Could dramatic estate tax changes be looming?
As was reported in our newsletter dated September 16, 2021, House Ways and Means Democrats Proposed Changes (link), the Ways and Means Committee of the United States House of Representatives (the principal tax writing committee) recently proposed substantial tax changes. Several of the provisions in the bill could have a dramatic impact on estate tax planning and commonly used planning techniques. As was noted earlier, the House Ways and Means Committee released a draft bill which included 881 pages of changes to the Internal Revenue Code with many alterations on all aspects of the tax structure. This newsletter will focus on several key provisions which, if enacted, could change several popular estate planning techniques.
Most attention has been on the possible reduction in the exclusion, called Basic Exclusion Amount (“BEA”), the amount of value that can pass free from estate tax to heirs. Current law allows an individual to pass wealth worth $11,700,000 to their heirs free from estate and gift tax. Because the estate and gift tax represents a combined “wealth transfer” tax structure, gifts made during life would offset the ability to make additional transfers tax free at death. Gifts made during life are accumulated and included in the taxable estate at the death of a taxpayer before offsetting the remaining BEA. The $11,700,000 amount now available is a result of a “doubling” of the previous estate tax exemption which had been set at $5,000,000 in 2010 and then indexed for inflation. The doubled amount was part of the 2017 Tax Cut and Jobs Act (“TCJA”) and is now set to expire at the end of 2025. One provision of this House proposal would be to allow the “doubled” exemption to expire at the end of this year, so that effective January 1, 2022, the BEA would be reduced. It appears, with the inflation adjustment, the BEA effective January 1, 2022 would be about $6,020,000.
The IRS has previously made clear that an individual can make irrevocable gifts before the law is changed so that such gifts would be “grandfathered” in the estate tax calculation. “Clawback” of estate tax exemption arises based on how the estate tax is calculated and occurs when the BEA amount decreases. When the TCJA was enacted, because of the “doubled” BEA from estate and gift tax and knowing the exemption would drop, Congress mandated that the Internal Revenue Service make adjustments to the calculation. On November 22, 2019, the IRS issued final regulations providing that when an individual makes a gift prior to the reduction of the BEA, the gift will be protected from future estate taxation. Now, where the cumulative gift amount exceeds the BEA in the year of the decedent’s death, the BEA for calculating estate tax is the higher of the allowable gifts made or the BEA in the year of death.
A second element to the regulations, relates to the “Deceased Spouse’s Unused Exemption” (“DSUE”). Since 2011, a surviving spouse can elect to “port” the exemption amount of a predeceased spouse by filing an estate tax return timely with the Internal Revenue Service. The regulations make it clear that when a spouse passes away that DSUE, if claimed by the survivor, must be used by a surviving spouse before utilizing any of his/her remaining exemption.
Due to the proposed new law, wealthy individuals should consider making substantial gifts at their earliest convenience. Unfortunately, in order to receive the benefit of this circumstance, more than the BEA at the time they pass (presumably $6,020,000 after the law has sunset) must be gifted. Thus, this is not an opportunity available equally to all taxpayers. Families with substantial wealth have had a much easier time making significant lifetime gifts to achieve “grandfather” status.
The House Ways and Means proposal makes a variety of additional significant changes. First, the proposal takes aim at “grantor trusts” a very useful technique. Under existing law, certain trusts could be removed from the taxable estate of a taxpayer by making a gift to a trust, but for income tax purposes the trust can still be treated as the grantor’s assets and subject to income tax. A trust can also be used to defer the timing of receipt of the benefits of the gifted property. This concept has presented a considerable planning opportunity for clients. Since the pronouncement of the IRS in Rev. Rul. 2004-64,[1] the grantor is obligated to pay income tax on all earnings of a grantor trust and that income tax payment is not considered a gift. Some families will establish a “grantor trust” not only to make a gift but also so that the grantor can pay the income tax (even though earnings remain with the trust beneficiaries) and the income tax paid by the grantor will reduce the estate (for estate tax purposes) of the donor. The primary reason is that the continuing payment of income tax obligations on trust assets (that inure to the benefit of the family) are not treated as wealth transfers.
The new proposal, if enacted, would repeal the estate and gift tax benefits of making gifts into a grantor trust. Unlike the reduction of the BEA that occurs at year end, this provision, like many others, is effective on enactment of the law, whenever that might be. While the new law will not affect (or “grandfather”) pre-existing trusts, future trusts and contributions to pre-existing trusts would no longer be permitted. It seems as though a future gift to a pre-existing “Grantor Trust” would taint that ratable portion of the trust by including it back into the estate tax base of the donor for estate tax purposes. Thus, an estate tax would be imposed on some or all of the trust at the death of the donor which would have otherwise been exempted under existing law. Also, on removal of grantor trust status, the donor will be deemed to have made a gift for gift tax purposes.
The change to grantor trust status has raised a variety of other problems. A trust for a spouse is almost always a “grantor trust.” As a result, the creation of a Spousal Lifetime Access Trust (“SLAT”) the topic of our July 29, 2020 post (link) would no longer be permitted.
More importantly, many clients have created irrevocable trusts to hold life insurance and, presumably, intended to make additional payments to the trusts over time to satisfy the trustee’s obligation to pay premiums in the future. If properly structured in an irrevocable trust, the death benefit could escape estate taxation. Because of this change to grantor trusts, it may be more difficult to continue to fund trusts in the future by making continuing payments. It may be beneficial to make a payment to the trust before the law is changed to pay future premiums.
The proposal also will presumably make changes to trusts previously existing under the law known as a Grantor Retained Annuity Trust (“GRAT”) allowed by Section 2702 of the Internal Revenue Code. With a GRAT only the value of a fixed annuity would be used in an individual’s gift tax calculation. Very briefly, this GRAT technique was a statutorily permitted approach which would allow growth in excess of a nominal sum to be passed to heirs on a tax-free basis. The new law would apparently prohibit this type of transaction because they are also grantor trusts.
Another type of transaction which will no longer be permitted is known as a “sale” to a Grantor Trust. The new law would create a new section of the Internal Revenue Code which would effectively prohibit this approach. Finally, commonly considered “discounts” on gifts of closely held business that occur because a fractional interest is both unmarketable and because it does not carry control of the entity, are likely to be restricted.
On a lighter note, there are several important benefits in the new law. One such benefit is not very obvious. For starters, several proposals announced this spring seemed to limit the so called “step-up” in income tax basis that occurs when an individual passes away. By way of background, when an individual holds an asset at death, the “basis” for determining gain or loss (for income tax purposes) is “stepped up” to the fair market value at death. This allows many families to escape an income tax on assets that have appreciated and are held by a decedent. One such proposal by the Biden Treasury Department would have even created a “deemed realization” at death meaning that a decedent’s estate would be obligated to pay income tax on all unrealized gains (within limits and exceptions) at the time they passed away. Neither of these provisions were included in the proposal from the House Ways and Means committee, however, as the legislation process continues, they could always be revisited.
Under the Ways and Means proposal, there are other benefits. First, a Subchapter “S” Corporation, (a common form of businesses for small business) that was in existence May 13,1996 would be permitted to convert tax free into a more modern form of business entity, a Limited Liability Company (LLC). Next, there is a significant benefit to farmers. Under the law, the “special use valuation” rules of I.R.C. 2032A, will now permit protections for farms worth $11.7 million in value to be protected from estate tax if the farm is a multigenerational business.
Clients should always monitor possible changes to the tax law that could effect their expectations. While estate planners frequently guess wrong on potential estate tax changes, these rules, if enacted, could take away common planning techniques.
[1] 2004-2 CB 7.