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Oxford Financial Group, LTD


Oxford Financial Group, LTD


Expert Perspective

News, research and market insights from our team of experts.


Current Issue | December 20, 2018

Year-End Review of Gifting and Estate Freezing Strategies

By: Julia Weaver, J.D., CWS®, Director, Family Office Services and The Trust Company of Oxford and
Keenan Pierce, J.D., Family Office Analyst

As the holiday season approaches and our focus shifts to gifts for our loved ones, it is a good reminder for families to reevaluate their gifting strategies from an estate planning perspective.

Income tax planning has taken on new significance for many families not subject to the federal estate tax. The goal of mitigating the income tax impact to heirs has become a new focus in the absence of federal estate tax exposure.

For families subject to the federal estate tax, there is tremendous merit in a comprehensive review of gifting strategies and the allocation of assets within the family's various trusts. If a family has previously gifted or sold assets to a trust, the tax impact can be maximized by the strategic swapping of assets within certain trusts in order to freeze more future appreciation from the taxable gross estate.

A Shift in Focus

The shift in focus from federal estate tax planning to income tax planning is a hot topic in the estate planning community. This shift has been driven in large part by the now elevated federal estate tax exemption, which will be $5.45 million per person and $10.9 million per married couple for the 2016 tax year. As such, there is a growing demographic of families that have structured gifting strategies to mitigate federal estate tax to which they may no longer be subject.

In broad strokes, federal estate tax planning and income tax planning are, at times, mutually exclusive. One arena in which we see this conflict is with basis planning. The Internal Revenue Code provides that assets passing through a decedent’s gross estate are entitled to a "step-up" in basis to the asset's fair market value (FMV) on the date of death. The tax implications are significant.

Assume this most rudimentary example: A lifetime gift versus a testamentary bequest of a low basis stock. With the lifetime gift, your heir takes your "carry-over" basis. With the bequest, your heirs receive a new basis equal to the FMV on the date of death. As such, if you held marketable securities in your name with a date of death FMV of $1 million and an income tax basis of $100,000, and if your heirs were to immediately thereafter sell the stock for $1 million, they experience no realized gain and, thus, no income or NII tax consequence. i. If, however, the securities were gifted during life, your heirs would have a $100,000 carry-over basis and would realize gain of $900,000 upon the future sale. In such a case, the greatest gift may be no gift at all.

In order to be eligible for the "step-up" in basis, however, the assets must be "owned" by the decedent on the date of death. i.i. Herein lies the conflict. Any asset that is "owned" by a decedent on the date of death is then subject to the federal estate tax. In other words, what we plan to exclude from the taxable gross estate upon death, will, absent very thoughtful planning, be deprived of the opportunity for basis step-up.

For a family with a net worth that will not produce federal estate tax exposure, prior planning should be critically reconsidered and in some cases altogether revised. It may be more tax efficient to retain certain assets in taxpayer's gross estate, at the highest possible valuation, in order to maximize the advantage of the basis step-up. Any entities structured to attain valuation discounts (such as FLP's and FLLC's) should be an additional topic for year-end review. In some instances, it may be more advantageous to restructure ownership and certain restrictions in order to actually create premiums in the valuation of interest in order to maximize the step-up in basis to which your heirs may be entitled.

A Traditional Focus and Maximizing Freezing Opportunities

Hence, as discussed above, we have the proverbial picking of one's poison. For families with federal estate tax exposure, the more potent poison remains the federal estate tax. For these families, a thorough evaluation of gifting strategies and any opportunities to "swap" assets, as further described below, is also an important undertaking.

Such a review should encompass not only a review of all entities and trusts, but also the assets in which they hold. It is not uncommon to see irrevocable trusts (structured to keep assets out of the gross estate) holding bonds, cash or other assets with low appreciation potential. There is an opportunity cost, however, in that these assets are taking the space of assets that may be appreciating in value. When appreciating assets are held outside of the gross estate, all future appreciation also incurs outside of the taxable gross estate, commonly referred to as "freezing" the value of an asset. A well-maintained freezing strategy can have significant impact on future federal estate exposure over the taxpayer's life expectancy.

A Power of Substitution is a provision available for certain types of trusts, such as many Irrevocable Life Insurance Trusts, Irrevocable Defective Grantor Trusts and Grantor Retained Annuity Trusts. Specific and properly crafted language must be included in the trust document for such powers. While outright distributions back to the Grantor are generally precluded from such trusts, a Power of Substitution, also referred to as "swapping powers", can be used to "swap" flat assets out, and rapidly appreciating assets in, to these "excluded" vehicles.i.i.i. A regular review of your assets and appreciation expectations can reveal opportunities for this type of strategic planning. All that is required is for the Grantor to substitute other property of an equivalent value. The only authority the Trustee has is to use diligence to ensure that property of equivalent value is substituted for the reacquired property and to make sure, to the extent the trust receives unproductive property in place of productive property, that swapped assets are converted to productive property to the extent feasible.

Notably, Powers of Substitution can also be utilized by families who do not have federal estate exposure and who seek to maximize basis planning opportunities, as discussed above. In this manner, low basis assets should be substituted out of the trusts and back into the taxpayer's gross estate for step-up opportunity. High basis assets should be substituted in to the excluded vehicles, because they will not meaningfully enjoy the advantages of the basis step-up. Any expectation of significant future appreciation will be a critical determinant in any final planning recommendations

A Final Caveat

The federal estate tax is a transfer tax and is only assessed upon the transfer of assets, whether by gift or transfer through one's gross estate. As such, a clear understanding of a family's wealth trajectory over their life expectancy is critical in order to assess the projected risk of federal estate tax exposure and in order to provide thoughtful and sound estate planning advice.

Due to the divergent planning strategies for families "with" versus "without" federal estate tax exposure, families need to continuously monitor their wealth trajectory, asset structure, appreciation expectations and the proper asset allocation in relation to their overall estate plan. Your Oxford Managing Directors and team of Family Office Technical Advisors have the financial modeling capabilities to provide a wealth trajectory analysis and to develop a plan for the ongoing review of your gifting strategies and planning techniques in light of these considerations.

i. For individuals, the NII tax is 3.8% of the lesser of net investment income or the excess of modified AGI over $250,000 for married taxpayers, $200,000 for single taxpayers and $125,000 for those married filing separately. Code Sec. 1411(a)(1). NII generally includes interest, dividends, annuities, royalties, rents, certain income from passive activity and net gains from the sale of investment property less expenses deductible in generating such income. Code Sec. 1411(d)

i.i. Notably, the term “owned,” for these purposes, will also include certain property in which the decedent has a beneficial interest on the date of death, an issue that is, in itself, the subject of volumes of rulings and case law well beyond the scope of this article

i.i.i. IRC § 675(4) provides that a trust is a grantor trust for income tax purposes if any person holds a power "in a non-fiduciary capacity…to reacquire the trust corpus by substituting other property of an equivalent value." The retained power to substitute assets of equivalent value will not prevent the grantor from having made a completed gift and will not trigger estate tax inclusion under IRC Section 2038. Exercising the power in a non-fiduciary capacity, means without the approval or consent of any person in a fiduciary capacity (i.e. the Trustee)