Potential Tax Law Changes as a Result of the Recent House Proposal
Summary of the recent House tax change proposal, introduced September 13, 2021:
Estate Tax Exemption Amount
The current $11.7 million gift and estate tax exemption would be reduced to approximately $6.03 million after December 31, 2021.
Taxpayers who feel comfortable making outright gifts of their remaining gift, estate, and generation skipping transfer tax exclusions could be encouraged to do so before January 1, 2022.
The effective dates in the House Proposal differ.
For example: (i) the reduction of the current $11.7 million gift and estate tax exemption to about $6.03 million will be effective January 1, 2022, (ii) capital gains increases will be effective for tax years ending after September 13, 2021 (when the House Proposal was introduced) and (iii) the grantor trust limitations described below will be effective upon the date of enactment.
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.
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% Obamacare tax.
A Note on Grantor Trusts
As noted above, taxpayers who feel comfortable making outright gifts of their remaining gift, estate, and generation skipping transfer tax exclusions should do so before January 1, 2022.
However, gifts in trust, especially to grantor trusts (as discussed below) need more careful analysis.
For reasons beyond the scope of this letter, 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 effective use of the current $11.7 million exemption.
This computation should be reviewed with us if you have questions. Please also consider the following:
Elimination of Grantor Trusts following Enactment
While some of the House Proposal provisions are simple to comprehend and planning options are relatively clear.
The House Proposal creates some confusion by eliminating the benefits of grantor trusts created and/or funded after enactment.
Grantor trusts have been a significant planning technique for many of our clients for over 20 years.
What is a Grantor Trust?
Grantor trusts allow the creator (also commonly referred to as the grantor) to make a gift to a trust that, with proper planning, will be excluded from the creator’s estate, and also allows the creator to pay income tax on all trust income without such payments being considered a gift to the trust or its beneficiaries.
The rationale is that the trust creator is considered the owner of the trust income for income tax purposes, but not for gift or estate tax purposes because the trust provides the creator with one or more retained power, such as the power to substitute the grantor’s other assets for trust assets of equivalent value.
As a result, the creator of the trust is obligated to pay income tax on trust income (both ordinary and capital gains) and because of such obligation, payment of income tax by the creator is not a gift to the trust or its beneficiaries.
Benefits of Grantor Trusts
An important benefit of grantor trust status has been the ability of the creator during his or her lifetime to take his or her high-income tax basis assets and substitute such high basis assets for low or even negative basis assets of equivalent value that are owned by the grantor trust.
Assets held in such a grantor trust do not benefit from a step up in income tax basis to fair market value upon the death of the creator whereas the law currently in effect allows a step up in basis to fair market value for assets owned by a person upon death.
The House Proposal does not currently eliminate step up in income tax at death.
Accordingly, as of the date of this letter, grantor trusts are a great estate planning techniques as they allow taxpayers who create grantor trusts to:
(i) pay the trust’s income tax and
(ii) maximize income tax basis planning for assets owned by the grantor trust at the creator’s death by allowing the creator to substitute his or her high income tax basis assets for low or even negative basis assets of equivalent value before the creator’s death and thereby the creator’s beneficiaries benefit from a step up in income tax basis at death as to the low income tax basis assets owned by the creator as of his or her date of death.
Grantor Trusts Created Prior to Enactment
Grantor trusts created before enactment should maintain full grantor trust benefits so long as the trust is not modified after enactment and there are no contributions to such trust.
Grantor trust status will be eliminated, at least to some degree, based upon the value of post enactment contributions in the event contributions are made to the trust after enactment.
As indicated above, the House Proposal is unclear as to whether a grandfathered trust will lose its grantor trust status if assets are substituted by the creator or sold by the creator to the trust subsequent to enactment.
We expect the rules to be clarified in the future as to sales and substitutions of assets as to grantor trusts created and funded before enactment.
However, we anticipate a race to create and fund new grantor trusts before enactment to take advantage of the grantor’s ability to pay income tax on grantor trust income and based upon the possibility that the law may be clarified to allow sales and substitutions for grandfathered trusts.
Sale or Swap of Assets
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” 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” 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.
It is unclear whether sales or swaps to grantor trusts created before enactment will be subject to the new rules subjecting post-enactment sales or swaps to tax and, until further guidance is provided, such post-enactment transactions should be avoided.
Valuation Discounts and FLPs
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.
Some Good News
The good news is that the House Proposal does not:
(i) address the elimination of the step-up in income tax basis from cost to fair market value at death;
(ii) tax unrealized appreciation at death; or
(iii) raise the current 40% estate, gift, and generation skipping transfer tax rate.
Plan now! As we prepare this letter, we grow increasingly concerned that trusts 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.
Of course, the process could drag on, but nobody knows. As a result, a prudent approach is to have any new grantor trusts, such as SLATs or traditional dynasty trust, created and funded as soon as possible.
Please understand that our firm may not have the capacity to prepare all of the documents our clients may need before enactment of the House Proposal.
We are very much aware that the House Proposal is only proposed legislation and that this could be a “fire drill” if Congress is unable to agree on a final bill. We are also very aware that if Congress does agree on a final bill, it may differ significantly from the House Proposal.
However, all we can do at this time is explain the House Proposal in its current form so that those that may be affected by it can consider their immediate options.