Last week, the House Ways and Means Committee released proposed legislation affecting numerous transfer and income tax provisions of the Code.  These changes, if enacted, will have a significant impact on estate planning and trusts.  While the proposed bill must receive Senate approval before it makes its way to President Biden’s desk for signature — and changes to any final bill are expected — these tax proposals should be heeded as a blueprint of what any final legislation may look like.  Below is a summary of some of the more significant facets of the proposed legislation, with a focus on transfer taxes:

• Reduction in Estate and Gift Exemption Amount (Unified Credit).  The federal gift and estate tax exemption, currently set at $11.7 million per individual, would be reduced to $5 million per individual, adjusted for inflation to approximately $6 million.  The exemption reduction would take effect beginning January 1, 2022.  The bill does not impose a “clawback” for exemption amount used in excess of the reduced amount prior to the end of 2021.  Accordingly, individuals would have until the end of this year to take advantage of the current high federal exemption amount.  To do so, transfers made prior to January 1, 2022 should exceed the reduced exemption amount (approx. $6 million).  For example, if a single taxpayer made a gift of $5 million dollars now and the exemption declined to $6 million as of January 1, the individual would have, as of January 1, a remaining exemption of $1 million.  Although as noted this exemption reduction would take effect as of January 1, 2022, wealthy individuals are encouraged to use as much exemption as is appropriate for them considering their circumstances as soon as possible given the restrictions on grantor trusts proposed in the bill and discussed immediately below.

• Changes to Grantor Trusts and Grantor Trust Taxation.  Certain taxation rules with respect to grantor trusts would be eliminated, effective upon enactment (i.e., when signed by the President).  Generally speaking, a grantor trust is a trust which allows the assets held in it to be treated as owned by the trust creator for income tax purposes, but which often removes the assets from the trust creator’s estate for estate tax purposes.  These trusts have long been a cornerstone of estate planning, with some of the most common forms of grantor trusts being qualified personal residence trusts (QPRTs), some charitable lead annuity trusts (CLATs), spousal lifetime access trusts (SLATs), grantor retained annuity trusts (GRATs), and irrevocable life insurance trusts (ILITs).  Under present law, a single taxpayer could transfer assets with a value of $11.7 million (her full exemption amount) to a type of grantor trust, pay income tax at her individual rate on the growth of those assets during her life and have the full value of those assets, including their growth, excluded from her taxable estate at the time of her death.  The proposed bill would effectively eliminate the use of grantor trusts after enactment by making the assets held therein includable in the trust creator’s estate and losing certain income tax benefits as well.  Importantly, grantor trusts created and funded prior to the effective date of the bill would be grandfathered under the proposals.  However, assets transferred to a grandfathered grantor trust after the effective date of the bill would be includable in the trust creator’s estate for death tax purposes.  Accordingly, while the bill would maintain the high current exemption through the end of the year, individuals who desire to utilize that exemption via the oft-preferred transfer of assets to an irrevocable grantor trust are urged to act now before the grantor trust as we now know it is a remnant of history.

• Changes to Certain Valuation Rules.  New valuation rules would be imposed for certain passive business assets.  Such passive or “non-business” assets are assets held inside a business entity not used in the active conduct of a trade or business.  Where these passive assets are concerned, the bill would eliminate the availability and use of valuation discounts for marketability and/or minority discounts  which are often utilized in planning. 

• Restrictions on Owners of Large Retirement Plan Accounts. Single taxpayers with taxable income over $400,000 and married taxpayers filing jointly with taxable income over $450,000 would be prohibited from making contributions to their IRAs, Roth IRAs, and/or defined contribution plans if those accounts have combined balance(s) in excess of $10 million.  Individuals who fall within this category would additionally be subject to an additional minimum distribution.  These restrictions would not apply if the taxpayer’s income levels fell below the applicable limits however.

• Expansion of 3.8% NIIT.  The 3.8% net investment income tax would apply to business income to married individuals filing jointly with taxable income over $500,000 and single taxpayers with taxable income over $400,000.  This tax will not be assessed on earnings already subject to FICA tax.  This change may affect individuals who own pass through businesses such as S corporations and limited liability companies.

• Limitations on 199A Deduction.  The 199A deduction for qualified business income would be limited to $500,000 for married taxpayers filing joint returns and $400,000 for single taxpayers.  The maximum deduction for trusts and estates would be only $10,000.  This would effectively eliminate the benefit for trust owned real estate and other trust owned qualifying business interests.  This change would take effect January 1, 2022.

• Increased Ordinary Income Rates.  The highest (marginal) individual tax rate would increase to 39.6%, applicable to married individuals filing joint returns with taxable income over $450,00 and single taxpayers with taxable income over $400,000. 

• Increase in Capital Gains Rates.  The capital gains tax rate would increase from its current rate of 20% to 25%.

These are just a few of the significant tax proposals that could come into effect.  While the bill is likely to change as it continues its way through the Senate and reconciliation process, most experts believe that enactment in a similar form is imminent.  Individuals who will be impacted by this bill are strongly encouraged to act now in coordination with their attorneys and financial advisors before any such law goes into effect.