Don’t Wait Until 2026: It Might Cost You Millions

As we approach 2025, future tax policy is bracing for change. With election results determined, policy shifts will begin to take shape as the new administration takes over. Any potential policy changes will provide a modified framework for strategic decisions on a forward-looking basis. However, wealth transfer planning for individuals still requires thoughtful consideration because it is unknown whether expiring tax provisions will be extended, modified, or allowed to lapse.

Inaction carries significant risks, and taxpayers should proactively position their tax strategy, no matter what lies ahead. This critically holds true regarding the transfer of assets.

The Tax Cuts and Jobs Act (TCJA) of 2017 brought about landmark tax reforms, one of which was significant increases in the federal estate tax exemption.

Estate and Gift Tax Exemption

In 2017, the estate tax exemption was $5.49 million for individuals and $10.98 million for married couples. Since then, the federal estate tax exemption currently stands at $13.61 million for individuals and $27.22 million for married couples in 2024. This amount is slated to increase in 2025 to $13.99 million per individual and $27.98 million for married couples. However, unless Congress acts, the exemption will revert to an inflation-adjusted base of approximately $7 million per individual in 2026. This reduction will lead to higher estate tax liabilities for individuals with estates exceeding the new threshold.

The beauty is that any gifts made under the current exemptions will not be subject to “clawback” even if the exemption is reduced in the future. Therefore, if a taxpayer holds assets with value greater than the sunset exemption of $7 million, it would be unwise to allow an opportunity to move significant wealth pass by and not capture the tax savings on the increase. To take full advantage of the high exclusion amounts now, married couples who may not utilize the entire exemption could consider using 100 percent of one spouse's exemption to lock in at least part of the increase, while still retaining more of the exemption for the other spouse.

The truth is that Congress may determine the large increases put forth by The TCJA have served their purpose as they were phased in since 2017 and that the reduction to $7 million is appropriate, since that figure is more in line with typical federal policy increases historically. At approximately a $6 million expected decrease in the exemption, it could put a taxpayer in a position to write a check for $2.4 million if his estate was valued at the full exemption amount.

Valuation: A Second Consideration

Interest rates

In a high-interest rate environment, there are opportunities to tap into tax-efficient wealth transfer and estate planning. Interest rates impact valuations. Higher interest rates make the appraisal of real estate, businesses, and other assets lower in such economic environments. This allows you to maximize the amount of wealth for every $1 of the estate tax exemption you use, which reduces the amount of taxes owed in the future on any remaining taxable estate. Simply, the higher the interest rate, the more advantageous this strategy becomes.

For example, suppose you were gifting an equity interest in a manufacturing company that has $100 million in sales and a 10 percent after tax net income margin and only carrying $10 million in long-term debt. Just comparing the impact of interest rates and their effects on the equity markets pre-pandemic and now, while holding all other variables constant in these two scenarios, the results are staggering. The movement in valuation would render a company like this, which could be worth $82 million before the rise in rates and bring it down to $67 million, an 18 percent decrease in equity value. The result is gifting in high-interest rate environments benefits the taxpayer strategically.

Now that inflation seems to have stabilized mostly, and the Federal Reserve has made two rate cuts this year, the likely direction for rates in the future is back down.

Discounts

The final piece of the gifting process, which cannot be overlooked, is discounting. While discounting is not a recognized economic concern in some asset classes, it is at least in two asset classes that there is economic basis for it when transferring non-controlling portions—real estate and business interests.

In real estate, this often falls into the business category when the real estate is owned by a limited liability company or a family limited partnership. However, even if the property is held directly by taxpayers and an undivided interest is transferred, discounts are allowable and sometimes quite significant depending on the property value and percentage ownership transferred.

In business interests, discounting falls into two primary categories for transferring non-controlling interests—discounts for lack of control (DLOC) and discounts for lack of marketability (DLOM). Both discounts can range in spectrum depending on several factors. The discount for lack of control can have a significant impact on businesses that are asset heavy or others where cash flow is not optimized. The discount for lack of marketability is driven more by the type of business operation, size, risk, and similar factors. Generally, we have observed empirically and applied discounts for lack of marketability ranging from 15 percent – 54 percent.

Taking both interest rates and discounting into consideration, a taxpayer could transfer much more wealth than the current exemption threshold. Using the illustrative 18 percent reduction in value from our example combined with a total DLOC and DLOM of 55 percent, this means for every $1 of exemption used a taxpayer could transfer $2.71 of what would be pre-pandemic asset values.

Next Steps

The time for transferring wealth that you may have procrastinated on is now. Take time to assess your financial situation and speak to your advisors about how you could maximize your tax savings before upcoming changes take effect and limit your options, potentially costing you real dollars. Work with your R&A advisor to identify the your best course of action before year-end and plan for 2025.