If you're a business owner, you may have heard about the impending sunset of the federal gift and estate tax exemption. If Congress does not act, the current lifetime exclusion amount (which is the amount of assets you can transfer without paying any federal gift and/or estate tax) of $13.61 million for an individual and $27.22 million for a couple married will expire on December 31, 2025. At that time, the exemption amount will revert to the law's pre-tax and jobs cut level of $5.6 million for individuals and $11.2 million for married couples (adjusted for inflation from 2017 to about 7 million dollars per individual).
This important tax change is especially important for individuals who have a net worth over $14 million. It also affects business owners who anticipate an exit in the next 18 months, which would likely put them at or above the $14 million joint gross asset threshold. Basically, every dollar above the lifetime exclusion amount will be taxed at a 40% tax rate upon death.
While January 1, 2026 may seem like “forever” from now, for business owners who are planning a sale in the near term, the time to start planning is now. Estate planning strategies that can help house assets take time to establish, and the IRS will often review such planning techniques that are done AFTER the signing of a letter of intent (LOI) with a potential buyer. Therefore, business owners are advised to implement estate planning strategies well in advance of any offer being documented or LOI drafted, generally at least 6-8 months prior to a transaction.
It is worth noting that the IRS has stated that the estate tax exemption amount will not be subject to a “return” if the sunset occurs. So business owners don't have to worry about fully utilizing the current exemption amount and later returning those assets.
Below are three estate planning strategies that business owners should consider using now in preparation for the possible sunset of the current estate tax exemption amount:
Spousal Lifetime Approach Trust (SLAT)
The objective of a SLAT is to extract assets from your estate so that they are not subject to any estate tax at death, while simultaneously reserving the right to use those assets. As the creator and grantor of the trust, you can benefit from the money in the trust indirectly through your spouse, even though you don't technically have a vested interest in the trust as long as you are married to your spouse and the spouse lives. . Not having an interest held in those assets as the person funding the trust is what makes those assets excluded from your estate. Ensuring your spouse has access to those funds as a designated beneficiary, if needed, is attractive to many couples who may be unsure of what their future liquidity needs may be or who may not be ready to transfer the property to children or other beneficiaries.
All future appreciation of the assets transferred to the trust is exempt from estate taxes. Therefore, to get the most money, it is ideal not to access those funds until you exhaust the money still held in your personal name.
Business owners who choose to wait and set up a SLAT until the federal estate tax exemption runs out (assuming it does) can forgo the opportunity to transfer up to $13.61 million to the trust. Instead, they would be limited to passing on just $7 million worth of assets to their heirs free of federal estate taxes (not to mention the potential appreciation of the assets placed in the trust).
Grantor Retained Pension Trust (GRAT)
A GRAT is a powerful and underutilized estate planning tool that transfers future asset growth from one's estate (and therefore is not subject to federal gift tax) either directly or into a trust for descendants. The creator of a GRAT retains an interest in the trust's assets for a specified period of time through the receipt of an annuity payment that is made each year until the total value of the assets originally placed in the GRAT is paid. Basically, a GRAT returns all the money you put into the trust during the GRAT term, plus interest at a rate known as the applicable federal rate. Those assets returned to the creator of the trust remain subject to estate tax, BUT all future appreciation of the assets placed in the GRAT is allowed to grow without being subject to federal gift or estate tax, which can represent millions of dollars over time .
Otherwise, without a GRAT, all future appreciation of those assets would be subject to a 40% estate tax on your pass-through.
For business owners awaiting a liquidity event, things get even more favorable with a GRAT. The reason is that private equity in a business must be valued before being placed in a GRAT to derive a value, which is typically discounted (generally 20-40%) due to the inherent lack of marketability of private equity. For example, if a business owner's shares of stock are valued at a discounted value of $5 million, but in fact, they are worth $8 million, this essentially represents an immediate valuation of $3 million, which again will to be free of property taxes if imposed. in a WOMAN.
Finally, business owners should generally explore using short-term GRATS (eg, 2 years) for two reasons: First, the tax-free benefit on the estate of a GRAT is provided only after a GRAT term expires. Second, the valuation of private equity vested in a GRAT occurs essentially immediately. In other words, if you were to pass away before the end of a GRAT term, the assets transferred to the trust will be pulled back into your gross estate and you (and, more importantly, your heirs) will not receive estate tax avoidance for the assessment of assets in GRAT. Longer-term GRATs can make sense in certain cases, but have a greater risk of assets being pulled back into one's estate in the event of an untimely death.
Sale to Defective Grantor's Trust (Installment Sale)
An installment sale is very similar to a GRAT, but can be more effective if the timing of the sale of the business is less certain. Similar to a GRAT, business stock can be sold to a trust in exchange for a promissory note. With an installment sale, only the IRS-mandated interest is required to be paid each year, but the unpaid principal owed to the originator can be made at the end of the term through a lump sum payment. Compared to a GRAT, the installment sale method is likely to result in more estate tax-free growth as the principal remains in the trust longer and, therefore, is likely to produce more growth and income.
Using the same numbers in the GRAT example above, you can implement an installment sale with a 10-year business stock loan that is valued at a discount of $5 million but is really worth $8 million. Between years 1 and 10, the business is sold and the shares owned by the trust would cash in for $8 million and remain in the trust. Small interest payments on the $5 million contributed will be paid each year, and in year 10, the trust will return the original $5 million valuation. Meanwhile, the $3 million difference, along with all growth and income earned on the total amount of assets held in the trust, would be eligible to pass to your beneficiaries estate tax-free. Keep in mind that even after the trust pays off the loan, the remaining trust assets ($3 million plus earnings) will continue to grow without estate taxes.
It is worth noting that these three strategies are not always implemented in isolation. Many families use a combination of SLATs, GRATs and installment sales to efficiently shield their assets from estate tax.
Cort Haber is a Managing Director at New Republic Partners.