Jim Farmer is Managing Partner of Financial Strategies Group, a leader in the insurance industry providing clients with practical solutions.
When it comes to your financial legacy, business owners and executives who accumulate a significant amount of their net worth in their company’s stock rely on the current tax law stating that the basis in assets left to heirs is “stepped up” at death, to the fair market value as of the date of death. For example, if you held stock that was valued at $500,000 when you received it and is now worth $3 million, your heirs would pay no capital gains tax if they sold the stock for its current value. Last year, a proposal to eliminate the step-up in basis narrowly escaped (subscription required) being included in President Biden’s The American Families Plan. Then, earlier this year, as a part of the president’s 2023 budget proposal, another attempt was made to end the step-up in basis for those with capital gains greater than $5 million ($10 million for couples).
While these attempts have been unsuccessful so far, for many business owners and others who have accumulated illiquid wealth, the survival of the step-up in basis does not mean that all of their assets receive a step-up. Most notably, assets held in an irrevocable grantor trust may not enjoy a step-up in basis for generations.
Benefits Of Irrevocable Grantor Trusts
One of the first steps you will likely undertake in an estate plan is gifting assets so they are no longer a part of your estate. By gifting assets that are expected to appreciate over time, such as company stock and real estate, into an irrevocable grantor trust and having those assets appreciate outside of your estate, you can reduce your estate tax exposure. The amount you can gift is not limitless and is restricted to you and your spouse’s combined lifetime federal estate and gift tax exemption (which is $25,840,000 in 2023).
As the grantor of the irrevocable grantor trust, you will be taxed on all income in the trust despite not receiving any of it. The good news is that the payment of taxes from your estate reduces the value of your estate proportionately. This also means the assets in the trust can grow unburdened by taxation.
One drawback of gifting appreciating assets into a grantor trust is that the assets will retain the tax basis you, as the grantor, had right before you gifted the assets. This means that since the assets are no longer a part of your estate when you die, the assets you transferred to the grantor trust will not receive a step-up in basis to what their value is at that time. Capital gains taxation occurs when the trustee or beneficiary sells the appreciated assets. The capital gains tax at the state level ranges from 0% to 13.3%, while the federal rate ranges from 0% to 20% (with an additional 3.8% tax for the highest earners).
Strategies To Avoid Capital Gains Tax
Assuming one of your goals for establishing the trust is to pay as little tax as possible, there are a few ways to avoid capital gains taxes inside a grantor trust.
As the grantor, you retain the power to take trust assets back by buying them with cash or replacing them with other assets—low-appreciation ones are ideal. For example, if you receive a large amount of your employer’s publicly traded stock, you might swap these shares for other publicly traded securities of equal value that have appreciated. Since the assets traded must be equal in value, there should not be a change to your estate’s value used for calculating estate taxes. After the trade, you will own the highly appreciated stock, but there will be no taxable gain when you die since you will receive a step-up on the basis.
Similarly, for grantor trusts containing appreciated real estate, an IRC §1031 exchange allows for capital gains taxes to be deferred when swapping one real estate investment property for another.
Another strategy to reduce or eliminate capital gains taxes inside a grantor trust is to establish a charitable remainder trust (CRT). The grantor can sell investments without being subject to capital gains taxes, receive income for the life of a beneficiary of the trust and obtain a partial tax deduction. Here’s how this would work.
• Grantor, an executive of a publicly traded company, donates $1,000,000 in his employer’s stock to a CRT.
• Trustee sells the stock free of taxes and reinvests the proceeds.
• Grantor receives a current income tax deduction and a stream of income of at least 5% of the fair market value of the proceeds in the CRT.
• At the beneficiary’s death, the remainder of the proceeds in the CRT go to a charity, private foundation or donor-advised fund.
If the grantor wishes to replace the value of the gift made to charity, life insurance can be used to provide an income-tax-free death benefit for their heirs that acts as a step-up in basis.
What about when a grantor trust has assets that are not highly appreciated, as is often the case when the trust is established at the grantor’s death? By investing in a low-cost, no surrender fee variable life insurance contract, future capital gains taxes can be eliminated. These contracts offer many high-grade underlying fund options that can be moved into and out of without taxation. Either the grantor or a beneficiary can be the insured. The trustee can distribute income from contracts tax-free, and when the insured dies, the trust receives the death benefit tax-free, much like a step-up in basis.
The cost of life insurance is roughly 1% of your income—much less than the capital gains tax rate.
These are just some of the options at your disposal to help achieve the goal of passing on assets with as little taxation as possible. Every situation is unique, and a financial advisor should be consulted to discuss the appropriate strategy for you.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.