Tax Proposal Could Bring Sweeping Changes to Estate Planning
On Sunday, September 12, 2021, the House Ways and Means Committee released a first draft of proposed tax legislation, including several provisions that could significantly impact the estate planning environment. The new tax plan, part of President Biden and Congressional Democrats’ $3.5 trillion budget and spending package, would increase taxes on the wealthy and potentially curtail the use of certain estate planning techniques. While the legislative process may result in modification or even removal of some of the provisions included in the draft legislation, estate planners should consider taking action now before any changes become effective.
Decrease in Lifetime Exemption
One of the revenue-raising provisions included in the proposed bill is a reduction in the estate and gift tax exemption amount which, as of tax year 2021, allows an individual to transfer up to $11,700,000 tax-free during life or at death. The draft bill would cut this amount in half as of January 1, 2022. As the amount is adjusted for inflation, this may result in a new exemption amount of approximately $6,000,000. This reduction is already set to take place on January 1, 2026 under current law, so the proposal would simply serve to move the scheduled change up by four years.
Note: There is no “clawback” provision, meaning that gifts made up to the $11,700,000 limit before the decrease becomes effective on January 1, 2022, would not be retroactively subject to tax if the donor were to then pass away after the exemption amount is reduced. As a result, wealthy individuals with unused estate and gift tax exemption should consider making gifts before year-end to take advantage of the more generous exemption amounts under current law.
Grantor Trust Limitations
The proposed legislation includes several provisions intended to limit the use of grantor trusts, which are commonly used to remove assets from an individual’s estate in a tax-efficient manner. If structured properly, then the transfer of an appreciating asset into a grantor trust combined with the use of valuation discounts can result in significant estate tax savings. The proposed law seeks to effectively end the use of grantor trusts for estate planning purposes, as new Section 2901 would cause assets held by a grantor trust created after the date of enactment to be included in a decedent’s taxable estate. Previously existing grantor trusts would be “grandfathered” in and their assets would generally not be includible in the taxable estate, although the grandfathering provision would not apply to any contributions made to the trust after the date of enactment.
Note: Many of the provisions of the proposed legislation, including the grantor trust provisions, would be effective on the date of enactment of the law. There are several steps required before the bill can become law, and its ultimate passage could still be several weeks away. Since the actual date remains unknown, taxpayers who wish to take advantage of the existing grantor trust rules should begin the process of making any additional transfers or drafting new trust documents as soon as possible.
In addition to the inclusion of trust assets in a grantor’s taxable estate, the new law would also cause any distribution to a beneficiary other than to the grantor or the grantor’s spouse, or to discharge a debt of the grantor, to be treated as a taxable gift. Similarly, assets held by a trust that ceases to be treated as a grantor trust for tax purposes (for example, due to the grantor’s renunciation of certain powers over the trust) would also be treated as a taxable gift of the grantor.
A second staple of estate planning that is being targeted by the proposed legislation is the sale between a grantor trust and its deemed owner, which under prior law did not result in a taxable gain to the grantor since the transaction was disregarded for tax purposes. New IRC Section 1062 would change this by causing these sales to be treated in the same manner as a sale between the owner of the assets and a third party. This provision would further limit the usefulness of grantor trusts by causing any sale of assets to a grantor trust as a gain to be subject to immediate income tax, while any losses would be disallowed. Sales made to grantor trusts (other than revocable trusts) created after the date of enactment would be subject to the new rules; the language of Section 1062 leaves some uncertainty as to whether sales to existing trusts would still qualify as tax-free transactions.
Note: A common estate planning technique under prior law was to sell assets into a so-called “intentionally defective” grantor trust (that is, a trust with a “defect” causing it to be treated as a grantor trust for income tax purposes, while still being respected as a completed transfer for estate tax purposes) in exchange for a low-interest-rate promissory note. This strategy would be rendered effectively useless under the House proposal. Not only would the initial sale of assets be subject to immediate income tax, but it appears that the assets held by the grantor trust would still be included in the grantor’s taxable estate at death.
Valuation Rules for Certain Non-Business Assets
As referenced earlier, the use of valuation discounts has historically been a powerful tool for wealthy individuals to transfer assets to future generations while minimizing the value of those assets for gift and estate tax purposes. To be able to utilize these discounts, the donor would first place the assets in a limited partnership or limited liability company and subsequently transfer a non-controlling ownership interest in the entity (rather than directly transferring the assets). Depending on the types of discounts applied and several other factors, this technique could result in the value of the gift being discounted in the range of 25% to 45%.
The proposed law contains a provision that would prohibit the use of valuation discounts for entities holding non-business assets, such as marketable securities or triple net lease real estate. As a result, the use of limited partnerships or limited liability companies would no longer be an effective estate planning tool for transferring these types of assets. The provision would not affect the valuation of business assets, so valuation discounts could still be applied to ownership interests in operating businesses. Similar to the new grantor trust rules, this change would also be effective as of the date of enactment.
Note: The language of the proposed legislation specifically applies to transfers of interests in entities holding non-business assets. There are certain circumstances where valuation discounts are appropriate for non-business assets held outside of an entity, such as a transfer of a partial interest in real estate. It appears that the use of discounts for these types of transfers would still be allowed.
The raft of proposed changes included in the House Ways and Means Committee’s proposed legislation will have a significant impact on estate planning if and when the bill is passed. Although the ultimate timing and outcome of the legislative process is unknown at this point, individuals and their estate planners should consider utilizing some of the more favorable provisions under current tax law while they are still available. Careful attention must also be paid to the effective dates of the various provisions to ensure that any transactions are completed in a timely manner.
While time may be running short on several of the “use-it-or-lose-it” estate and gift tax benefits, any decisions should be carefully considered and made in consultation with a professional estate tax planner. For additional guidance on these potential changes, please contact your Bennett Thrasher Tax advisor by calling 770.396.2200.