In the United States Congress, there is an arduous journey before a bill becomes law. See https://youtu.be/FFroMQlKiag. But there is a common theme running through some gift and estate tax bills that have been introduced in Congress this year. That is: an appropriate way to raise revenue (for pandemic relief, infrastructure improvements, jobs, whatever the reason) is to collect more taxes when so-called “wealthy” individuals transfer their assets through lifetime transfers and transfers at death.
In this context, “wealthy” generally means an individual who is likely to own assets at death that are worth more than $3.5 million ($7 million for married individuals). If you are in that group, or think you might be in the future, there are things you can do now to eliminate wealth transfer taxes upon your death, or at least minimize them, even if the law changes. The emphasis is on now, because most of the planning strategies that are currently available to eliminate or minimize transfer taxes may no longer be available after the date a bill is enacted into law. (Good news for those who believe none of these proposals will become law – you can stop reading right now.)
There is no one-size-fits-all when it comes to gift and estate tax planning. What is appropriate for your situation depends on your objectives, the circumstances of your beneficiaries, and your particular assortment of assets. With that understanding, here is a list of proposed changes in federal law that may affect your ability to accomplish your objectives:
- Reduction of Exemptions and Increase in the Estate Tax Rate. Most proposals would reduce the current estate tax exemption (meaning the amount you may transfer free of estate tax) from $10 million ($11.7 million in 2021 after adjustments for inflation) to $3.5 million (not adjusted for inflation). The gift tax exemption would be reduced from $10 million ($11.7 million in 2021 after adjustments for inflation) to $1 million (also not adjusted for inflation). In addition, transfers in excess of the exemption amounts would be taxed at progressive rates (rather than the current flat rate of 40%) as follows:
- 45% of the value of an estate between $3.5 million and $10 million;
- 50% of the value of an estate between $10 million and $50 million;
- 55% of the value of an estate between $50 million and $1 billion; and
- 65% of the value of an estate in excess of $1 billion.
For the vast majority of Americans (estimates are 99.5% of the people who will die in any given year), a reduction of the estate tax exemption to $3.5 million is of no consequence. But for those who have assets in excess of $3.5 million ($7 million for married individuals), the reduction would reduce their ability to shift wealth out of their estates or into protective structures that may limit the reach of their creditors and their beneficiaries’ creditors, including claims of divorcing spouses. This might mean that there is a great advantage for individuals to use the current $11.7 million exemption now, or as much of it as possible, before a change is enacted. There are several ways to do that while at the same time preserving access to the gifted assets.
- Gift Tax Exclusion for Annual Gifts. The proposals seek to return the use of the annual gift tax exclusion (currently $15,000 per donee) to the original intent, which was to shield the normal giving done around holidays and birthdays from tax and recordkeeping requirements. Thus, use of the annual exclusion would still be available for outright gifts of cash or marketable securities. However, the annual exclusion for gifts to trusts and for gifts that cannot be immediately liquidated by the donee, such as interests in family business entities that may be subject to sale restrictions, would be significantly limited. It appears that the unlimited gift tax exclusion for tuition and medical expenses paid directly to a provider would be preserved.
- Limitation on Use of Long-Term (Dynasty) Trusts. Under the laws of Wisconsin and several other states, trusts may be established to last forever, or at least for hundreds of years, thus preventing the trust assets from being taxed or subject to creditor claims as they pass from one generation to the next. The proposals would “strengthen” the so-called generation-skipping transfer tax (currently a 40% tax on distributions from certain trusts to grandchildren and more remote descendants) by applying it to any trust established to last more than fifty years.
- The End of Grantor Trusts and Sales of Appreciating Assets to IDGTs? A so-called “grantor trust” is ignored as a separate taxpayer for income tax purposes. Thus, the grantor (the creator of the trust) can sell appreciating assets to this type of trust in return for a note from the trust without realizing capital gains because, for income tax purposes, no sale is considered to have occurred. (This transaction is sometimes referred to as a sale to an intentionally defective grantor trust, or IDGT). Another consequence of grantor trust status is that all trust income is taxed to the grantor because, for income tax purposes, the trust does not exist. Thus, the trust can increase in value without the burden of paying income taxes. Normally, if a taxpayer were to pay another taxpayer’s income taxes, that would be gift. However, the IRS has ruled that it is not a gift when a grantor pays taxes on the income of a grantor trust. The proposals would effectively end the use of grantor trusts as wealth-shifting devices by including the value of such trusts in the grantor’s gross estate for estate tax purposes and taxing distributions from such trusts as gifts from the grantor.
- The End of GRATs? A specific type of grantor trust is a grantor retained annuity trust (or GRAT). A GRAT allows an individual to transfer an appreciating asset to the trust, retain an income stream from the trust for a term of years (the present value of which is deducted from the value of the gift, sometimes reducing the gift to slightly more than zero), and have the assets of the trust pass tax-free to the next generation at the end of the term of years. The proposals would not prevent the use of GRATs but would place so many restrictions on how they can be structured that hardly anyone would want to use them.
- The End of Valuation Discounts for Family Business Entities? Currently, the value of an interest in a family business, such as a corporation, limited liability company or limited partnership, may be discounted for gift and estate tax purposes if certain restrictions apply. The proposals would require those interests to be valued without regard to such discounts.
Not all of the new tax proposals are designed to raise revenue. Some would protect family farmers by allowing them to lower the value of their farmland by up to $3 million for estate tax purposes. Some also would enhance the tax savings from creating conservation easements on real estate.
The proposed effective date for changes in the gift and estate tax exemptions and tax rates is January 1, 2022. However, the proposed effective date for almost everything else described in this notice is the date of enactment of the new law.
Will any of these proposals be adopted? Will some but not all of them be included in a bill that is designed to gain the necessary votes in the U.S. Senate? No one knows. But certainly the drumbeat of change in federal gift and estate tax laws can be heard.