By Teresa J. Rhyne
– Warren Buffett said that the perfect inheritance is enough money so that children feel they can do anything, but not so much that they could do nothing. This is pithy advice. How much inheritance that is, when to give it, and how, is the real crux of the matter for most families.
New Laws motivate gifting
Intergenerational transfers of wealth are nothing new. Passage of California’s new Proposition 19 caused significant lifetime gifting of real property recently. And now, President Biden’s tax proposal seeks to lower the estate tax exemption to $3.5 million per person, lower the gift tax exemption to $1 million, eliminate the step-up in income tax basis at death, and raise the capital gains tax rate. As a result, we are likely to see another tsunami of intergenerational gifting to take advantage of the current more favorable tax laws.
Current law allows for lifetime gifts or gifts at death up to $11.7 million per person. With the expected decrease in the estate and gift tax exemptions, it’s likely many parents will consider gifting assets to children before any new tax law tax effect. If a parent gifts $5 million in assets now, the gift would be covered by the current exemption. If the estate tax exemption is later dropped to $3.5 million, the parent will have no further estate tax exemption remaining, but will not be subject to gift or estate tax on the “excess” $1.5 million they were able to gift before the law changed. In addition, the appreciation of the $5 million in assets between the time of the gift and the death of the parent will occur in the child’s hands, and thus outside the estate of the parent, saving even more in estate taxes.
The tax tail wagging the dog
While there can be significant benefits to gifting property to your children, or even grandchildren, sooner rather than later, how that is done should be considered carefully. Whether your estate is likely to be taxable or not, taxes are not and should not be, the only concern. Also consider your family goals, the legacy you mean to leave, and whether or when your child or grandchildren might be able to handle the responsibility of such a gift. Also consider the vehicle for the gift, whether that should be a gift outright, in trust, in family partnership interests, or another business entity.
Gifts in trust
Large gifts to children and grandchildren should almost always be made using trusts. A gift during lifetime or at death can be made through an irrevocable trust for the benefit of your children, and even your grandchildren. An irrevocable gifting trust allows you to do tax planning while also providing your heirs other benefits. It is not “controlling from the grave” so much as it is giving your heirs a leg up.
A trust can serve as a vehicle to train your heirs in the management of assets by providing for a third party to serve as trustee, allowing your heir to become a co-trustee at a certain age, and a sole trustee at a later age. If your heir is in a high-risk job where lawsuits are a concern, a trust can provide them with protection from creditors. If you’re worried your child’s spouse would burn through your child’s inheritance, a trust can be structured to prevent that.
Think of the grandchildren
Grandparents can also provide for their grandchildren in a trust. A trust can provide for the benefit of a child during the child’s lifetime and then for the grandchildren under similar terms. If the child has no choice and the grandchildren are the mandatory successor beneficiaries, the assets of the trust will not be included in the child’s estate, which could save significant estate taxes. However, such a trust, known as a “Generation Skipping” trust (the tax skips a generation, not the trust’s benefits) would mean there is no step-up in income tax basis in the assets. If instead, the child was not likely to have a taxable estate even with the trust assets counted in their own estate and the income tax step-up in basis would be more valuable, the trust could simply give the child the option to exercise a power of appointment to say where the assets go at the child’s death. If the power is not exercised, the trust terms providing for the grandchildren will prevail. In a sense, this is advance estate planning for the children by providing a default plan.
Trusts, whether for children or future generations, can provide very specific terms for when income or principal can be distributed to the beneficiaries to assure that your family goals and values are maintained.
The family business
A family-owned business often presents the biggest dilemma for parents, especially if one or more of the children (or perhaps the spouse of a child) is involved in the business, but the others are not. Generally, a family business should be held in an entity (corporation, limited liability company, or partnership) for centralized government, protection from creditors, and ease of transferring between generations. With an entity, parents can assure that control is in the hands of the active participants in the business by creating voting and non-voting ownership interests, adopting a business succession plan for leadership, and/or giving the majority interest to the child involved in the business.
If the parents also own the real estate on which the family business operates, consider gifting the real estate to the children not involved in the operating business, and the business itself to the active child. Gifts of business interests in trust should also be considered since the trustee can then be carefully selected to manage the interest on behalf of all beneficiaries.
Carefully considering when and how your children and grandchildren receive an inheritance is an opportunity for leaving not just property, but a legacy. A well-drafted and often reviewed trust is a vehicle that allows for that legacy to be maintained for generations to come.
Note: This is not legal advice to you individually, and you should rely on your own family law and estate planning attorneys to advise you.
Teresa J. Rhyne is an attorney practicing in estate planning and trust administration in Riverside and Paso Robles, CA. She is also the #1 New York Times bestselling author of “The Dog Lived (and So Will I)” and “Poppy in The Wild.” You can reach her at [email protected].