In this post, we address the top 10 estate tax strategies that are used to reduce estate tax. Let’s get started.
Table of contents
- Special Valuation of Farms and Businesses – §2032A
- Crummey Trusts
- Charitable Remainder Trusts
- Minor Trusts
- Family Limited Partnerships
- Grantor Retained Income Trusts
- Qualified Personal Residence Trusts (QPRTs)
- Grantor Retained Annuity Trusts (GRATs)
- Grantor Retained Unitrusts (GRUTs)
- Buy-Sell Agreements
Special Valuation of Farms and Businesses – §2032A
In general, the real estate value must be determined based upon its highest and best use. However, when specific requirements are met, an executor may elect to value estate tax purposes, real estate used as a farm, or other closely held business based upon its actual use rather than its highest and best use (§2032A).
Thus, farmland and real property used in a closely held business can be valued at less than fair market value. The election cannot reduce more than $1,180,000 (in 2020) in fair market value. Suppose the real property is later sold to non-qualified heirs or the qualified use of the property ceases. In that case, the tax savings are recaptured, and the amount of the additional tax that would have been payable if the election had not been made is then required to be paid.
This concept takes its name from a court case lost by the IRS. In the case, the taxpayer wanted to set up a trust for several beneficiaries and take advantage of the $15,000 (in 2021) annual exclusion.
While the taxpayer could have made outright gifts, they wished to do it through a trust that would immediately discourage the beneficiaries from spending the gifts. However, making gifts to a trust presents problems when one also wants to take advantage of the annual exclusion. The annual exclusion requires that any excluded gifts must be present interests, not future – as in a trust.
A Crummey trust is meant to overcome this problem. Under this estate planning tool, gifts are made to an irrevocable trust. The beneficiaries are given only a short period each year to withdraw the gift from the trust. If they do not make such a withdrawal, the funds remain in the trust and are administered according to its terms. Hopefully, the result is the use of the annual exclusion with subsequent control of the funds by the trust.
Charitable Remainder Trusts
A charitable remainder trust can provide substantial annual payments to one’s heirs and a tax deduction to the grantor while at the same time benefiting a charity. The heirs can receive payments during their lifetime or a fixed term of up to 20 years. In general, the payments to the heirs must be at least 5% of the value of the trust’s assets. They cannot exceed 50%, and the present value of the amount going to the charity must be at least 10% of the amount contributed. On the death of the heirs, the remainder must pass to the charity.
The grantors of the trust can also be life or term beneficiaries and receive payments. Charitable remainder trusts are tax-exempt and do not pay any income taxes. However, the beneficiaries who receive payments are taxed on income that is distributed to them. There are three basic types of charitable trusts: (1) Charitable remainder annuity trusts, (2) Charitable remainder unitrusts, and (3) Charitable lead trusts.
Minor trusts under §2503 are similar in purpose to Crummey trusts. However, unlike Crummey trusts, minors’ trusts are based on a federal statute, not written court opinion. If properly structured, these trusts qualify in whole or in part for the annual gift tax exclusion by law. Minor trusts come in two variations.
In the §2503(c) trust, the annual income may be accumulated. However, the trust must provide that both income and principal can be used for the minor’s benefit. Unfortunately, all trust assets must be distributed when the beneficiary turns age 21. In the §2503(b) trust, the annual income cannot be accumulated. However, the trust can continue past age 21. Trust principal is not required to be distributed to the income beneficiary and can go to someone else.
Family Limited Partnerships
A family-limited partnership can be a great income, estate, and gift tax savings device. Senior family members can control property transferred to such a partnership while discounted gifts of limited partnership interests are made to the remaining family members.
During its operation, partnership income can be split among family members through their ownership of interests in the partnership. In the meantime, senior family members can continue to exercise control of the partnership assets by retaining general partnership interests. Finally, on the death of a senior family member, an estate tax discount may be in order because of the minority interest held at death.
Grantor Retained Income Trusts
A grantor retained income trust is an estate planning tool. A grantor transfers specific property to an irrevocable trust to benefit their heirs while retaining an income or beneficial right in the property. In the estate and gift tax setting, the retention of an income or beneficial ownership in the property arguably reduces the initial transfer value to the trust.
As a result, this discounted transfer would absorb less of the applicable exclusion amount. The longer the grantor has a right to the income generated by the trust property, the lower the value of the remainder interest.
If the grantor dies before their benefits are terminated under the terms of the trust, the trust assets are subject to estate taxes in the grantor’s estate. However, if the grantor outlives their right to receive benefits under the trust, the trust assets are excluded from their estate. Over the years, Congress has limited the use of this tool to particular types of trusts.
Qualified Personal Residence Trusts (QPRTs)
A qualified personal residence trust (QPRT) is a grantor retained income trust still permitted under federal law. In this variation of the tool, a grantor transfers their primary personal residence to a trust that allows the grantor to continue to reside in the home for a designated time. When the specified time expires, the property passes to the grantor’s heirs.
While the gift to the grantor’s heirs is subject to federal gift tax, the value of the present gift is determined under IRS tables after considering the term of the grantor’s retained interest, the grantor’s age, and the applicable interest rate published by the IRS monthly. The reduction in value can be substantial.
Grantor Retained Annuity Trusts (GRATs)
Grantor retained annuity trusts (GRATs) have similar rules to those of charitable remainder annuity trusts. The grantor transfers the assets to a trust and retains a right to annuity payments. GRATs allow the gift of remainder interests that are discounted for gift-tax purposes under the IRS valuation tables. Longer terms produce lower remainder values.
Grantor Retained Unitrusts (GRUTs)
Grantor retained unitrusts (GRUTs) have similar rules to those of charitable remainder unitrusts. The grantor transfers the assets to a trust and retains a right to unitrust payments. Grants are not considered as effective as GRATs, where the trust’s assets are expected to appreciate.
Whenever two or more people are in business together, it is an absolute necessity that they have a buy-sell agreement.
Buy-sell agreements have several benefits, including: (1) Liquidity for the deceased owner’s family, (2) The ability to set the value of a business interest for estate tax purposes, (3) Providing funds for retirement, and1-24 (4) Lifetime transfer restrictions.