Wealthy tax return filer? Silver lining graces challenging IRS season

This year’s chaotic tax filing season has a bright side for the affluent.

As pandemic challenges and temporary tax law changes besiege the IRS, the agency’s official watchdog has forecast a particularly turbulent season for the more than 160 million Americans who could begin filing their federal returns on Jan. 24. But when it comes to gift tax returns that are typically filed by the affluent, the picture appears much calmer.

That’s because glitches bedeviling the nation’s tax collector for a third pandemic year largely concern individual returns, not gift tax ones, which are filed far less frequently. This means that there’s less friction in getting those latter documents — and the wealth transfer strategies they reflect — across the finish line.

Among the tax strategies that rich clients have been using amid potential rate hikes: Under-the-radar trusts. Escape hatches to protect fortunes if rates increase under the Biden administration’s stalled legislation. And a medieval English rule that works under 21st-century U.S. laws.

“We’re moving forward under traditional planning that works under current law and that we think will work” if the Biden administration’s stalled tax-and-spending bill moves forward, said Laura Zwicker, the chair of the private client services group at law firm Greenberg Glusker in Los Angeles.

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Last year, donors could give $15,000 a pop to as many relatives, friends or other recipients as they wished. So each spouse in half of a married couple could use the limit to give their three married children and five grandchildren — 11 recipients in all — a total of $333,000. IRS returns for most gifts over the threshold and, crucially, some under the threshold are due April 18, the same deadline this year as for individual returns. Taxpayers can apply for an automatic six-month extension for both.

Advisors and accountants know that the annual gifts don’t cut into a taxpayer’s lifetime exemption from the 40% estate and gift tax. That makes them an ideal way to move assets out of an estate. For 2021, which covers returns now being filed, individuals could pass $11.7 million ($23.4 million for married couples) to heirs without triggering the levy. The levels are due to fall back by half come 2026. For 2022, the gift tax exemption is $16,000.

Gift tax returns go hand-in-hand with the strategic tax planning that wealth advisors have raced to conduct for their rich clients over the past year amid potential tax changes. Many trusts, an engine of wealth transfer, are seeded with gift money that typically requires a gift tax return.

As of Dec. 18, 2021, the IRS had still not processed 6.3 million electronically-filed individual returns and 2.3 million amended individual returns, which are filed on paper and take longer to wade through. Fueling the backlog are pandemic-related staffing shortages, the child tax credit and economic stimulus payments.

Very few Americans send in gift tax returns. Around 236,000 such returns were filed in 2018, according to the Congressional Budget Office, which cited the most recent data available. These taxpayers tend to be wealthy: more than one in five, or 22%, of taxable gifts that year totaled at least $1 million.

$15,000 can turn into a boatload
How can a gift of $15,000 or less be valuable to people whose net worth has many zeroes? When it’s used in tandem with a special trust.

By giving away as little as a few thousand dollars to a so-called beneficiary defective inheritance trust, a donor can set into motion a path for its heir to shield millions of dollars from estate taxes.

“I have clients that have used this and other” trust strategies “that in some cases have hundreds of millions protected,” said Jamie Hargrove, an estate planning lawyer, certified public accountant and founding partner of Hargrove Firm, in Louisville, Kentucky.

A BDIT, as it’s called (pronounced “BEE-dit”), is an irrevocable trust that’s set up for a child, grandchild or other person and lets a beneficiary manage and use its assets without causing them to be included in her estate. Under current tax law, it can be initially funded with up to $5,000 in cash and then later filled with assets that are expected to grow in value, like shares in a private company. The beneficiary sells the shares to the trust in exchange for a promissory note under which the trust pledges to repay her. Promissory notes often have “balloon” terms, meaning that they’re not repayable for 30 years.

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Taxpayers generally file a gift tax return only when gifts are over the $15,000 mark. But returns must be filed for gifts of any size involving “future interests” in property or assets, an arrangement that typically involves a trust. Hargrove said that most clients who use a BDIT file a gift tax return.

He cited one Nashville client whose mother started a BDIT for her son with $2,500 in cash. The son then sold his shares in a local business to the trust for $2.5 million in exchange for a promissory note. The business is likely to sell to a private equity buyer within a few years, for maybe $25 million. So the son can easily repay the trust the original $2.5 million in cash. Meanwhile, his trust post-sale has $22.5 million in stock that’s been moved out of his taxable estate. If the stock one day becomes worth $100 million, he will have saved $40 million in estate taxes.

Five-page pitfall
It’s only five pages long. But the gift tax return is notoriously complicated, requiring details on whether gifts are “generation skipping” — made to grandchildren — and documents proving valuations and discounts involving assets contributed to trusts. Not correctly reporting a gift, which is easy to overlook, could leave it open to being hit with the 40% generation-skipping transfer tax, Zwicker said.

Last fall, estate planners for the wealthy held their breath as the House of Representatives introduced a $2 trillion tax-and-spending bill that would have curtailed or ended most strategies used by the 1 percent to pass on money tax-free to heirs. That early version of the Build Back Better bill curbed the use of grantor trusts, hiked the capital gains rate to 28.8%, increased the top ordinary rate, banned the use of large retirement accounts and halved the current gift and estate tax exemption six years early. A watered-down version of the bill passed in November but is withering on the vine in the Senate due to opposition from a majority of Democrats.

The legislative cartwheels fueled “intensified and more frequent conversations” with clients about estate planning and gifting, said Emily Irwin, a senior director of advice for Wells Fargo Wealth & Investment Management.

Stopping ‘negative capital gains events’
The early version of the bill prompted some advisors to tweak clients’ trusts by weaving in escape hatches and disclaimer provisions to unwind a gift or transaction if the law changed and taxes increased, Zwicker said. With those clauses, “we can stop any negative capital gains event” should the earlier version get reintroduced, she added.

Another intensified strategy for protecting transfers of wealth to heirs involves giving an independent person a so-called “power of appointment” to direct the distribution of trust assets to beneficiaries. The concept, which dates back to medieval English law, centers upon giving an "neutral" third party the legal power to oversee how a trust’s assets are dispersed. Doing that insulates the beneficiary from exposure to gift taxes, Zwicker said.

The appointed person has to be someone that the beneficiary knows and trusts and is ideally a non-family member, Zwicker added. Because, she said, “you’re giving them super powers, god-like powers” over your wealth.