Clients want their estates to grow until it is tax time—when they want to give the Internal Revenue Service as small a target as possible. While the federal wealth transfer tax exemptions run into the millions of dollars, some clients’ estates exceed these amounts and result in large estate tax bills. Fortunately, several methods are available to reduce the amount of a client’s estate for tax purposes. Here are ten strategies to limit your client’s exposure.

Optimizing Exemptions, Credits, and Deductions

Estate tax liability is calculated by multiplying the value of the estate and adjusted taxable gifts by the tax rate, which is currently 40 percent. However, exemption amounts are applied first.

1. Use the Basic Exclusion Amount

Most clients have a basic exclusion amount to shield assets from estate and gift tax. The basic exclusion amount is the amount the client can give during their lifetime or at death to people other than their spouse or a charity without generating an estate or gift tax liability. That number increased in 2022 from $11.7 million to $12.06 million. However, the number is expected to go down to about $6 million in 2026 with the sunset of certain Tax Cuts and Jobs Act provisions, or it could change sooner with the political tides. Clients who can benefit from the larger current exemption amounts may be wise to take advantage of them while they last.

2. Use the Generation-Skipping Transfer Tax Exemption

The generation-skipping transfer (GST) tax exemption is currently $12.06 million for individuals. This exemption allows the client to pass wealth on to their grandchildren or younger generations without paying the GST tax. Keep in mind that the GST tax exemption is not portable: when a client dies, their spouse may be able to use the remainder of the client’s estate tax exemption, but not the client’s GST tax exemption. Like the estate tax rate, the GST tax rate is 40 percent. 

3. Use the Annual Exclusion

Another strategy is to employ the annual exclusion, which has increased from $15,000 to $16,000 for 2022. This exclusion, which applies per recipient per year, can be used for gifts to an unlimited number of recipients. Gifts in excess of this amount will require a client to file a federal gift tax return (Form 709) and will count against the client’s lifetime exclusion amount (unless the tax is otherwise offset).

4. Use the Ed/Med Exclusion

When a client has maxed out their exemptions and annual exclusions, there may still be other strategies available. One less widely known strategy is the ed/med exclusion. This involves the direct payment of someone else’s medical or educational expenses. These gifts are not subject to federal gift or GST taxes. 

Only certain payments qualify, so you should read the rules carefully. In general, these payments must be made directly to schools or medical providers. For example, only tuition payments are eligible, so money spent on room and board, supplies, and books does not qualify. The educational institution must also meet certain requirements. 

5. Use the Spouse’s Exclusion Amount

In general, each spouse has an exclusion amount when gifting to third parties, and gifts can be split between the spouses each year. When spouses split gifts, gifts made by one spouse during the year will be treated as if each spouse gave half, allowing the use of both spouses’ exclusion amounts. 

Another method for using a spouse’s basic exclusion amount is using portability. The unused portion of the deceased spouse’s exclusion amount can be transferred to the surviving spouse, effectively increasing the exclusion amount available to the survivor. Portability requires a valid election within a short time after the spouse’s death.

6. Move to a State Without an Estate Tax

If you practice in one of the seventeen states that has an estate or inheritance tax, you might assess whether it would be worth it for a client to move to one of the other thirty-three states to avoid those taxes. The states with an estate or inheritance tax are Connecticut, Hawaii, Illinois, Iowa, Kentucky, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, Vermont, and Washington. The District of Columbia also has an estate tax.

7. Leverage the Estate or Gift Tax Charitable Deduction

Setting up an irrevocable trust for charitable giving also has tax advantages. The charitable contributions may be deductible for income, estate, or gift tax purposes, and the trust may also serve the client’s other tax or nontax objectives.

Reduce the Value of Assets in the Estate

Certain assets will always be part of a client’s estate, but there are ways to reduce their taxable value to minimize your client’s exposure.

8. Use Valuation Discounts to Leverage Exemptions

Setting up a family limited partnership for valid business purposes and transferring assets to it is one way to reduce the value of a client’s estate through valuation discounts. Giving a descendant or other beneficiary an interest in the limited partnership can have a lower tax cost than giving the same interest in the assets, because a limited partnership interest often has a lower fair market value than the same proportion of the underlying assets. If a client has the kinds of assets suitable for contribution to a family limited partnership, the entity can also provide valuable nontax benefits.

9. Use Grantor Trusts to Leverage Transfers

Placing assets into a grantor trust is another effective strategy to make the most of clients’ exemptions. The client who contributes assets to a grantor trust pays the income tax on the income generated by the trust assets. That payment does not count as a gift, and the value of the trust is not diminished by those tax payments. 

10. Remove Assets from the Estate 

Freeze techniques aim to move assets that could appreciate out of a client’s estate at a low gift-tax cost, effectively freezing the value of the asset for the client’s wealth transfer tax purposes. Grantor retained annuity trusts (GRATs) and installment sales to grantor trusts are common trusts for utilizing freeze techniques. Both allow the client to transfer away the appreciating asset but receive something in exchange—an annuity in the case of a GRAT and a promissory note in the case of an installment sale. The annuity, note, or payments made on either may be includible in the client’s estate, but the potential value of those items should be less than that of the appreciating asset the client previously held. 

Aside from estate tax liability, here are some other things to consider when advising your clients about wealth transfer tax strategies:

• The client’s financial needs
• The client’s liquidity to pay taxes (for example, using proceeds from life insurance)
• Income tax basis
• Deferral to the marital deduction (which does not always save on taxes)
• Building in flexibility to adapt to changing tax laws

Learn More About Reducing Estate Tax 

You can learn more at the WealthCounsel webinar, “Reducing Estate Tax: Strategies Every Planner Needs to Know,” February 8. Stephen Liss will discuss the economic benefits of lifetime gifting and many more specific planning techniques. Register for the webinar today.