The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
Victoria is a 44-year-old venture capitalist who is looking to minimize her taxes. In this article, we’ll walk through her situation, goals, and plans, and explain the logic behind each potential tax strategy.
In Victoria’s case, by pursuing some advanced tax strategies, she’ll be able to cut her income-tax bill by millions of dollars while more than doubling the amount of wealth that she is able to leave to her children.
Now that we know Victoria’s basic situation, let’s discuss her goals:
Given her situation and goals, Victoria has decided to transfer half of her interests in her new fund and half of her interests in her former employer’s funds to irrevocable trusts. After weighing the advantages and disadvantages of grantor trusts and non-grantor trusts, she’s decided to hedge her bets by doing both.
Charitable Giving: She will establish a donor-advised fund or private foundation and contribute appreciated stock to it each year. For now, her plan is to transfer about $400,000 of stock annually to the charitable vehicle. By doing so, Victoria will generate close to $200,000 of income-tax savings each year while avoiding capital gain realization on the donated stock.
The first piece will be an intentionally defective grantor trust (”IDGT”). An IDGT is a type of irrevocable trust that is optimized for minimizing estate tax. Any appreciation in the IDGT will occur outside of Victoria’s estate for estate-tax purposes. Importantly, with an IDGT, Victoria is allowed to pay the trust’s income taxes each year since the trust is totally ignored for income-tax purposes. While paying the trust’s taxes might not sound appealing, from an estate-tax perspective, it is: each time Victoria pays the trust’s taxes, she’s essentially making a gift to the trust, but the IRS doesn’t consider those payments to be gifts so they don’t count against her lifetime gift-tax exemption. The annual tax payments will add up to many millions of dollars over the course of Victoria’s lifetime. Finally, the IDGT is extremely versatile. Victoria can borrow from it, lend money to it, invest the funds in her future business ventures, sell assets to it, and much more. (Sales to an IDGT have no income-tax consequences, since IDGTs are ignored for income-tax purposes.) Victoria can even name her spouse as a beneficiary of the trust — if she does that, her spouse will be able to receive distributions whenever necessary.
Victoria will be gifting a “vertical slice” (see discussion below) of her interests in the new fund to the IDGT. That way, if there are any capital calls, she can lend money to the trust, and if her fund ends up being worth even more than she anticipates, the trustee can make distributions to her spouse (if she decides to name her spouse as a beneficiary). Victoria will hire an appraiser to appraise those interests. If she gifts one-half of her estimated $3 million interest — so, $1.5 million — the appraiser will likely appraise it at around $1 million for gift-tax purposes, since interests in her fund are highly illiquid. The gift will consume a small portion of Victoria’s $13.61 million lifetime gift-tax exemption, leaving her with about $12.61 million of exemption to work with.
If Victoria lives to be 94 years old, assuming she’s able to generate 10% annual returns, this relatively small gift to the IDGT will reduce her children’s estate-tax liability by about $75 million. If, instead, she had made a larger gift to the IDGT or taken steps to maximize the IDGT’s power, she could have saved her children hundreds of millions of dollars. These are very powerful trusts!
Second, Victoria is setting up non-grantor trusts and transferring to them a $3 million interest in her old employer’s fund. There will be two non-grantor trusts: one for each child. A non-grantor trust is a type of trust that is treated as a separate taxpayer for income-tax purposes. Since the trusts will be a tax resident of a state with no income tax, like South Dakota, they will be able to avoid state income taxes on both the fund exit and future investment returns. The interests will likely be appraised for about $2 million for gift-tax purposes, leaving Victoria with around $10.61 million of unused gift tax exemption (after accounting for her $1 million gift to the IDGT).
The non-grantor trusts will be able to invest in Victoria’s future business ventures, but for the most part Victoria will not have direct access to the funds in the non-grantor trusts. Neither she nor her spouse will be beneficiaries, so they can’t receive direct distributions from these trusts. Since the trusts are separate taxpayers, she can’t borrow money from them, lend money to them, sell assets to them, buy assets from them, or swap assets with them without generating taxable income. She also can’t pay the trusts’ taxes without those payments being considered gifts for gift-tax purposes. But the ability to avoid state income taxes is a major perk.
Over a long enough time horizon, the compound returns from paying a substantially lower effective tax rate could easily reach into the millions of dollars. And, as with the IDGT, any appreciation in the non-grantor trusts will occur outside of Victoria’s estate for estate-tax purposes, minimizing future estate taxes.
To be more concrete, if Victoria lives to be 94 years old, assuming she’s able to generate 10% annual returns, her non-grantor trust should save about $60 million of taxes. As with the IDGT, she could have saved even more taxes if she had made larger gifts or optimized in other ways.
Third, Victoria considered two charitable structures, both of which qualify for upfront charitable deductions and are fully tax exempt:
Victoria has decided to set up a private foundation. She will contribute $400,000 of appreciated stock to it each year, which she will be able to deduct for both state and federal income-tax purposes.
Tax-planning strategies — which include strategies for minimizing income tax as well as strategies for minimizing estate tax, gift tax and other taxes — involve tradeoffs. Most tax strategies require a taxpayer to put a portion of his or her assets in a trust or some sort of investment structure that limits the taxpayer’s control and/or access to the transferred assets. There are also often tradeoffs between income-tax minimization and estate-tax minimization. Often, the most income-tax-efficient strategy is suboptimal from an estate-tax perspective, and vice versa.
There’s a special provision of the tax code that governs transfers of most fund interests: Section 2701. You can read more about that provision here. The gist of it is that when someone has multiple classes of interests in a fund, they have to be careful to structure the transfer of the fund interests in a way that does not inadvertently result in a deemed gift that is larger than their intended gift. Often, fund principals will contribute a “vertical slice” of fund interests – that is, a proportionate amount of carry and non-carry interests.
There is more that Victoria could do:
She could set up a charitable remainder unitrust (”CRUT”), transfer appreciated assets to it, sell the assets inside of the CRUT, and then receive distributions over the course of her life. She’d eventually have to pay the capital gains tax on the sale, but the tax would be deferred for years. At the end of the CRUT’s term, which would likely coincide with Victoria’s death, the remaining principal would pass to charity.
She could buy a private placement life insurance (PPLI) policy and invest in income-producing assets — such as alts — through that. PPLI, like other types of life insurance policies, is exempt from both federal and state income and capital gains taxes. But compared to other forms of life insurance, PPLI has very low fees.
She could create zeroed-out GRATs and put publicly traded stocks in them — if the stocks appreciate, the excess returns above the IRS hurdle rate would pass to her beneficiaries free of gift tax. This strategy wouldn’t use any of Victoria’s lifetime gift tax exemption.These strategies are covered elsewhere but are beyond the scope of this article. You can read more about them in our Learning Center.
Victoria is obviously very fortunate, and even without tax planning she would be in a position to leave a large legacy to her family. But with smart tax planning, she can turbocharge that legacy. Valur is here to help.
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