Estate Planning Basics for Large Estates. Find a Starting Point

For individuals with significant wealth, particularly estates that exceed the federal estate tax exemption (which is currently $13.61 million per individual as of 2023), proper estate planning is crucial. Without a well-thought-out plan, a large portion of the estate could be subject to federal estate taxes, which can significantly diminish the wealth passed to heirs. In this post, we'll explore fundamental strategies for mitigating taxes, protecting assets, and ensuring a smooth transfer of wealth.

1. Understanding the Federal Estate Tax Exemption and Why It Matters

The federal estate tax applies to estates valued above the exemption threshold. For 2024, the exemption is set at $13.61 million per individual, with a maximum estate tax rate of 40% on amounts above that. Married couples can effectively double the exemption by utilizing portability, allowing them to shield up to $27.22 million from federal estate taxes. However, for individuals with estates exceeding these limits, thoughtful planning is essential to minimize the tax burden.

2. Step-Up in Basis vs. Freezing Techniques

One of the most significant benefits of retaining appreciated assets until death is the "step-up in basis" provision. This rule allows heirs to inherit assets at their current market value, not the decedent's original purchase price, reducing capital gains taxes if they choose to sell. Here's an example:

• Step-Up in Basis Example: If a decedent purchased stock for $1 million that appreciates to $3 million by the time of their death, the heirs inherit it with a basis of $3 million. If they sell it immediately, they incur no capital gains tax.

However, relying solely on the step-up in basis can be risky for large estates.

Freezing techniques can be more effective in reducing the overall estate tax burden.

• Freezing Techniques: These methods involve freezing the value of certain assets at today’s value, allowing future appreciation to accrue outside of the estate. Some common freezing techniques include:

  • Grantor Retained Annuity Trusts (GRATs): The grantor transfers assets into a trust but retains the right to receive annuity payments for a specified period. After that period, any appreciation above the IRS-determined rate passes to beneficiaries tax-free.

  • Family Limited Partnerships (FLPs): A vehicle often used to "freeze" the value of an estate by transferring ownership of business or investment assets while maintaining control. Valuation discounts (which we will discuss later) are often used with FLPs to further reduce estate values.

Both the step-up in basis and freezing techniques can play crucial roles, depending on the estate’s composition and goals for transferring wealth. Ultimately, savvy estate planners will balance the benefits of basis step-up and freezing techniques.

3. Trusts: The Backbone of Estate Planning for Large Estates

Trusts are one of the most powerful tools for controlling how wealth is transferred, minimizing taxes, and protecting assets. Here are some common types of trusts used in large estate planning:

• Revocable Living Trusts: While not specifically for tax savings, a revocable living trust allows you to avoid probate, maintain privacy, and manage your assets during your lifetime. However, because the trust is revocable, assets are still part of your taxable estate.

• Irrevocable Life Insurance Trusts (ILITs): Used to remove life insurance proceeds from the taxable estate. The grantor transfers ownership of a life insurance policy to the trust, and upon death, the proceeds can provide liquidity to pay estate taxes or debts without adding to the estate's value.

• Grantor Trusts: Similar to GRATs, grantor trusts (including Intentionally Defective Grantor Trusts or IDGTs) allow for the transfer of appreciating assets to heirs without those assets being included in the taxable estate. The grantor is responsible for paying income taxes, further reducing the estate over time.

• Charitable Remainder Trusts (CRTs): These trusts provide a win-win for large estates by allowing the grantor to retain income during their lifetime, with the remainder going to charity. This reduces the taxable estate and can provide significant income tax deductions.

4. Valuation Discounts: Leveraging Lower Asset Valuations

For large estates, especially those with illiquid assets such as family businesses or real estate, valuation discounts are essential for reducing the taxable estate. By using strategic discounts, it is possible to significantly reduce the value of assets that are transferred to heirs.

• Minority Interest Discount: If heirs only receive partial ownership of an asset, such as shares in a family business, the value of that interest can be reduced because it does not represent a controlling stake.

• Lack of Marketability Discount: When transferring interests in non-publicly traded assets, a discount can be applied for lack of liquidity or marketability.

These discounts, when combined with techniques like FLPs or GRATs, can provide substantial tax savings, but it’s important to work with a qualified appraiser to ensure the IRS will accept the discount values.

5. Key Decisions When Creating an Estate Plan for Large Estates

When planning for a large estate, there are several important decisions that must be made to ensure the plan aligns with the family's goals and values. Here are a few key decisions to consider:

• Choosing Trustees and Executors: It’s important to select responsible individuals (or corporate entities) to manage your trusts and carry out your wishes. They should have the financial acumen and trustworthiness to manage significant assets and follow the estate plan.

• Selecting Beneficiaries and Structuring Gifts: Beyond simply naming heirs, it’s crucial to determine the structure of the inheritance. For example, should gifts be made outright, or held in trust with stipulations? Many high-net-worth individuals choose to use dynasty trusts to ensure wealth is preserved for generations.

• Gifting Strategies During Your Lifetime: Consider making lifetime gifts to reduce the size of your estate. This can be done through annual exclusion gifts ($17,000 per person in 2023) or larger gifts that utilize part of your lifetime exemption. Lifetime gifts not only reduce the taxable estate but can also help avoid future appreciation being taxed.

• Charitable Giving: Charitable donations can be an important part of estate planning, especially for those looking to reduce estate taxes while supporting causes they care about. In addition to CRTs, donor-advised funds or private foundations can also be used to manage charitable giving.

• Wealth Transfer Timing: When and how assets are transferred can have significant tax implications. Some families may choose to make substantial gifts during their lifetimes to reduce the estate's value, while others may rely on trusts that distribute wealth after death. A strategic combination of both approaches is often most effective.

6. Integrating State Tax Planning

While this post focuses on federal estate tax planning, it’s essential not to overlook state-level estate or inheritance taxes. Many states have much lower exemption thresholds, and without proper planning, state taxes can further diminish the estate’s value. For estates in states with high estate tax rates, incorporating state tax planning into the overall strategy is crucial.

7. Updating the Estate Plan Over Time

Finally, estate planning is not a one-and-done task. As tax laws change, personal circumstances evolve, and the estate grows or shifts, it’s essential to revisit the estate plan regularly. Working with an estate planning attorney, accountant, and financial advisor ensures that the plan remains aligned with your goals and continues to maximize tax efficiency.