Proposed Legislation to Change Estate and Gift Tax Planning

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Democrats recently unveiled the Build Back Better Act, which, if passed, would bring significant changes to the Tax Code and would have a drastic impact on common estate planning techniques, including gifts to trusts. The House Ways and Means Committee approved the plan on September 15, 2021, and now the legislation must work its way through the House Rules Committee and the House at large before going to the Senate.

The focus of this alert is on estate planning changes, which include lowering of the estate, gift, and generation-skipping transfer (also known as “transfer tax”) exemptions. The estate planning aspects will be covered in a future alert about the proposed changes subjecting certain irrevocable grantor trusts to the estate tax, and attempting to overhaul the “grantor trust” income tax rules. We will cover the proposals to increase ordinary income and capital gains tax rates for high-income earners in a future alert as well. Please note this is only proposed legislation and will almost certainly change before it is enacted.

Lower Gift and Estate Exemptions

The proposals reduce the federal estate and gift tax exemption from the current $11.7 million (inflation-adjusted for 2021) to $5 million (inflation-adjusted) effective January 1, 2022, instead of January 1, 2026. The inflation-adjusted exemption is anticipated to be about $6 million.

Some potential changes that had been previously discussed did not appear in this proposal. The 40% estate and gift tax rate did not change. The estate and gift tax changes are not retroactive. There is no limit on the number of annual exclusion gifts, and generation-skipping or dynasty trusts are not limited to 90 years if governed by state law that permits a longer duration.

Because the reduced exemption is not effective until January 1, 2022, there is a period for possible tax planning in advance of the impending changes. We recommend considering using the 2021 exemption to move assets out of your estate by December 31, 2021 (or prior to enactment, if grantor trusts are used). For example, if you have been considering making gifts using your remaining gift tax exclusion and/or GST exemption amounts but have been worried about the potential for retroactivity, the proposed changes may provide you with sufficient comfort to proceed with the gifts before the end of 2021. If you are considering a complex strategy, such as a sale or gift to a grantor trust or the gifting of discounted assets, the trust must be created sooner rather than later because the changes to grantor trusts would become effective upon the enactment of the legislation, as we will discuss more in our next alert. All of the other factors that must be considered when gifting are still factors, such as the income tax implications of the loss of the step-up in basis and the loss of control and use of the asset. These factors were discussed in prior alerts (see Post-Inauguration Estate Planning: Should Large Gifts Be Made Now? and Gift-Giving and Other Planning Under the New Political Landscape).

Valuation Discounts

Valuation discounts have been challenged by the IRS for many years. If an individual owns a closely held business interest that is not publicly traded and does not have voting control, it is unlikely that a third-party purchaser would purchase the interest for its liquidation value (i.e., the partnership interest’s pro-rata value of the underlying assets in the partnership). Rather, a third-party purchaser would want a discount from the liquidation value. For transfers of interests in a closely held entity, the proposals eliminate valuation discounts for lack of control or lack of marketability that are attributable to the nonbusiness assets held by the entity. Nonbusiness assets are passive assets that are held for the production of income and not used in the active conduct of a trade or business. Exceptions are provided for assets used as working capital of a business.

This provision is designed to eliminate the strategy of creating family LLCs or limited partnerships to hold passive assets (i.e., a portfolio of stocks, bonds, or mutual funds), and have the LLC or partnership valued for gift and estate tax purposes at a lesser value due to discounts for lack of marketability and minority interests. This change would be effective for transfers made after the effective date of the legislation, so it would be important to make discounted gifts of entities holding passive assets in the very near future. Discounts will likely not be available for year-end gifts of entities holding passive assets.

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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