Estate Tax Law Changes – What To Do Now
The opportunity to make proper use of the present $11,700,000 Federal Gift Tax exemption, and the opportunity to fund and sell to Grantor Trusts, form and fund Grantor Retained Annuity Trusts, fund Qualified Personal Residence Trusts and other planning techniques, may be gone in a matter of days.
As of this writing, the 881 page Build Back Better Act introduced in the House of Representatives on September 8, 2021 remains a hot potato. While Republicans lob grenades from outside the fence, Democrats are engaged in mortal combat to pass a $1.2 Trillion bi-partisan infrastructure bill, AND the $3.5 Trillion Build Back Better Act. President Biden and House and Senate Democrats are furiously negotiating how to spend the $4.7 Trillion, but virtually no one is talking about the tax law changes that are proposed to “cover it”.
While providing a comprehensive and extensive summary or analysis of all the proposed new laws would prove to be cumbersome, especially since the terms of any bill can be expected to be materially different than the original House bill, this letter will cover many of the primary changes, points of confusion, and effective dates provided in the proposed legislation as they relate to estate tax planning, along with some key planning ideas.
A few of the new rules would impact transactions or transfers made even before the new Act would be enacted, whereas several provisions would not become effective until January 1, 2022. Many of the draconian changes will be effective on the date of enactment. Significantly, for those that wish to transfer wealth to irrevocable “Grantor Trusts” that are disregarded for income tax purposes before the exemption amounts are cut in half, it is necessary to act by the day that the law is enacted. Alternatively, based on the plain language of the bill, potentially affected individuals may plan to gift such amounts to individuals or entities other than grantor trusts, if they do this after the date of enactment and before year end.
The law of “survival of the fittest” will cause many wealthy families to lose a large portion of their net worth to estate tax, while smarter and properly situated families may have little to no estate tax. The train may be leaving the station very soon, leaving much wealth exposed, so please contact us without delay to discuss the impact of these proposals and to complete any planning that is in progress.
Below is a section by section analysis of the major proposed changes and effective dates, and thoughts relating to actions to take or not take while we wait to see what changes are made to the Bill, and whether any substantial bill will be passed this year, and if so when (the Manchin/Sinema factor). While all of this is subject to change, we do not expect to see anything more severe or taxpayer unfriendly than the House bill, and it could have been a lot worse.
The first in priority on the list of action items for many wealthy American families is to get their houses in order in preparation for increased federal estate taxes. After months of being presented with the prospect of a lower estate tax exemption, and the possibility that the exemption would come down before there was time to make large gifts, the reality of what is proposed should have sunk in by now, and action needs to be taken.
A. Use It or Lose It – Estate/Gift Tax Exemption Cut in Half Effective January 1, 2022
The good news on this front is that the reduction of the estate and gift tax exemption from
$10,000,000, as adjusted for chained inflation (presently $11,700,000 per person), will be intact through the end of 2021. The bad news is it will be reduced to one half of the applicable amount effective January 1st, 2022. This means that the “use it or lose it” gifting decisions for wealthy individuals can be made up through the end of this year, but most well advised wealthy families will be better off making such gifts before such legislation is passed, because of the Grantor Trust and discount rules that would be changed as of the date of enactment.
As an example, Alice has used $700,000 of her estate and gift tax exemption from prior gifting, and therefore has an $11,000,000 exemption remaining that she may wish to use prior to the end of the year. If she has a $21,000,000 estate and makes an $11,000,000 gift, her remaining estate will be $10,000,000. If Alice then dies in 2022, or thereafter, she would have no exemption remaining, and the estate tax will be $4,000,000 ($10,000,000 x 40% = $4,000,000). Fortunately, the proposed law would not increase the estate tax rate the way that the Bernie Sanders bill would have.
Alternatively, if Alice does no gifting in 2021 and dies in 2022, or thereafter, when the exemption would be based upon one half of $11,700,000 adjusted for inflation (perhaps $6,000,000), then her estate will be $21,000,000 reduced by her remaining exemption amount of $5,300,000 ($6,000,000 less prior gifts of $700,000), and estate taxes of $6,280,000 ($15,700,000 x 40% = $6,280,000) will be owed to Uncle Sam 9 months after her death. It will not feel good to stroke that check for $6,280,000, when it could have been $4,000,000, and the $2,280,000 difference does not take into account the growth of Alice’s estate, which would be expected to make the difference greater.
B. No Clawback.
It is important to note that there will be no “clawback” for use of the increased exclusion amount, meaning that Alice 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.
C. Lost Opportunity If You Use Less Than Half and Uncle Sam Gets a Laugh.
Another factor that warrants consideration is that in order to use the temporary increased exemption, gifts must exceed what the exemption will be reduced to. For example, if Alice were to gift $5,000,000 in 2021 when the applicable exclusion amount is $11,700,000 and then pass away in 2022, or thereafter, when the applicable exclusion amount is only $6,000,000, Alice’s applicable exclusion amount would only be $1,000,000. Therefore, in order to take full advantage of the increased exemption, Alice will need to gift all $11,000,000 of her remaining exclusion. That being said, those who decide that they cannot afford to 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, 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.
The good news is that families will have until the end of this year to make large gifts if the law passes. The bad news is that very important trusts and other tools that we commonly use for gifting and estate tax planning may be lost before then – read on.
II. Is A Grantor Trust Really A Must?
Grantor Trusts can be separate and apart from the Grantor and contributor of the trust for estate tax purposes, while still considered as owned by the Grantor for income tax purposes. Because of this dichotomy allowing the Grantor to be the “owner” of the trust for income tax purposes, transactions between the trusts and the grantor are “disregarded,” meaning that assets can be sold or exchanged with the trusts and the trusts can pay interest on low interest notes owed to the Grantor without triggering any income tax consequences.
The majority of well positioned wealthy clients who have engaged in estate planning have established “Grantor” trusts, which permit the Grantor to pay the income tax on the trust assets on behalf of the beneficiaries, and also allow the Grantor to sell assets that may qualify for a discount, such as non-voting LLC interests for long term low interest notes without paying any income taxes on the sale. The numbers can be startling where instead of owning a valuable asset that may have income and growth at 7% or more, the client has a note bearing interest at 2% that will not grow in value. An additional benefit of the Grantor Trust is that the Grantor continues to pay the income taxes associated with the Trust’s assets, and the payment of income taxes is not considered a gift to the trust, allowing the trust to grow income tax free and further reduce the Grantor’s estate.
Our hypothetical client Alice from the examples above could place $14,000,000 of investments into an LLC and after waiting a proper amount of time gift the 99% non-voting membership interest in the LLC to a Grantor Trust for her descendants. Due to the discounts mentioned above this might result in an $11,200,000 gift (assuming a 20% discount applies). Alice can pay the income tax on the income from the investments for her remaining lifetime, which will further reduce estate taxes for her family upon death, but only if she acts before the date of enactment of the new bill, if it passes.
A favorable provision of the new proposal allows Grantor Trusts established and funded before the enactment of the new law to be grandfathered, as would promissory notes in place at the time of enactment, so we and our colleagues doing estate tax planning expect to be very busy completing trusts and sale arrangements that are in progress now, and remain uncertain of how many more we have the capacity to handle given the short time frame Congress is providing us with here.
III. Potential Impacts on Discounts and Other Estate Planning Tools
In addition to preventing the use of post enactment contributions to Grantor Trusts for estate tax purposes, 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 language and effect of the new bill may also cause us to lose other very powerful tools in our toolbox, such as Grantor Retained Annuity Trusts (GRATs), Qualified Personal Residence Trusts (QPRTs), and lifetime Grantor Charitable Lead Annuity Trusts (CLATs) depending upon how the bill is applied and interpreted. The bill may also change how life insurance trusts will be funded and structured in the future, but we expect that the life insurance lobby will do what it takes to preserve its status as a favored child of Congress.
The following discussion of what is available now, that may not be available after a law is enacted:
IV. Bye Bye QPRT’s
A Qualified Personal Residence Trust (“QPRT”) allows a homeowner to transfer his or her primary residence or a vacation property into a Trust that enables the Grantor to make use of the property at no rent charge for a term of years, and to report the gift of the ownership interest in the home to be less than the full value of the home because of the discount attributable to the present value of the free use possessory term.
Nevertheless, after the death of the Grantor, the entire value of the property held under the Trust escapes estate tax, and the Grantor will pay rent after the possessory term of years lapses, which further reduces the Grantor’s estate and enables the Grantor to continue to use the property.
The QPRT can be drafted to be disregarded for income tax purposes, both during and after the possessory term, so that rent paid for use is not taxable to the Trust, and the property is treated as owned by the taxpayer in the event of sale, to qualify for the $250,000 or $500,000 exclusion for the sale of a primary residence.
Reading the newly proposed act literally, 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.
V. So Long and Farwell to GRATs
Similar to a QPRT, a Grantor Retained Annuity Trust (“GRAT”) is an arrangement whereby an individual can transfer property to a trust which provides for payments back to the individual over a term of years in fixed dollar amounts that are sufficient to cause there to be no gift for gift tax purposes.
Nonetheless, if the assets in the GRAT appreciate in value by more than approximately 1.0% a year, based upon present rate for GRATs entered into this year, the excess value remaining after the term of years can pass estate and gift tax-free.
A 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. We 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.
VI. Income Tax Deductible CLAT’s Will Vanish
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.
Unfortunately 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.
The above analysis of the impact of the newly proposed rules on QPRTs, GRATs and CLATs may not be accurate, or what the Ways and Means Committee is intending, and guidance with respect to this will likely be forthcoming in any legislation that would pass. Nevertheless, individuals and families who are considering the use of QPRTs, GRATs or Grantor CLATs should proceed without delay.
Although the loss of the vehicles and planning techniques reviewed above seems more than formidable, other techniques will continue to exist. Regardless, estate tax planners will feel like carpenters who have lost their hammers, nails and pliers, and have significant construction to do somehow without those tools. The result for wealthy families will be increased exposure to pay much more in estate taxes.
VII. How About Some Good News?
We were pleased to find the absence of a number of items on the bill that had been tossed around by lawmakers, including the following:
A. No “capital gains tax on death” was included, or any rule that would detrimentally affect the present tax laws that permit the assets of a deceased individual to be considered to have been purchased for the fair market value thereof on the person’s date of death to eliminate capital gains taxes attributable to appreciation and depreciation taken up through the date of death.
B. Proposals that would have imposed a tax on placing appreciated assets into separately taxed trusts, or transferring appreciated assets out of separately taxed trusts are also thankfully not mentioned.
C. Proposals which would have reduced the amount of annual gifts using Crummey withdrawal powers that an individual or married couple could have made to irrevocable trusts or otherwise were not included.
D. Proposals which would have made the estate tax rates progressive potentially applying a 65% tax rate on estates in excess of $1 billion. Thankfully under the current proposal the estate tax remains at a flat rate of 40%.
E. Proposals to decrease lifetime gifting allowance to as low as $1,000,000. Under the current proposal the estate and gift tax exemption remains the same, although reduced to one-half of what would have otherwise applied.
F. Specific provisions that would eliminate a step up in basis for assets held by a Grantor Trust. While it is unclear under present law if a step up in basis applies to assets held by Grantor Trusts, many practitioners take the position that a step up in basis does apply since the grantor is considered to be the owner of the assets for income tax purposes, and the inclusion of the elimination of step up in basis for Grantor Trusts in prior proposals further supports this proposition.
G. Proposals to apply generation skipping taxes via a deemed termination of Generation Skipping dynasty trusts every 50 years.
The good news for our clients is that grandfathering will allow us to be proud of and continue the structures that have been put into place and properly maintained. Please call me to discuss how these proposals will impact your plan.
Very truly yours,
PIERRO, CONNOR & STRAUSS, LLC
Louis W. Pierro