Incorporating Equity Compensation into a Multi-Generational …

Creating wealth that can provide financial security for generations to come is an incredible feat, and it requires careful planning, consideration, and communication among family members. One of the most important aspects of developing a thorough estate plan is tax planning, as this has the potential to diminish the impact of your gifts and your loved ones’ inheritances. And for those with equity compensation in the mix, some extra consideration is required.

Let’s take a look at how taxes play a role in the most common wealth transfer strategies, as well as what steps you can take now to incorporate your equity compensation into your estate plan.

Wealth Transfer Strategies

Generally speaking, you have two options for transferring wealth: Gifts during your lifetime or transfers after your passing.

Let’s take a look at the tax impact and other considerations of each.

Transfer After Death

The IRS does impose a federal estate tax—though the exemption limit in 2024 is at a historically high rate of $13.61 million per taxpayer (meaning couples filing jointly can transfer up to $27.22 million before triggering federal estate taxes).¹ (the exemption amount will increase to $13.99 million per taxpayer in 2025). If your estate exceeds the exemption limit, the portion above the limit will be subject to federal estate tax, which ranges from 18% to 40%, depending on the size of your taxable estate.

In the chart below, you’ll see how much tax liability your estate may incur if it exceeds the federal exemption limit. Note that there is both a base tax charge and a marginal tax rate, which combined create your estate’s total tax liability.

Federal Estate Tax Rates²

Most people plan on transferring the majority of their estates after death. For average earners or those with modest-sized estates, doing so will not create a federal estate tax event for their estate or inheritors. Large or complex estates that exceed the federal estate tax exemption limit, however, can be subject to a hefty tax bill (as shown above).

For this reason, affluent families and high earners are generally keen on adopting tax-centric wealth transfer strategies that can both reduce the size of their taxable estate prior to death and support the financial needs of future generations.

One of the most commonly used strategies for doing so is gifting, which we’ll touch on shortly.

What About State Estate Taxes?

So far we’ve been focused on federal estate tax liability and exemption limits—but if you’re one of the “lucky” few who has established residency in a state with state-imposed estate or inheritance taxes, your estate or surviving loved ones may be hit with a double whammy of estate tax liability.

As of September 2024, the states that currently impose an estate or inheritance (or both) tax include:³

Some states match the federal estate tax exemption limit of $13.61 million per individual tax payer, but others (like Oregon) have exemption limits as low as $1 million. Another important note about state estate tax is that some states, such as New York, Illinois, and Massachusetts, will tax the entire estate’s net worth if it exceeds the exemption limit.

Say your state imposes an estate tax for estates over $1 million, and your estate is found to be worth $1.01 million. The entire estate will be subject to the estate tax, not just the $10,000 over the limit (as would be the case with federal estate tax).

Who Pays Estate Taxes?

Estate tax is intended to tax the estate itself for the privilege of transferring wealth to others—typically aside from a spouse. Therefore, any estate tax that is owed will come directly out of the estate. It is the responsibility of your estate’s executor to file the estate tax return and pay any outstanding tax liability.

While this means that your heirs wouldn’t be left with an unintended tax bill, the estate tax can, of course, reduce the amount of inheritance they receive.

For the states that impose an inheritance tax (there is no federal inheritance tax), the tax liability falls on the inheritor for the privilege of receiving the wealth—not on the estate itself.

Gifting

Other than transferring assets after death, the other primary way to transfer wealth is to gift portions of your estate during your lifetime.

So, can you sign over your entire estate to someone tax-free, as long as you’re still alive? If your estate’s net worth exceeds the federal estate exemption limit… then no, not exactly. Gifting comes with its limitations and potential tax liability—but it’s an effective tool for gradually and thoughtfully transferring wealth over time.

Every year, you are given an annual gifting exclusion. You can gift up to this amount during the calendar year without incurring federal gift tax liability (remember, any tax liability incurred is your responsibility as the “donor”). Here’s a big bonus: the annual gifting limit is per beneficiary—and there’s no limit on the number of beneficiaries you can gift to.

For 2024, the annual gifting limit is $18,000⁴ (this amount will increase to $19,000 in 2025). If you have 17 grandchildren, you could gift up to $18,000 per child—that’s $306,000 knocked off the top of your estate’s net worth. If you’re married, you and your spouse can double it since the limit is per taxpayer, not per couple.

What happens if you exceed the annual gifting exclusion limit?

As we mentioned before, if you exceed the annual exclusion limit ($18,000 for 2024), you will be required to disclose the gift on your tax return. You don’t however, have to pay a tax on the excess amount gifted (though it might feel that way, since you’re reporting it on your tax returns).

Rather, anything disclosed will be subtracted from your lifetime gift limit—which is the same as your estate tax exemption limit ($13.61 million in 2024). Any amounts subtracted from your lifetime gift limit will have the effect of reducing the amount available for your federal estate exemption amount.

The IRS does offer some exclusions, meaning in the following circumstances, you can gift above the annual limit without having to disclose it or take it from your lifetime gift exemption limit:⁵

• Directly paying someone else’s tuition
• Directly paying someone else’s medical bills
• Giving to qualified charities
• Donating to political organizations

You don’t just have to gift cash either. Gifting can include assets or property, equity (including vested stock options that are deemed transferable), bonds, and other valuable items.

However… If you are considering gifting stocks or other investments, it may be worth considering the cost basis—and namely, the potential benefit of allowing your intended recipients to inherit the equity instead.

Cost Basis Considerations

When your beneficiaries inherit investments or assets, the cost basis of those assets will be based on the fair market value of the asset on the date of your death—as opposed to the value of the asset on the date you purchased or received it.

If the investment or asset has gained value between when you obtained it and when your beneficiaries inherited it, they can benefit from what’s called a “step-up in basis.” Essentially, the cost basis is adjusted to a new value, and your inheritors don’t have to pay capital gains tax on any growth that occurred prior to death. If they wanted to, your inheritors could immediately sell the stock and enjoy little (or possibly no) capital gains tax liability.

Let’s look at an example:

Say you purchased 200 shares of Apple stock on December 31, 1999 for $0.92 a share. Then, say you died on January 2, 2024, when the stock was worth $188.44 a share.

Now, let’s assume Apple stock today is worth $200 a share and your child is ready to sell it.

If you had gifted your child that Apple stock while you were still alive, the cost basis would be based on the original value of the stock when you (the donor) bought it—$0.92 a share. That means their capital gains tax liability would be based on:

$200/share (today’s fair market value) – $0.92/share (original cost basis) = $199.08/share in capital gains

$199.08/share x 200 shares sold = $39,816 in taxable capital gains

But, if your child inherited the shares upon your death, their capital gains would be based on the step-up in cost basis.

$200/share (today’s fair market value) – $188.44/share (fair market value the day you died) = $11.56/share in capital gains

$11.56/share x 200 shares sold = $2,312 in taxable capital gains

That’s a significant difference in capital gains tax liability—certainly enough to make it worth considering the impacts of cost basis and step-up in cost basis when establishing your estate plan.

Generation-Skipping Transfer Tax (GSTT)

It is worth noting that there’s another tax consideration to be aware of as you build out your multi-generational wealth transfer plan.

If you plan on transferring wealth to your grandchildren, great-grandchildren, or grandnieces and grandnephews, your estate may be subject to a separate generation-skipping transfer tax (GSTT). The good news is, the GSTT carries the same exemption limit as the federal estate tax ($13.61 million in 2024).

Here’s where things differ: The GSTT is only reduced by lifetime gifts (above the annual gift exemption limit) if they’re made to someone 37.5 years or more younger than you (the donor).

Upstream Gifting

One gifting strategy that’s gained some momentum in recent years is called “upstream” gifting—so named because the flow of wealth is reversed.

Here’s a quick synopsis of how it works:

If your parents or other older relatives have smaller estates than you (and it’s unlikely they will surpass federal or state estate exemption limits), you would gift them a portion of your estate—most commonly, highly appreciated assets (this strategy won’t work with tax-deferred accounts). They become the owners of those assets and agree to leave them to your children—the true intended heirs—upon death. The assumption is that your older relatives will die before you, meaning your kids will receive the assets sooner than if they inherited them from you—plus, the longer you hold onto the assets, the larger they grow (in most cases).

The benefit of taking an upstream approach is two-fold. You reduce the size of your estate (if you’re approaching or exceeding the exemption limit) and your heirs can enjoy a step-up in cost basis—because remember, now they’re receiving the appreciated assets as an inheritance, not a gift.

As with any other estate planning strategy, there are some pros and cons to consider before pursuing this strategy (and you’ll likely want to run through the intended scenario with your legal and financial team first).

Namely, once you give ownership of the assets over to someone else, you have no legal claim over them. You can’t force your parents to leave the assets to your child if they don’t want to—which is why it’s important to make sure all involved parties are onboard first.

A Caveat About Current Estate Tax Exemption Limits

The current gift and estate tax exemption limits are historically high, due to the Tax Cuts and Jobs Act (TCJA) of 2017. However, the provisions outlined in the TCJA are set to sunset in 2026, meaning unless further legislation action is taken, they will return to their pre-TCJA levels indexed for inflation.

For reference, the federal estate tax exemption limit is set to revert back to $5 million (or around $7 million when adjusted for inflation).

What About Your Equity Compensation?

Your equity compensation won’t be treated all that differently from other types of equities or assets—what matters most is whether your stock options or units have vested yet.

Until your stock options or restricted stock units (RSUs) are vested, they may or may not be transferable to another person. If you own shares of an employee stock purchase plan (ESPP), however, you are generally able to transfer them to someone else.

For this reason, it’s important for employees to keep a close eye on their vesting schedule and talk to their benefits representative about their options for transferring vested shares and units. The rules are determined on a company-by-company basis, and some may limit who is allowed to receive transferred shares.

Name a Beneficiary Designation When Possible

If you have the option to name a beneficiary, do so—whether it’s for your equity compensation or other accounts like a 401(k), IRA, brokerage account, etc. A beneficiary designation will override other documents (including what’s written in your will), so it’s important that you keep your designations up to date. Even if you divorce an ex-spouse, for example, but don’t remove them as the designated beneficiary, they have legal rights to your shares or other assets after death.

Depending on your company or plan’s rules regarding beneficiaries, your named person (or entity, if you choose to designate a trust or third-party professional as the beneficiary) may be able to make decisions and take action (like exercising options or selling shares) after your passing.

Are You in the Process of Building Your Estate Plan?

For high earners or families with sizable generational wealth, strategic estate planning is the key to preservation, longevity, and future financial security. If you are an employee or business owner who receives equity compensation, it’s also important to consider how your vested and unvested options or units are treated from an estate planning perspective.

If you’d like to speak to someone about incorporating your equity compensation into your estate plan—or if you have other questions about developing and executing a multi-generational wealth transfer plan, we encourage you to reach out to our team today.

Sources:

1Estate Tax

2 A Guide to the Federal Estate Tax for 2024

3 Estate and Inheritance Taxes by State in 2024

4 Frequently asked questions on gift taxes

5 Frequently asked questions on gift taxes

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.