Estate Tax Exemption Clock Is Ticking Even Faster for These Wealthy Clients

Clients with a substantial portion of their legacy wealth tied up in private equity investments have less than 18 months to prepare for the sunset of key provisions of the 2017 tax overhaul known as the Tax Cuts and Jobs Act — particularly the reduction of the estate tax exemption.

“That is just not a lot of time to get some potentially complex planning done,” warned Mike Kirkman, a partner and certified public accountant at Cherry Bekaert. “Specific strategies such as lifetime gifting and vertical slice planning can be very effective for wealthy clients looking to mitigate their estate taxes, but they aren’t straightforward.”

Adding more pressure is that legal and accounting professionals with the expertise to help clients enact these and other wealth-protection strategies are already in sky-high demand. So much so that clients who wait too long may find themselves out of luck.

“This is the busiest time for CPAs in a long time, certainly since the big rule changes that we saw back in 2012,” Kirkman recently told ThinkAdvisor. “I would actually argue that the TCJA sunset issues that we are grappling with right now are even more substantial, and they’re coming at a time when the public accounting space is facing a notable talent shortage.”

Kirkman urged financial advisors and their clients with significant private equity holdings to study up on the investments’ rules and requirements. While it’s possible that the historically high estate tax exemption will be extended beyond 2025, that’s far from a guaranteed outcome in a divided Congress.

“So, this is likely a use-it-or-lose-it situation with respect to the current exemption amount,” Kirkman said.

Gifting Today vs. Tomorrow

As Kirkman explained, the gift tax applies to asset transfers made during life rather than at death — but it does draw from the same exemption amount. So, the lifetime exemption can be used in whole or in part during life or at death, but it represents a lifetime aggregate of allowable transfers.

Apart from the time value of money, estate and gift taxes are generally neutral as to when individuals transfer their assets to heirs, Kirkman said. Many wealthy individuals, therefore, choose to make lifetime gifts of assets instead of waiting to transfer them at death.

In addition to allowing clients to see the impact of their gifting while they are still alive, this allows post-gift appreciation to escape the taxable estate at death, significantly reducing estate tax liability for beneficiaries.

Tricky Issues

The gifting of assets varies substantially by asset type, Kirkman noted. Gifting cash and liquid assets is often straightforward, but the complexity ramps up when considering private equity ownership.

This is because a given fund manager’s shares in a carried interest entity consist of multiple layers, including an “ownership” portion and carried interest rights. The ownership portion will generally consist of the standard 2% management fee — along with any other payment rights — but it does not include carried interest rights.

“If transferred early, the carried interest rights usually do not have a high value for gift tax purposes because the entity’s investments have not yet started making large profits,” Kirkman explained.

Conversely, the ownership interest consisting of the 2% management fee and other payment rights has immediate value. Historically, Kirkman said, this dynamic has led fund managers to gift carried interest rights at low gift tax values while retaining the ownership rights, which did not have the same growth potential.

“Sunset planning may be especially apt for PE principals holding carried interests,” Kirkman continued, “since those assets begin at lower values with the potential to increase by multiples over time.”