The Democrats of the House of Representatives have released a much-anticipated tax plan that would significantly impact the federal estate and gift tax system. Importantly, the House could still amend this legislation and the Senate is actively working on its own bill. Nevertheless, the time for estate planning is now.
Below are key takeaways from the new proposal.
Time is now of the essence for utilizing gift and estate tax exemptions. The good news is that the once-in-a-lifetime estate and gift tax exemption of $10 million as adjusted for inflation (presently $11.7 million per taxpayer or $23.4 million for married couples) will be intact through the end of 2021. The bad news is that such numbers are slated to be reduced to $5 million as adjusted for inflation (approximately $6.02 million per taxpayer or $12.04 million for married couples), effective January 1, 2022. The IRS will tax any amount transferred to certain heirs in excess of the relevant exemption number at 40%.
Clients who wish to take advantage of these historically high exemptions must act quickly. This type of planning often includes establishing new trusts and accounts in the names of those trusts. In prior years, banks have imposed strict deadlines and have often not allowed new accounts after December 1. The deadlines could be even earlier this year.
The new plan proposes to include any grantor trust—a trust where the taxpayer is the “deemed owner” for income tax purposes—in a taxpayer’s estate so that the assets would be subject to federal estate tax at the grantor’s death. In addition, sales between a grantor trust and its owner would be taxed under regular income tax rules, whereas under the current rules such sales are not recognized for federal income tax purposes.
For many years, grantor trusts have been highly effective vehicles for transferring wealth to heirs. Taxpayers have also been very successful in shifting wealth by selling assets to grantor trusts in exchange for low interest rate promissory notes. If the assets sold to a grantor trust appreciate by more than the interest rate on the note (mandated rates published by the IRS), all of such appreciation is out of the taxpayer’s estate tax free.
Fortunately, grantor trusts established and funded prior to the enactment of any new law will be grandfathered, as would promissory notes in place at the time of enactment. Of course, this further increases the pressure on estate planning lawyers and advisors to complete trusts, funding, and sale arrangements now.
It must be noted that existing grantor trusts would be grandfathered, but if a “contribution” is made to a grandfathered trust, a portion of that trust would be subject to these new rules. The new bill does not define the term “contribution.”
Note that the proposal relating to grantor trusts would be effective as of the date the legislation is enacted, which could be earlier than the end of the year. So it is even more important to act quickly in regard to this type of planning.
It is not clear how all these rules will work in practice. Below are some common types of grantor trusts that would be subject to scrutiny under the proposed tax plan.
Insurance Trusts
Insurance trusts are almost always grantor trusts. They are designed to ensure that life insurance proceeds are not subject to estate tax. Typically, the taxpayer makes annual gifts to the trust to cover the premium payments on the insurance policy owed by the trust.
Technically, existing insurance trusts will be grandfathered under the proposed tax bill. However, if the taxpayer makes additional contributions to the trust to fund insurance premiums, these contributions will result in some portion of the trust, and eventually the insurance proceeds, being taxable in the taxpayer’s estate. Following January 1, 2022, if a newly established insurance trust is deemed a “grantor trust” under the proposed plan, the death benefit on any insurance owned by the trust will be subject to estate tax, defeating the purpose of creating the trust.
Spousal Lifetime Access Trust (SLAT)
A SLAT is a trust for a spouse (and typically for descendants either at the outset or following the death of the spouse). In general, naming a spouse as a trust beneficiary results in that trust being classified as a grantor trust. As a result, under the new proposed tax plan, it will be very difficult to create an irrevocable trust for the benefit of a spouse without subjecting the assets of that trust to estate tax at the taxpayer’s death.
Grantor Retained Annuity Trusts (GRATs)
A GRAT is a common—and often effective—estate planning technique for high-net-worth taxpayers. In essence, the taxpayer transfers assets to a trust and is then entitled to a series of payments, approximately equal to the value of the contributed property, over the following two or more years. As a result, the taxpayer has made a net gift of almost zero (these are sometimes called “zeroed out GRATs”) which uses little of the taxpayer’s gift and estate tax exemption. If the assets appreciate, and the grantor survives the annuity term, substantially all of that appreciation can pass estate and gift tax free to the next generation.
However, under the proposed tax plan, it appears GRATs will no longer effectively shift assets to the next generation. In contrast to current rules, at the end of the annuity term, if a GRAT transfers assets to a continuing grantor trust, these assets will still be subject to estate tax. If assets pass to a non-grantor trust or to children outright, the transferor will be treated as making a gift equal to the value of the transferred property—an undesirable result. In either situation, a GRAT offers no benefits. The taxpayer would be better off simply making gifts directly to their children or nongrantor trusts at the outset. Furthermore, under the new legislation, if a grantor uses appreciated assets to make a required annuity payment to a grantor, that payment would constitute a deemed sale and force an unwanted capital gains event.
The proposed tax plan would also drastically restrict the use of discounts in valuing closely held business interests.
Currently, taxpayers can get a valuation discount on investment assets, including publicly traded stock, by “wrapping” such assets inside an LLC or another entity and then transferring interests in such entity to other family members or trusts for their benefit. Appraisers will discount these minority interests since none of the owners can control the entity.
The new law would preclude valuation discounts for minority interests in LLC or limited partnerships, at least for “passive” assets. The proposed tax bill would still allow discounts for assets used in “active businesses”—an apparent concession to concerns raised by family farms and other family businesses.
In addition, determining whether an asset is “passive” or “active” under the proposed restriction on valuation discounts is also likely to be difficult, especially in cases where a taxpayer has both types of assets.
The legislation does not address dynasty trusts, which are trusts that can be used to pass wealth from generation to generation without ever having to pay estate, gift, or generation-skipping transfer taxes. There was discussion of taxing these trusts every certain number of years, but that provision did not make it into the tax plan.
The plan also currently excludes President Joseph Biden’s proposal to impose capital gains on appreciated assets held by taxpayers at death, which would end a benefit known as a step-up in basis.
Please contact the authors or your Morgan Lewis contact immediately if you would like to discuss further, ahead of busy year-end planning due to these proposals.
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If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Boston
Laura B. Lerner
Sara Wells
Philadelphia
Daniel R. Cooper
Christina Mesires Fournaris
Francis J. Mirabello