Family Gifting

Gifting for Families and Others

Transferring wealth process requires a thorough understanding of tax implications, family circumstances, the choice of assets to be gifted, and the structure and recipient of the gift.

Estate Planning and Lifetime Gifts

Lifetime gifts, also known as lifetime gratuitous transfers or inter vivos transfers, are gifts given during the lifetime of the donor, the individual bestowing the gift. The term “gratuitous” signifies a transfer made with purely donative intent, implying no expectation of reciprocation.

Factors Influencing Taxation of Gifts

The taxation of gifts is contingent on several factors. These include the jurisdiction of the donor or donee (the gift recipient), the relationship between the donor and donee, the tax status of the donor or donee (e.g., whether they are non-taxable or nonprofit entities), the interval between the gift’s creation and the donor’s death, the type of asset (movable or immovable), and the asset’s location (domestic or foreign).

Gift Making and Transfer Tax

Comprehending whether, when, and how to make a gift necessitates knowledge of how assets are taxed when their ownership is transferred at or before death. While taxes can be imposed on income, spending, or wealth, the tax on wealth transfers (transfer tax) is the primary concern of estate planning. The two main forms of taxes on wealth transfers correspond to the two primary methods of transferring assets: gifting assets during one’s lifetime and bequeathing assets upon one’s death through a will or another structure.

Wealth Transfer Taxes

Wealth transfer taxes are a crucial aspect of financial planning and wealth management. They are levied on the transfer of wealth, either during the lifetime or at the time of death of the transferor. The liability of these taxes can fall on either the donor or the donee, depending on the jurisdiction.

Gift Taxes

Gift taxes are a type of wealth transfer tax designed to prevent tax evasion through excessive gifting. For example, in the United States, a person might gift a large sum of money to their child to avoid estate taxes upon their death. The tax rate can be flat or progressive, increasing as the amount of wealth transferred increases. Often, the tax is applied after the deduction of a statutory allowance, such as the annual gift tax exclusion in the U.S. The tax rate may also vary depending on the relationship between the donor and the donee, with transfers to spouses often being tax-exempt.

The liability for gift taxes varies across different jurisdictions. For instance, in the United States and the United Kingdom, gift taxes are payable by the donor. Conversely, in Germany, the Netherlands, India, Japan, and South Korea, gift taxes are payable by the donee or beneficiary.

Determine Estate Planning Goals

Estate planning is a strategic process aimed at ensuring the financial security of a family and its descendants across multiple generations. The complexity of this task arises from the exponential growth in family members from one generation to the next, often doubling with each subsequent generation. Research suggests that the sustainable spending rate lies between 3.5% and 6% of the initial portfolio value, assuming that the remaining portfolio value and spending increase by the inflation rate in subsequent years.

Sustainable Spending Rates

Sustainable spending rates refer to the rate at which an individual or family can spend their wealth without depleting their portfolio. For instance, if a family has a portfolio worth $1 million, a sustainable spending rate of 4% would mean they could spend $40,000 annually without reducing the portfolio’s value. However, these rates are often modest, and it’s easy to adopt an unsustainable rate, especially over extended periods.

Impact of Taxes

Taxes can further complicate sustainable spending rates. Each time assets are transferred, they may be subject to taxes, which can erode the portfolio’s value. For example, inheritance tax can significantly reduce the value of an estate passed on to the next generation.

Managing Conflicting Interests

Managing wealth across generations can be challenging due to differing interests and goals. The first generation’s wealth transfer goals may be influenced by the character, maturity, and life circumstances of the individuals involved.

The first step in estate planning is deciding how much wealth to transfer and to whom – future generations, philanthropic causes, or elsewhere. This decision is often based on the first generation’s spending needs.

Strategies for Making Lifetime and Charitable Gifts

Transfer Tax Savings

• In estate planning, gifts are often made to reduce overall transfer taxes for bequests made at the time of one’s death. This is a common practice in countries like the United States and Canada.
• In jurisdictions with an estate tax, such as the United States, or an inheritance tax, like in the United Kingdom, gifting during one’s lifetime can lower the value of the taxable transfer, thereby reducing estate or inheritance taxes.
• However, in some jurisdictions, like Italy and Spain, the value of the gift is added back to the estate for estate or inheritance tax purposes if the gifts are made within five years of their death.

Gift or Donation Taxes

• To counter this tax minimization strategy, jurisdictions that impose estate or inheritance taxes typically also impose gift or donation taxes. Countries like France and Japan are examples of this.
• Some gifts can avoid transfer tax by falling below periodic or lifetime allowances. For instance, South Africa allows taxpayers to make tax-free gifts of up to ZAR 100,000 per tax year, and UK taxpayers may make annual gifts of GBP 3,000 that escape gift tax.

Allowances for Gifts

• Germany has allowances for gifts to close family members, and the size of the allowance depends on the relationship between the donor and the donee.
• Each parent may make a EUR 400,000 gift to a child (including stepchild, adopted child, or child born out of wedlock) every 10 years. This exemption applies to each parent, so a couple may gift EUR 800,000 total without gift tax, allowing a substantial amount of wealth to be transferred over time.

Tax Relief and Exclusions

Various countries offer different types of tax relief and exclusions. For example, in the United States, there is a standard deduction that reduces the amount of income that is subject to tax. In France, a unique system is in place where a 50% tax relief is applicable to gifts from donors who are less than 70 years old. If the donor is between 70 and 80 years old, a 30% tax relief is applied. This system encourages the transfer of assets by gift in a tax-efficient manner.

Gifting and Estate Tax

Consider a scenario where a donor gifts a total of USD 510,000 over a period of 30 years. If the donor had retained this amount, it would have increased the value in their estate and their estate tax liability. However, with gifting, any appreciation of the gifted amounts also escapes estate tax. Given certain assumptions, there would be approximately USD 193,000 of real appreciation (after adjusting for inflation), for a total value of USD 703,000.

Tax-Efficient Investment Strategy

Alternatively, a tax-efficient investment strategy that defers the 25% tax on investment returns until the end of the investment horizon can increase the accumulated sum of the gifts to almost USD 809,000. This sum represents the amount of capital that can be transferred in today’s dollars and can therefore be a sizable proportion of many estates. The benefit of such a tax-efficient strategy is that appreciation on gifted assets is effectively transferred to the donee without gift or estate taxes.

Tax on Investment Returns

It is important to note that appreciation on the gifted assets is likely still subject to tax on investment returns (e.g., dividends and capital gains) whether they are transferred to a donee or whether the assets remain in the donor’s estate. However, if the tax-free gift had not been made and had remained in the estate, the appreciation on it would have been subject to estate or inheritance tax.

Valuation Discounts

Private wealth management is a specialized field that focuses on the financial needs of high-net-worth individuals. It involves estimating a client’s required core capital based on their lifetime spending and liquidity needs, and their available surplus capital. This can be achieved through various methodologies such as the life balance sheet approach and Monte Carlo simulation analysis. These methods help in making an informed decision about the size of gifts that can be given during the client’s lifetime without jeopardizing their lifestyle.

Once the decision to make a gift is made, and the amount of capital that can be transferred is determined, the selection of assets to gift can maximize the value of the gift. Transfer taxes can also be mitigated by transferring assets that qualify for valuation discounts or structuring assets to qualify for such discounts.

Taxation and Valuation of Assets

Tax is typically levied on the fair market value of the asset being transferred. This is a straightforward determination in the case of cash or marketable securities. However, if shares in a privately held family business are being transferred, establishing fair market value is not straightforward and requires a valuation according to some pricing model or models, which requires assumptions.

Valuation of Privately Held Companies

The valuation of privately held companies often involves discounting estimated future cash flows at a higher cost of capital to reflect the lack of liquidity associated with their shares. Estimates of the average discount for lack of liquidity (i.e., illiquidity discount) range from 20% to 25% of the value of an otherwise identical publicly traded company. The size of the discount tends to be inversely related to the size of the company and its profit margin.

Valuation Discounts in Asset Transfers

When transferring shares that represent a minority interest in a privately held company, an additional discount is often applied due to the lack of control associated with a minority interest. This valuation discount is separate from, but not independent of, an illiquidity discount. This is because positions of control are more marketable than minority positions that lack control. Lack of control discounts resulting from minority stakes can be substantial, ranging between 25% and 40%. However, their interaction with illiquidity discounts is not additive.

For example, if a stake in a privately held business like a local bakery warrants a 20% illiquidity discount and a 35% lack of control discount, then the combined discount may be multiplicative and will result in a lower figure than 55% as follows:

Family Limited Partnerships (FLPs)

• High net worth investors sometimes use family limited partnerships (FLPs) to intentionally create illiquidity and lack of control over assets by transferring minority interests to separate individuals rather than gifting or bequeathing the underlying assets directly.
• The FLP’s lack of liquidity and control can qualify it for valuation discounts in some jurisdictions, although the extent of the discount can vary depending on the asset type. FLPs with cash and marketable securities generally receive smaller discounts compared to privately held operating companies.
• Tax authorities often scrutinize these transactions closely, necessitating that such structures be carefully constructed by experienced attorneys to ensure they are eligible for the maximum allowable discounts.
• FLPs also offer non-tax benefits, such as allowing family members to pool resources to access investment opportunities like hedge funds, private equity, and venture capital, which might be unattainable individually due to high minimum investment requirements.
• Through an FLP, family members can equitably share in the gains and losses of the family’s investments, promoting a balanced distribution that may be crucial in managing family dynamics.

Trusts

Trusts, a concept rooted in common law, are frequently utilized in estate planning. They are structures that facilitate tax planning and offer non-tax benefits. The structure of a trust has implications for asset transfer and control, protection from potential future creditor claims, and tax implications on assets.

What is a Trust?

A trust is an arrangement established by a settlor, also known as a grantor. For instance, a wealthy individual might establish a trust to manage their assets after their death. The grantor’s assets, which could be referred to as capital, corpus, or principal, are used to create the trust. These assets are transferred to the trust and a trustee is appointed.

Trustee

The trustee could be the grantor themselves, another individual, or an institution such as a trust company. The trustee’s fiduciary duty is to manage the assets for the benefit of the beneficiaries. Hence, the beneficiaries are considered the beneficial, not legal, owners of the trust assets.

Beneficial Ownership

Beneficial ownership is a legal term that implies that certain rights, such as the right to the income from the securities or the right to live in the house, belong to the beneficiary. However, the title to, or actual ownership of, the securities or the property is held by another person or entity.

Trust Document

The trust document, also referred to as the trust agreement, outlines the terms of the trust relationship and the principles used by the trustee to manage the assets and distributions to the beneficiaries.

Trusts play a pivotal role in financial planning, offering a structured way to manage assets. They can be classified based on two primary dimensions: revocability and distribution structure.

Revocability

• Revocable Trust: A revocable trust allows the settlor (the person who creates the trust) to rescind the trust relationship and regain control of the trust assets. For instance, if John Doe creates a revocable trust and places his property into it, he retains the right to reclaim the property. However, this power of revocation exposes the trust assets to potential claims from creditors.
• Irrevocable Trust: In contrast, an irrevocable trust does not allow the settlor to revoke the trust relationship. For example, if Jane Doe creates an irrevocable trust and transfers her assets into it, she cannot reclaim those assets. This type of trust offers better protection against creditor claims, provided the settlor was not insolvent at the time of creating the trust.

Distribution Structure

• Fixed Trust: A fixed trust specifies the distribution of assets to beneficiaries in the trust document. For example, a trust might be set up to distribute $10,000 to a beneficiary each year.
• Discretionary Trust: a discretionary trust allows the trustee to decide the distribution based on the beneficiary’s welfare. This structure offers additional protection as the creditors of the beneficiaries cannot easily access the trust assets.

Why Use a Trust?

There are several main objectives for using a trust structure:

• Control: Trusts are often used to provide resources to beneficiaries without giving them full control over those assets. For instance, a parent might set up a trust to fund their child’s college education, ensuring the money is used for its intended purpose and not squandered due to the child’s immaturity or lack of financial management skills.
• Asset Protection: Trusts can also serve as a shield against creditors. For example, a business owner facing bankruptcy could place assets in an irrevocable trust, making them inaccessible to creditors. Trusts can also be used in community property jurisdictions to prevent the dilution of a family business’s ownership in the event of a divorce or death.
• Tax-Related Considerations: Trusts can be a powerful tool for tax management. A high-income individual might transfer assets to a trust, where the income may be taxed at lower rates. For instance, a wealthy person could establish a trust in a jurisdiction with a low tax rate, reducing their overall tax liability.

Trust Duration

The traditional common law rule, known as the rule against perpetuities, stipulated that trusts could not exceed a certain number of years. Specifically, trusts had to end within 21 years following the death of the last individual from a designated group who were alive at the time the trust was established.

However, in recent times, many states in the United States and certain countries have abolished this rule, allowing trusts to remain intact for a significantly longer period or even indefinitely. Such trusts are referred to as dynasty trusts. For instance, the Walton family, heirs to the Walmart fortune, have used dynasty trusts to preserve their wealth for multiple generations. Dynasty trusts are designed to benefit multiple generations of a family, thereby facilitating the creation of a family dynasty. If properly structured, these trusts can avoid most or all forms of wealth transfer taxation as they pass from one generation to the next.

Optimizing Wealth Transfer with Generation Skipping

High-net-worth individuals often have wealth transfer goals that extend beyond the second generation (i.e., their children). For example, Warren Buffet has set up trusts that will benefit his grandchildren and beyond. In such cases, where allowed, transferring assets directly to the third generation (i.e., grandchildren) or beyond, or to a trust that benefits these multiple generations, can reduce transfer taxes. A technique known as generation skipping, which involves transferring capital in excess of the second generation’s needs for spending, safety, and flexibility, directly to the third generation, can help avoid a layer of this double taxation.

Transferring Capital Across Generations

Transferring capital across generations strategy involves the transfer of surplus capital from the first and second generations to subsequent generations, bypassing the immediate next generation. The relative value of this practice is calculated using the formula \(\frac{1}{1 – T1} \), where T1 represents the tax rate of capital transferred from the first to the second generation.

Generation-Skipping Transfer Tax

In certain jurisdictions, such as the United States, a special tax known as the generation-skipping transfer tax is imposed to discourage this strategy. This tax is levied on transfers to grandchildren or subsequent generations, in addition to the usual transfer tax. The aim is to replicate the tax effect as if the assets were sequentially passed through two generations.

Dynasty Trust

Despite this tax, a substantial exemption (USD 12.96 million in 2023) can be sheltered for multiple generations in a dynasty trust. This exemption allows a significant amount of wealth to be transferred across generations without incurring the generation-skipping transfer tax. Non-US persons, however, are exempt from this tax and can shelter all their assets from all US transfer taxes in a dynasty trust.

Gifts to Trusts

There involves two main types of trusts: Irrevocable Inter Vivos Trust and Testamentary Trust.

• Irrevocable Inter Vivos Trust: An Irrevocable Inter Vivos Trust is a type of trust that is created and funded during the grantor’s lifetime. For instance, if a wealthy individual wants to set aside assets for their child, they might establish an irrevocable inter vivos trust. The key characteristic of this trust is its irrevocability, meaning once the trust is established, it cannot be altered or terminated without the permission of the beneficiary.
• Testamentary Trust: A Testamentary Trust is created under the will or estate plan of a deceased individual. For example, a person might specify in their will that upon their death, their assets should be placed in a trust for their minor children until they reach a certain age.

Taxation of Trusts

Trusts are subject to taxation, and the rules can vary significantly depending on the jurisdiction. In the United States, for example, trusts are taxed at the same rates as individuals, but they reach the highest income tax rate more quickly.

Irrevocable Trusts and Taxation

In some jurisdictions, including the United States, tax laws allow for the creation of irrevocable trusts that remove the gift from the grantor’s estate, yet the grantor continues to pay income tax on the assets in the trust. This type of trust, known as an Intentionally Defective Grantor Trust, can reduce the size of the taxable estate by removing the original corpus, future investment returns on the corpus, and the taxes paid by the grantor on those investment returns.

Offshore Trusts

Offshore trusts are financial instruments utilized by affluent individuals for wealth management. These trusts are set up in foreign jurisdictions, often in countries recognized as tax havens, such as the Cayman Islands or Switzerland. The assets transferred to these trusts grow without the depletion from income tax payments.

Benefits of Offshore Trusts

• Tax Advantages: Offshore trusts are typically established in jurisdictions with zero income taxes, offering substantial tax benefits. For instance, a high-net-worth individual from the United States might set up an offshore trust in Bermuda to take advantage of its zero income tax policy.
• Confidentiality: These trusts safeguard the grantor’s financial information, ensuring privacy.
• Asset Protection: Offshore trusts provide superior protection of assets compared to traditional trusts. They can protect assets from creditors, lawsuits, and other financial risks.
• Investment Opportunities: They offer access to investment opportunities that may not be available in the grantor’s home country, such as investing in international real estate or foreign stocks.

Setting Up an Offshore Trust

Establishing an offshore trust mirrors the process of creating a conventional trust. However, it’s essential to understand and comply with the legal and tax regulations related to offshore trusts in both the home country or countries of the settlor and beneficiaries and the jurisdiction where the trust is established.

Countries like the United States have strict reporting requirements for offshore trusts. Non-compliance can result in severe penalties, including hefty fines and potential jail time.

Non-Trust Jurisdictions

The concept of Non-Trust Jurisdictions revolves around the legal recognition of trusts. While civil law jurisdictions generally do not recognize trusts, exceptions exist, such as Switzerland and Germany, which have enacted trust legislation. Additionally, 14 countries have adopted the Hague Trust Convention, a multilateral treaty that ensures each party recognizes the validity of trusts, irrespective of their own trust law.

Individuals from non-trust jurisdictions often establish trusts in jurisdictions that do recognize them. This is typically done to circumvent forced inheritance rules in their home countries, which legally mandate the allocation of a portion of one’s estate to certain family members. Establishing trusts in recognizing jurisdictions also offers privacy and helps avoid local probate.

Alternative Structures in Civil Law Jurisdictions

In lieu of trusts, some individuals in civil law jurisdictions utilize hybrid structures to implement their wishes. Two such structures are Liechtenstein’s Stiftungs and Anstalts. An Anstalt is a hybrid between a company and a foundation, while a Stiftung is akin to an institution created for personal, non-commercial purposes.

These entities are recognized in civil law jurisdictions, but their taxation in common law jurisdictions may be uncertain. Consequently, founders often convert these entities to a trust structure for beneficiaries residing in common law jurisdictions.

Investment of Trusts

Investment of trusts refers to the process where trustees are obligated to invest trust assets in compliance with the law that governs trust investments in the jurisdiction where the trust is regulated. In the United States and most common law jurisdictions, this law is referred to as the prudent investor rule. This rule is a codification of modern portfolio theory and mandates trustees to take into account the purposes, terms, distribution requirements, and other circumstances of the trust when choosing investments for a trust.

Factors to Consider in Trust Investment

Trustees are required to consider several factors when making investment decisions. These include:

• General economic conditions: For example, the state of the economy can affect the performance of investments.
• The potential impact of inflation or deflation: Inflation can erode the purchasing power of investment returns.
• The anticipated tax consequences of investment decisions or strategies: Certain investments may have tax advantages or disadvantages.
• The role each investment plays within the overall trust portfolio: Diversification can help to manage risk.
• The investment’s expected total return from income and appreciation/depreciation: This is a key aspect of trust investment decision-making.
• The other resources of the beneficiaries: Other resources may affect the need for income or capital growth.
• The need for liquidity, regularity of income, and preservation or appreciation of capital: These needs can influence the choice of investments.
• An asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries: For example, a family business may have special value to the beneficiaries.

Trustees are legally accountable to the beneficiaries to adhere to the prudent investor rule. It is considered best practice to document the decision-making process in accordance with this rule.

Practice Questions

Question 1: John, a wealthy businessman, is considering transferring some of his wealth to his children during his lifetime. He is aware that this process involves several important considerations. In order to ensure that the gifting is financially viable and appropriate, which two main factors should John primarily consider?

1. The current market value of his assets and the potential return on investment
2. Tax implications and family circumstances
3. The structure of the gift and the choice of recipient

Answer: Choice B is correct.

When considering wealth transfer during one’s lifetime, the two main factors to primarily consider are the tax implications and family circumstances. Tax implications are crucial as different types of gifts may have different tax consequences. For instance, in some jurisdictions, gifts of a certain value may be subject to gift tax. Understanding these implications can help John plan his gifts in a way that minimizes tax liability. Family circumstances are equally important. The financial needs, maturity, and reliability of potential recipients should be considered to ensure that the gift will be used wisely and will not create family discord or legal issues. Furthermore, John’s own financial security should not be compromised by the gifting. Therefore, understanding the family’s dynamics and needs is crucial in this process.

Choice A is incorrect. While the current market value of his assets and the potential return on investment are important considerations, they are not the primary factors in determining the financial viability and appropriateness of gifting. These factors are more relevant to investment decisions rather than gifting decisions.

Choice C is incorrect. The structure of the gift and the choice of recipient are important considerations, but they are secondary to the tax implications and family circumstances. The structure of the gift and the choice of recipient should be determined after considering the tax implications and family circumstances. For instance, the choice of recipient may be influenced by family circumstances, and the structure of the gift may be influenced by tax implications.

Question 2: Sarah is planning to gift some of her assets to her daughter. She understands that the choice of assets to gift is a critical aspect of wealth transfer. What should be the basis of her decision while choosing the assets to gift?

1. The popularity of the assets in the current market
2. The value of the assets, the recipient’s needs and preferences, and the potential tax implications
3. The age and health condition of the recipient

Answer: Choice B is correct.

The basis of Sarah’s decision while choosing the assets to gift should be the value of the assets, the recipient’s needs and preferences, and the potential tax implications. The value of the assets is important because it determines the amount of wealth that is being transferred. The recipient’s needs and preferences are crucial because they determine whether the gift will be useful and appreciated. The potential tax implications are also important because they can significantly affect the net value of the gift. For example, certain types of assets may be subject to gift taxes, which could reduce the net value of the gift. Therefore, it is important to consider all these factors when choosing the assets to gift in order to maximize the effectiveness of the wealth transfer.

Choice A is incorrect. The popularity of the assets in the current market is not a reliable basis for choosing the assets to gift. While popular assets may have high market value, their value can fluctuate significantly over time. Moreover, the popularity of an asset does not necessarily mean that it is suitable for the recipient’s needs and preferences.

Choice C is incorrect. The age and health condition of the recipient are not the primary factors to consider when choosing the assets to gift. While these factors may affect the recipient’s ability to manage and use the assets, they do not directly determine the value of the assets, the recipient’s needs and preferences, or the potential tax implications. Therefore, they should not be the basis of the decision.

Glossary

• Gifting: The act of giving assets to another individual or entity during one’s lifetime, often for the purpose of wealth transfer.
• Donor: The person who gives the gift.
• Donee: The person who receives the gift.
• Transfer Tax: The tax levied on the transfer of ownership of assets.
• Generation Skipping: A technique that involves transferring capital in excess of the second generation’s needs for spending, safety, and flexibility, directly to the third generation, to avoid a layer of double taxation.
• Estate Planning: The process of arranging for the disposal of an estate during a person’s life.
• Estate Tax: A tax levied on an heir’s inherited portion of an estate if the value of the estate exceeds an exclusion limit set by law.
• Gift Tax: A tax imposed on the transfer of ownership of property during the giver’s life.
• Dynasty Trust: A legal agreement allowing the grantor to pass wealth across generations without incurring estate taxes.
• Trustee: The individual or institution responsible for managing the trust’s assets.

Private Wealth Pathway Volume 2: Learning Module 7: Transferring the Wealth; LOS 7(a): Discuss and recommend appropriate wealth management planning approaches for transferring wealth during the lifetime of the giver through gifts.