American Muslim Guide to Estate Tax Planning
You already know about Islamic Inheritance and Islamic Estate Planning (and if you don’t, click on the links. However, for those blessed with substantial wealth (which I will define soon, you know estate tax planning is essential for you. The tax rate on estates in the United States is 40% after your wealth clears an exemption. As I am writing this in 2021, it stands at $11.7 million. At this point, some of you might stop reading because a tiny percentage of American families need to worry about the federal estate tax (though I hope you still find the article beneficial). Those that do need to play closer attention.
The federal gift and estate tax system is quite different from the income tax system. In some ways, the systems scarcely use the same language. While pretty much everyone needs to pay some income tax (unless there is no or almost no income), the federal estate tax is more a tax on laziness and a failure to plan. Several states have state estate taxes and inheritance taxes. I won’t be discussing those here. However, the exemptions are much smaller where they exist. The
Here is a disclaimer (which should apply throughout the website)- don’t get your tax advice from blog posts. This guide is for general educational purposes. I am simplifying concepts and will do my utmost to avoid needless jargon.
How Federal Estate Tax Planning Works
The federal tax code has an estate tax that you pay a certain percentage of your estate after you pass away. The Estate Tax is a tax on the transfer of wealth from one generation to another. To avoid the estate tax, we have a gift tax to stop an obvious “loophole” of people giving away money. The estate and gift tax systems are “unified.”
In the examples below, note that there are a wide range of permutations of strategies. I wrote about them in “Estate Planning for the Muslim Client”- my 2019 book published by the American Bar Association. I go into these strategies far more in that book than I do here.
Abbas finds out his estate would be subject to $4 million estate taxes if he dies. To prevent this, he gives this to his son. This gift causes a gift tax bill for about the same amount.
Say Abbas figures he is going to pay a tax anyway. But to avoid his son bearing the burden of the gift tax, his grandson has to pay it again; he gives it to the grandson. In this instance, he pays both the gift tax and the generation-skipping tax so that the government will tax Abbas twice.
What Estate Tax Planning does
Now Abbas has a problem. He has a hefty tax bill. How does he go to a lawyer and make it all disappear? Is there a magical document that will make it all go away? No, not really. Abbas needs to plan.
All Gift and Estate Tax planning involve two ingredients. The first is that the federal tax code has exemptions to the estate tax. You are already familiar with this if you have paid the income tax. You get a mortgage deduction or a charitable deduction, and so forth. The second is what we would call the “time value of money.”
What precisely we do and how we structure estate tax planning varies widely.
Here are a few examples:
Charitable Lead Trust (CLT)
Abbas is interested in giving to charity. So his estate tax planning is likely to have some of this. He has $10 million subject to Zakat, and he expects this to grow at a clip of at least 15% a year for the next 20 years. He places half those assets in a “Charitable Lead Trust.” He is the Trustee of this trust, and he manages the funds. Under the terms of this trust, he pays 5% of the value of the charitable lead trust for 20 years. After this 20-year period has ended, the funds go to a resulting trust, a gift to his children and grandchildren.
This gift to his family will not be subject to either the gift tax or the estate tax. I write more about Islamic charitable planning here (it is useful to families who are below the estate tax exemption as well).
Grantor Retained Annuity Trust (GRAT)
Abbas has a start-up, and he expects its valuation to increase twenty-fold in the next year or two. Right now, the business is worth $5 million. So, he creates a trust that turns this into an annuity. The Trustee pays him this money ($5 million), plus a government-mandated interest rate (he is essentially paying interest to himself). Anything left over after the GRAT period is outside his estate for estate tax purposes.
You can value the same asset differently if you change the details around that asset. If you own most of the company, your shares are worth more than if you own a minority of the company. Each portion of the company is worth the same in isolation. However, the effect of a “minority discount” and a “majority premium” cannot be ignored when we value things. Estate Tax planning does not ignore this.
Abbas has land appraised at $10 million. His lawyer recommends converting ownership of this land from real estate to personal property. The lawyer does this by putting the property in a business entity. He structures the business with restrictions on transfer and voting. The appraiser reviews the business entity (usually either a Limited Liability Company or Limited Partnership) and appraises the same property for $5 million.
Valuation issues are standard fodder for disputes between the IRS and taxpayers since the IRS often views the strategy as aggressive.
Sale to a Grantor Trust
Abbas has an estate of $100 million, most of it a business that he built. He wants to move it out of his estate so his family won’t be stuck with a hefty estate tax bill. His lawyer comes up with a plan based on the knowledge that the income tax system and the gift and estate tax system don’t work the same way. His lawyer drafts a trust that is Abbas’s property for income tax purposes but is not for estate tax purposes. He then gives a gift to this trust. He may use some of his significant (11.7 million) exemption, so he files a Form 209 (gift tax return) but does not pay a gift tax. Abbas creates this trust is to make sure the transaction about to happen has “economic substance.”
Next, this trust purchases Abbas’s business in an installment sale. The result is this trust, not Abbas’s for estate tax purposes but his for income tax purposes, owns the entire company. There is no income tax consequence for this sale since the government does not tax people for selling things to themselves. The estate tax consequence is substantial, he eliminates the estate tax completely.
How the Islamic Rules of Inheritance Works for Estate Tax Planning
Often, estate tax planning involves what is deceptively called “irrevocable trust” planning. That sounds like you are giving away your wealth, and when it’s gone, the Islamic Rules of Inheritance do not apply. That can be true for some Muslims. However, people who have built wealth are often not eager to give most of it away. They typically maintain control of their wealth even after they have devised various estate planning strategies.
We effectively have three standards then. The same asset may belong to Abbas for income tax purposes but not for Estate Tax purposes, but then for Islamic inheritance purposes, it is his.
A lot of how the rules apply in Islam is a function of Abbas’s intent. An Islamic Estate Planning Attorney can always structure an estate tax plan where the transfer is a “true gift,” or the rules apply because Abbas plans to control his empire longer.