Estate planning has changed dramatically over the past few years. The increase in the estate, gift and generation-skipping transfer tax exemption to the current (2020) amount of $11,580,000 has made estate planning decisions for smaller estates much more difficult, as the increased federal exemption presents multiple competing planning options for smaller clients.

Those options require a detailed analysis that can make it harder for the client to decide among them. Planning for high-net-worth clients remains focused on traditional estate planning techniques. These clients, generally defined as those with estates in excess of the $11,580,000 exemption, have a number of techniques available to them to either transfer appreciation to younger generations or to reduce the value of assets included in their taxable estate.

The federal transfer tax system, which includes the estate, gift and generation-skipping transfer tax, imposes a tax on gifts made when the client is alive or on clients’ assets when they die if their estates’ value exceeds the $11,580,000 exemption. A decedent’s gross estate includes all of the assets over which he or she has control, including taxable gifts the decedent made while alive. The gross estate is reduced when qualifying amounts are left to a surviving spouse and charity. It is also reduced by administration expenses and debts. The result is the taxable estate, which, if over the amount of the exemption, is taxed at a rate of 40%. As a result, high-net-worth clients will want a plan to avoid or minimize the gift and estate tax.

Preliminary planning. Planning for high-net-worth clients involves a collaborative effort by a number of advisors, including the clients’ attorneys, CPAs or other tax advisors, investment advisors, insurance professionals and the trustees. Working together, these professionals strive to not only minimize taxes but to make sure the disposition of the estate meets the client’s goals and objectives.

Developing the plan. There are a number of tax planning strategies available to high-net-worth clients. Some may be interested in how to efficiently transfer assets to their descendants. Others may have charitable goals. Still others, especially those involved in high-risk ventures, may be interested in asset protection. Some are interested in all three. It is important to identify which goals the client has in mind and develop a plan consistent with those goals.

Tax-efficient transfer of wealth. There are a number of techniques a high-net-worth client can take advantage of to transfer wealth in a tax-efficient manner. Some techniques are useful for transferring wealth to the next generations while others aid in tax-efficient charitable giving or asset protection.

For those interested in transferring wealth to descendants, the primary objective is valuation. The goal is to lower the value of transferred assets or the value of assets retained by the client. This is accomplished by discount valuation—the idea being to put some type of legal wrapper around assets that will make the valuation lower.

For example, a client could sever the ownership of an asset into a tenancy-in-common ownership with another person, giving both owners an undivided 50% interest in the asset. Since neither owner would have control over the asset, the value would not be 50% of the whole but something less. There are few buyers for a 50% interest in an asset, so the 50% interest in the asset should be entitled to a valuation discount.

Advisors will often recommend establishing a family limited partnership or limited liability company, transferring assets to the entity and giving the client a limited ownership interest in it. This limited interest should be entitled to a valuation discount. The client will retain it until he or she dies or transfers the ownership interest to lower generation heirs at its discounted value, thereby saving gift taxes. Clients should be aware, however, that such structures should have a significant and independent reason for being other than for their tax advantages. Otherwise, the values may be challenged by the Internal Revenue Service.

Another popular technique for transferring assets that are expected to appreciate significantly in the future is a sale to a grantor trust (also sometimes referred to as an intentionally defective grantor trust). This is an irrevocable trust in which the grantor retains a power that will cause the income of the trust to be taxed to the grantor without the assets of the trust being included in the grantor’s gross estate for federal estate tax purposes. A sale to a grantor trust of an asset expected to appreciate in the future is a widely used estate planning technique to freeze the value of the client’s estate.

This technique involves a four-step process:

First, the client sets up an irrevocable grantor trust for the benefit of his heirs.

Then the client funds the trust with 10% of the amount to eventually be transferred to it. This is a taxable gift that can be offset by using some of the client’s $11,580,000 exemption.

Next, the client sells an appreciating asset to the grantor trust in return for a promissory note. The appreciating asset is now in the trust. The client holds the promissory note. Since the value of the promissory note is fixed and will not appreciate, the client has frozen the value of his or her estate at the note’s value. The appreciating asset, meanwhile, is out of the client’s estate.

The IRS has ruled that transactions between the client and grantor trust are not subject to income tax recognition, so the sale of the appreciating asset to the trust is not a taxable event. Since the income of the grantor trust is taxed to the client, the client reduces his estate by the amount of income tax he pays on the trust income. Meanwhile, the trust is able to grow without the income tax burden.

The final step is that the client pays the note off over time, preferably before he or she dies.

Charitable planning. Clients interested in planned giving have a number of choices. Many high-net-worth clients would like to establish and make charitable gifts to their own private foundations. Gifts to a private foundation are generally subject to more restrictive limitations for purposes of the income tax deduction and are also subject to certain penalty taxes if not administered properly. Given the complexity of the rules applicable to private foundations, high-net-worth clients might favor establishing a donor-advised fund instead.

These are funds established at a public charity, such as a community foundation, university, hospital or another charitable organization. The donor-advised fund is a public charity, allowing for higher limitations for an income tax deduction. The fund will do the administrative work involving the charitable giving, from making the charitable gift to filing the applicable tax returns. In donating to a donor-advised fund, the client gives up legal control over the assets but retains advisory privileges over which charities receive the donation. In effect, the donor-advised fund is a simplified version of a private foundation.

Other planned giving vehicles used by high-net-worth individuals include charitable remainder trusts and charitable lead trusts. These are so called “split-interest” trusts, which means the client gets some benefit as well as the charity. In general, the charitable remainder trust pays the client a certain amount for a set period of time, either for life or for a period of up to 20 years, with the balance at the termination of the client’s interest passing to charity.

The charitable lead trust is the mirror image of the charitable remainder trust. The charitable lead trust will pay the up-front interest to charity with the remainder interest going to individuals. Both the charitable remainder trust and charitable lead trust are subject to complicated rules, not discussed here, that a client must fully understand before deciding to use either vehicle for charitable giving purposes.

Asset protection. Finally, high-net-worth clients may be interested in limiting their assets to exposure to creditor claims. Those clients are interested in asset-protection planning. In some cases, state or federal laws may provide automatic protection for those assets.

For example, many states protect life insurance proceeds from creditor’s claims. States may allow a homestead exemption to protect part or all of a client’s home. Additionally, federal law generally protects qualified pension plans from a creditor’s claims. In lieu of statutory protection, 19 states currently allow a client to transfer assets to a domestic asset-protection trust. These trusts, while differing from state to state, generally allow the client some access to the assets in the trust while preventing creditors from accessing trust assets to satisfy a claim against the client. In some situations, a client may want to use an offshore jurisdiction for asset protection, although the rules for offshore protection are complicated.

There are a number of techniques available for transferring wealth, giving to charity and protecting assets. Which planning opportunity is best for a particular high-net-worth client depends on the client’s particular situation. The most important point is to plan ahead and build flexibility into the plan to be able to adjust to changing and unanticipated circumstances.   

Jere Doyle is an estate planning strategist for BNY Mellon Wealth Management and a senior vice president of BNY Mellon.