number of planning opportunities that benefit from low valuations. Those described in this writing are some of the more common such opportunities, but there are others. For example, anyone considering a Roth IRA conversion would be well served to do so while the value of those accounts is lower which reduces income tax on the conversion. Loss harvesting to unlock appreciated assets without current tax liability can be valuable for many reasons. Other strategies, such as charitable lead trusts, also benefit from low values, assuming they recover.
Finding assets which are disproportionally “punished” in times where markets are volatile can provide these planning opportunities. Do not let a decline in the market, or market volatility generally, deter estate planning. Rather, those who could experience a taxable estate, whether now or after sunset of current increased exemptions, should look for opportunities to use a decline in assets expected to recover their value. This can be a time when significant wealth can be transferred at reduced transfer tax costs.
[1] Currently, the exemption for generation skipping transfer tax purposes is the same. However, this writing is limited to gift and estate tax, thereby not addressing planning considerations specific to allocation of generation skipping transfer tax exemption.
[2] Note, however, that there is a tradeoff to obtaining this benefit in that the stock would not obtain a cost basis adjustment at death under IRC § 1014 eliminating all income taxable gain. Therefore, assuming this stock is a capital asset, a lifetime gift under these facts costs an additional $800,000 in capital gains tax at the 20% capital gains rate. As such, the total net benefit is $800,000 rather than the full $1,600,000. Planning based on these variables was discussed in Joshua W. Sage, “Estate Inclusion: The New Estate Plan, Step-Up,” Aug. 8, 2018, https://www.esapllc.com/inclusion-planning/. In addition, there are special split basis considerations for property where the basis exceeds fair market value (i.e. loss property). See IRC § 1015(a).
[3] A grantor trust is one which is ignored for federal income tax purposes under Subchapter J of the Internal Revenue Code. The result is that the trust’s grantor continues to report the income, gain, or loss with respect to trust assets on their individual income tax return.
[4] Note that loss ordinarily would not be recognized due to IRC § 267 which generally prohibits recognition of losses on sales between related parties.
[5] Note here that selling for “adequate and full consideration,” particularly in the family entity context, can be important in preserving the intended estate tax result. See, e.g., IRC § 2036(a).
[6] See Rev. Rul. 2023-2. Note that this discussion is focused on irrevocable grantor trusts established for estate tax planning. Other irrevocable grantor trusts, such as certain domestic asset protection trusts or Medicaid planning trusts, may be includable in the grantor’s taxable estate and, therefore, receive this cost basis adjustment.
