Proposed Federal Tax Law Changes Affecting Estate Planning

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The House Ways and Means Committee recently released its plan to pay for President Biden's proposed Build Back Better Act. Many of the changes to the Internal Revenue Code proposed by that plan would directly impact gift and estate tax planning.

While the plan is still in negotiations, and changes to the legislation are likely, the impact of the proposed changes on common estate plan strategies make it worth taking notice now.

Decrease of Estate and Gift Tax Exemption

The proposed law would reduce the federal gift and estate tax exemption from the current $10 million exemption (indexed for inflation to $11.7 million for 2021) to $5 million (indexed for inflation to roughly $6.2 million) as of January 1, 2022. Under current law, the existing $10 million exemption would revert back to the $5 million exemption amount on January 1, 2026.

The proposal seeks to accelerate that reduction. If such proposal is adopted, the resulting federal gift and estate tax exemption would reduce to just over $6 million as of January 1, 2022. For this reason, individuals may want to consider using any remaining gift tax exemption prior to the end of the 2021.

Changes to Grantor Trust Rules

The proposal would make major changes to dramatically curtail the ability to use grantor trusts as an effective estate planning technique.

Grantor trusts are a highly valued estate planning technique that allows transferring assets out of a grantor's estate for estate tax purposes, while having the grantor remain the owner for income tax purposes. This has provided the benefit of allowing transactions between a grantor and his/her grantor trust to occur without income tax ramifications (sales, loans, leases, etc.).

It has also allowed a grantor to continue paying the income tax attributable to the assets transferred without such payments being considered additional gifts, and additionally preserving the trust corpus for the beneficiaries. The proposed legislation would turn this structure on its head in several ways:

  • First, the proposed legislation would require inclusion in a grantor's estate of the value of all assets held in a grantor trust as of the grantor's date of death.
  • Second, any sale transactions between a grantor and a grantor trust would be subject to income taxation as if between the grantor and a third party.
  • Third, all distributions from a grantor trust to a beneficiary other than the grantor or the grantor's spouse will be treated as a taxable gift from the grantor to the distribution recipient.
  • Finally, if a grantor chooses to "turn-off" the grantor trust power during his or her lifetime, thereby commuting the trust into a nongrantor trust, the proposed legislation would treat such action as an additional gift of the assets of the trust to the trust beneficiaries, valued as of the date the power is relinquished.

These foregoing changes would apply only to trusts established on or after the date of enactment of the proposed law, and to any contributions to grandfathered grantor trusts made on or after the date of enactment. While the date of enactment will most likely be some time in the future, there is a possibility that any such change could be made effective retroactively.

Additionally, it is unclear as to whether post-enactment transactions between a grantor and his or her grandfathered pre-enactment grantor trust (such as payment of income taxes by the grantor, lease payments by the grantor, or "turning-off" grantor trust status) will be subject to these new rules and the various negative outcomes (including, for example, partial inclusion in a grantor's estate or additional gift tax consequences) as a result.

In particular, the proposed changes to the grantor trust rules will impact several popular grantor trust planning strategies, as described below.

Spousal Lifetime Access Trusts

A Spousal Lifetime Access Trust (SLAT) is a trust set up by a grantor for the benefit of his or her spouse and issue. It is difficult to structure a SLAT as nongrantor trust given the fact that the grantor's spouse is the primary beneficiary.

If a SLAT is established after date of enactment of the proposed law, it will likely be included in the Grantor's estate on his or her death.

Irrevocable Life Insurance Trusts

Irrevocable Life Insurance Trusts are most often established to hold life insurance on the grantor's life in a manner that excludes the death benefit from the grantor's estate. Some life insurance trusts are structured as grantor trusts. Under the proposed law, this would result in the value of the death benefit being included in the grantor's estate upon his or her death.

While grandfathered insurance trusts would be exempt from this inclusion, care must be taken going forward regarding the source of funds for future premium payments. Annual premium payments are often funded by the grantor through annual gifts to the trust. If the proposed changes are successful, these additional contributions to otherwise grandfathered grantor trusts would result in some portion of the insurance trust assets being included in the grantor's estate.

Clients with existing life insurance trusts may want to explore options for pre-funding all future premium payments to avoid this outcome. Alternatively, clients with existing grantor life insurance trusts may seek to modify such trusts to make them nongrantor trusts, if possible, prior to the enactment date of the proposed law.

Grantor Retained Annuity Trusts

The effectiveness of Grantor Retained Annuity Trusts (GRATs) in transferring wealth to beneficiaries could be significantly reduced. Under the current proposal, the distribution of assets to beneficiaries (or to nongrantor trusts for the benefit of trust beneficiaries) at the end of the GRAT term will result in a gift by the grantor to such beneficiaries calculated on the fair market value of such assets at the time of distribution. If a grantor does not have sufficient gift tax exemption remaining at that time to fully cover the gift upon termination, gift tax could be due at that time.

The proposed change effectively renders the GRAT worthless as a mechanism for a leveraged transfer of assets—the grantor is no better off than if he or she made a direct transfer of the assets to his or her chosen beneficiary. Additionally, if a GRAT uses appreciated assets to pay the annuity payment owed to the grantor during the trust term, that payment will be viewed as a sale for which income tax is recognized.

Clients who have funded GRATs with highly appreciated assets may want to consider swapping those low basis assets with high basis assets to reduce the possibility of gain resulting from the annuity payment.

Qualified Personal Residence Trusts

It also appears as though Qualified Personal Residence Trusts (QPRTs) may be rendered similarly useless under the new legislation for the same reason applicable to GRATs. If the distribution to beneficiaries at the end of the QPRT term is subject to gift tax on the fair market value of the asset at that time, the benefit of the QPRT is eliminated.

Valuation Rules for Nonbusiness Assets

A common estate planning strategy has been to transfer marketable securities or nonbusiness real estate to a family limited partnership or family limited liability company, and then transfer via gift or sale fractional or minority interests in the entity. The fractional and/or minority status of the transferred shares has generally resulted in significant valuation discounts, allowing the transferor to gift or sell the interests at a much lower value than simply transferring the interests directly, outside of an entity.

The proposed legislation would eliminate the use of valuation discounts when valuing nonbusiness assets held in an entity. Nonbusiness assets would likely include assets not used in the active conduct of business—cash, marketable securities, triple net leased assets, etc., although the specific definition of "nonbusiness assets" is still unclear.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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