As longevity continues to increase, many children and grandchildren are filled with mixed emotions: The joy of having loved ones with them for many years longer is tempered by another somewhat less enjoyable reality, that of the postponed inheritance. A recent Wall Street Journal article, “Cash-Strapped Entrepreneurs Seek Early Inheritances,” makes note of this phenomenon.1 Human ingenuity knows no bounds, of course, and in this instance, that means children and grandchildren often adopt various strategies to inspire the transfer of inheritances in advance. The idea of early inheritance (more simply called “gifts”) is one that has been embraced by the estate-planning community for as long as it’s existed. Here are some of the planning alternatives that families may consider in implementing early inheritances, as well as some of the technical, practical and other personal challenges and issues that should be considered before doing so.
Impact of Longevity
The fact that people are living longer is changing the way wealth is transferred between generations. Given the trend of extended life expectancy and advances in medical science, it’s not uncommon in today’s society for people to live well into their mid- to late-90s or even to 100 or more. With these longer life expectancies, it’s possible that under a traditional approach, in which assets are held by the current generation until death, family assets likely wouldn’t pass down to the second generation until they themselves are in their 70s.
Indeed, the popularity of trusts over the last generation means that some are waiting until past retirement to receive inheritances from their own grandparents, who may have passed away decades ago. At that point, it’s very likely that the second generation has already accumulated significant assets of their own and may have no need to receive assets from the first generation at that time—when they could have really benefited from the assistance of those assets decades before. The senior generation doesn’t necessarily benefit from this arrangement either, as they’ll never have the personal satisfaction of witnessing the second generation enjoying and putting family assets to good and productive use.
Tax Savings from Giving Early
Planning strategies are often used to minimize, or perhaps even avoid, gift and estate taxes. Estate planners typically focus on the tax concerns when encouraging clients to plan, as there’s a quantifiable reason to do lifetime transfers. With some individuals facing a blended federal and state estate tax rate north of 50 percent, these tax savings encourage people to act during their lives. These savings typically arise from four sources.
First, valuation discounts may be more readily available for lifetime gifts than for testamentary transfers. The value of a gift of an interest in an entity for transfer tax purposes isn’t the value of its underlying assets, but what a willing buyer would pay for such entity interest in an arm’s length transaction—that is, its fair market value (FMV). Planners often take advantage of this distinction in structuring wealth transfer transactions. For example, a common technique used by many planners is to contribute assets, such as real estate or marketable securities, which are held outright by the senior generation, into partnerships or limited liability companies (commonly referred to as a “family limited partnership”). Placing transfer and voting restrictions on the entity interests can affect the FMV of those interests for gift tax purposes. Such techniques have had much more success, based on the reported court opinions, when used in connection with lifetime gifts, rather than for testamentary transfers.
Second, there are transfer tax-free techniques that are available for lifetime transfers, which may not be possible or as effective if made on the transferor’s death. These planning techniques involve gifts in which the donor retains an interest in the transferred property for a term of years. If properly structured, the interest the grantor retains can reduce the value of the gift for transfer tax purposes, and the Internal Revenue Code may overvalue that interest; thus, artificially reducing the value of a gift. An example is the value of annuity interests. The IRC Section 7520 rate, which is mandated by the IRC for use in valuing annuity and other interests in the family estate-planning context, has been at historical lows ranging from 1 percent to 2.4 percent in 2013. The Section 7520 rate is deemed to be the total return rate on an asset, regardless of its actual appreciation. So, to the extent that the asset appreciates in excess of the Section 7520 rate, that appreciation passes free of gift tax to the designated beneficiaries.2
Third, any appreciation in the value of the assets given away will be removed from the federal transfer tax base without transfer tax because the appreciation simply escapes federal estate and gift tax. Many times, the most effective way to transfer future appreciation is to sell assets to a grantor trust because all appreciation is transferred in excess of the interest on the note. The interest can be as low as the applicable federal rate (AFR), which is determined monthly by the Internal Revenue Service. Like the Section 7520 rate, the AFR is at historical lows. By selling assets, appreciation can be transferred out of the estate, while the donor maintains a stream of cash flow (in the form of installment payments) from the assets for a period of time.
Finally, a benefit to making transfers during life is that the gift tax is calculated on a tax exclusive basis, rather than tax inclusively. The difference is that the gift tax calculated is based on the amount transferred, while estate taxes are based on the size of the estate—including those assets that will ultimately be used to pay the taxes; thus, the estate tax is effectively taxed, while the gift tax isn’t.
Despite the transfer tax savings potential of lifetime giving, income tax considerations present a countervailing and complicating tax consideration due to the carryover basis and the potential for increased income taxes that come from the loss of a step-up in basis at death.3 More complications arise when state inheritance taxes are taken into consideration (and gift taxes in Connecticut and Minnesota), as well as local and state income taxes that may be owed if gifted assets are sold. With the increase in federal capital gains rates, the new 3.8 percent net investment income tax and the reduction of the maximum estate, gift and generation-skipping transfer tax rates to 40 percent, the possibility of additional income taxes outweighing transfer tax savings has become more pronounced.
Thus, before any gift is made, a full analysis of the income tax exposure must be made, including the amount of state and local taxes and the likelihood that the property to be given will be sold (and, if so, when). Given that the vast majority of families will have no federal estate tax exposure because of the new, large, indexed federal estate and gift exemptions, parents and grandparents may reasonably ask whether they ought to hold on to their assets.4 If there’s no transfer tax reason to transfer them and there exists potential future income tax savings, some might want to keep the assets for their own needs or, instead, give to charity. Or, they may feel that holding on to the assets will ensure that their heirs are appropriately appreciative (and continue to visit) if an inheritance still hangs in the balance! In those circumstances, what other points of inspiration might be offered by children and grandchildren to prompt the senior generation to provide an early inheritance?
Giving on Your Terms
Many parents and grandparents want to provide financial assistance to descendants at a time in their lives when they can most benefit. Often, that takes the form of helping children with accomplishing specific goals, such as buying a first home, paying for education, allowing for a lifestyle that encourages civic engagement or, perhaps, providing some “seed capital” to assist in starting a new business venture. With a more traditional approach of passing assets to the next generation upon the senior generation’s death, the donors are left hoping that others, such as their designated trustees or the beneficiaries themselves, put the assets to good use after they’re gone. However, providing lifetime inheritances gives parents the satisfaction of witnessing their children enjoy the family assets, while also having the opportunity to select how they invest their assets in the junior generation(s). Additionally, making lifetime gifts provides the senior generation with a glimpse as to how the next generation(s) will handle the balance of the assets when they’re passed down; thus giving the senior generation a chance to evaluate whether their existing disposition scheme is sufficient to ensure the preservation of the assets.
A university president successfully engages in fundraising by pointing out that the university is in good shape and regularly exceeds expectations in carrying out its stated mission, before slyly adding, “[b]ut, of course, if we had just a little more, like a gift from you, we could undertake the new program that I just described and which you just admired.” Without pushing the analogy too far, children and grandchildren might consider inspiring the transfer of inheritances early as a form of fundraising. If a grandchild can discuss great accomplishments—“I just won a prize for my documentary in film class”—then the suggestion of a gift (“what the natural next step for me would be is a year in Europe studying…”) could have great appeal. Or, a child might say, “I’m so delighted that I can buy into this business, although I’m always a little bit behind: My division is growing so fast that the value of the business is increasing faster than I can provide it capital to grow,” in hopes of reminding a parent that a gift now would generate financial and psychological rewards later.
This approach takes the onus off of the senior generation in planning how best to distribute the funds. Instead, it puts the burden on junior generations to plan how they can improve themselves and the entire family in the long run by convincing their parents or grandparents how an early inheritance won’t just be a gift, but an investment in the family. Like any investment, it will have to perform to attract future investments, encouraging junior generations to produce results based on the goals the senior generations articulated in making the gift.
Continuing with the fundraising theme for a moment, under this approach, the senior generation is put in the position of a donor or sponsor. The parent could be pro-active and set out clear goals of what junior generations need to do to obtain their inheritances early, essentially using the power of the purse to inspire the junior generation to achieve family goals or influence behavior. This method gives the senior generation an influence that would be left to trustees of trusts funded on the senior generation’s death or with no control if given outright. One of the most common complaints from beneficiaries of trusts is the “dead hand control” the deceased donor has over the assets through the terms of the trust. With early inheritances, the hand that gives is still very much alive and has influence (in the form of controlling future inheritances). The influence the donors can have over the assets and the satisfaction of wielding it prudently can be just as rewarding, if not more so, than the tax savings that can be achieved.
Keeping it Fair
Despite benefits of lifetime giving, both the senior and junior generations ought be prepared for a few common complications that often are associated with accelerating inheritances. One of the primary issues is the potential disturbance of an otherwise equal estate plan. If parents plan to divide their assets “fairly” among their children, a lifetime gift to one child must be “equalized” somehow, or some form of “rough justice” needs to be achieved. The easiest way to keep things balanced is to make equal gifts to children at the same time, but often, that’s not practical—perhaps the parents are prepared to make a gift of the amount needed to help a particular child to pursue a specific objective, but aren’t willing to make a current gift two or three times as large so that each receives the same amount. The potential intra-family conflict that can be created by providing a gift to one child without providing an equal amount to other children often discourages lifetime giving.
However, these challenges aren’t insurmountable and, with the senior generation making distributions during their lifetime while coordinating lifetime gifts with testamentary transfers, they can keep the peace and their plan fair. While each family will have its own unique dynamics and assets that will factor into determining what “fair” means, three issues should always be considered:
1. Transfer tax impact. With the unified lifetime exemption, a gift to one family member reduces the remaining exemption, exposing the recipient’s siblings to potential disproportionate transfer tax liability on their inheritances.
2. Need for sufficient assets to provide equalization at a later time. As mentioned before, people are living longer, and senior generations will likely deplete more of their wealth during life, potentially leaving a shortfall of assets to equalize upon death.
3. Time value of money. Even if the senior generation gives $10 million to one child and $10 million to another, if the transfers are separated by two decades, the child who received the funds later may feel that there was an unequal distribution.
Assuming that the goal of the senior generation is to maintain an equal distribution among its children, two common methods of addressing these problems are to structure the gift as a loan to the child, rather than a gift, or to provide for a testamentary equalization.
Financing the Future
If the idea of making a large gift to a child who has an intended use for the assets (such as purchasing a new home or investing in a company) proves to be an emotionally and/or politically charged family issue, given the senior generation’s desire to maintain some semblance of equality, then the senior generation might consider making a loan to the child or, perhaps, a much smaller gift (for example, $100,000), coupled with a loan of the balance (for example, $900,000). Assuming that the parties respect the formalities of the loan and adequate interest is imposed, no gift tax or utilization of gift tax exemption should result, aside from the small gift.
The family will have a great deal of leeway in customizing the terms of the note to meet its needs. The note could be structured so that the interest rate provides the parents a stream of income from the transferred assets, while still providing the child the resources he requested. The interest rate could be as low as the AFR, which provides financing at a rate far lower than commercial lenders, without any transfer tax impact. A primary advantage if the parents own the promissory note is that the balance owed will be an asset in their estates, which will eliminate, or at least lessen, the equality issue.
While loans provide certain advantages, there are other situations in which a gift is more appropriate. For example, certain families may be hesitant to turn parents and children into lender and debtor, or the gift may be to help a child acquire something that won’t produce an income stream to pay off a loan. While an outright gift or a gift to a trust for the benefit of one child may be the most straightforward method of transferring wealth, the issue that arises immediately is whether there’s a time value of money element to the equalization that will occur later.
One question to consider when gifting assets is how an early gift to one child will be treated in the parents’ estate plan if their desire is to achieve equality among their children. In other words, should both parents amend their estate plan so as to provide for an upfront bequest equal to the value of the lifetime gift to each child who didn’t receive the lifetime gift before dividing the balance of their estate equally at their deaths? As mentioned above, a related consideration is whether some factor should be incorporated to account for the time value of money concern, in that a $1 million gift today will be worth much more than $1 million in 20 years. Another consideration is the transfer tax consequences of a gift to only one child. The current lifetime exemptions are only “permanent” in the sense that there’s no sunset provision built into the current law. In fact, the Obama administration has already proposed lowering the exemption. If transfers to the other descendants of the parents were later subject to transfer taxes, then the tax impact of the lifetime transfer should be considered the equivalent of an additional bequest and an adjustment made accordingly.
There are no absolute right or wrong answers to these inquiries, but these are important issues to consider in connection with the implementation of an early inheritance program. A pro-active approach by the senior generation is important, as the children may not see eye-to-eye on what’s fair. For example, if a parent gives the family business to one child, but not the other, and the company grows over time, how does the parent attribute the growth over time and adjust an estate plan accordingly? The child who ran the business will likely see the growth in the company not as a result of the time value of money, but rather, as a product of the child’s work. The sibling who didn’t get the business may see it very differently, as the gift wasn’t just of a company, but a job for life, meaning the gift was worth even more than the assets and appreciation. Only the parents can have an objective view of what’s fair and, more importantly, are the only ones who can decide how best to equalize their estate plan.
To address these complications, parents might establish a value of a gift and provide that the value will be adjusted using some independent index—one of the Consumer Price Indices for instance—rather than the appreciation, or depreciation, of the actual property. Another approach is to refer to a percentage of the estate at the time of the gift. For instance, suppose that parents have a $10 million estate and give $1 million to one of their three children. Later, when the parents die, they provide that their other two children each receive one-ninth of their estates before what’s left is divided three ways, equally. The theory behind this so-called “but-for” approach is that the parents would have had more “but for” making the gift. Probably more important than what method of equalization is chosen is that it be expressed clearly and that the parents understand the implications if assets appreciate, depreciate or are spent and if tax regimes and exemptions change.
One of the concepts discussed in the Wall Street Journal article is senior generations “sharing in the success,” by serving as co-investors in a child’s business venture. While parents will certainly get emotional satisfaction, at the same time, they may be interested in enjoying some of the economic upside potential of the venture; therefore, they might be interested in participating in the venture as well. Given that parents are living longer, the idea of building an additional nest egg while helping their children is something that resonates well. By acting as an investor in a child’s business, the parent gets the chance to partner with the next generation in continuing to build the family’s fortune. The partnership not only makes sense in terms of the family, but also for the business. The child provides the sweat equity for the business, while the parents provide the financial equity to help it succeed.
Investing in a child’s (or grandchild’s) venture can also provide the senior generation with options in terms of equalizing their estate. The parents may find themselves in a situation in which the child’s inheritance is the interest the parents held in the business, while their other assets will go to other descendants. These other assets would include some of the parents’ return on their investment in the company, which mitigates the issue of appreciation in the property. If the parents find themselves in the position where it’s not possible to equalize the estate without distributing their interest in the business to others, they still have control of the assets to do so, as opposed to if they had made an outright gift.
Bottom line: Parents and grandparents who can be inspired to accelerate inheritances by making gifts may bring joy to themselves and to their beneficiaries. For many families, tax reasons aren’t as compelling as they once were, but resourceful heirs will likely be able to make persuasive arguments of the benefits and overcome the objections in most instances. Estate planners can help by encouraging that the process be fully thought through, which generally means ensuring that all the consequences, tax and non-tax, are considered.
1. Neil Parmar, “Cash-Strapped Entrepreneurs Seek Early Inheritances,” Wall Street Journal (Aug. 19, 2013).
2. While these transfers techniques involving retained interests by the grantor can avoid gift and estate taxes, such techniques generally aren’t exempt from generation-skipping transfer taxes.
3. Assets that are includible in a decedent’s estate receive a step-up in basis equal to the fair market value of the assets at the date of death by virtue of Internal Revenue Code Section 1014. In the case of gifted assets, the donee inherits the donor’s basis for purposes of gain under IRC Section 1015.
4. Today’s exclusion of $10.5 million per couple may grow to $18 million in 20 years, even if there’s low inflation.