The Great Estate Planning Cake Bake Off: How to Make It, Give It Away, and Eat It Too
By JoAnna Fellon, Partner, National Leader - Private Client Services
Think about your wealth like a cake. You spend a lifetime finding the best recipe, gathering all the ingredients, baking, and decorating. You invest time and resources and watch your legacy come together. No matter where you are in the cake-making process, now is the time to plan for when and how you want to share your cake with your loved ones, relatives, friends, and possibly those you believe are most in need. However, if you start passing out pieces while you are still alive, you may be concerned about having enough cake left over for you to enjoy. And you also need to keep in mind that if your cake gets too big, the government has a sweet tooth and would be more than happy to take almost half your cake and possibly waste it, or let it go stale while politicians argue over who gets to eat the pieces of the cake you spent a lifetime making.
This article will touch on a few popular estate planning “recipes” to consider. By no means is it a comprehensive “cookbook” that covers all the available strategies that might help you (or your client) depending on the particular facts and circumstances.
The strategies below apply to those who have enough gift tax exemption to make large taxable gifts now; those who may have already used most of their gift tax exemption; and those who are charitably inclined but want to retain a steady stream of income. These planning strategies can really put the “icing” on the cake.
Historic and Current Gift and Estate Tax Exemptions
The act of transferring assets during life (gifts) or at death (estate) has incurred taxes in one form or another for hundreds of years in the U.S. However, it was the Revenue Act of 1916 that created a framework that closely resembles the fundamentals of our current gift and estate tax rules. Notable changes in the last few decades include the unification of the gift and estate tax exemptions and the amount of the exemptions. The estate tax exemption was set to disappear at the end of 2010 after increasing incrementally from $675,000 to $3.5 million during that decade while the tax rate decreased from 55% to 45% (although a $1 million lifetime gift tax exemption remained).1 But in 2010, Congress passed short-term legislation setting the exemption at $5 million for 2011-2012 with a 35% tax rate. The bill temporarily allowed a spouse’s unused exemption to be transferred to the surviving spouse, with the exemption set to revert back to $1 million in 2013.2
In 2012, during highly partisan congressional negotiations related to the infamous “fiscal cliff” showdown (which included an extended government shutdown), Congress eventually passed legislation in the early morning hours of January 1, 2013, that unified the estate and gift exemption at $5 million (indexed each year for inflation) and made the portability of a deceased spouse’s unused exemption permanent.3 In 2017, when the exemption amount had increased for inflation to $5.49 million, sweeping tax legislation was passed that doubled the exemption amount to $11.18 million through the end of 2025. It will then revert to half of the original $5 million as indexed for inflation since 2013.4 Which is estimated to be somewhere around $7 million in 2026.
The 2022 exemption amount is $12.06 million, and the Internal Revenue Service (IRS) recently announced that the inflation-adjusted exemption amount for 2023 is $12.92 million. This effectively allows a married couple to transfer a combined $25.84 million, by gift or at death, to others during 2023. Due to inflation adjustments, this number could rise above $15 million ($30 million for a married couple) before it is scheduled to be cut in half at the beginning of 2026. Additionally, the IRS indicated that no gift tax will be owed when the exemption is cut in half if gifts in excess of the estimated $7 million amount were made prior to 2026.6 When considering gifts that will exceed the projected 2026 exemption, make sure only one spouse maximizes their exemption if both spouses are unable or unwilling to use all of their exemption prior to 2026. That way, the other spouse retains some exemption that can be used for future gifts after the reversion at the end of 2025.
Spousal Lifetime Access Trust (SLAT) and Domestic Asset Protection Trust (DAPT)
For those who have a cake big enough that they want to share it but aren’t sure how much they will want to eat during their lifetime, giving away the whole cake isn’t a particularly good option. However, there are a few ways to give away your cake but retain the ability to have a few pieces when you are tempted.
One of the most effective ways to reduce estate tax exposure is to transfer assets out of your estate at their current value if they could appreciate significantly in the future. This is sometimes referred to as an “estate freeze” strategy. It is accomplished by transferring assets into an irrevocable trust at today’s fair market value, allowing any appreciation to escape estate tax at your death. Note that the transfer into the trust would use part of your exemption.
One of the biggest disadvantages associated with outright gifts or gifts to an irrevocable trust is the loss of control and access to the assets gifted. Generally, if you put your assets into an irrevocable trust and retain any type of beneficial interest in the trust assets, such as the ability to receive income or access the assets, the value of the appreciated assets will be pulled back into your taxable estate at death, which melts your “estate freeze” into nothing. This would be especially devastating for those who prefer ice cream cake.
If you are married, have not previously used up your exemption, and want to ensure you have enough assets left to continue the lifestyle you have become accustomed to, a spousal lifetime access trust (SLAT) may be the right solution for you. This strategy may evoke memories of your wedding day, when you cut the cake and fed your spouse a piece or possibly just smashed it on their face.
A SLAT typically allows some indirect access to the income and assets you transferred to the trust by way of your spouse. This is done by naming your spouse as a beneficiary of the trust, which means they can receive distributions. As long as you and your spouse are getting along, they may be inclined to use distributions to take you out to a nice dinner, pay for things that benefit you, or even buy you something special. Though it is considered a taxable gift from your spouse to you, there are no gift tax consequences due to the unlimited gift tax marital deduction rules. If your spouse (or you indirectly) has no need for distributions, the assets can remain in the trust to grow and benefit your children, their children, or other loved ones without incurring additional gift tax or the estate tax at your death (or at the death of any of those beneficiaries).
Additionally, if you transferred assets to your spouse using the unlimited gift tax marital deduction, or your spouse transferred their own assets into a trust they create, then they could set up a SLAT for your benefit. However, such an arrangement should not be done on a quid pro quo basis. The terms of the two SLATs should be different, funded at separate times, and contain a different mix of assets to avoid the reciprocal trust doctrine, which would cause each trust to be disregarded for transfer tax purposes. If set up properly, you and your spouse could both indirectly benefit from the assets in the other’s SLAT, while also excluding any appreciation of the assets in the trusts from your estates for tax purposes.
Keep in mind that when a distribution is made to a spouse, it essentially increases the amount of assets subject to estate tax. Those assets were previously shielded when you used your exemption when funding the SLAT, so there is a tax advantage to using assets outside of the SLAT to fund your lifestyle needs. When both spouses are not fully using their exemption when funding both SLATs, it may make more sense to fully fund only one SLAT so the other spouse still has exemption remaining to use later (especially after 2025 when the exemption is set to be reduced by 50%).
If you are not currently married or are worried about not being able to access assets in your SLAT after your spouse passes away, keep in mind that some states have implemented self-settled trust rules. These rules may allow you to access and benefit from assets you transfer into a trust, or allow you to be added as a beneficiary of the SLAT after your spouse dies without causing the trust’s assets to be included in your taxable estate. Trusts created under one of these states’ self-settled rules are referred to as a Domestic Asset Protection Trust (DAPT). About 17 states have passed such legislation over just the last two decades or so.
While DAPTs may provide some estate planning benefits, as the name suggests they were created mainly to provide additional protection against potential creditors. They do so by allowing you to transfer assets into the trust, retain access to and control over the assets, and avoid claims made by creditors against you. There is usually a waiting period before the trust becomes creditor-proof, which varies by state. In most states, debts such as child support or alimony cannot be avoided even after the waiting period.
Due to the infancy of these rules, it is uncertain whether one state will respect another’s DAPT statutes, especially if a non-resident sets up a DAPT in a state that has not adopted DAPT statutes. Using a trust created under another state’s DAPT statutes may be enough of a deterrent to prevent a creditor from pursuing a claim, or at least consider a much more favorable settlement. The strength of the creditor protection DAPTs provide is beyond the scope of this article. But when considering the possible benefits from a federal estate tax perspective, DAPTs have gained some popularity among those willing to accept that there is a risk that federal tax rules could possibly prevail over the state self-settled trust rules.
Grantor Retained Annuity Trust (GRAT)
Using a GRAT can be an effective way to transfer wealth, especially if you have already used most of your exemption making other gifts. This is another “estate freeze” technique that works best with assets expected to appreciate significantly. In the simplest terms, a GRAT is an irrevocable trust that you fund with appreciating assets. The trust then pays you a specified amount each year for a specified period of time. At the end of that period, if you are still alive, the remaining trust assets and appreciated value (after making the annuity payments) pass to the trust’s remainder beneficiary without being subject to estate tax. The beneficiary can be a person or a trust, such as a SLAT or DAPT.
The value of the gift to the trust is determined based on the current value of the annuity payments you will receive from the trust. That value is calculated using the IRC Section 7520 interest rate (7520 rate) and IRS annuity tables in effect when the trust is funded. The GRAT can be structured so the present value of the annuity payments is very close or equal to the value of the assets initially transferred to the trust. This is referred to as a “zeroed-out” GRAT. When it is funded, no taxable gift occurs and no exemption is used. To receive this specific gift tax treatment, the GRAT must meet certain requirements beyond the scope of this article. A popular strategy is to use “rolling” GRATs, which usually have a short term of two to four years. After that, the remaining assets can be put into a similar short-term GRAT each time the term ends. Assuming the assets are growing in value, the appreciation can be continuously transferred to others without incurring gift or estate tax.
Charitable Remainder Trusts
During the French Revolution in the late 18th century, while the vast majority of France was suffering from a severe bread shortage, rumor is that the Queen of France, Marie Antoinette, said “Let them eat cake!” While this may or may not have occurred, implementing a charitable remainder trust (CRT) may be an effective way for you to share some of your cake charitably to help those most in need.
A CRT is a split-interest trust consisting of both income and remainder interest. During the trust’s term, the non-charitable income beneficiary receives payments (at least annually). At the end of the term, the remaining assets are passed to one or more charities of your choosing. The trust’s term can be for a certain number of years, your lifetime, the lives of you and your spouse, or even the lifetime of another person. The income payment can also be set up as an “annuity” providing a fixed amount each year (a CRAT) or what is known as a “unitrust,” providing a payment equal to a percentage of the trust’s fair market value each year (a CRUT).
CRTs are classified as tax-exempt entities, so the trust itself is not required to pay any tax on the income it generates. Instead, the non-charitable income beneficiary pays tax on the amount received each year, to the extent there is built-up taxable income within the trust. Funding the trust with highly appreciated assets provides the greatest tax benefit because the assets can then be sold by the trust and reinvested without any immediate tax implications. This allows you to spread your taxable income over multiple years, possibly allowing the income to be taxed at a lower rate each year while also reducing your exposure to the 3.8% surtax on net investment income for high-income taxpayers.
And the icing on the cake? You also receive a current charitable income tax deduction for the present value of the remainder interest that will pass to charity. This is calculated by using the 7520 rate in effect at the time the trust is funded. Additionally, if the only non-charitable income beneficiaries are you or your spouse, and you retain the ability to change the remainder charitable beneficiary (which is a common provision included in a CRT), none of your exemption will be used when the trust is funded. This is because any interest your spouse may have is covered by the unlimited gift tax marital deduction, and the rest is considered an incomplete gift since you can change the ultimate charitable beneficiary. Subsequently, at your death, any remaining assets in the CRT qualify for either the marital or charitable estate tax deduction.
Adjusting Your Recipe Based on the Current Baking Environment
Unless you are using cash or publicly traded securities to make gifts to fund these trusts, it is imperative to obtain a “qualified” appraisal to substantiate the value of any assets transferred. Certain information must be disclosed to the IRS for the appraisal to be considered qualified.7 The qualified appraiser may also be able to determine, substantiate, and calculate a discount for lack of marketability or control when valuing an interest in a closely held entity (operating business, real estate, family partnership/LLC investments, etc.). This would reduce the overall value by up to 30% or more depending on your facts and circumstances. While the upfront cost of obtaining an appraisal may seem expensive depending on your situation, not obtaining one can end up being exponentially more expensive after the fact.
Failure to obtain an appraisal may mean the three-year statute of limitations never starts. This would allow the IRS to challenge the value you used years down the road when you probably no longer have access to information to support that value. Recreating the information and defending an IRS audit could be very expensive, not to mention the compounded taxes, penalties, and interest the IRS will assess.
The valuation date of the appraisal is also especially important and should coincide with, or be as close as possible to, the date the transfer was made. The IRS has become more and more aggressive recently in challenging values when a proper appraisal was actually done, but the appraisal’s valuation date is more than a few months or even weeks before or after the transfer took place. Additionally, the IRS is paying particular attention to events internally and externally that would affect the value of an asset due to the passage of time.8 The IRS said it would challenge a seven month old appraisal based on events that took place before and after the valuation date; such as negotiations that occurred before the transfer to a trust and eventual sale of the company soon after the transfer at three times the appraised value.9 The IRS also recently issued guidance saying that a gift of cryptocurrency requires a separate qualified appraisal, because even though the asset is traded on a public market with easily determinable daily values, it is not technically considered a “publicly traded security.”10
Inflation and Interest Rate Environment
Inflation over the last year or so has been extremely high. The Federal Reserve has been continuously raising interest rates and in conjunction with other economic indicators the markets have been very volatile. You may have even considered getting out of the markets and sitting on the sidelines, analogous to the saying “If you can’t stand the heat, get out of the kitchen.” This is especially true for those who were not around to experience the era of Great Inflation that occurred from the mid-1960s to early 1980s, with mortgage rates reaching almost 20%. GRATs, CRTs, and many of the more complex estate tax planning techniques are also affected by the prevailing interest rates at the time the strategy is implemented. For GRATs and CRTs, the present value of the annuity/income interest and remainder interest are calculated using the 7520 rate, which is 120% of the mid-term applicable federal rate (AFR) that is set by the IRS each month.11 The AFR is the minimum interest rate required for loans between related parties to avoid imputed interest and other negative tax consequences. The AFR rates are generally lower than normal “market” interest rates (those offered to the general public by banks or negotiated with an unrelated third party). However, the AFR tends to rise and fall in tandem with market rates due to macroeconomic factors and the Federal Reserve’s policy decisions.
Interest rates and, subsequently, the 7520 rate, inversely affect the GRAT and CRT planning strategies. GRATs tend to be more effective for transferring wealth tax-free in a low interest rate environment, while CRTs provide a better charitable deduction in a higher interest rate environment. This is because if the assets in the GRAT grow at a rate higher than the 7520 rate, that amount passes to the remainder beneficiary (loved ones or a trust for their benefit) without incurring gift tax. Using short-term rolling GRATs may help you better manage the assets you’re using to fund the trusts depending on their rate of return compared to the 7520 rate. However, it is possible to structure the trust so that you can substitute underperforming assets for other assets you believe will overperform. With the 7520 rate expected to rise in the mid- to long-term, it may be better to use a longer-term GRAT (5-10+ years) to lock in a lower 7520 rate upfront and pass along more wealth tax-free as long as you outlive the term of the GRAT.
For a CRT, the calculation of the present value of the charitable remainder beneficiary (the amount of the charitable income tax deduction you receive personally) assumes the trust assets will appreciate at a rate equal to the 7520 rate — so the higher the 7520 rate, the higher the charitable deduction. It is also more common for a CRT to be structured using a term of your lifetime, rather than a specified number of years, since there are little to no adverse estate tax consequences other than the subsequent distributions you received firm the CRT that you did not spend before your death being included in your taxable estate. Overall, CRT for the term of your life will provide a steady stream of income until you pass away (as long as the trust does not run out of assets) without any adverse gift or estate tax consequences — while also providing an upfront benefit of a charitable deduction.
General Economic and Market Environment
The stock and bond markets have pulled back multiple times over the last year or so, and fears of a looming recession abound. If I were able to predict the ebbs and flows of our publicly traded markets, I would most likely be the one reading this article in search of advice rather than providing it. However, this could be an excellent opportunity for you to transfer assets out of your estate now or in the next year or so at a much lower value, allowing any future appreciation to benefit loved ones or trusts without being subject to gift and/or estate tax.
After careful consideration, implementing one or a combination of these planning strategies will bring you direct and indirect benefits. In other words, you can “have your cake and eat it too.”
- See Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16)
- See Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312); also included ability for 2010 to elect a $5 million exemption in lieu of the modified step up in basis rules under the 2001 legislation
- See American Taxpayer Relief Act of 2012 (P.L. 112-240)
- See Tax Cuts and Jobs Act of 2017 (P.L. 115-97)
- See Rev. Proc. 2022-38
- See Proposed Treasury Regulations § 20.2010-1 (83 FR 59343)
- See Treasury Regulation § 301.6501(c)-1(f)(3)
- See IRS Chief Counsel Memo 201939002 (In this non-binding IRS position, an anticipated merger was required to be considered in valuing the shares of publicly traded stock, although the IRS gave no consideration to whether disclosure of that information to a third party buyer would have been in violation of SEC insider trading rules)
- See IRS Chief Counsel Memo 202152018 (In this non-binding IRS position, an owner of a successful privately held company transferred shares to a two-year GRAT using the value from an appraisal obtained for the purpose of valuing a nonqualified deferred compensation plan dated seven months prior to transfer; subsequent to the appraisal, the owner started negotiating a sale of the company and received four offers to buy the company prior to the time of the transfer to the GRAT; and subsequently sold the company six months after the GRAT was created for three times the value reported on the original appraisal)
- See IRS Chief Counsel Memo 201939002
- See www.irs.gov/applicable-federal-rates