What you need to know: On September 13, 2021, the House Ways and Means Committee released its proposed tax plan to fund President Biden’s $3.5 trillion “Build Back Better” social and economic spending package. If enacted as currently drafted, the plan would bring sweeping changes to the tax law, including a reduction of the federal estate and gift tax exemption and the generation-skipping transfer (“GST”) tax exemption; limitations on the use of grantor trusts; an elimination of valuation discounts for closely-held entities that hold non-business assets; increased income tax rates for individuals, trusts and estates; an increase in the capital gains tax rate from 20% to 25%; and a prohibition on Roth IRA conversions.
The House Budget Committee has now advanced the reconciliation bill to the House floor ahead of a likely vote next week. Meanwhile, the Senate is developing its own version of the reconciliation bill. The final version of the Build Back Better package that President Biden enacts into law will most likely vary from the current draft legislation. It is impossible, however, to determine which proposed tax law changes will be retained at this stage in the legislative process. While the tax landscape remains uncertain, some of these proposals would take effect on the date of enactment and others would take effect January 1, 2022. Those likely to be impacted should act now to take advantage of significant planning opportunities that may no longer be available after year end.
Reduction in Federal Estate and Gift Tax Exemption Amounts: As of January 1, 2021, an individual may give up to $11,700,000 during life or at death without incurring any federal gift or estate tax. Married couples may give up to $23,400,000. State death taxes paid are deductible from the federal gross estate for estate tax purposes. Federal estate and gift tax are assessed at a flat rate of 40%. Current law provides that the individual estate and gift tax exemption will be reduced to $5,000,000 (adjusted upwards each year for inflation) in 2026. The House Ways and Means Committee proposal accelerates this reduction, lowering the exemption amount to $6,020,000 (after the inflation adjustment), effective as of January 1, 2022.
In addition to the federal estate and gift tax, the federal generation-skipping transfer (“GST”) tax, applicable for gifts to “skip persons”, is also assessed at a flat rate of 40%. If the federal estate and gift tax exemption is in fact reduced to $6,020,000 in 2022, the GST exemption will mirror that reduction.
Changes Affecting Grantor Trusts: The proposal would have a significant impact on grantor trusts – trusts in which the grantor is the deemed “owner” of the trust for income tax purposes. Specifically, the plan would include any grantor trust established after the date of enactment of the legislation in the taxpayer’s gross estate, subjecting the trust assets to federal estate tax upon the grantor’s death. Existing grantor trusts would be grandfathered, but with an important caveat: if a “contribution” is made after the date of enactment to an existing grantor trust, the portion attributable to the contribution would be subject to the new rules. The bill does not define what would be considered a “contribution”, but it could include not only a new contribution but also a swap (i.e., the grantor’s substitution of their own assets for trust assets).
The most notable provisions applicable to grantor trusts are as follows:
- Estate Tax Inclusion: Any grantor trust established or funded after the date of enactment would be includable in the grantor’s gross estate for federal estate tax purposes, valued as of the grantor’s date of death.
- Gift Tax Consequences: Except for grantor trusts created and funded before the effective date, a distribution from a grantor trust (or the applicable portion) to someone other than the grantor or the grantor’s spouse or which discharges an obligation of the grantor will be treated as a taxable gift from the grantor on the date of distribution.
- Termination of Grantor Trust Status: After the date of enactment, termination of grantor trust status during the grantor’s lifetime will be treated as a taxable gift of the trust assets (or the applicable portion) on the date of the change of status. The new rules should not apply to automatic termination of grantor trust status due to the grantor’s death.
- Sales or Exchanges Not Disregarded: Sales and exchanges between a grantor and a grantor trust will no longer be disregarded for income tax purposes and will result in the recognition of capital gains or losses.
Importantly, the rules above are effective as of the date the legislation is enacted. Accordingly, clients should act now to avoid the potential impact of these rules.
The practical effect of the rules is not entirely clear, but some of the common types of trusts which will likely be ensnarled by the new rules are:
- Irrevocable Life Insurance Trusts (“ILITs”): ILITs are designed to ensure that insurance proceeds are not subject to estate tax. Typically, the grantor makes gifts to the ILIT each year to fund the premium payments. Although existing trusts are grandfathered under the proposed bill, the contributions made to fund premium payments will fall under the new rules, subjecting a portion of the trust, and eventually the insurance proceeds, to estate tax inclusion, defeating the purpose of the ILIT.
- Grantor Retained Annuity Trusts (“GRATs”): A GRAT is a common strategy used by high net-worth taxpayers to move appreciating assets out of their estate to the next generation. In the typical GRAT, the grantor transfers assets to the GRAT and then receives annuity payments, typically over two or three years, which are equal to the value of the original contribution, and therefore the grantor is not treated as having made a gift for federal gift tax purposes (a so-called “zeroed-out GRAT”). At the end of the GRAT term, if the assets in the trust have appreciated beyond the annuity payments, the appreciation passes estate and gift tax-free to the grantor’s children. The proposed rules would render the GRAT strategy useless, as the transfer at the end of the trust term to the trust beneficiaries would be treated as a gift for the full amount of the appreciated assets. Furthermore, if appreciated assets are used to make the annuity payment to the grantor, that would be a deemed sale and result in appreciation of capital gain.
- Spousal Lifetime Access Trusts (“SLATs”): A SLAT is a trust created by a grantor for the benefit of the grantor’s spouse during the spouse’s lifetime. It is a mechanism that allows the grantor to utilize their estate tax exemption by making a completed gift for gift tax purposes, while still having access to the benefits of the trust vis-à-vis distributions to their spouse. Naming a spouse as beneficiary generally results in the trust being classified as a grantor trust. Fully funded SLATs will be grandfathered, but going forward, it is not likely that this will be a viable planning strategy, as the assets in a SLAT would be subject to estate tax inclusion.
- Qualified Personal Residence Trusts (“QPRTs”): A QPRT is a grantor trust that removes a primary or secondary residence and all future appreciation thereon from the grantor’s taxable estate. At the outset, the grantor transfers the residence to the QPRT for a term of years and reports the gift at a discount. The grantor retains the right to live in the residence rent-free during the QPRT term and continues to pay all expenses. At the end of the term, the residence passes to the beneficiaries free of estate and gift tax, and is removed from the grantor’s taxable estate. QPRTs would no longer be viable under the proposed plan because the distribution to the beneficiaries at the end of the trust term would be treated as a gift for the full value of the residence at that time.
Other Important Provisions:
- Increase in Capital Gains Taxes (effective as of September 13, 2021): The proposal includes an increase in the highest capital gains tax rate from 20% to 25%. However, the plan does not include Biden’s proposal to impose income tax on unrealized gains held at death, which would end the so-called basis “step-up”.
- Elimination of Valuation Discounts on Non-Business Assets (effective as of date of enactment): The proposal would eliminate valuation discounts for lack of control and lack of marketability for minority interests of closely-held entities made up of “non-business assets” (i.e., passive assets held for the production of income and not used in an active trade or business).
- Increased Income Tax Rates for Estates and Trusts (effective as of January 1, 2022): Trusts and estates would be subject to a 3% surcharge on taxable income in excess of $100,000, as opposed to individuals who would only be subject to this surcharge once their taxable income exceeds $5,000,000.
- Prohibition on Roth IRA Conversions: The proposal would prohibit individual taxpayers with taxable income over $400,000 and married taxpayers with taxable income over $450,000 from converting a traditional IRA (which is tax-deferred) to a Roth IRA (which is tax-exempt) as of January 1, 2032. This conversion strategy is known as “back-door” Roth IRA funding because an account owner can circumvent both income and contribution limits. Additionally, effective January 1, 2022, the proposal would prohibit all taxpayers, regardless of income level, from converting after-tax IRA contributions to Roth.
Planning Strategies to Consider Implementing Now: In light of the proposed changes and the short timeframe, some strategies that clients may consider are as follows:
- Create and Fully Fund Grantor Trusts now: It is still possible to create a grantor trust, as long as it is created and fully funded before enactment and avoids the application of the new rules. Keep in mind that it takes time to draft the trust, open the trust account, and fund the trust.
- Use Remaining Estate & Gift Tax and GST Exemption: Consider using remaining exemption now, either by making further contributions to an existing grantor trust, or outright gifts to individuals or non-grantor trusts. Even if the exemption amounts are not reduced next year, they are scheduled to be reduced in 2026. To minimize GST tax on trust assets distributable to grandchildren or more remote descendants, consider making a late allocation of GST exemption to trust assets that are not already GST exempt.
- Engage in any sales or exchanges with an existing grantor trust: If advantageous to do so, consider having the grantor sell or exchange high basis assets for low basis assets in an irrevocable grantor trust prior to the date of enactment to avoid a capital gain realization event.
- If you have an ILIT, consider prepaying insurance premiums or other funding alternatives: ILITs are in danger and the stakes may be very high if you have a large policy, the proceeds of which you intend to keep out of your taxable estate. You should consider how you might fund premium payments after the date of enactment, without exposing the assets of the trust to estate tax inclusion. Subject to future legislative or regulatory guidance, it may be possible for a grantor to make loans to an ILIT to fund the insurance premiums.
- Terminate grantor trust status: In some cases, terminating grantor trust status may be advantageous if you wish to continue making contributions to the trust after the date of enactment.