Put a Lid On It – Using the Charitable Lid in Your Estate Plan
If you have paid attention to news out of Washington D.C., you know that Congress is presently considering a reduction of the gift and estate tax exemption. The current exemption amount was scheduled to be reduced in January 1, 2026 anyway, but current proposed legislation would reduce it beginning on January 1, 2022. If your estate will now have greater exposure to the tax, one common estate planning technique that should be considered is the charitable lid. Although it can be structured in a variety of ways, a charitable lid is a planning technique that guarantees that if the IRS questions a valuation discount on a gift or estate tax audit and succeeds in reducing the amount of the discount, the difference will not go to the IRS in the form of estate or gift tax, but rather to one or more charities named in the estate plan.
Here is an example. Susan owns 50% of an LLC that owns real property. The real property is appraised at $20 million. Susan gifts her 50% interest to her two children. The business valuation of the interests transferred determined that a valuation discount for lack of marketability and minority interest of 40% was warranted. Therefore, the value of the gift on the gift tax return was listed as $6 million. On audit, the IRS challenged the valuation and reduced the discount from 40% to 25%. The gift document, however, provided that any reduction in the discounted value “as finally determined for federal gift tax purposes” passed to her favorite charity. Assuming the difference in value between the 40% and 25% would otherwise be taxable, the charitable lid formula avoids a tax of $1.4 million (40% of $3.5 million) while the charity receives an allocation of an additional $3.5 million in interests. The IRS still doesn’t get anything.
While this keeps money out of the hands of the IRS, understand that it doesn’t necessarily mean that your family gets more. As the example demonstrates, instead of $1.4 million going to the IRS, $3.5 million goes to charity. So it is important that you have charitable intent. But, this strategy should effectively act as a disincentive to an IRS challenge in the first place. Win or lose, the IRS does not get any additional tax revenue – so presumably they would not want to put in the same level of effort in challenging the original valuation allowing more latitude for settlement.
This planning technique can be further enhanced by establishing a donor advised fund (DAF) or private foundation to be the beneficiary. With the DAF or private foundation as the charitable beneficiary, you or the person you appoint can continue to direct the timing of distributions to charities and benefit a broader array of charities. If you will be gifting closely held business interests, it is important to have a strategy for the DAF or private foundation to exit the business due to certain income tax consequences.
If you think your estate may now be subject to estate tax, consider putting a lid on it. A charitable lid.
This post is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.