Summary of Proposed Federal Estate and Gift Tax Changes

Posted: October 20, 2021

Note: This summary is presented as general information for clients and others and is not intended to constitute legal advice. This summary only pertains to legislation in draft form as of the date of publication, and will undoubtedly change if/when the legislation moves through the U.S. Congress. We would be pleased to meet with clients and discuss what action, if any, we might recommend and assist you in the implementation of that action.

The House Ways and Means Committee released its tax law proposal (the “House Proposal”) to be incorporated in a budget reconciliation bill on Monday, September 13, 2021. The House Proposal, if enacted in its present form, could have a significant and adverse impact on estate planning and result in increased exposure to federal estate and gift taxes.

Among the provisions of the House Proposal are some of the following:

The estate and gift tax exemption, currently $11,700,000, would be reduced on January 1, 2022 to approximately $6,030,000, which will make many more estates subject to estate tax.
The use of a number of planning techniques used to reduce estate and gift taxes, including the use of irrevocable grantor trusts, including life insurance trusts, Spousal Limited Access Trusts (SLATs), Qualified Personal Residence Trust (QPRTs), Grantor Retained Annuity Trusts (GRATs), and Charitable Annuity Lead Trusts (CLATs), would be substantially curtailed or eliminated.
The use of discounts to reduce the amount of the value of an interest in an entity, such as LLCs, partnerships or corporations, that hold assets other than an “active trade or business” will be effectively eliminated.
There are significant increases in income tax rates, including capital gains.

If the House Proposal is enacted and becomes law, certain of the provisions have differing effective dates, including the date of enactment (when the President signs the legislation into law). Clients who may be affected by the House Proposal, should it become law, should consider if steps should be taken now. These may include, among other things the following:

Planning before the House Proposal is Enacted^{^[1]}

Clients who expect to have taxable estates if the proposal becomes law (individuals with estates of at least $6,000,000, or married couples with combined estates of at least $12,000,000) should consider whether to make gifts or other transfers. If a grantor trust is used or if valuation discounts are sought for gifts of ownership in an entity (such as a corporation, LLC, or partnership), such gifts should be completed prior to enactment of the Proposal. Other gifts would need to be completed prior to January 1, 2022.

Clients who were considering Spousal Limited Access Trusts (“SLATs”), Grantor Retained Annuity Trusts (“GRATs”), or sales of discounted partnership or LLC interests using their remaining gift, estate, and generation skipping transfer tax exclusions, selling assets to a grantor trust, or substituting assets into a grantor trust for other assets of equivalent value^[2] (if authorized in such grantor trust), should act now before enactment.

For those concerned about asset protection planning, inter vivos QTIP trusts can provide excellent results. However, creating inter vivos QTIP trusts before enactment is necessary to avoid the possibility of double estate tax inclusion should the creator die before his or her spouse.

Clients with family limited partnerships and/or limited liability companies that hold passive assets should consider whether gifts or sales of partnership or LLC interests should be made before enactment.

Life insurance trusts should be established and policies transferred before enactment. For existing life insurance trusts, consider gifting sufficient other assets to pay future premiums.

Clients who have used their entire gift tax exemption but have generation skipping tax ("GST") exemption remaining may make a gift equal to their remaining GST exemption and pay the gift tax on such gift and, provided the donor lives three years from the date of the gift, the gift tax paid will be removed from the donor’s estate.

Additional Information on House Provisions

Federal Estate Tax Rate

Under the current proposal the estate tax remains at a flat rate of 40%.

Reduced Exemption Amount

Current $11.7 million gift and estate tax exemption could be reduced to approximately $6.03 million after December 31, 2021.

There will be no “clawback” for use of the increased exclusion amount, meaning that a person will not be penalized for gifting $11,000,000 of assets if she passes away in a year when the applicable exclusion amount is $6,000,000.

Taxpayers will only fully benefit from current exemptions by using their entire $11.7 million exemption (reduced by prior taxable gifts) as compared to making a gift of, for example, $5,670,000, which will not result in the full effective use of the current $11.7 million exemption.

Example: Assume estate value of $21,000,000, $700,000 prior use of exclusion, currently leaving $11,000,000 of exclusion.

Gift in 2021 of $5,000,000. Death in 2022. Estate is 16,000,000, Exemption $1,000,000. Estate Tax ($15,000,000 X 40%) $6,000,000.

Gift in 2021 of $11,000,000. Death in 2022. Estate is 10,000,000, Exemption $0. Estate Tax ($10,000,000 X 40%) $4,000,000.

Gift in 2021 of $0. Death in 2022. Estate is 21,000,000, Exemption $5,300,000. Estate Tax ($15,700,000 x 40% = $6,280,000)

Those who decide that they cannot gift the full $11,700,000 may still be well advised to gift what they are comfortable with to get future growth in value out of the estate and to gift limited liability company or partnership interests when possible in order to lock in discounts that may not apply once the new Act is passed, and to make the gifts to Grantor Trusts while there is time to do so.

Discounts on Gifts

The new bill would also eliminate discounts after the date of enactment unless the asset gifted or sold is an “active trade or business”.

The House Proposal seeks to limit the estate and gift tax valuation discounts applied to transfers of closely-held non-business assets. This provision is designed to limit the strategy of creating family limited partnerships to hold passive assets (i.e., a portfolio of stocks, bonds, mutual funds, any like type assets), and have the partnership valued for gift and estate tax purposes at a lesser value due to discounts for lack of marketability and minority interests. The Proposal defines “non-business assets” as passive-type assets, which is held for the production or collection of income and is not used in the active conduct of a trade or business. In other words, forming a family limited partnership or limited liability company and funding it with marketable securities would no longer be a viable technique for transferring marketable securities at a discounted value. This provision, if enacted, would apply to transfers after the date of enactment. Included in the valuation discount prohibition rule is passive real estate held in partnerships and LLCs. Currently, it appears that fractional gifts of interests in real estate (not owned in a business entity) could still qualify for valuation discounts, but such transfers could create catastrophic title issues such as where one owner of a small fractional interest does not agree to a sale or if such an interest is conveyed upon divorce to an ex-spouse.

Irrevocable Grantor Trusts

Grantor Trust Provisions in House Proposal - Estate Tax Inclusion (effective date: trusts created on or after the date of enactment (or to any portion of a trust that was created before the date of enactment which is attributable to a contribution made on or after the date of enactment)):

New Section 2901 to the Code:

· Includes in a grantor’s taxable estate any portion of a grantor trust’s assets of which the person is the “deemed owner” for income tax purposes.

· Treats a distribution made from a grantor trust as a gift, unless (a) the distribution is made to the grantor’s spouse or (b) the distribution discharges an obligation of the deemed owner.

· Provides that if the trust’s grantor status is terminated during the grantor’s lifetime, the assets will be treated as being gifted at that time by the grantor.

Grantor Trust Provisions in House Proposal - Income Taxation on Sales to Grantor Trusts (effective date: trusts created on or after the date of enactment (or to any portion of a trust that was created before the date of enactment which is attributable to a contribution made on or after the date of enactment)): Under existing law, when a grantor sells appreciated assets to a grantor trust, no capital gain is triggered. In addition, under existing law, the “swap” or “substitution” of assets of equal value for assets in a grantor trust does not trigger capital gain. The House Proposal would add new Section 1062 to the Code, which would require gain to be recognized on sales of appreciated assets to a grantor trust, but deny the recognition of a loss. Under new Section 1062, if enacted, “swap” or “substitution” transactions would no longer be free of capital gains tax consequences as to post enactment created grantor trusts. Furthermore, if a post-enactment “contribution” is made to a grandfathered trust a portion of that trust would be subject to these new rules. The term “contribution” is not defined and has caused much confusion, especially as to existing life insurance trusts where the trust creator typically makes annual trust contributions to pay the current year’s life insurance premium. The provision is generally effective for (1) trusts created on or after the date of enactment and (2) any portion of a trust established before the date of enactment that is attributable to a contribution made on or after such date. The portion of the provision relating to sales and exchanges between a deemed owner and a grantor trust is intended to be effective for sales and other dispositions after the date of enactment.

Trusts that are to be created to take advantage of the current gift and estate tax exemption must be executed before enactment of the House Proposal in its final form, which could possibly be much earlier that December 31, 2021.

Life Insurance Trusts

Life insurance trusts are generally considered to be grantor trusts under Section 677(a)(3) of the Code which states that a trust shall be considered owned by the grantor if income from the trust may be applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse.

As a grantor trust, contributions to the trust for the payment of premiums after the date of enactment may cause a portion of the trust, and ultimately the policy proceeds, to be included in the grantor’s estate. In addition, a life insurance trust established after the date of enactment could be ineffective to take life insurance out of the grantor’s estate.

QPRTs

Qualified Personal Resident Trusts ("QPRTs") that are entered into and funded by deed before the date of enactment will be grandfathered to receive the above benefits, but those that are executed and funded by deed after the date of enactment will lead to gain being recognized as if the property was considered to have been sold to the trust upon contribution, and then considered to be a gift by the Grantor following the possessory term when the property is transferred to the beneficiaries, although a credit may be received for gift taxes paid on the initial transfer when the second transfer occurs.

GRATs

A Grantor Retained Annuity Trust ("GRAT") is treated as a Grantor Trust while the Grantor is receiving annual payments, and can be considered to be a Grantor Trust thereafter, if drafted to facilitate that result.

Under the proposed new rules, the funding of a GRAT after the date that the law would be enacted could cause income tax to be imposed on the excess of the fair market value of the assets placed into the GRAT over the tax basis of such assets. Further, the excess value remaining after the GRAT term may be considered a gift when distributed, notwithstanding that Internal Revenue Code Section 2702 maintains under present law that no gift results when the actuarial value of the annual payments made to the Grantor equals the value of assets placed into the Trust.

While 2, 3 and 4 year GRATs have been most common, longer term GRATs will lock in values for a longer period of time and should be more popular before the new law passes. Most planners will prefer to use long term installment sales to Grantor Trusts, for this reason, but GRAT’s will normally be used when the risk of gift tax is high, or the value of assets is above what would typically fit under an installment sale.

CLATs

A Charitable Lead Annuity Trust (“CLAT”) functions in a manner similar to a GRAT, except that the fixed annual payments will go to a charity, and assets remaining in the CLAT after the term of years can be held for to family members without being considered to be a gift.

A Grantor CLAT is a variation of a CLAT that is drafted to be disregarded for income tax purposes to allow for an income tax deduction on funding, which causes the Grantor to be subject to income tax on the CLAT’s income during the charitable payment term.

Grantor CLATs that are funded after the date of enactment may trigger income tax on the excess of the fair market value of the assets placed in the GRAT over the income tax basis, with the remainder interest passing to descendants being subject to federal gift tax when the payments to charity end.

Income Tax Rates

Tax rates: The top marginal individual income tax rate would increase from 37% to 39.6%. This marginal rate would apply to married individuals filing jointly with taxable income over $450,000; to heads of household with taxable income over $425,000; to unmarried individuals with taxable income over $400,000; to married individuals filing separate returns with taxable income over $225,000; and to estates and trusts with taxable income over $12,500.

High-income surcharge: The House Proposal would impose a surcharge tax equal to 3% of a taxpayer's modified adjusted gross income (MAGI) in excess of $5 million (or in excess of $2.5 million for a married individual filing separately). For this purpose, modified adjusted gross income means adjusted gross income reduced by any deduction allowed for investment interest (as defined in section 163(d)).

Capital gains: The House Proposal would increase the 20% tax rate on capital gains to 25%, effective for tax years ending after September 13, 2021 (note that President Biden had considered a 40% capital gains tax). However, a transition rule would provide that the current statutory rate of 20% would continue to apply to gains and losses for the portion of the tax year prior to September 13, 2021 and gains recognized after September 13, 2021 that arise from transactions entered into before September 13, 2021 pursuant to a written binding contract (and which is not modified thereafter in any material respect). Note: Most capital gains are also subject to an additional 3.8% tax.

Non-grantor irrevocable trusts (“non-grantor trusts”) may have increased income taxes from the tax proposals:

· Taxable income retained by a non-grantor trust above $12,500 will be subject to a tax rate of 39.6%. To put the impact of this in perspective, the taxable income of married individuals filing jointly will not be subject to the 39.6% tax rate until it exceeds $450,000.

· Modified Adjusted Gross Income above $100,000 of a non-grantor trust will be subject to a surcharge of 3%.

· With the 3.8% Net Investment Income Tax, the 3% Surcharge, and the 39.6% top tax rate, some non-grantor trusts will be subject to a 46.4% tax rate.

Retirement Plans

IRA and Retirement Plan Provisions: The House Proposal creates significant tax increases, accelerates taxable withdrawals, and prohibits additions to IRAs of high-income taxpayers who already have retirement assets in excess of $10 million and other modifications described below. If the House Proposal is enacted, taxpayers must consult with their retirement plan advisors to make sure they are in compliance.

Contributions to IRAs: The House Proposal would prohibit further contributions to a Roth or traditional IRA for a tax year if the total value of an individual's IRA and defined contribution retirement accounts generally exceeds $10 million as of the end of the prior tax year. The limit on contributions would only apply to single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of household with taxable income over $425,000 (all indexed for inflation) (“high-income taxpayers”).

Required Minimum Distributions: For high-income taxpayers, as defined in the preceding item, whose combined traditional IRA, Roth IRA, and defined contribution retirement account balances generally exceed $10 million at the end of a tax year, a minimum distribution would be required for the following year as follows:

· If the individual's prior-year aggregate traditional IRA, Roth IRA, and defined contribution account balance exceeds the $10 million limit, but is less than $20 million, 50% of the value in excess above $10 million must be distributed as taxable income.

· If the individual’s prior-year aggregate traditional IRA, Roth IRA, and defined contribution account balance exceeds $20 million, 100% of the value in excess above $20 million must be distributed as taxable income.

Roth conversions: The House Proposal would eliminate Roth conversions for both IRAs and employer-sponsored plans for single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of household with taxable income over $425,000 (all indexed for inflation). This provision would apply to distributions, transfers, and contributions made in taxable years beginning after December 31, 2021. This provision would also prohibit all employee after-tax contributions in qualified plans and after-tax IRA contributions from being converted to Roth regardless of income level effective for distributions, transfers, and contributions made after December 31, 2021.

[1] The date of enactment of the House Proposal, if it is enacted, is unknown and cannot be predicted.

[2] If the existing Irrevocable Grantor Trust will not be included in the grantor’s estate, there is no step up in basis at death of grantor. Consider substituting assets with greater adjusted basis relative to value for highly appreciated assets.