During times of volatility, clients are often tempted to reconsider their gifting plans. But it’s important to consider the opportunities that gifting can present in uncertain markets.
In 2020, interest rates have declined to historic lows as a result of consistent market volatility. This factor, combined with the substantial gift tax exemptions established by the 2017 Tax Cuts and Jobs Act ($11.58 million for individuals and $23.16 million for married couples), can allow affluent clients to transfer significant wealth while maximizing transfer tax savings.
ESTATE PLANNING IN UNCERTAIN TIMES
One way to maximize clients’ gifting plans in a volatile market is to gift assets that are undervalued as a result of market instability, but that would otherwise be expected to appreciate in value. These gifted assets would be reported on a gift tax return at their fair market value at the time of the transfer, which would presumably be lower in a volatile market. Assuming the IRS accepts the reported values, the gifts would then successfully appreciate outside of your clients’ estate for estate tax purposes.
One notable tax consequence of gifting undervalued assets is that the assets will not receive a cost basis adjustment (step-up or step-down) to fair market value at the transferor’s death. As a general rule, assets that are included in an individual’s estate for estate tax purposes will receive a new cost basis for income tax purposes, which will be the fair market value of the asset at the individual’s death. The fair market value will presumably be higher than the departed individual’s cost basis in the asset – hence the step-up in basis.
With a lifetime gift of an asset, however, the recipient gets a carryover basis in the asset, which means they will have the same cost basis the transferor had at the time of the gift. If the asset does appreciate in value after it is gifted and the recipient later wants to sell the asset, the recipient would have to pay income tax on the difference between the carryover cost basis and the value of the asset at the time of the sale.
ESTATE PLANNING WITH DISCOUNTED VALUES
The value of a gift can be further reduced through the use of valuation discounts. The two most common valuation discounts in estate planning are the discount for lack of control (also known as the minority discount) and the discount for lack of marketability, which are typically used in valuing the transfer of ownership interests in closely held family entities.
The discount for lack of control recognizes that the interest transferred may not give the owner of the interest in the closely held family entity the right to decide when to distribute earnings, when to liquidate the entity and how the activities of the entity will be managed, among other business decisions.
Alternatively, the discount for lack of marketability recognizes there may be no readily accessible market to sell an interest in a nonpublicly traded, closely held entity. It also acknowledges the legal restrictions limiting the owner’s ability to transfer the interest.
To take advantage of these and other valuation discounts, wealthy families may want to consider contributing undervalued assets to a closely held entity, such as a family limited liability company or family limited partnership. This enables them to then make gifts of limited liability company membership interests or limited partnership interests to other family members at a discounted value.
ESTATE PLANNING WITH LOW INTEREST RATES
There are estate planning techniques that can allow you to make the most of low interest rates. These include establishing grantor retained annuity or charitable lead annuity trusts; using intrafamily loans; completing an installment sale to an intentionally defective grantor trust, or IDGT; and using self-canceling installment notes. Each technique has its benefits and potential drawbacks, so it’s important to understand when each strategy can be successful before proceeding with clients.
Before postponing wealth transfer plans, be sure to consider these strategies with your clients and the potential benefits of gifting in uncertain markets.
Rose Watson is vice president and wealth planning strategist at Raymond James.
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