Jim Farmer is Financial Strategy Groupa leader in the insurance industry, provides customers with practical solutions.
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When it comes to your financial estate, business owners and executives who have amassed a substantial net worth in company stock rely on current tax laws that provide that the asset base left to heirs “increases” upon death until the date of death fair market value. For example, if you held stock that was worth $500,000 when you received it and is now worth $3 million, you would not be subject to capital gains tax if your heirs sold the stock at the current value. Last year, President Biden’s American Families Plan included a proposal to eliminate basis upgrades (subscription required). Then, earlier this year, as part of the president’s 2023 budget proposal, there was another attempt to end the base hike for those with capital gains of more than $5 million ($10 million for couples).
While these attempts have so far been unsuccessful, for many business owners and others who have accumulated illiquid wealth, the fact that basis continues to rise does not mean that all of their holdings are up. Most notably, assets held in an irrevocable grantor trust may not be promoted on a multi-generational basis.
Benefits of an Irrevocable Settlor Trust
The first step you may take in estate planning is to gift assets so they are no longer part of your estate. You can reduce estate tax exposure by gifting assets such as company stock and real estate that are expected to appreciate in value over time to an irrevocable grantor trust and letting those assets appreciate outside of your estate. The amount you can gift is not unlimited, but limited to your and your spouse’s combined lifetime federal estate and gift exemption ($25,840,000 for 2023).
As the grantor of an irrevocable grantor trust, you will be taxed on all income from the trust, even though you receive no income. The good news is that taxes paid out of your estate reduce your estate value proportionally. It also means that the assets in the trust can grow without tax liability.
One disadvantage of gifting appreciated assets to a grantor trust is that the assets will retain the tax base you, as the grantor, had prior to gifting the assets. This means that the assets you transfer to the grantor trust will not be enhanced from their then-current value since the assets are no longer part of your estate when you die. Capital gains taxes arise when a trustee or beneficiary sells an asset that appreciates. Capital gains taxes at the state level range from 0% to 13.3%, while federal rates range from 0% to 20% (with top earners paying an additional 3.8%).
Strategies for Avoiding Capital Gains Tax
Assuming one of your goals in establishing a trust is to pay as little tax as possible, there are several ways to avoid capital gains taxes in a grantor trust.
As the grantor, you retain the right to get back the trust assets by purchasing them for cash or replacing them with other assets – low appreciation assets are ideal. For example, if you receive a large amount of your employer’s publicly traded stock, you can exchange those stock for other publicly traded securities of equal value that have appreciated. Since the value of the trading assets must be equal, the value of the estate used to calculate the estate tax should not change. After the trade, you’ll own this highly appreciated stock, but you’ll have no taxable gain when you die because you’ll be boosted on the basis.
Likewise, for grantor trusts that contain appreciating real estate, IRC §1031 exchanges allow capital gains tax deferral when exchanging one real estate investment property for another.
Another strategy for reducing or eliminating capital gains taxes in a grantor trust is to establish a charitable remainder trust (CRT). The grantor can sell the investment without paying capital gains tax, earning income and receiving partial tax deductions during the life of the trust beneficiary. Here’s how it works.
• Grantor, a public company executive, donated $1,000,000 of his employer’s stock to CRT.
• The trustee sells the stock tax-free and reinvests the proceeds.
• The grantor receives a current income tax deduction and an income stream of at least 5% of the fair market value of the CRT proceeds.
• Upon the beneficiary’s death, the remaining proceeds in the CRT are donated to a charity, private foundation, or donor-advised fund.
Life insurance can be used to provide an income tax-free death benefit to its heirs as a base boost if the grantor wishes to replace the value of the donation to charity.
What if the assets in the grantor trust are not worth much (typically the trust is created upon the grantor’s death)? Save yourself from future capital gains taxes by investing in a low-cost, no-surrender premium variable life insurance contract. These contracts offer a number of advanced underlying fund options that can be entered and exited tax-free. Either the grantor or the beneficiary can be the insured. The trustee can distribute contract income tax-free, and when the insured dies, the trust receives a death benefit tax-free, much like a foundational boost.
Life insurance costs about 1% of your income — well below the capital gains tax rate.
final thoughts
These are just some of the options available to you to help achieve your goal of transferring assets with as little tax as possible. Every situation is unique, and a financial advisor should be consulted to discuss strategies that are right for you.
The information presented here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.
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