Strategies for the Great Wealth Transfer

We all have these issues inside of our families. When people look at planning for the future and planning for their wealth transition, they sometimes get stuck because they do not want to open that can of worms from the past that could lead to future difficulty, or they just might not want to think about some of the past family situations at all.  

Also, many people do not like to talk about death. For me, I like talking about death. I like planning for my death. I think estate planning is a beautiful topic, but death is scary and unknown. Sometimes, when people look at their death, they also contemplate their life, which can be scary for some people, looking at how they might be remembered, their legacy, and what they can do to accomplish that. Moving forward, creating a good legacy can sometimes be overwhelming.

We know that when we talk about taxes or April 15^th, many of us feel uncomfortable in our gut. Tax time and doing taxes are not something people enjoy. People are also concerned that tax-advantaged strategies could be tax schemes and that some things are not necessarily legal. We just want to keep it mainstream because the IRS can be quite scary.

I always like to throw out the acronym “THE IRS,” if you put that together, it means “theirs.” When you think about doing tax-advantaged planning, there is certainly an opportunity for a higher level of scrutiny by the IRS, which can scare people. However, the tools and tactics we will discuss today have been well entrenched in the tax code for a very long time, and there is nothing fringy within the tax code.

One question I always like to ask parents as they look at transitioning their wealth is, how much is too much to leave to your children? When I say wealth, that could be $1 million or $10 million. It could be $500,000. Wealth does not mean that they have to be of high net worth, but there is always something that you are going to have to leave behind, because as we know, hearses do not have trailer hitches, and you cannot take it with you. Asking our clients about how much is too much to leave to their kids can lead to a very interesting conversation.

Some studies show that for families of wealth, 70 percent of the time, wealth does not reach the second generation, and 90 percent of the time, wealth does not reach the third generation. How do we help our clients of varying levels of wealth transition wealth and their values for the next generation? I like to call this value-based estate planning, and I think it is important in all of our practices to be able to have these conversations with our clients, because it will enrich our relationship with our clients.

Wealth transfer planning also provides the opportunity to get to know the next generation. For most advisors, 70 percent of the time, when their clients pass away, so do the accounts. It gets paid out to the children, and the children have other advisors. Suppose we can work through value-based estate planning and have some good conversations with our clients about how much is too much to leave to their kids, and how they would like to transition their wealth. In that case, we will have opportunities to get to know the next generation and potentially keep those accounts open after the passing of the patriarchs.

How Wealth Transfer Can Teach Through Philanthropy

We have great opportunities to save on taxes and keep more hard-earned assets working for the family versus benefiting the IRS. But we also have the opportunity to teach morals and values to future generations. We can nurture business acumen.

I discuss with families about having a little extra on the side to create a family bank account, if you will. This could be $50,000 or $100,000, but this is an account for future generations. Say a family member wanted to start a business. They must match whatever amount out of their funds, such as $25,000. Then, just as they would apply to a bank for financing, they go to the family and provide a business strategy, what they want to accomplish, and apply for a loan as they would potentially with a bank. This is going to teach some wonderful business acumen and is a great way to pass on morals and values and the knowledge of the patriarchs of the family and matriarchs.

I also like to help families create a governance structure. It is important when we look at a family’s assets that they are not just financial but also human and intellectual capital. Utilizing our family’s resources, about what is their strength, and what is their weakness be able to come up with a great family governance structure can be an awesome way to be able to successfully transition wealth, morals, and values at the same time while also creating a legacy.

One of my favorite ways, also, is to teach through philanthropy. We all know that there is time, treasure, and talent, but teaching with time and talent can be a wonderful way to get morals and values passed on to future generations. One thing that I have helped some families accomplish is creating milestones. When grandchildren reach a certain age, the grandparents may take them out for a volunteer opportunity or a memorable trip, but helping them have those milestones at those different times can really help a family transition more than just the wealth.

Donor Advised Funds

A tool that I love to use for planning and for passing on morals and values of philanthropy is a donor-advised fund. A donor-advised fund is a fund where there is a sponsoring 501(c)(3) organization, where a donor can make a fund inside of that sponsoring 501(c)(3). That 501(c)(3) could be a community foundation, Fidelity Charitable, or Raymond James Charitable.

Most broker-dealers have a sponsoring 501(c)(3) platform for donor-advised funds, and if not, there are companies out there that do so. Ren and American Endowment come to mind, where they only work with advisors. They allow the advisors to manage all of the assets inside the donor-advised fund program, and they just act as the sponsoring 501(c)(3) organization.

What is nice here is that the donor can make a gift, and at the time of the gift, they receive an immediate tax deduction. Then, over time, they can choose when and how they want those funds to go out to charity. But the real power here is that we can fund a donor-advised fund with an asset, let us say, appreciated stock or with business interest. That asset can be sold tax-free inside the donor-advised fund, allowing it to grow tax-free compounding inside. It can be a very powerful tool.

I had a client selling their insurance practice, and the deal’s structure was to be tax-advantaged. However, this gentleman had had a wayward past and had fallen into some drug and alcohol issues when he was young. He was so grateful for coming out of it whole that he gave 10 percent of every single check that he ever got. He was not necessarily religious, and I know many people tithe and tithing is absolutely wonderful, but he felt that this was his payment back to community and society.

His accountant was a little fed up because he had to track so many charitable receipts. In the year that he sold the business, we went ahead and pre-funded a donor-advised fund for him. The accountant loved it because there was only one receipt that needed to be documented for tax times, and it was in the year that he needed it the most when he was selling his business, and now, he was able to pre-fund his philanthropy.

Donor-advised funds can also be used as a mechanism to teach philanthropy to future generations. One client had three grandkids, and one of them was going wayward. She was in college, but not attending classes. Again, drugs and alcohol were becoming an issue.

The grandparents did not want to leave her out of receiving those funds. Instead, we put it inside a donor-advised fund. At first, that granddaughter was not grateful for that donor-advised fund. One day, she happened to walk into a bakery and realized that all the employees were of special needs. It was a functioning charity that employed those with special needs and gave them a great purpose.

She ended up loving that organization. She made a $5,000 contribution from her donor-advised fund. Within nine months, she actually ended up working at that bakery, helping along with that charity. Over a few years, she ended up granting all of her $16,000 in donor-advised funds, plus the growth that had been incurred in the account. From that time on, and she got her life back on track. It is a wonderful tool to teach philanthropy.

Donor-advised funds are also great for year-end planning. If a client has a high-income year, it is a great tool for the, “Oh, no, I have to pay a lot of taxes next year.” Using a donor-advised fund is quick and easy to get that set up. Do not plan on creating a donor-advised fund on December 27^th. You do not want to push it that late, but it definitely can be done for year-end planning. Another neat thing about a donor-advised fund is it can be used as the charitable beneficiary of charitable remainder trusts and charitable lead trusts.

Another thing I have done with donor-advised funds is for grandparents. It does not have to take much money – it could be $10,000, $50,000 – have them allocate that into a donor-advised fund, leave their children out of it, bring the grandkids in, and have it be a donor-advised fund where the grandkids get to make grants from the donor-advised funds. Have the grandkids do research and then create a proposal that they will present to their cousins, siblings, and grandparents about why they want to support those charities at their age level. That creates not just teaching philanthropy but also business and presentation skills.

The Taxation of Wealth Transfer

Many of us know that the estate tax is at 40 percent, and the tax exemption is extremely high right now at $13,610,000 per person. However, the estate tax sunset is scheduled to happen on December 31^st, 2025, and that would take the exemption back to 2017 levels, plus inflation. The estimate right now is about $7 million, but as we know, inflation has been slightly wild lately. Most people are saying it should be about $7 million in 2026. That will make more people have to do some estate planning, but still, many families have a husband and wife who will not need to worry about it, with it being at $14 million.

Any asset under the exemption can get a step up in basis at death, meaning that the value of the cost basis will be the value at the date of death. One thing that gets overlooked is IRD assets (income in respect of a decedent). The rule of thumb I have is that the IRS is going to get theirs. If it has not been taxed in life, it will get taxed in the next generation. This impacts our qualified retirement plans. Also, any gains in investment annuities do not get a step up in basis at death, and CDs do not get a step up in basis either. We need to plan well with those assets to help transition them to the next generation. If you have families above the $14 million or $7 million per person, you might want to look at utilizing some planning in 2024 and 2025 before the sunset.

We know that each spouse has their exemption in 2024. It is $13,610,000. Let us just say that a family wanted to give their kids $6 million. They went ahead and gifted out $6 million to their kids, and that left us with $7.6 million exemption remaining. In 2026, if the exemption then becomes $7 million, they will only have a million dollars remaining. It is use it or lose it at the bottom. It does not come off the top, and I think it is important to share with our clients if they are at this level.

Also, looking at what does not qualify as a gift is important. That would be direct payments for medical providers, direct tuition payments, and the annual gift exclusion.

When we look at estate planning, there are some great assets to leave to charity, including your qualified assets and investment annuities. Both are very easy to gift to charity because of the simple designation form.

However, I get many questions about what advanced estate planning is. There are many different options, but the reality is that you have to give your wealth to someone or something. You can give it to kids, grandkids, or heirs, give it to your spouse, or give it to charity. You are hearing a lot about some great tools right now as people are doing some of this planning for the estate tax transfer. Here is a tools matrix that goes through some of these irrevocable wealth transfer trusts.

Some of these tools do best in high-interest-rate environments; those are the top four, and others do best in low-interest-rate environments. However, I will state that even if we are, as we are, in high interest rate environments, it is still prudent to look at some of the strategies that perform better in low interest rates.

One other item of estate planning that I do not know that many people are taking a look at as much as they should is the annual gift exclusion. Mom and Dad can give both… they can give their annual exclusion to as many people as they want, and they can give it to the same person. If you had parents, they could give a child and their spouse $72,000 a year, and that would not use their estate tax exclusion.

Of course, as financial advisors and as advisors to clients, we realize that we can always pre-fund their 529 plans, as well. Funding an irrevocable life insurance trust and utilizing those annual exclusions could be great planning options for our clients.

We discussed how retirement plans are taxed to the next generation, but if the assets are above the estate tax exclusion, then there is the opportunity for double taxation on the IRA or retirement assets. They qualify for income to heirs and could qualify for estate taxes if our clients are in that realm.

I think we have gotten a little lazy about thinking about estate taxes. I did a lot of research and thoughtful planning when Biden and Harris first came into office, and I looked at the Green Book and the things they were looking to add or change in the tax code.

For me, the estate tax is pretty easy to reduce. I have seen it as low as $1 million. I did much planning around that, and the reason is that people who pay the estate taxes are no longer with us. It is not like a huge tax hit that people feel in life. When wealth transfer happens, people can feel that hit there, too, so we must consider estate taxes above and beyond their high levels.

What is an IRA Stretch Charitable Remainder Trust?

A great planning tool for an IRA is an IRA stretch trust. As many of us realize, the 10-year stretch option for an IRA is the only option – beyond the spouse and those who do not have special needs and other considerations – that the next generation has to stretch out an IRA asset.

However, if we make a Charitable Remainder Trust the beneficiary of the IRA, we could stretch out that IRA for their lifetime and potentially the term of years for grandkids. I like to call it an IRA stretch trust, but we are really just using a Charitable Remainder Trust as the beneficiary of the IRA.

The asset is an apple tree, and the apples are the income. We can put the tree (your IRA assets) inside the Charitable Remainder Trust. Then, at the end of life and/or a term of years, that tree goes to charity or your donor-advised fund.

In this case, the heirs can nurture the tree. Even the grantors, the IRA owners, can put some provisions inside the trust to help their children manage it, but the children can be their own trustees of their trust. The income will then go to the heirs for longer than 10 years. Let us look at what that looks like in motion.

Let us say we have a $2 million IRA, and at the death of the IRA owners, we will make the beneficiary of that IRA the charitable trust for the heirs. Now, this is a non-taxable event, but the charitable trust needs to be in place before, because if it is the beneficiary of the IRA, it must exist.

Typically, we draft these trusts; we put a little schedule behind the trust that says it was funded with $10; you can staple a $10 bill on there if you want to, and then, the trust exists. However, we do not give the trust a tax identification number or any other responsibilities, like filing taxes, until it is funded with the IRA assets.

If we went ahead and transferred this $2 million asset into the Charitable Remainder Trust, let us just pretend for a moment that we have some kids who are not very responsible with money. After Mom and Dad died, they decided that they wanted to take all of the funds out of the IRA in the first year. They would likely have to pay about $740,000 in taxes at a 37 percent tax rate if that $2 million came in all in one year. We can have those tax savings, and then, after the death of the heirs plus a term of years, if the heirs are old enough, the remainder will go to charity or the family donor-advised fund.

This also provides an estate tax exemption. Not everyone will need that estate tax exemption, but it is available.

What we are looking for this trust to do is solve for yearly distributions and income to the heirs of the IRA owners. If they are old enough, if the heirs are in their mid-50s, there is a reasonable probability that they could then have, after their death, the trust continue to pay their kids; so, it would pay the grandkids for up to 20 years. We created a great lifetime income source that went to charity, and we had some good tax deferral and tax-free compounding growth, and we can have some good outcomes on the estate tax side.

To do this, create a separate trust for the kids. Say we have that same $2 million IRA, but we will split it in half at the death of the two owners. We will create one trust for Beth, who is 55 years of age. At that time of transition, no taxes were due because the trust was the beneficiary of the IRA. Then, after the death of the children plus the term of years, the remainder will go to charity. The remainder for Beth is $3 million at this point and also provides a state tax deduction.

Let us look at how the $1 million will work for Beth. We are going to do a five percent yearly distribution, and at her death, we are going to go ahead and put on a 20-year term for her two children. That provides her with $5 million of income over her life, plus the term of 20 years. Now, that is great, but let us look at the taxation of that. If she were in a 24 percent tax bracket, that would be $3.7 million, which would benefit her from the $1 million IRA charitable stretch trust.

Let us not forget her brother. We will do a trust for her brother, who is a bit older. We’ll do the same $1 million, same five percent distribution. We can include his children, as well. His lifetime income is $4.5 million because he is slightly older and in a higher tax bracket. He will only walk out with $3 million of after-tax income. His remainder interest to charity will be $2.8 million.

Yes, the charity will get $5.8 million, but let us look at what the family gets. The Total lifetime income for Beth, Jim, and their families was $9.5 million from the initial $2 million in the Charitable Remainder Trust. The after-tax combined total is $6.8 million. This is really powerful.

We can affect how much charity would get here, but when we are having it go to our own family donor-advised fund, it really can create a win-win, where now we have future generations, the grandkids of these IRA owners. Their grandkids and their kids will be able to distribute their donor-advised fund and the family donor-advised fund in the name of the grandparents, and they will create a very empowering legacy.

Also, as advisors, if you help your clients utilize the charitable remainder trust as the beneficiary of an IRA, it is not likely that the children will take those assets to another advisor or try to manage them on their own.

IRA Qualified Charitable Distributions (QCDs)

For people over age 70½, QCDs are a great strategy or a smart way to give to the causes they care about through their qualified charitable distribution from their IRA.

Say we have a 73-year-old with a $500,000 IRA. His required minimum distribution is approximately $20,000 a year, he is taxed in a 25 percent tax bracket, and he already gives $10,000 a year to charity from assets that get a step up in basis at death for his kids. Why not leave those assets for the kids and let us go ahead and instead gift our retirement assets that will be taxed to our kids?

Before the qualified charitable distribution, he received his $20,000 RMD, paid his 25 percent taxes ($5,000), made his charitable contribution of $10,000, and received $5,000 back in his pocket. Suppose instead he makes a qualified charitable distribution directly to charity. In that case, he has that same $20,000 required minimum distribution (RMD) but now can give $13,000 of his RMD to charity, netting him $7,000, upon which he is taxed at a 25 percent tax rate, leaving him with $5,250.

The charity receives 30 percent more, and the client has five percent more back in their pocket. The QCD limits are now being indexed for inflation, so a person can directly donate up to $105,000 from their IRA each year to as many charities as they like.

The Perfect Storm for Tax-Advantaged Business Sales

Some important statistics are that 40% of Baby Boomers are business owners, and over 10,000 retire daily. Seventy-nine percent of owners do not have any written transition plan. Entrepreneurs are also the most charitable class of people out there. This creates a perfect storm for tax-advantaged business planning.

How a donor-advised fund is structured matters. If the donor-advised fund is a corporation, it probably cannot handle S-Corp stock. However, you can make a donor-advised fund in a trust format, and then it can handle S-Corp.

Let us look at the taxation of business sales. If we have a $1 million business and it gets sold as a stock sale, we will pay 20 percent in federal capital gains tax, 3.8 percent net investment income tax likely, and whatever the state tax is.

However, 75 percent of the corporations are S corporations, and most buyers do not want to do a stock sale on S corporations. They want to get a step up in basis and new depreciation cycle, and they do not want the lingering liability of the company.

If a business is sold as an asset sale, it could be taxed anywhere from 23 to 40 percent; for Californians, it could get up to 50 percent. It is important to talk to your business owners about taxation for the sale of their business.

How do we use a Charitable Remainder Trust to sell a business? We will let the donor (business owner) manage the trust. They get to be the trustee, and they also get to receive the income for life.

Say we have a $2 million business, but rather than putting all the business into one tool, we only put half in. We will allocate $1 million of the $2 million business into a charitable remainder trust. When we do that, we pay zero taxes and save a capital gains tax of $288,000.

After the second spouse’s death, we will have nearly $2 million go to charity or the family donor-advised fund, and they can get an income tax deduction today for that future gift. We can also take an income stream of five percent income for our client couple, who are both 60 at the time of this trust, with a 34-year joint life expectancy.

This can give them almost $2.5 million in lifetime income, but they do not want to disinherit their kids. So, we bought life insurance from the lifetime income, which reduced their lifetime income a bit but provided an inheritance and an income tax deduction.

Let us compare the two. On the left, we have the sale with no trust.

On the right, we have the sale with a trust; here, lifetime income went up even after life insurance premiums. They received a little bit more for their inheritance with no trust, but we could have purchased more life insurance. The charity did well with nearly $2 million.

But let us look at that income tax savings. We had a $266,000 deduction for life insurance, so at a 40 percent tax rate, they have $106,000 back in their pocket. Let us grow that for their same life expectancy, and that provides us with another $1 million. The net benefit is $3.6 million by using a charitable remainder trust. Sure, you might say, “Yes, but charity got $2 million,” still, on a $1 million asset, this family walked out ahead $1.6 million.

The only real negative here is that if the two donors pass away early, the lifetime income would obviously be less. But happy people give, and giving makes you happy, so people who give tend to live longer.

We must be careful not to work for an S corporation and watch out for unrelated business-taxable income.

Qualified Small Business Stock

One other quick strategy about business sales that I would like to discuss is something accountants should be discussing, but I think they get too busy looking in the rear-view mirror. Suppose you have a business owner with a C corporation, and they have held it for over five years. In that case, there is a good chance that they could qualify for qualified small business stock and get up to $10 million tax exclusion, or 10 times the basis of their investment in that asset.

Here are some of the parameters to qualify for this. CPAs can let if the business qualifies, or some outside professionals can look at C corporations to see if they qualify for the qualified small business stock 1202, a $10 million tax exclusion.

One neat thing you can also do is there could be the opportunity if you, let us say, have a $40 million business and three kids. You could use your exclusion; maybe do some discounting; gift to your kids, and now each one of your kids can get that $10 million exclusion.

There is also the opportunity to 1045 exchange qualified small business stock. Let us say you sold before the five years, there is some planning you could do to get it still, and you could invest in other qualified small business stocks with a 1045 exchange and now get a $10 million or 10 times basis exclusion for each of those new companies.

There is some excellent planning to do if it is a C corporation, and I think it is important to have people just keep their eye out there for those business owners who are going to sell, and it is a C corporation. This could be a great planning strategy, and you can be a big hero by all the taxes that you will be saving them.

Key Takeaways

Having charitable conversations with your clients and looking at some of these tools allows you to connect at a deeper level and retain those clients whenever there is difficulty. They will seek you for your advice, not just managing assets.

People do not go to cocktail parties and talk about their amazing portfolio. Still, they will go to cocktail parties and tell their friends about how their advisor talked about their philanthropy and helped them implement some very good and creative planning. As we mentioned, this is a great opportunity to get to know the next generation.

Also, donor-advised funds and charitable remainder trusts allow for more assets under management. If somebody sells their business and is able to not have to pay tax because they qualified for the Small Business Qualified Stock of a C corporation, you will have more assets to manage there as well.

There are specialists out there. There are other advisors. There are plan-giving council members, community foundations, and even third-party nonprofits that can help with some of these more complex strategies. Just know that you are not on your own private island. The important part is to start the conversation.