The Budget is Here![i]
Earlier this week the White House released its Fiscal Year 2025 Budget.[ii] Of course, the federal government has not yet adopted a budget for the Fiscal Year 2024 even as we approach that year’s halfway mark. But I digress.
The release of the budget comes four days after the State of the Union and only one day after the Oscar ceremonies.[iii] It seems appropriate that these three events should follow one another in relatively close succession considering each provides an opportunity for varying degrees of staging, theatrics, arrogance, and storytelling.[iv]
Indeed, in its explanation of the Fiscal Year 2025 Budget,[v] the Treasury describes the significant across-the-board tax increases called for by the Administration as “a series of reforms that would raise revenues, expand tax credits for workers and families, and improve tax administration and compliance. These reforms cover all areas of tax policy and together they result in a tax system that is both more equitable and more efficient.”[vi] [Applause.]
Because these measures are too numerous to address in one installment, today’s post will focus on the Administration’s wish list for the “reformation” of the income tax and transfer tax regimes applicable to an individual’s lifetime and testamentary dispositions of property for the benefit of the individual’s family (for our purposes, the “transfer tax regime”).
Opening Salvo
“Wish list”? Yes, that’s right. The Fiscal Year 2025 Budget doesn’t stand a chance of being enacted by this Congress.[vii] After all, the Republicans have a majority in the House[viii] which practically ensures these revenue raisers will not become law during 2024.
It should be noted, however, that most of the revenue provisions included in this budget were also part of the White House’s Build Back Better plan for the Fiscal Year 2022 Budget.[ix] At that time, the Democrats controlled both Chambers of Congress, and their slightly revised tax wish list would have been enacted into law but for the unexpected opposition of Senators Manchin and Sinema.[x]
The significance of this near miss cannot be understated. Likewise, the Democrats’ determination to avoid a repetition of this failure should not be underestimated.
The spirit and much of the letter of that earlier tax plan, as manifested in the Fiscal Year 2025 Budget, represent the White House’s tax platform for the Presidential election campaign. The budget also sets forth the Democrats’ tax agenda for 2025 and beyond.
In other words, the enactment of the budget’s so-called tax reforms is contingent upon the Democrats’ retaining control of both the White House and the Senate while also recapturing the House in the upcoming federal elections.
At this point, everything is up for grabs.
Tax the “Rich”
With that in mind, let’s consider the Administration’s proposed reforms for the transfer tax regime.[xi]
Deemed Sale of Assets
i. An individual donor or a deceased owner of an appreciated asset who makes a gift or testamentary transfer of such asset, whether outright or in trust – other than to a grantor trust that is deemed to be wholly owned and revocable by the donor – would be treated as having sold the asset on the date of the gift or on the decedent’s date of death. Any capital gain deemed to have been realized, based upon the fair market value[xii] of the asset and the donor’s or decedent’s basis in that asset, would be taxed at ordinary rates in the hands of the donor or the decedent’s estate.[xiii]
ii. An in-kind distribution of property by a trust, other than a grantor trust that is deemed to be wholly owned and revocable by the donor, would be treated as a taxable recognition event by the trust for purposes of the income tax. In the case of a revocable grantor trust, the donor, as the deemed owner of the trust, would recognize gain on the unrealized appreciation in the asset distributed from the trust to any person other than the donor or the donor’s U.S. spouse.[xiv]
iii. All of the unrealized appreciation on the assets of a revocable grantor trust would be realized at the deemed owner’s death or at any other time when the trust becomes irrevocable.
iv. As a result of this gain recognition, the recipient of the asset in question would take the asset with a fair market value basis.[xv]
Exclusion from Gain
v. Every individual donor would be allowed a $5 million exclusion from recognition of unrealized capital gains on property transferred by gift during their life. This exclusion would apply only to the unrealized appreciation on gifts to the extent that the donor’s cumulative total of lifetime gifts exceeds the basic exclusion amount under the unified estate and gift tax[xvi] in effect at the time of the gift.
vi. In addition, the proposal would allow any remaining portion of a donor’s $5 million exclusion, that has not been used during the donor’s life, as an exclusion from recognition of other unrealized capital gain with respect to property transferred at the donor’s death.
vii. The unused exclusion of a deceased donor would be portable to and usable by the decedent’s surviving spouse for purposes of determining the amount of gain recognition on the death of the surviving spouse.
Deferral of Gain
viii. A donor-taxpayer may elect not to recognize the unrealized appreciation of certain family-owned and -operated businesses until the interest in the business is sold or the business ceases to be family-owned and -operated.
ix. A decedent’s estate may elect to pay the income tax on appreciated assets transferred at death using a 15-year fixed-rate payment plan This option would not be available to an estate that has elected to defer the tax attributable to the testamentary disposition of a family business (see above); nor would it be available for liquid assets.[xvii]
Trust Reporting
x. Certain trusts administered in the U.S. – whether domestic or foreign[xviii] – would be required to report certain information to the IRS with respect to any year for which the estimated total value of the trust on the last day of the taxable year exceeds $300,000 or whose gross income for the taxable year exceeds $10,000.[xix] This information would be reported on the annual income tax return for the trust and would include the name, address, and TIN of each trustee and grantor of the trust, as well as general information regarding the nature and estimated total value of the trust’s assets.[xx]
xi. Every trust, regardless of its value or income, would be required to report on its annual income tax return the inclusion ratio[xxi] of the trust at the time of any trust distribution to a non-skip person, as well as information regarding any modification to the trust or any transaction with another trust that occurred during that year.
Formula Clause
xii. A defined value formula clause[xxii] will be disregarded for purposes of determining the “proper” fair market value of a gift or bequest if such value under such a provision is determined by reference to the value determined as a result of an IRS audit of the donor’s transfer tax return. In that case, the value of such gift or bequest would be deemed to be (i.e., would remain) the value as reported by the donor or their estate on the corresponding gift or estate tax return.
xiii. However, a defined value formula clause would be effective if: (a) the value of the gift or testamentary transfer is determinable by something “identifiable,” other than activity of the IRS, such as an appraisal that occurs within a reasonably short period of time after the date of the transfer,[xxiii] even if such appraisal is obtained after the due date of the return,[xxiv] or (b) the defined value formula clause is used for the purpose of defining a marital or exemption equivalent bequest at death based on the decedent’s remaining transfer tax exclusion amount.
Annual Gifts
xiv. A donor would be allowed to make up to $50,000 of gifts in a single year without incurring a gift tax liability or using part of their unified gift and estate tax exemption amount. Significantly, this new $50,000 limit would not provide an exclusion in addition to the existing annual per-donee exclusion;[xxv] rather, it would be a further limit on those amounts that otherwise would qualify for the annual per-donee exclusion. Thus, a donor’s transfers in a single year in excess of a total amount of $50,000 would be taxable, even if the total gifts to each individual donee did not exceed the annual per-donee exclusion.
xv. In addition, the present interest requirement for annual exclusion gifts would be eliminated.[xxvi]
GRATs
xvi. The remainder interest in a GRAT, at the time the interest is created, would be required to have a minimum value for gift tax purposes equal to the greater of 25 percent of the value of the assets transferred to the GRAT or $500,000 (but not more than the value of the assets transferred).
xvii. A GRAT would be required to have a minimum term of ten years and a maximum term equal to the life expectancy of the annuitant plus ten years.
Grantor Trusts
xviii. The grantor would be prohibited from acquiring in an exchange an asset held in the trust without recognizing gain or loss for income tax purposes.[xxvii]
xix. The transfer of an asset for consideration between a grantor trust[xxviii] and its deemed owner would result in the seller recognizing gain on any appreciation in the transferred asset.[xxix]
xx. The grantor-deemed owner’s payment of the income tax on the income of a grantor trust (other than a trust that is fully revocable by the grantor) would be treated as a gift made at the end of the year in which the income tax is paid, unless the deemed owner is reimbursed by the trust during that same year.[xxx]
Generation Skipping Tax
xxi. The GST exemption would be applicable only to: (a) direct skips and taxable distributions to beneficiaries who are no more than two generations below the transferor, and to younger generation beneficiaries who were alive at the creation of the trust (skip beneficiaries); and (b) taxable terminations occurring while any such individual is a beneficiary of the trust.[xxxi] As a result of these limitations, the benefit of the GST exemption, which shields property from the GST tax, would only shield distributions to trust skip beneficiaries who either are in a generation no younger than that of the transferor’s grandchild or who are members of a younger generation who were alive at the creation of the trust. Similarly, the exemption would shield a taxable termination from GST tax only as long as any such skip person is a trust beneficiary. Upon the expiration of this limit on the duration of the GST exemption, the trust’s inclusion ratio would be increased to one, thereby rendering no part of the trust exempt from GST tax.[xxxii]
xxii. A trust’s purchase of assets from another trust that is subject to GST tax would be treated as a change in trust principal that would require the redetermination of the purchasing trust’s inclusion ratio when those assets are purchased.[xxxiii] The same rule would apply to a trust’s receipt of assets pursuant to a decanting of another trust.[xxxiv]
Loans from Trusts
xxiii. Loans made by a trust to a trust beneficiary would be treated as a distribution for income tax purposes, carrying out each loan’s appropriate portion of distributable net income to the borrowing beneficiary.[xxxv]
xxiv. A loan to a trust beneficiary would be treated as a distribution by the trust for GST tax purposes, thus constituting either a direct skip or a taxable distribution.
Valuation
xxv. Under a new consistency requirement, if a taxpayer-lender (say, a parent) treats any promissory note as having a sufficient rate of interest[xxxvi] to avoid the treatment of any foregone interest on the loan as income or any part of the transaction as a gift,[xxxvii] then that note must subsequently be valued for gift and estate tax purposes by limiting the discount rate to no more than the greater of the actual rate of interest of the note, or the applicable minimum interest rate for the remaining term of the note on the lender’s date of death.
xxvi. The value of a partial interest in non-publicly traded property – whether real or personal, tangible or intangible[xxxviii] – that is transferred to or for the benefit of a member of the transferor’s family[xxxix] would be equal to the interest’s pro-rata share of the collective fair market value of all interests in that property held by the transferor and the transferor’s family members, with that collective fair market value being determined as if held by one individual.[xl]
xxvii. In applying this rule to an interest in a trade or business, passive assets[xli] would be segregated and valued as separate from the trade or business. Thus, the fair market value of the family’s collective interest would be the sum of the fair market value of the interest allocable to a trade or business (not including its passive assets), and the fair market value of the passive assets allocable to the family’s collective interest, determined as if the passive assets were held directly by one individual. This valuation rule would apply only to intrafamily transfers of partial interests in property in which the family collectively has an interest of at least 25 percent of the whole.
Where Are We Heading?
It is easy to conclude, based upon the foregoing high level summary of the Fiscal Year 2025 Budget’s estate, gift and GST tax provisions, that the Administration’s plan for “reforming” the transfer tax regime is both aggressive and ambitious. In summary, it will:
- tie the step-up in basis for a decedent’s assets to the payment of income tax with respect to the gain inherent in such assets;
- accelerate the recognition of gain on the gift transfer of appreciated assets;
- eliminate the use of formula clauses that was heretofore approved by the Courts in Wandry and other cases;[xlii]
- limit the use of Crummey powers, thereby making it more costly to fund larger trust-owned insurance policies;
- eliminate short-term and zeroed-out GRATs;
- eliminate sales to grantor trusts;
- make it more difficult for a trust to achieve grantor trust status;
- make the use of a grantor trust more tax expensive for the grantor;
- reduce the tax effectiveness of dynasty trusts;
- make it more difficult for trusts to make loans to beneficiaries; and
- limit the ability of a donor to discount the value of interests in a family-owned business gifted to members of their family.
In short, the White House wants to eliminate many if not most of the tools on which business owners and their advisers have relied over the last three decades for transferring the equity in their businesses and other assets to their families.
In the past, this sort of overreaching would have been dismissed as political posturing, especially in an election year.
I believe that is no longer the case. Once again, I have to point to how close Congress came to passing the Build Back Better plan toward the end of 2021. Three years later, there seems to be a genuine belief among Democrats that such legislative “reforms” must be enacted to “preserve democracy” and to make sure the “rich” pay their fair share.[xliii]
I hope I’m wrong.
Stay tuned for future posts in which we’ll address some of the Administration’s income tax proposals – they’re even more troubling than what the budget has in store for the transfer tax regime.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Remember the “phone book line” from the 1979 movie, “The Jerk”, with Steve Martin? Make what you will of the reference.
[ii] For the fiscal year beginning October 1, 2024. Only six and one-half months from now.
[iii] For years, I have refused to watch the Oscars and the State of the Union.
[iv] I suspect one may safely add the use of “performance enhancing” drugs to the list.
I’ve often heard acting described as a form of lying. That is certainly true in the case of most political theater.
[v] The so-called Green Book.
[vi] Among the objects of these euphemistically termed “reforms” – i.e., tax increases – are the income and assets of closely held businesses and their owners, a group that seems to occupy a special place in the hearts and minds of el presidente and xirs advisers.
[vii] The 118th – an especially unproductive one for obvious reasons.
[viii] Albeit one that seems to be slipping away day by day. Just a few days ago, Rep. Buck of Colorado decided to accelerate his retirement to next week. Thus, the party makeup in the House will be 218 Republicans and 213 Democrats.
[ix] https://www.whitehouse.gov/wp-content/uploads/2021/05/budget_fy22.pdf?utm_medium=bgov&utm_campaign=3D566974-BFDC-11EB-B3E2-6B512AECE977&utm_source=facebook
[x] Both of whom are leaving Congress.
[xi] Future posts will address other parts of the budget.
[xii] The transfer of a partial interest in an asset would be valued at its proportional share of the fair market value of the entire property – it would not be discounted. However, this no-discount rule would not apply to an interest in a trade or business to the extent that its assets are actively used in the conduct of that trade or business. I have no issue with this approach; it is one that the 2016 proposed regulations should have taken.
[xiii] The budget proposes to increase the maximum ordinary rate from 37% to 39.6%. This change is already scheduled to occur after 2025 – the budget would accelerate it.
[xiv] Transfers to a U.S. spouse or to a charity would carry over the basis of the donor or decedent. Capital gain would not be realized until the surviving spouse disposes of the asset or dies, and appreciated property transferred to charity would be exempt from the capital gains tax. However, the transfer of appreciated assets to a split-interest trust – such as charitable remainder trust – would be subject to the capital gains tax, with an exclusion from that tax allowed for the charity’s share of the gain based on the charity’s actuarial share of the value transferred as determined for gift or estate tax purposes.
In addition, the exclusion under current law for capital gain on certain small business stock would continue to apply. IRC Sec. 1202.
[xv] The basis step-up at death under current law would be eliminated. IRC Sec. 1014.
[xvi] The basic exclusion amount is currently $10 million, but it is scheduled to revert to $5 million for gifts made after December 31, 2025 and for decedents dying after that date. IRC Sec. 2010.
[xvii] This echoes the application of IRC Sec. 6166 to defer payment of the estate tax.
[xviii] IRC Sec. 7701(a)(30) and (31).
[xix] Not a typo.
[xx] The extent of the disclosure being required by both federal and state governments is getting out of hand.
[xxi] IRC Sec. 2642. I suppose it was only a matter of time before fiduciary income tax returns were adapted as a tool for enforcing the GST tax.
[xxii] For example, one that established the donor’s intent to transfer a specific dollar amount of property: “I intend to transfer that number of shares of Corp stock that have a fair market value, as finally determined for transfer tax purposes, of $2 million.” If the value determined as a result of, say, a gift tax audit exceeds the value reported by the donor, then some portion of the property transferred by the donor may be returned to the donor or directed elsewhere (for example, a spouse or a charity).
[xxiii] Not an uncommon event.
[xxiv] Gift tax returns are due on April 15 of the year immediately following the year of the gift transfer. Estate tax returns are due within nine months of the decedent’s date of death.
[xxv] Currently set at $18,000 per donee. In other words, a donor may transfer up to $18,000 of cash or other property to every individual residing in New York without incurring a gift tax liability and without using any of their lifetime exemption amount. Of course, New York isn’t willing to wait for some donor to make such gifts, so they take the money through exorbitant taxes which they then redistribute among the population, with illegal aliens enjoying a preferred status. I suppose that’s one reason why so many New Yorkers of all income levels – not just the wealthy – are exiting the state.
[xxvi] Good-bye Crummey powers and Crummey letters?
[xxvii] Thereby eliminating a grantor’s reliance upon IRC Sec. 675(4) to remove property – say, low basis property – from a trust in exchange for property of equivalent value.
[xxviii] Other than a revocable trust.
[xxix] Good-bye sales to so-called intentionally defective grantor trusts (IDGT).
[xxx] Or, if earlier, immediately before the deemed owner’s death, or on their renunciation of any reimbursement right for that year.
See Rev. Rul. 2004-64. For an interesting twist, see CCA 202352018 (a deemed gift by the trust beneficiaries).
[xxxi] IRC Sec. 2612.
[xxxii] Good-bye dynasty trusts?
[xxxiii] The inclusion ratio would be redetermined in the same way as in the case of a consolidation of trusts: the purchased assets would be included in the total value of the trust in the denominator of the applicable fraction, and only the portion of those assets excluded from GST tax immediately before the purchase would be added into the numerator of the fraction. Reg. Sec. 26.2642-2.
[xxxiv] Generally, the distribution of trust property to another trust pursuant to the trustee’s discretionary authority to make distributions to, or for the benefit of, one or more beneficiaries of the decanted trust.
[xxxv] IRC Sec. 643.
[xxxvi] At the AFR.
[xxxvii] IRC Sec. 7872.
[xxxviii] For example, shares of stock, or partnership/LLC membership interests, in a closely held business.
[xxxix] Family members for this purpose would include the transferor, the transferor’s ancestors and descendants, and the spouse of each described individual.
[xl] Thereby limiting valuation discounts.
[xli] Passive assets are assets not actively used in the conduct of the trade or business, and thus would not be discounted as part of the interest in the trade or business.
[xlii] Wandry v. Comm’r, T.C. Memo. 2012-88.
[xliii] According to The Tax Foundation’s summary of the most recently released federal tax data:
- The average income tax rate in 2021 was 14.9 percent. The top 1 percent of taxpayers paid a 25.9 percent average rate, nearly eight times higher than the 3.3 percent average rate paid by the bottom half of taxpayers.
- The top 50 percent of all taxpayers paid 97.7 percent of all federal individual income taxes, while the bottom 50 percent paid the remaining 2.3 percent.
https://taxfoundation.org/data/all/federal/latest-federal-income-tax-data-2024/?utm_medium=email&_hsmi=298156901&utm_content=298156901&utm_source=hs_email .
