Garden-variety affluent investors embrace estate planning of the ultra-rich

Ordinary affluent people increasingly share an emerging challenge with their extremely moneyed peers: Figuring out how to minimize taxes when passing wealth to heirs.

On the surface, President Joe Biden’s proposals for sweeping tax hikes appear to hit ultra-rich individuals the most. A higher top individual rate, a near doubling of the capital gains rate on investment profits and the elimination of the main loophole for transferring wealth to children and grandchildren are all aimed at people Biden has repeatedly referred to as “billionaires.” Those individuals’ wealth stems primarily from investments, not work — even the bulk of compensation for GE CEO Larry Culp, the highest paid corporate leader in the nation, comes from stock awards, not salary.

In fact, the Biden administration’s tax proposals would affect many individuals who, while well-off, are several zeroes below the richest .01% (that rarified tranche has a minimum net worth of over $25 million, according to one measure). The policy reach has spawned what might be called trickle-down estate planning for clients who are well off but not stratospherically wealthy.

Amid the potential changes, what some advisors call “the basic, garden variety trust” — something known as an intentionally defective grantor trust, or IDGT (pronounced “id-jit,” to rhyme with widget) — has emerged as a favored means to ward off impending tax pain.

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“The most meaningful thing to clients right now is accelerating planning around setting up and funding” these trusts, says Lawrence Gingrow, the co-president of Eaton Vance WaterOak Advisors, a fee-only advisory firm that’s part of Morgan Stanley.

Biden’s proposals aren’t yet law, and no one knows to what extent, or even if, Congress will approve them. Nonetheless, with the certainty of at least some tax increases in the air, advisors are pushing their clients to rethink which assets they want to hold onto and which ones they want to give to their children or grandchildren. Along with making large gifts, like real estate, to the next generation, some advisors say that ordinary affluent clients are increasingly turning to the same tool — an IDGT — that billionaires use.

An IDGT involves an investor putting assets, like stocks or private investments, into a trust, and then paying taxes annually on any realized profits, interest or dividend income that they generate. One key tax benefit involves the grantor using installment sales, with promissory notes lasting perhaps a decade or longer, to move assets into the trust without triggering the gift tax threshold of $15,000 a year, and without triggering capital gains taxes.

The grantor is still the owner of the trust for tax purposes (that’s what makes it “defective,” in IRS parlance), but the assets have been removed from her estate as far as estate tax is concerned, so they can grow tax free. When the grantor dies, the beneficiary inherits the trust but pays taxes only on its distributions. “Those assets could double or triple over time,” Gingrow says. “So the assets could stay in the trust for their entire life and the next generation’s life.”

IDGT trusts come in a variety of flavors. One type favored by the super-rich, a dynasty trust, has been used to financially seed multiple generations of descendants without triggering gift, estate or generation-skipping transfer taxes. Biden wants those engines of wealth to pay capital gains tax on their profits every 90 years, starting on Dec. 31, 2030.

Another type, called a spousal lifetime access trust, allows a grantor’s spouse to maintain control. So-called SLATs are the flavor of the day, according to Luke Harriman, a vice chair of law firm Much Shelist’s wealth transfer and succession planning group. “It is an historic window for making gifts and planning,” he says.

The popularity of IDGT trusts is not without risk. Some advisory and accounting firms, including KPMG, say that it’s not clear whether Biden’s tax proposals, outlined in Treasury’s “Green Book” last May, would levy capital gains tax on sales of assets via promissory notes to the trusts. Meanwhile, EY writes that the proposals “should not affect” such sales.

Biden’s tax proposals don’t mention changes to the 40% estate tax, which now kicks in at more than $23 million for married couples (nearly $12 million for individuals). Those record-high levels are due to expire come Jan. 1, 2026, when they will revert back to their pre-2017 levels of less than half those amounts.

But under Biden, a parallel noose would tighten sooner: a longstanding benefit in which capital gains taxes are erased on the increased value of investments held by a deceased person at death. The step-up in basis loophole has allowed families to pass on to heirs massive fortunes of stock and real estate free of tax. Biden wants to eliminate the benefit for those with incomes over $1 million. That’s also the level at which the current 20% capital gains tax would nearly double, to a new individual top rate of 39.6% (with an additional 3.8% Obamacare subsidy for both levels).

Under tax laws, IDGTs don’t get the step-up in basis benefit, unless they’re structured to include certain complicated maneuvers with asset swaps. But using them to move assets out of an estate reduces the tax hit on the estate if the basis step-up goes away. “If we can’t rely on the step up for our tax planning, we need to look elsewhere,” says Gingrow.

Which means that heirs may be inheriting not just their parents' or grandparents’ fortunes, but also a higher tax bill, if Biden’s increases in capital gains and ordinary rates come to fruition. Says Gingrow: “It’s a shifting of the tax liability to the beneficiary.”