For a long time, in wealth planning and transfer conversations it has been taken for granted that values do and will go up, but a recent spate of events, such as the collapse of FTX and stock market rout of 2022 suggest that's a mistake. How should conversations and plans be framed?
The following article on estate planning comes from Marnin J Michaels, who is senior partner at Baker McKenzie in Zurich. He tackles a question stretching far beyond the confines of Switzerland: should clients try and base wealth planning around the assumption that assets will – hopefully – rise in value? While this piece uses US examples, its relevance goes beyond the States. The article has already been published by the global law firm and is reprinted by this news organisation with the firm’s permission. The editors are grateful for the opportunity to add this article and invite readers to respond. Email firstname.lastname@example.org
A fundamental estate planning principle frequently discussed when I was a student studying for my LL.M in the estate planning programme at the University of Miami, and which remains a teaching point to this day, is that it is better to gift assets before they further appreciate in value. I recall professors sharing examples of estate planning benefits that would have resulted if one had gifted certain stock before an IPO or before specific assets had significantly appreciated in value. The common assumption was that gifting assets that one anticipates will appreciate in value in the future is a good thing, because it results in a gift tax saving and removes them from the donor's estate. The reasoning for this argument is that the gift freezes the value of the assets (as to the donor) for transfer tax purposes. Thus, if the assets appreciate in value after the gift, the donor or donor's estate will not owe additional transfer taxes on any future appreciation.
As the global markets emerge from the Covid-19 era with some asset values trending lower, coupled with the US federal gift, estate and generation skipping transfer (GST) tax basic exclusion amount set to return to its 2017 level at the end of 2025 (1), many estate planners believe now is the perfect time to transfer to younger generations assets anticipated to appreciate in value. For most of my professional career, I have worked and advised clients along this premise; however, I am beginning to realise that perhaps this common perception is not always correct.
In this short article, I will explore the potential flaws in this line of reasoning. I acknowledge that some readers will find this article somewhat controversial and counterintuitive. And further, in more instances than not, I will continue to advise clients to consider the future appreciation of their assets while planning their estates. However, the point here is to illustrate that anticipated appreciation of asset values does not always occur and values can decline (and even become worthless) and result in negative economic consequences for the donor (and sometimes the donee).
At the outset of the planning process, I believe practitioners should consider the following points when evaluating whether a client should gift an asset that they believe, or hope will appreciate in value:
1. Is the client certain that the value of the asset will
2. Is it possible that the value of the asset could decline significantly or even become worthless after the transfer?
3. Is the client prepaying a tax now to gift an asset whose current value may be overstated compared with its future value?
4. Are there potential civil law issues that can be triggered by donations during the lifetime that subject the donor to challenges that might not otherwise exist?
Asset values do not always appreciate
Many people who have invested successfully in the last 40 years are biased by the fact that asset values, even with economic corrections, have, for the most part, only moved in one direction: up. However, a closer look at the system in some detail reveals that certain assets have not only declined in value but have lost all their value. Additionally, certain external factors beyond the donor's control can cause an asset value to decline or even become worthless. Consider the following real-life scenarios:
Example 1: In 2006, believing that her Bernie Madoff investment account would only continue to increase in value, Ms F, a UK resident, transferred it to a family foundation, which triggered a UK donation tax. Less than three years later, however, Madoff's Ponzi scheme was discovered, and the investment account is now worthless in the hands of the family foundation. This example illustrates that acting in haste to gift what one believes is a rapidly appreciating asset can result in negative tax consequences if the anticipated growth does not occur or, as was the case with Madoff investment accounts, the asset was essentially worthless before the transfer.
Example 2: In a divorce settlement, H1 and H2 agree to divide the marital assets equally. H1 agrees to take the portfolio assets (all marketable securities) and H2 agrees to take the cold storage wallets containing crypto tokens. One year after the divorce decree is entered, H2's cryptocurrency is now worthless, and H1's portfolio asset values are down 22 per cent.
Example 3: Ms Jones donated her entire interest in Luna tokens to her favourite charity on 25 February 2022, for which she was then able to claim a charitable deduction for the value of the tokens on the date of the transfer. A few months later, the value of Luna collapsed, and the digital tokens are basically worthless to the charity. The result is a windfall to the donor in the form of a charitable deduction, whereas, unless the charity immediately liquidated the tokens, the charity has lost all the value of its gift. Furthermore, what is the result if the Luna tokens were donated to the charity in exchange for the donor's naming rights to a building? Could the charity rescind its agreement to name the building in honour of the donor if it did not liquidate the tokens before their collapse and lost all value of the donation? Therefore, these value fluctuations also can result in negative economic consequences to the donee.
Examples 2 and 3 collectively illustrate the negative impact that volatile assets, such as cryptocurrency, can have on both donors and donees, as well as domestic matters. These examples also illustrate the negative economic consequences that can result from gifting such assets. Thus, the question becomes, when working with and planning for families (and perhaps when representing a charity), are we working from a flawed analysis with respect to valuation?
Is there a flaw in our thinking influencing our decisions? Ultimately, too many mistakes and personal relationships have been based on this assumption. It is especially important to discuss with the client the planning risks associated with volatile assets, and make sure that they understand that if the assets decline in value after the transfer, they may not be able to recover the taxes paid on the transfer or restore any exemption used on the transfer. One planning objective should be to ask the client to consider the impact of valuation on a prospective basis.
Assets can and often do decline in value
There seems to be a misconception that assets tend to generally go up in value. However, that is not always true. Even the most stable of assets, such as real estate, have a history of declining in value. For instance, real estate tends to depreciate when the general area is no longer viewed as attractive, when the property requires significant improvements, when environmental damage occurs or, as we recently witnessed, from the economic impact of a global pandemic.
Example 4: Ms Y believes real estate in New York City will always appreciate, and she heavily invested in midtown Manhattan for the better part of the last 10 years. In 2020, the Covid-19 pandemic hit, and property values and occupancy rates have never fully recovered even as we enter 2023.
Example 5: In 2015, Mr Smith began investing heavily in the UK real estate market in prime locations in downtown London. Although the market values of his properties declined as a result of the pandemic, many have since returned to their pre-Covid-19 market value. However, the depreciation of the British pound that has resulted from Covid-19 and Brexit, coupled with recent inflation, has created a situation where there is actually a net negative value when compared with the purchase price.
Various economic factors influence pricing. Thus, even where an asset's fair market value increases, its purchase value can decrease.
It is not always beneficial to prepay tax
Particularly in places like the US, where recently there have been large gift, estate and GST exclusions, and gift taxes are tax-exclusive, but estate taxes are tax-inclusive, there seems to be a mindset that paying a tax early is always beneficial. The reasoning is that the donor avoids paying transfer tax on the growth, and it is no longer a part of the donor's estate for estate and GST tax purposes. Although that is true, what if a donor makes a gift, pays the gift tax, but the asset declines in value or becomes worthless shortly after the gift is made? The problem then is that there is no corresponding credit system to make the donor whole for transfer taxes paid, or the wasted exemption that cannot be recovered.
Example 6: Believing that her investment in FTX would only continue to increase in value, Ms C gifted her entire investment in FTX to her children in December 2021 when the market value was $50 million. As a result of the transfer, she used up her entire $12.06 million basic exclusion and paid over $15 million in gift taxes. In November 2022, and after Ms C paid the gift taxes, FTX collapsed and the children's investment in FTX is now worthless.
This example illustrates that the valuation for a gift is based on the asset's fair market value on the date of the transfer. If the asset's value declines or becomes worthless post-transfer, the donor cannot seek a refund of the gift taxes paid or have any basic exclusion amount restored. In essence, the donor wastes both the money used to pay the tax and the equivalent monetary value of the exemption that could have been used for other assets. In contrast, in the estate tax context, however, there is an opportunity to revalue assets six months after death if the assets have decreased in value. Thus, in Example 6, if Ms C had held onto the FTX stock until it imploded or if it had imploded within six months after her death, then her estate potentially would have an additional $27 million in assets.
Example 7: A Swiss tax resident gifts his Tesla shares in November 2021 to his cousins, because he has no other relatives. The cousins, thrilled to have the Tesla shares, are happy to pay the inheritance tax at the third-party rate. Unfortunately, the value of the Tesla shares declined so much that, by the time the taxes are due, the cousins have no choice but to sell the shares to realise the cash to pay the inheritance tax. Certainly, this was not the intended result.
There are nontax reasons where gifting can be important. Tax lawyers love to talk about taxes and money, and families like to think about who gets what and when in the most expeditious way possible. If someone gifts assets to address succession issues or forced heirship issues and those assets significantly change in value from the time the agreement was signed until the donor's death, one runs the risk that someone will attempt to reopen the issue. This happens not only in the context of inheritance, but also in the context of divorces and other similar situations. Thus, clients sometimes do not give as much thought as they should to the consequences of a gifting transaction.
As I noted earlier, I recognise that many readers may view this article as controversial and counterintuitive. Yet, in these changing times following market bubbles, Ponzi schemes, crypto implosions and a pandemic, the point here is that practitioners should be mindful that asset values can and do decline, or even become worthless, post-transfer. Thus, when advising estate planning clients to follow the norm of gifting away assets anticipated to appreciate, it is also important to counsel them of the potential negative economic consequences that can result if the asset value declines or implodes after the gift is complete. There is no way of going backward to make them whole.
1, In 2017, the basic exclusion amount for US gift and estate tax and GST was $5 million (before indexed for inflation). This amount doubled in 2018 to $10 million, and increased to $11.18 million after indexed for inflation. In 2023, as indexed for inflation, the basic exclusion amount is $12.92 million. The $10 million basic exclusion amount sunsets on 31 December 2025 and returns to $5 million indexed for inflation unless extended or made permanent by Congress.