A Guide to Generational Estate Planning

Generational estate planning refers to the process of managing and transferring wealth across multiple generations within a family. It involves creating a comprehensive plan to preserve and distribute assets in a tax-efficient manner while also considering the long-term well-being (financial and otherwise) of heirs. In this guide, we will focus on the wealth transfer and tax planning aspects of generational estate planning. We will explore three distinct case studies, each showcasing several wealth transfer techniques. We will highlight the use of various trust and entity structures to shift future appreciation to the next generation and reduce potential estate tax liabilities.1

1 For tax year 2024, the federal estate tax exemption is $13.6 million per individual and $27.2 million for a married couple. However, these exemption amounts are subject to a “sunset” provision in the 2017 Tax Cuts and Jobs Act. Without Congressional action, the 2026 exemption amounts are likely to be reduced by ~50% to approximately $7 million per individual and $14 million for a married couple. Estates exceeding these amounts would be subject to a 40% tax under current tax law.

Key Aspects of Generational Estate Planning

  • Wealth Preservation – The primary goal is to preserve the family's wealth and assets for future generations. This may involve various strategies such as investing in diversified portfolios, minimizing tax liabilities, and protecting assets from potential risks.

  • Wealth Transfer and Tax Planning – Estate taxes can significantly reduce the value of an estate transferred to heirs. Generational estate planning often involves strategies to minimize estate taxes and may include forming trusts, lifetime gifting, charitable planning, and establishing life insurance policies.

  • Family Governance and Communication – Establishing frameworks for managing family assets and making financial decisions is essential in generational estate planning. This may involve creating family constitutions, establishing family offices, and appointing trustees or advisors to oversee the management of assets. Communication and education are also critical components. It can be beneficial to involve family members in discussions about wealth management, financial responsibilities, and the values that guide the family's legacy.

Wealth Transfer Techniques

Wealth transfer planning requires careful coordination of legal documentation and tax reporting. Here are some of the commonly used structures for generational wealth transfer:

Grantor Trusts

Key Characteristics – Irrevocable and a completed transfer for estate and gift tax purposes. Disregarded for income tax purposes, may be designed to allow asset swaps, sales, and promissory notes between the grantor and the trust without income tax consequences. Some level of control can be maintained. 

  • Intentionally Defective Grantor Trust (IDGT) – A permanent trust designed to “freeze” a portion of grantor’s estate for estate tax purposes while allowing the trust assets to grow free of estate tax outside the grantor’s estate. The grantor may retain certain powers to provide flexibility in managing the trust assets and all income flows to the grantor’s individual tax return. The payment of the trust’s income tax by the grantor is a tax-free gift to the trust.

  • Grantor Retained Annuity Trust (GRAT) – A temporary trust that returns some (*or all) of the contributed value plus interest to the grantor and transfers appreciation outside your estate. Returned assets can be contributed to a series of new GRATs established each year to create a laddered structure. *A zeroed-out GRAT can be structured to eliminate use of the lifetime exemption.

  • Spousal Lifetime Access Trust (SLAT) – Similar to the IDGT, except the primary beneficiary is a spouse and children are secondary beneficiaries.

  • Qualified Personal Residence Trust (QPRT) – A grantor trust specifically designed to acquire and hold real estate. A gift to the trust can be discounted for the value of the retained interest (i.e. the grantor continues to live in the home during the trust term). Note: QPRTs have become less attractive in California since Proposition 19 went into effect in February 2021, as QPRTs now typically result in increased property taxes for California real property.

Non-Grantor Trusts

Key Characteristics – Irrevocable and a completed transfer for estate and gift tax purposes. Treated as a separate taxpayer and pays taxes at the compressed trust and estate tax brackets. The grantor of the trust relinquishes control to an independent trustee.

  • Non-Grantor Trust – There are two types, simple and complex (described below). Less flexible than a grantor trust, although these trusts may be structured to provide protection from creditors and lawsuits. Non-grantor trusts are also eligible for their own $10M Qualified Small Business Stock (QSBS) exclusion, in addition to that of the grantor.

    • Simple Trust – Required to distribute all annual income to beneficiaries, must retain trust principal, and cannot make gifts to charitable organizations.

    • Complex Trust – May accumulate income, distribute trust principal, and make charitable gifts.

  • Upstream Trust – Instead of transferring assets down to the next generation, you instead transfer assets up to parents. Highly appreciated assets can receive a stepped-up basis and eliminate unrealized gains when parents pass away, and this trust can apply the parents’ unused lifetime exemptions and Generation-Skipping Transfer (GST) tax exemptions.

Charitable Trusts

Key Characteristics – Irrevocable and a completed transfer for estate and gift tax purposes. Can be structured as a split interest gift with one or more non charitable beneficiaries receiving an income stream or a remainder interest.

  • Charitable Remainder Annuity Trust (CRAT) – Provides an upfront tax deduction and a fixed income stream to you or another beneficiary. At the end of the trust term, the remainder goes to your preferred charitable organizations. If appreciated stock is contributed to a CRAT and sold, the capital gains are deferred until a distribution is made.

  • Charitable Remainder Unitrust (CRUT) – Similar to a CRAT, with a variable annuity payment based on the value of the trust each year.

  • Net Income with Makeup Charitable Remainder Unitrust (NIMCRUT) – Provides the ability to delay annuity payments and shift income into future years. Requires an investment strategy that minimizes income during the accumulation period.

  • Charitable Lead Annuity Trust (CLAT) – Provides a fixed income stream to charitable organizations during the trust term with your designated beneficiaries receiving the remainder of the assets. A grantor CLAT can be structured to provide an income tax deduction in the year it is funded. A non-grantor CLAT files a separate tax return and receives its own charitable deductions each year as the annuity payments are made to charity.

  • Charitable Lead Unitrust (CLUT) – Similar to a grantor CLAT, with a variable annuity payment based on the value of the trust each year.

  • Donor Advised Fund (DAF) – A pooled charitable trust that allows the grantor to direct gifts over multiple years. Provides a charitable tax deduction up front and sales of appreciated assets inside the DAF are non-taxable.

Other Structures

  • Irrevocable Life Insurance Trust (ILIT) – A trust specifically designed to acquire and hold a life insurance policy. The proceeds from a life insurance policy are used to offset estate taxes paid by the beneficiaries of the trust.

  • 529 College Savings Plans – An education savings account designed for children and grandchildren. Contributions are subject to the gifting limits; however a 5-year election can be made to pre-fund up to 5 years’ worth of annual exclusion gifts.

  • Family Limited Partnership (FLP) – A holding company for a family’s investments. In a typical structure, parents serve as General Partners (GP) and retain control over investment decisions and distributions. They gift Limited Partner (LP) interests to children or trusts for other descendants. Valuations discounts for lack of marketability and lack of control can be applied to reduce the value of the gifted LP interests.

  • Carried Interest Derivative – A legal agreement that establishes criteria for a future settlement based on the value of carried interest distributions received over a specified period. Provides added flexibility over a straight gift of carried interest. A carried interest derivative includes a hurdle value, participation rate, and a settlement date. The derivative is sold to a grantor trust and at the end of the term the cash settlement (including any gains) is disregarded for gift and estate tax purposes under current tax law.

Frequently Asked Questions

How much can I transfer before paying federal gift, estate, or generational skipping tax?

There are three limits, the Annual Exclusion ($18k - 2024), the Lifetime Exemption ($13.6M - 2024), and the Generation Skipping Transfer (GST) Tax Exemption ($13.6M – 2024). These limits are per person and are doubled for a married couple. If you exceed the annual exclusion, you will use up a portion of the lifetime exemption. After the lifetime exemption is exhausted, the 40% federal estate and gift tax applies. The GST exemption can be applied for gifts to beneficiaries more than one generation below the grantor.

How do I report a taxable gift?

Taxable gifts are reported on a Form 709 gift tax return or Form 706 estate tax return.

Do I need to file a tax return for my trust?

Grantor trusts are disregarded and included on the grantor’s Form 1040 individual return. Non-grantor trusts require a separate Form 1041 trust return. Distributions to non-grantor trust beneficiaries will receive a Form K1 to report their share of taxable income and gains.

When do I need an independent 3rd party valuation?

A valuation is required if the asset is not traded on a public market. Interests in real estate, closely held businesses, collectibles, private company stock, etc. will require an independent 3rd party valuation.

Does my trust need a separate tax ID?

Grantor trusts are disregarded entities and are reported under the grantor’s social security number, but a separate tax ID can be obtained for convenience, privacy, or protection against identify theft. Non-grantor trusts require a separate tax ID.

Does my state have a wealth transfer tax?

Several states have an estate or inheritance tax, as illustrated on the map below. Only one state (Connecticut) has a gift tax, and Maryland is the only state with both estate and inheritance tax.

Adero Client Case Study 1

Wealth Transfer for Startup Founder Using Qualified Small Business Stock

Meet Adam, a serial entrepreneur with a promising AI start-up. The company’s Series A round was oversubscribed, and the platform was in high demand. Adam already had a taxable estate from a previous liquidity event and wanted to shift future growth into a trust for his three children. Adam met with his advisor to provide an update on the company and discuss estate planning strategies. His advisor recommended using a Grantor Retained Annuity Trust (GRAT), a temporary trust structure with a three-year term.

Adam contributed shares of his founder’s stock to the GRAT and received an annuity payment on each anniversary date. The annuity payments were paid in stock, equal to one-third of the original value plus interest. An independent valuation determined the number of shares Adam received from the GRAT each year. During the second year, the company raised a Series B at a significant premium to the prior round. The second and third annuity payments returned a fraction of the remaining shares and the balance of the GRAT was distributed tax-free to irrevocable trusts for the children. Since Adam received 100% of his original value back, there was no taxable gift, and he preserved his lifetime exemption. This technique is commonly known as a “zeroed-out” GRAT.

The children’s trusts were established in Delaware, taking advantage of favorable trust laws, dynasty provisions, no state income tax, and no requirement to inform the children of the trust’s existence when they turn 18. The trusts were structured as non-grantor for tax purposes, allowing each trust to claim a separate $10 million exclusion for Qualified Small Business Stock (QSBS).

In summary, through the strategic combination of a zeroed-out GRAT for wealth transfer and leveraging multiple QSBS exclusions, Adam's advisor facilitated substantial savings in estate, gift, and income taxes, potentially amounting to millions. The non-grantor trust structure enhanced the QSBS benefits, opening the possibility for the family to exclude up to $40M of future gains.

For more information about QSBS planning, you can read our Adero QSBS Article and reference our Adero QSBS Guide

Adero Client Case Study 2

Comprehensive Retirement Planning for C-Suite Executive

Meet Natalie, a distinguished Fortune 500 executive transitioning into retirement amidst a complex financial landscape. Endowed with a high income, a taxable estate, and concentrated low basis stock holdings, Natalie turned to her advisor to craft a multifaceted plan. This comprehensive strategy aimed to secure retirement income, diversify assets, minimize taxes, support charitable organizations, and facilitate the seamless transfer of wealth to her children.

To address Natalie’s retirement income needs while diversifying her investment portfolio, the advisor recommended a Charitable Remainder Trust (CRT) funded with a portion of her low basis stock. The CRT provided an immediate charitable income tax deduction and allowed for the sale of the stock while deferring capital gains tax. This strategy enabled her to receive a steady stream of income during retirement from a diversified portfolio while also supporting charitable causes at the end of her life.

With lifetime income and a charitable legacy in place, Natalie’s advisor proposed two additional strategies to reduce her concentrated stock exposure. A portion of the stock was contributed to a Donor-Advised Fund (DAF) in her final high-income year, maximizing the value of the charitable income tax deduction and prefunding grants she intends to make during her lifetime. Another portion of her stock was directed to an Exchange Fund to further diversify her portfolio while deferring capital gains taxes.

Furthermore, Natalie’s advisor recommended two wealth transfer strategies to benefit her children. A Family Limited Partnership (FLP) was established with Natalie as the general partner and her children as the limited partners. She contributed several rental properties managed by her two children, fostering both family involvement and wealth preservation. The FLP structure allowed Natalie to retain control over the assets while receiving liquidity and minority interest discounts on the value of the gifted interests. Additionally, a Qualified Personal Residence Trust (QPRT) was utilized to transfer ownership of a high-value vacation home to her children while Natalie retained the right to use the property for a specified term. Both strategies preserved more of her lifetime exemption when compared to a direct gift of real estate with no retained interest.

In conclusion, Natalie's comprehensive retirement plan exemplifies strategic foresight and proactive wealth management, guided by the expertise of her advisor. By implementing a diverse array of strategies, Natalie successfully navigated the complexities of retirement planning while achieving her personal goals, optimizing tax efficiencies, and securing her legacy for future generations.

To learn more about managing concentrated stock with Exchange Funds, read our Exchange Funds Article or watch our Exchange Funds Webinar

Adero Client Case Study 3

Flexible Wealth Transfer for Venture Capitalist with Carried Interest

Meet Anthony, a solo venture capitalist residing in Silicon Valley. Anthony’s earliest investments were beginning to return capital and he had just closed a much larger follow-on fund. In anticipation of future liquidity and wealth creation, Anthony met with his advisor to discuss tax and estate optimization strategies for his family.

Anthony’s advisor recommended creating an Intentionally Defective Grantor Trust (IDGT) to provide a flexible structure for generational wealth transfer. An IDGT is treated as a completed gift for estate tax and an incomplete gift for income tax. Assets placed in the trust would appreciate outside his estate while any capital gains or income would flow through his individual tax return. Anthony could pay taxes on behalf of the trust, without generating a taxable gift.

The intentional “defect” in the trust agreement granted Anthony the ability to exchange promissory notes and swap assets with the trust. These so-called defects provided a significant benefit, allowing Anthony to address future liquidity needs by borrowing cash or swapping illiquid assets (e.g. personal real estate) for income-producing bonds and stocks.

Once the trust was established, Anthony and his advisor discussed funding options. Several assets were identified, including a seed gift of cash, carried interest in the new fund, and a carry derivative on the first fund. His advisor brought up a critical tax rule under IRC Sec 2701 and recommended that Anthony include a proportional share of GP and LP interests (i.e. the Vertical Slice exception) to avoid adverse tax treatment. Anthony also sold a derivative contract on the first fund to the trust in exchange for a cash payment and a small promissory note. A carry derivative acts like an out-of-the-money stock option and is an efficient tool for transferring future appreciation in a venture fund. Cash was also gifted to the trust to cover the LP commitments and the purchase of the carry derivative. All these transfers required independent 3rd party valuations and gift tax filings.

In summary, Anthony's strategic partnership with his advisor led to a robust tax and estate optimization plan. By leveraging the IDGT structure and strategically allocating assets, Anthony positioned his family for future financial success while navigating the complexities of the U.S. tax code and state trust laws.

Conclusion and Resources

Overall, generational estate planning aims to ensure the smooth transition of wealth and assets from one generation to the next while promoting financial stability, unity, and continuity within the family. The case studies presented here demonstrate the power of advanced techniques such as GRATs, Non-Grantor Trusts, QSBS, CRTs, DAFs, Exchange Funds, FLPs, QPRTs, IDGTs, and transfers of Carried Interest. These strategies enable clients to optimize their financial position, minimize tax consequences, and create a legacy for future generations.

It is crucial to emphasize the importance of seeking advice and guidance from financial advisors and estate planning attorneys to tailor these strategies to your individual circumstances effectively.

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Contact Aaron White - aaron@aderopartners.com

These fictional clients and their hypothetical situations are provided for illustrative purposes only to provide an example of the firm’s client base, process, and methodology. Past performance is no guarantee of future results. The experiences portrayed in these case studies are not representative of all of the firm’s clients or the clients’ experiences. Different types of investments involve varying degrees of risk, and actual results may vary materially than those portrayed herein. An individual’s outcome may vary based on his or her individual circumstances and there can be no assurance that the firm will be able to achieve similar results in comparable situations. No portion of these case studies is to be interpreted as a testimonial or endorsement of the firm’s financial and investment advisory services and it is not known whether the clients referenced approve of the firm or its services. The information contained herein should not be construed as personalized financial or investment advice. Please contact us for additional information with respect to the strategies and/or investments described herein.

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