The lifetime estate tax exemption now is about $13.6 million for an individual and $27.2 million for a couple.
Under current law, the exemption is scheduled to drop, about in half, on January 1, 2026. The new exemptions[1] will be about $7 million for an individual and about $14 million for a couple.
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Where you have clients with taxable estates (now or who will if the exemption falls as scheduled) you probably have an opportunity to pick up new assets, while helping your clients save millions of dollars of taxes.
Basis Step-up at Death
We talk to many advisors who have clients who could use their estate tax exemption now, but don’t.
Why don’t the clients use the exemption?
Because the clients own an appreciated asset –stock, real estate, a business, or something else – and they want to hold the asset so their heirs can get a basis step-up when the client dies.
Penny-Wise and Pound-Foolish?
If the estate tax law changes as scheduled, holding an appreciated asset in your estate to get the step-up in basis will prove to be a costly mistake.
The capital gains tax ranges from about 23.8% for people who live in zero income tax states like Florida and Texas, to about 37.1% for people who live in high tax states like California.
All of those rates are lower than the Federal estate tax rate of 40%.
Conundrum
Nick and Susan are both 75 years old. They have three children, ranging in age from 39 to 47. Nick and Susan own approximately $15 million of Nvidia stock. Their basis is $479,000. They own other assets, including a house worth $3.5 million, some private equity, and a stock portfolio. Both are retired with pensions. They’re don’t expect to ever need the principal, or income, from the Nvidia stock.[2] But they live in California, and don’t want to pay the $5,400,000 in tax that they estimate would result from selling Nvidia.
They don’t want their kids to have to pay the tax either. So they don’t sell the Nvidia stock, and they don’t use their lifetime estate tax exemptions.
When we sat down with their advisor and them, we discussed what they’d really like to accomplish. Their main goals are:
- Avoid capital gains tax associated with sale of the stock
- Use at least one of their lifetime exemptions in full, now before the opportunity goes away
- Maintain flexibility consistent with tax minimization
- Create a tax-deferred investment vehicle which provides optional income
Together, we came up with the following solution which addresses all their goals. Here are the highlights of the solution:
- Create a Master LLC
- The Master LLC will initially be owned by Nick and Susan
- If estate planning counsel concurs, the LLC can be structured to provide discounting for gift/estate tax purposes[3]
- Nick and Susan contribute the $15 million of Nvidia stock to the Master LLC
- Nick and Susan create three tax-exempt Stock Diversification Trusts
- Trust 1 – for Nick, Susan, and Will (their oldest child).
- Nick and Susan will be lifetime income beneficiaries of the Trust, and after the second of Nick and Susan dies, Will will be the lifetime income beneficiary.[4]
- Trust 2 – for Nick, Susan, and Josie (their second child).
- Nick and Susan will be lifetime income beneficiaries of the Trust, and after the second of Nick and Susan dies, Josie will be the lifetime income beneficiary.[5]
- Trust 3 – for Nick, Susan, and Chris (their youngest child).
- Nick and Susan will be lifetime income beneficiaries of the Trust, and after the second of Nick and Susan dies, Chris will be the lifetime income beneficiary.[6]
- Trust 1 – for Nick, Susan, and Will (their oldest child).
- Nick and Susan fund each of the three trusts with ⅓ of the Master LLC units
- Each trust is funded equally
- Nick and Susan create a Generation Skipping Trust for the benefit of their descendants.
- Nick and Susan contribute the lead interests in the three trusts to the Generation Skipping Trust. The gift is valued at $13.5 million, and just exhausts only one of their two lifetime exemptions.
- The Master LLC sells the stock owned by the Master LLC; the Master LLC is owned by the Stock Diversification Trusts
- During Nick’s and Susan’s lives, the Master LLC can be managed as a single account, or divided into separate accounts
- After the second of Nick and Susan dies, the children can decide to keep the Master LLC, or distribute the assets in two portions so they can be managed individually.
Key Outcomes
- Capital Gains Tax Savings: The stock can be sold with no capital gains tax being due.[9] The capital gains tax saved is estimated at approximately $5,4000,000.[10]
- Zero Estate or Gift Tax: The entire $15 million is out of the taxable estate.
- Risk Reduction: The Nvidia stock can be sold, and the proceeds reinvested in a diversified portfolio.[11]
- Tax Deferral on Future Investments: Nick and Susan can use the Stock Diversification Trusts as tax-deferred investment vehicles. They are not required to receive income from the trusts in any given year. Income that is not distributed to them remains in the trusts where it can compound tax-deferred, for eventual distribution to the GST trust.[12]
- Each trust will last for the lifetime of Nick and Susan, followed by the lifetime of the respective child.[13]
- Immediate Income Tax Savings: Nick and Susan receive an income tax deduction of approximately $1,500,000 upon funding the trusts, assuming that the fair market value of the assets contributed to the trusts is $15 million.[14]
- Liquidity: Nick and Susan, and later their children, retain a reasonably high degree of liquidity, despite the fact that the investments are owned in an irrevocable trust.[15]
If you have clients who may fit the situation described above, or if you’d like to learn more, please reach out to us.
Request a case study here, or
request an Advisor Guide to Concentrated Stock Positions here, or
email Connor Barth at [email protected], or call 703 437 9720.
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[1] They are to be calculated by a formula, and so the exact numbers are not yet known.
[2] Nvidia’s June 2024 dividend is set to be one cent per share, while the stock trades at close to $1100 per share.
[3] This would typically involve separating the control from the value, and the non-control units would be contributed to the trusts. This would be done as part of an overall estate planning strategy. The estate planning can be done separately from the income tax planning to avoid the capital gains tax on sale of the stock.
[4] The term of the trust is determined at the time the trust is funded, and is a function of several variables including the birthdates of all the beneficiaries, interest rates in effect at the time, and certain tables and formulas. How long the trust actually lasts will depend on how long the associated individuals live.
[5] See previous footnote.
[6] See previous footnote.
[7] For tax valuation purposes, following the funding of the trusts, the value of these lead interests will be approximately 90% of the value of the assets owned by the trusts.
[8] The lead interests are capital assets, and can be used in estate planning much like other capital assets.
[9] The trusts are tax-exempt under §664 of the Internal Revenue Code.
[10] Calculated as 37.1% of $14,600,000. Federal capital gains tax of 20% + Obamacare tax of 3.8% + California income tax of 13.3$.
[11] The trusts can invest in a wide variety of investment types, including stocks, bonds, mutual funds, many hedge funds and alternative investments, real estate, REITs, etc. Certain rules apply to the management of the trust assets, including a prohibition on self-dealing, and the desirability of avoiding “unrelated business income” also called “UBI.” Unrelated business income is not prohibited, but is taxed up to one hundred percent.
[12] The trust is typically structured such that it is possible for a non-disqualified person (generally a person who is not in the family of the grantors) to make one or more decisions each year regarding how much or how little income to distribute. Income that is not distributed will remain in the trust, and will remain payable in the future. In the meantime, the undistributed income can compound tax-deferred.
[13] The surviving spouse will continue to be the income beneficiary until that second spouse dies.
[14] For the trust to qualify as tax-exempt under §664, when the trust is initially funded the actuarially calculated value of the tax deduction must be equal to a minimum of ten percent of the fair market value of the assets contributed. Certain other technical provisions must also be included in the trust.
[15] The right to receive income from the trust is called the Lead Interest. The Lead Interest is a capital asset, and as such may be used like any capital asset. It may be gifted (as in this example when the Lead Interest is gifted to the “baby LLCs” or if needed, sold. The sale of a Lead Interest will generally result in realized capital gain for income tax purposes.
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