The Obama Administration recently released its budget proposal for the federal government’s upcoming fiscal year of October 1, 2013 to September 30, 2014. The budget proposal contains a variety of changes to the tax laws designed to raise revenue.
Estate Tax, Gift Tax, and Generation Skipping Transfer Tax
The most notable proposed tax law change is for the estate tax, gift tax, and generation skipping tax laws to apply as they did in 2009. In 2009, the top marginal tax rate for each of these taxes was 45% and the exemption amounts were $3,500,000 for the estate tax and generation skipping transfer tax. The exemption amount for the gift tax, however, was only $1,000,000. Currently, the top marginal tax rates are 40% and both exemption amounts are $5,250,000, which will increase based on inflation. In 2009 there was not “portability” of a deceased spouse’s estate tax exemption amount but the proposal provides for portability to continue. The budget proposes for this change to occur in 2018. Another important feature of the proposal is that prior gifts of more than $3,500,000 would not be recaptured so that any lifetime gifts in excess of $3,500,000 would not result in an increase in estate tax for a decedent dying in 2018 or after.
Our belief is that there is little appetite in Congress to reduce the exemption amounts for these taxes or to increase the tax rates. This proposal is perhaps a bargaining chip for the President and an issue he can concede in exchange for another proposed change.
Some clients have recently engaged in long-term planning involving “Dynasty Trusts”. Dynasty Trusts are designed to continue in perpetuity for the benefit of family members (and possibly spouses of family members). Dynasty Trusts have become popular in the last few years with the significant increases in the exemption amounts for estate tax, gift tax, and generation skipping transfer tax and the repeal of the “rule against perpetuities” that prevented perpetual trusts.
The President’s proposal includes a change to the generation skipping transfer tax that would terminate the generation skipping transfer tax exemption amount allocated to a trust on the 90th anniversary of the trust’s creation. In essence, the generation skipping transfer tax will be applied to a trust every ninety years and (under the current rates) 40% of the trust’s assets would be lost to tax. Trusts created prior to this proposed change in the law would be exempt from the tax.
It is difficult to predict whether this proposal will gain any traction. Nonetheless, a client who implemented a Dynasty Trust may want to consider contributing additional assets to the trust if the client has any unused gift tax exemption amount. Clients who are considering long-term planning may want to act in the near future to make sure any trust that is established is exempt from this proposed tax.
Defective Grantor Trusts
Some clients have engaged in transactions involving Intentionally Defective Grantor Trusts (“IDGTs”). An IDGT is a trust that does not exist for income tax purposes, but does exist for estate tax purposes. Therefore, a client can “sell” an asset to the IDGT and not realize a capital gain while at the same time excluding the “sold” from the client’s estate. IDGTs work well (a) in a low interest rate environment, (b) with assets that can be discounted for valuation purposes, such as fractional interests in real estate or limited partnership interests, and (3) with assets that will appreciate substantially after the sale. The President’s budget proposal provides that the assets of an IDGT would be subject to estate tax, which would essentially end the utility of this planning tool.
Individual Retirement Accounts
Under current law, when an IRA owner dies, a non-spouse beneficiary, such as a child or grandchild, generally is required to take withdrawals from the IRA based on the beneficiary’s life expectancy. The President’s budget proposal seeks to amend this rule so that all non-spouse beneficiaries must withdraw the IRA in full within five years following the IRA owner’s death. For many clients, an IRA is the most significant or one of the most significant assets of their estate. The proposed restriction will eliminate the ability to stretch out an IRA over the lifetime of a child or grandchild. This proposed change would take effect on January 1, 2014, and has the obvious impact of raising additional income tax revenue. If this proposal is adopted, then clients may consider designating young beneficiaries to mitigate the income tax consequence or perhaps funding Charitable Remainder Trusts to avoid this rule (assuming this is possible).
The President’s budget proposal is just that – a proposal. It is difficult to predict the substance of the next budget and the tax law changes given the anticipated lobbying of interested parties and the negotiations that will take place between the executive and legislative branches. We do not expect a “grand bargain” and instead expect that “sausage will be made” once again. Regardless of the tax law changes, we will seek to identify planning opportunities for clients.