As we approach the sunset of the current federal estate tax law at the end of 2025, it's essential for high-net-worth individuals to understand the impending changes and explore strategic estate planning tools to mitigate potential tax liabilities. The upcoming revisions in federal estate tax law will significantly impact estate planning, making it crucial to act promptly.
Post-2025 Federal Estate Tax Law Changes
The Tax Cuts and Jobs Act (TCJA) of 2017 temporarily doubled the federal estate tax exemption, significantly reducing the number of estates subject to the federal estate tax. However, this provision is set to expire at the end of 2025. Here’s a breakdown of what to expect after the sunset:
Exemption Amount Reduction: The federal estate tax exemption will revert to its pre-TCJA level, adjusted for inflation. This means the exemption amount will drop from approximately $12.92 million per individual in 2024 to around $6.5 million per individual (or $13 million for a married couple) in 2026.
Increased Tax Liability: Estates exceeding the reduced exemption amount will be subject to the federal estate tax, with rates starting at 18% and reaching up to 40% for the largest estates.
Broader Impact: More estates will become taxable due to the lower exemption threshold, necessitating a reevaluation of estate planning strategies to minimize tax burdens and preserve wealth for heirs.
Understanding Grantor Retained Annuity Trusts (GRATs)
One of the most effective tools for reducing estate taxes before the law changes is the Grantor Retained Annuity Trust (GRAT). A GRAT allows individuals to transfer significant wealth to beneficiaries with minimal gift tax consequences. Here’s how it works and why it’s beneficial:
Structure and Operation: A GRAT is an irrevocable trust into which the grantor (the person creating the trust) transfers assets while retaining the right to receive fixed annuity payments for a specified term. After the term ends, any remaining assets in the trust pass to the beneficiaries, typically free of additional estate or gift taxes.
Tax Advantages: The primary advantage of a GRAT is that it allows the grantor to transfer the appreciation of the trust assets to beneficiaries at a reduced gift tax cost. The initial transfer to the GRAT is valued for gift tax purposes, but the annuity payments reduce the taxable value of the gift.
Zeroed-Out GRATs: A popular strategy is the "zeroed-out" GRAT, where the annuity payments are set so that the present value of the annuity equals the value of the transferred assets. This results in little to no gift tax liability when the GRAT is created.
Leveraging GRATs Before the Sunset: Establishing a GRAT before the TCJA sunsets can be particularly advantageous.
For example, imagine a widow with a $20 million net worth. By transferring assets expected to appreciate significantly, she can lock in the higher exemption amount and potentially transfer substantial wealth to her beneficiaries tax-free. If the assets in the GRAT appreciate more than the IRS-assumed interest rate, the excess growth passes to the beneficiaries without further estate or gift tax implications. Without the GRAT, if she dies in 2026, her estate will be subject to federal estate tax. Here's a step-by-step calculation:
Net Worth: $20,000,000
2026 Estate Tax Exemption: $6,500,000
Taxable Estate: $20,000,000 - $6,500,000 = $13,500,000
Estimated Estate Tax: 40% of $13,500,000 = $5,400,000
Now, let's assume the widow uses a GRAT before the sunset in 2025 and transfers $13 million into the GRAT. The key here is that she utilizes the higher exemption amount available before the sunset. Here’s how this would work:
Assets Transferred to GRAT: $13,000,000
Remaining Net Worth: $20,000,000 - $13,000,000 = $7,000,000
Taxable Estate: $7,000,000 - $6,500,000 = $500,000
Estimated Estate Tax: 40% of $500,000 = $200,000
Therefore, by using a GRAT, the taxable portion of her estate would be significantly reduced, resulting in an estimated estate tax liability of only $200,000, saving more than $5 million in federal estate taxes!
Conclusion
As the federal estate tax law approaches its sunset in 2025, it’s imperative for individuals with significant estates to reassess their estate planning strategies. The reduction in the federal estate tax exemption will expose more estates to substantial tax liabilities, making advanced planning essential. Utilizing tools like Grantor Retained Annuity Trusts (GRATs) can help mitigate these impacts and preserve wealth for future generations. Consulting with a knowledgeable estate planning professional will ensure you navigate these changes effectively and optimize your estate plan for the coming years.
Disclaimer
The information provided on this blog is for general informational purposes only and is not intended as legal advice. Readers should not act upon this information without seeking professional counsel from an attorney licensed in their jurisdiction. Ari Weisbard is a member of the DC and NY bars and is not licensed to practice law in any other state. Consult with a qualified attorney to obtain advice tailored to your specific legal situation.