Income tax vs. estate tax: Minimizing your overall tax burden

How can you best plan for the tax responsibilities of generational wealth? It all starts at the intersection of two tax systems: income taxes and transfer taxes (estate, gift and generation-skipping transfer taxes). Balancing the impact of these two systems is critical to the wealth planning process.

You are likely familiar with the demands of federal, state and local income taxes. Depending on your income, the federal income tax rate on ordinary income, such as wages, can be as high as 37%. Federal capital gains taxes on investment appreciation can be as high as 20%. In addition, the net investment income tax can apply at 3.8%, depending on your income level.

In terms of transfer taxes, the good news is that the federal estate and gift tax exemption currently is $13.61 million per person, or $27.22 million for a married couple, although the exemption amount is scheduled to be cut in half at the end of 2025 unless congress acts.

The bad news is there's a 40% tax on anything above that exemption amount. If you choose to pass any assets down to grandchildren or future generations, the federal generation-skipping transfer tax can apply to gifts above the exemption level.

In this Q&A, we'll answer common questions on navigating this tax landscape.   

Q: What’s the best way to approach income tax vs. estate tax?

I like to look at these taxes one at a time. It’s often simpler to start with the estate tax. Are you going to land above the federal estate tax exemption? If you are under the threshold amount ($13.61 million per person or $27.22 million per married couple), you generally can turn your focus to the income tax because the estate tax is less of a danger.

In this situation, we usually recommend that families keep assets in their estate because the tax benefit will be greater. Through what’s called the step-up basis, assets that have increased in value are appraised at the current value at the time of your death. So, all your unrealized capital gains disappear. If you were instead to gift those assets during your lifetime, you would lose out on this tax benefit.

Another option to mitigate capital gains tax is to gift assets to a senior generation, such as a parent, where you will ultimately be the beneficiary of the estate. If you gift to an older generation and you inherit those assets back later, the tax on the unrealized capital gains goes away because the cost basis is stepped up when those assets are passed back to you.

Q: What if my assets will be subject to estate tax?

This is where we begin to review some more sophisticated strategies to efficiently transfer wealth. This concern has become greater the closer we get to 2026, because the gift and estate tax exemption is scheduled to be cut in half at that point unless there is legislative action beforehand. The goal is to move assets out of your estate sooner rather than later, because, as noted above, anything left in your estate when you die that’s above the tax-free exemption will be taxed at 40%.

Bear in mind that when you make that gift, you lose the benefit of the step-up in cost basis for income tax purposes. So, the key is to be selective in what you gift. You may not have the luxury to pick and choose, but it’s important to review the possibilities to be certain you are making the most tax-effective decision.

Q: What if my estate is not subject to estate tax now, but it might be in the future?

It’s common for some people, such as business owners or early investors in startups, to expect to have significant asset growth in the future that may put their net worth into estate tax territory. In this case we think about if or when they will need those assets. We often recommend moving assets out of the estate early so any future growth can take place outside of the estate. This may entail setting up irrevocable trusts, perhaps in a tax-friendly jurisdiction such as Delaware.

For example, a business owner we worked with recently transferred his private company shares into an irrevocable trust for the benefit of his children. This had both an estate tax and an income tax benefit. Gifting the shares was important to mitigate estate taxes since it moved the assets out of his estate and into the trust. By gifting the shares early, he did so when the shares had a lower valuation and therefore used less of his tax-free exemption amount.

On the income tax side, his company was a U.S. C Corporation with less than $50 million in gross assets, so it qualified as Qualified Small Business Stock (QSBS) exclusion. By gifting the stock to a trust that was a separate taxpayer, he was able to multiply the $10 million federal capital gain exclusion that would apply if and when he sold the stock. There are specific requirements around this exclusion, so it doesn’t apply to everyone, but it helped in this case. (For more information on QSBS, see the article How to Take Advantage of the Qualified Small Business Stock Exclusion.)

Q: What are important tax considerations when selling a business?

A major liquidity event such as a business sale ideally would be planned well in advance to maximize tax savings. You don’t have to precisely plan the date but thinking about it in advance allows you to maximize tax mitigation strategies and plan for the wealth that can potentially be transferred to heirs, whether before or after a sale.

It’s important to maximize the value of the business for the sale, but it is also important not to miss opportunities for tax mitigation. For estate tax purposes, typically, we want to plan gifting strategies early in the process, capturing them when the valuation of the business is still as low as possible. For income tax purposes, there are a range of strategies that can be considered to limit capital gains taxes.

We also step back and look at the bigger picture to understand the broader issues that come into play for the family. We want to help them think about what their post-retirement lifestyle needs will be and what their cashflow needs will be. All of this impacts the decisions on gifting and transfers. Our goal is to personalize a strategy to put them in the best position now and in the future.

Q: What if I have already sold the business. Is it too late to plan?

Rarely is anyone able to plan everything in advance. Inevitably you run out of time to get it all done in advance, but there is also planning that can be done post-sale.

For example, after the sale, it is still possible to make charitable gifts that can offset the capital gains from the sale if you do it in the same year. After a sale can be the time to discuss their future charitable goals with spouses and children.  Clients will often want to do a large charitable gift in the year of sale to a private foundation or a donor advised fund, which can then fund their charitable giving for a long time after the sale.

Donor advised funds have become more popular in the past decade because they are simple to create. You can name it for the family if desired, such as “The Smith Fund” or “The Smith Foundation.” You can call it whatever you would like.

There can be more complexity to a private foundation. There are ongoing administrative needs and ongoing expenses. For example, you must pay out a distribution of 5% of the foundation’s assets every year, which is not the case with a donor advised fund.

Q: What tax planning advice do you have for clients who have already done significant planning and have various irrevocable trusts as part of their financial picture?

The first thing we consider is who pays the income taxes on the trust assets. We want to determine how to reduce income taxes on each trust where feasible.

If the trust is a “grantor” trust, the grantor pays all the taxes related to the trust and the trust income is rolled up onto his or her personal return and any taxes on trust income are paid at the grantor’s rate.

If the trust is a “non-grantor” trust, either the trust bears the income tax, or, if income is distributed to the beneficiary, the beneficiary pays the tax on the income he or she receives. This presents an income tax planning opportunity for non-grantor trusts since trusts reach the highest marginal income tax rate at a much faster pace than individuals. For example, the highest marginal income tax rate for both individuals and trusts is 37%, but an individual reaches the 37% at bracket when he or she has taxable income over about $609,350. A trust, on the other hand, reaches that same 37% bracket when it has taxable income over $15,200.

Cleary, then, if a beneficiary is in a lower tax bracket than the trust--and most beneficiaries are--it will make sense for the trustee to distribute all or part of the income to the beneficiary so that the distributed income can be taxed at a lower rate than it would be taxed if it had stayed in the trust.

To add flexibility, the IRS gives trustees an extra 65 days at the end of each year to determine a trust’s taxable income for the prior tax year and to distribute income to beneficiaries. Depending on the tax implications each year, we can help trustees and beneficiaries determine the optimal tax savings. 

Q: What is the best way to manage the capital gains tax burden of a trust?

Many trusts hold assets with unrealized gains because the grantor initially gifted them with a low basis which carried over to the trust. Other times the assets may have a low basis simply because they've been held in the trust for a long time and there has been significant appreciation since the trust was funded.

One of the things we often discuss with clients is whether we can swap assets.

The tax code allows the grantor to swap assets out of a “grantor” trust without a tax recognition event. So, if the grantor has assets outside the trust with a higher cost basis, they could swap those assets with ones in the trust, decreasing the capital gains tax liability for the beneficiaries.

And, the lower cost basis assets that remain in the grantor’s name will get a step-up in basis at the grantor’s death, which they otherwise would not have received if they had been held in the trust.

Another simple strategy we often recommend is to move the trust to a state that does not impose income tax. For example, a New York resident trust is subject to tax on its income and capital gains at rates ranging from 4% to 10.9%. Moving the trust to Delaware, which does not tax trust income or capital gains, can eliminate these taxes in certain circumstances. There are specific requirements relating to trustee domicile, the location of real and tangible property held in the trust, and all trust income being sourced outside of New York, but as long as these are met this strategy can save significant taxes for beneficiaries.

Q: When do I need to worry about the generation-skipping transfer (GST) tax?

The GST tax comes into play when assets skip a generation -- for example, when assets pass from you to your grandchildren, skipping your children. It also can be levied if there is an indirect step -- for example when assets held in trust for your children pass to your grandchildren.

There is an exemption for the GST tax, though, which is the same as the estate and gift tax exemption. In 2024, the GST exemption is $13.61 million per person, and it can be allocated to outright gifts to grandchildren or to trusts where grandchildren are current or future beneficiaries.

If the exemption applies to all the assets of a trust, the trust can pass to multiple future generations without ever incurring a GST tax. Often, we'll have clients who are beneficiaries of both exempt and non-exempt trusts. The first trust contains GST-exempt assets, while the second holds the balance of assets in a non-exempt trust. Assets in that non-exempt trust are taxed at a 40% tax rate when they pass from one generation to the next, so we try to manage that and minimize it where possible. One easy way is to spend down the non-exempt trust before distributing assets from a GST-exempt trust.

There also are certain qualified transfers, for things like tuition and healthcare expenses, that can be made to anybody from a non-exempt trust, including grandchildren or other descendants, without incurring the GST tax.

Also, we may consider distributing all or part of a non-exempt trust to the beneficiary so the beneficiary can then gift to the next generation using his own estate and gift tax exemption. We worked recently with a client where we distributed enough assets from a non-exempt trust to her, so that she could gift assets to an exempt dynasty trust for her children. This gave her the ability to use both her current GST exemption and her estate and gift tax exemption amounts before they are potentially cut in half in 2026.