Transfer tax planning is a lifelong process and should evolve to accommodate changes in personal circumstances, tax laws and the broader economic climate. The current economic uncertainty, particularly with the current rising inflation, presents unique challenges and opportunities for estate and gift tax strategies.
Inflation has the potential to affect succession planning in important ways. The most obvious is the impact inflation will have on asset values and future appreciation. Estate planning typically involves lifetime transfers and “freeze” strategies. These hinge on asset values and allow taxpayers to remove future growth from their estate. Many freeze strategies also depend on assets appreciating faster than the IRS-prescribed interest rates, where inflation will also play a major role. Add to these developments the prospect of unfavorable legislative changes to gift and estate tax rules, taxpayers should be acting quickly to adjust their strategies and seize time-sensitive opportunities.
This piece will discuss key transfer planning considerations in the current environment and is part of our series of articles covering the tax planning implications of inflation. Our first article provides a high-level introduction to the series, while other articles provide a deeper dive into considerations for federal and state and local tax planning.
Impact on lifetime transfers
Large lifetime transfers should form a significant part of any estate plan. Transfers can be made tax-free using the annual exclusion ($16,000 in 2022) or lifetime exclusion ($12,060,000 in 2022). Taxable gifts also have benefits because, while gift and estate tax rates are both 40%, the gift tax is “exclusive” of the tax itself while the estate tax is not.
There are two significant tax benefits available with both taxable and tax-free lifetime transfers that may be affected by inflation:
- Valuation discounts: Certain types of assets may qualify for valuation discounts for characteristics such as lack of management or control.
- Removing appreciation: Transferring assets during life will remove any future appreciation from the taxpayer’s estate.
The rapid onset of inflation over the past 18 months is already making an impact on asset values and will clearly affect future appreciation. It has also not yet shown much sign of abating. The most recent numbers show the standard consumer price index up more than 8.6% year-over-year in May and 9.1% in June, representing the largest increases in more than 40 years.
Inflation, fears of a recession due to the Fed’s response, and the war in Ukraine have roiled markets. The potential upside to a falling market is the natural valuation discount. Even private company valuations are often based on public company comparables and equity market earnings multiples. It may be much cheaper to make a gift now than it was entering 2022 when the market was at an all-time high.
It is even more critical to consider how inflation may affect future appreciation. It is very inefficient to transfer an asset that loses value. Taxpayers should consider which business investments may be more able to adjust or even profit from a high inflationary environment than others. Certain financial assets, such as fixed rate bonds, can suffer in an inflationary period. Taxpayers should look for opportunities to transfer assets with depressed values and good prospects for appreciation in an inflationary environment.
Impact on freeze strategies
Freeze strategies are among the most powerful lifetime transfer options, but they will also be heavily affected by inflation and interest rates. There are many variations of freeze strategies, including grantor-retained annuity trusts, intentionally defective grantor trusts and charitable-lead annuity trusts. These strategies generally pay income to the giver or a charity for a term, and then leave any remainder interest to heirs. The value of the gift for gift tax purposes is calculated using IRS-prescribed interest rates to determine how much is expected to be left at the end of the term. If the assets appreciate more than the Applicable Federal Rate (AFR) used by the IRS in the calculation, the remainder is passed on to heirs tax-free. For more on freeze strategies, see our recent article.
AFRs are tied directly to Treasury bond yields, and for years, extremely low interest rates made these strategies especially effective. The “quantitative easing” the Federal Reserve Board employed as economic stimulus beginning in 2008 kept Treasury yields historically low. To fight inflation, the Fed is now tapering this quantitative easing and seeking to raise interest rates, leading to significant increases in AFRs. The AFR for mid-term loans has already doubled since the beginning of the year, and the trend is expected to continue. Taxpayers employing freeze strategies should act quickly before AFR rates increase further.
Freeze strategies also depend on appreciation in the underlying assets, so as noted above, taxpayers should carefully consider which assets are expected to perform well in the current economic climate.
There are other reasons to act quickly. Without legislation, the current lifetime gift and estate tax exemption is scheduled to be cut in half in 2026 when major aspects of the Tax Cuts and Jobs Act are set to expire. The IRS has issued guidance providing that it will not “claw back” the benefit of gifts made using the increased exemption even if it is reduced, making it even more important to act now. In addition, Democratic lawmakers have proposed tightening restrictions on many of the freeze techniques currently available. Although the legislative outlook is uncertain, these changes could happen even more quickly.
The economic outlook remains volatile. Asset values and appreciation could continue to shift as the economy responds to inflation, interest rates changes, and other external events. Taxpayers should be seizing time-sensitive opportunities and preparing to adjust planning and lifetime transfer strategies as the situation evolves.
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