Overplanning: Skip This Wealth Transfer Strategy Mistake

The fallout from an overly burdensome tax planning decision can have long-lasting effects—a hard lesson learned by many who rushed to capture 2012’s increased lifetime exclusion from federal gift and estate tax (the “federal exclusion amount”).¹ Indeed, some individuals who made sizeable gifts during this period later experienced “buyer’s remorse” when they realized their decisions were at odds with other financial goals.

More than a decade later, we stand at the precipice of another rush to plan before 2026’s scheduled drop in the federal exclusion amount.² Yet, the transactions at the heart of many tax minimization strategies are often irrevocable and difficult to change without serious financial repercussions. To avoid future regret, consider the larger context when evaluating potential wealth transfer strategies.

Liquidity Concerns

Keeping the big picture in mind, let’s first consider a gift’s impact on your long-term spending needs. Here, there are several questions to explore:

• Does the transfer leave behind sufficient liquid assets to support your lifestyle over time?
• If not, is there a tax-efficient means of generating additional liquidity, such as an asset sale?
• Will the strategy generate additional liquidity needs in the form of required rental payments, additional income tax liabilities, or insurance premiums?
• Do you anticipate future extraordinary expenses, such as a major purchase or a new business venture?

Take Amir and Dalia, a 60-year-old married couple with $40 million in assets. While those assets currently generate enough income to support $300,000 in annual spending, Amir and Dalia intend to draw on the liquid part of their wealth after they retire in five years. At the same time, they’re concerned about preserving use of today’s $12.92 million federal exclusion amount prior to its scheduled 2026 drop to our forecasted amount of $6.9 million. Their estate planner has advised that they can only “keep” the current exclusion amount by making a gift of more than the forecasted $6.9 million prior to the end of 2025. In other words, use it or lose it.

To that end, the couple discussed the possibility of funding two irrevocable trusts—one created by each of them for the benefit of the other and their children as follows:³

• Amir plans to fund his trust with $6.92 million of his individually held marketable securities and $6 million of the couple’s rental properties. Since he’s still actively involved in his business, he doesn’t want to transfer his business interest to the trust.
• Dalia plans to fund her trust with $5 million of her inherited stake in a family business and $7.92 million of individually held marketable securities. 

Before moving forward with these tax minimization strategies, their attorney notes that distributions from the trusts carry certain downsides and risks. Most notably, distributed property will become a part of each recipient’s taxable estate—which erodes the potential tax savings. What’s more, to avoid potential estate tax inclusion, funding the trust should meaningfully alter the couple’s relationship to the transferred assets. In other words, Amir and Dalia should view the trusts as “rainy day funds” available on occasion, rather than consistently using the trusts to pay for their personal expenses. Upon hearing this, the couple decides to check in with their Bernstein team to better understand if and when they might need to tap the trust assets to satisfy long-term spending and other financial goals (Display 1).⁴

Our analysis shows that they should retain access to between $9.2 and $11.4 million in liquid assets to sustain their current lifestyle for the balance of their lives (Display 2). However, their current wealth transfer strategies would leave them with just over $7 million in liquid assets—including tax-deferred retirement accounts that they hoped to let grow untouched for as long as possible. 

Amir and Dalia are also concerned that their liquidity needs might climb. Amir’s business involves periodic capital calls and the couple had also weighed renovating their primary home. Plus, each trust qualifies as a “grantor trust” for income tax purposes since one spouse is named as a beneficiary. This means that the trust’s income tax liabilities flow back to them individually, resulting in an additional drag on their liquid investments.

With these findings in mind (and hoping to avoid any unnecessary risks), Amir and Dalia decide with their estate planner to move forward solely with Dalia’s trust. They’ll investigate other less restrictive tax minimization strategies—like yearly annual exclusion gifts, short-term rolling grantor retained annuity trusts,⁵ and testamentary charitable planning—to address any remaining estate tax concerns.⁶

Furthering or Frustrating the Cause?

Lifestyle considerations are just one aspect of the broader planning backdrop. When it comes to tax minimization strategies, the sizing of a gift also matters—and may support or frustrate your intended impact. For example, if a transferred asset’s value is likely to change significantly in the future, consider what this might mean for the beneficiaries. Assuming it’s likely, what actions can you take to reinforce the gift’s original purpose without triggering negative tax consequences?

Let’s revisit our couple but assume that Dalia wants to create a trust solely for the benefit of their children and future descendants, without Amir as a beneficiary. This time, she plans to fund the trust with $5 million of her inherited family business interests (which have a cost basis of $0 for simplicity’s sake). What’s more, the business is likely to sell for four times its current value within the next five years.

Dalia is pleased that this gift will remove $15 million of appreciation from her taxable estate. But she worries that the trust might grow to a level that would undermine her original intent. She wants to satisfy her children’s and grandchildren’s basic needs but doesn’t want to leave such a large inheritance that it becomes a crutch.

To help Dalia visualize the growth potential of various wealth transfer strategies, we illustrated the range of values for the trust over the next 35 years based on several suggested asset allocations (Display 3). We also compared it under two scenarios: 

1. if Dalia were to continue paying the trust’s taxes due to its grantor trust status, and
2. if Dalia were to “turn off” grantor trust status after the company’s sale, thereby making the trust responsible for its own tax liabilities.

Dalia can now see how the trust’s asset allocation and grantor trust status significantly influence its long-term growth. After sharing the results, her counsel recommends:

1. allowing the trustee to take advantage of different asset allocations via broad trustee investment powers, and
2. turning off grantor trust status more easily by incorporating only those grantor trust provisions that Dalia can waive.⁷

For example, Dalia could retain a waivable substitution power—under which she can acquire trust property in exchange for an asset of equal fair market value—to trigger such status, rather than relying on the appointment of a certain trustee, use of a discretionary distribution standard, or including Amir as a beneficiary, all of which would require action by others to change. I.R.C. §§ 672-677.

Dalia’s estate planner also suggests adding one more “escape valve”: appointing Dalia’s close friend—who is neither a beneficiary nor a contributor to the trust—to serve as a trust protector with the ability to add trust beneficiaries, including charitable entities, in the event the value of the trust’s assets exceeds the trust’s original purpose.⁸

Dalia loves this idea, as it positions the trust to take advantage of the income tax benefits of grantor trust status while preserving Dalia’s intent for her descendants. However, Dalia’s counsel notes that their state’s laws impose a presumption that someone serving in this capacity operates as a fiduciary. Put simply, this could give rise to fiduciary liability concerns when adding beneficiaries.⁹ For this reason, Dalia and her counsel decide to create the trust under a different state’s laws that do not impose this same presumption.¹⁰ By considering the long-term impact of asset allocation and tax-free growth, Dalia and her attorney are better able to craft a trust that serves Dalia’s ultimate goals—no matter what the future holds.

There's More to the Story Than Taxes

Tax minimization strategies can yield considerable savings. But they can also effect meaningful changes in the lives of those who transfer property and those that benefit from it. That’s why wealth transfer strategies are best evaluated in the context of the financial goals and futures of all involved parties—to maximize the strategy’s savings while furthering the intent and lifestyle of those looking to implement it.