Four months into the 117th United States Congress, the anticipated federal legislative proposals to restructure the federal estate tax are finally seeing the light of day. Senator Bernie Sanders and others recently introduced the For the 99.5% Act (the “Act”). True to its name, the Act takes direct aim at income and wealth inequality through a series of proposed changes that, if passed, will result in a larger number of estates (and trusts) paying more federal estate, gift, and generation-skipping transfer (“GST”) taxes. The following is a short overview of many of the Act’s more significant revisions to the federal estate tax. There is no certainty on when, how, or if the federal estate tax will change, so taxpayers remain in a bit of wait-and-see mode.
Current Federal Estate Tax
The current lifetime estate, gift, and GST tax exemption amounts are $11.7 million per person (which is indexed for inflation and will rise through 2025, unless changed), or $23.4 million per married couple. Estates larger than the federal exemption face a 40% federal tax, in addition to any state estate taxes.
Reduction to Exemption and Increase in Tax Rate
With the Senator’s characteristic focus on wealth and income inequality, it is not a surprise that the Act aims to address both in a number of different ways. Most prominently, the Act would reduce the federal estate and GST exemption by $8.2 million to $3.5 million per person (not indexed for inflation). The lower exemption will subject a higher number of estates to the estate tax. The Act gradually increases estate tax rates based on the value of the estate. The estate tax rate would be 45% on estates between $3.5 million to $10 million; 50% between $10 million and $50 million; 55% between $50 million to $1 billion; and 65% on estates over $1 billion. GST is taxed at the highest federal estate tax rate, so it would rise from 40% to 65% under the Act. When taken together, the lower exemption and high estate tax rates would result in more estate taxes paid by more estates as of January 1, 2022.
To illustrate the differences between the current law and proposed revisions, if a person dies in April 2021 with a $10 million estate, the $11.7 million exemption entirely covers the estate and the heirs would receive all $10 million. If the Act passes in 2021 and the same person dies in 2022, the estate can exempt only $3.5 million, and the remaining $6.5 million is taxed at a rate of 45% for $2,925,000 in estate taxes. There, the heirs would receive $7,075,000.
Reduced Options to Gift
On January 1, 2022, the Act would also lower the gift tax exemption from $11.7 million to $1 million and leave the amount of the current annual gift tax exclusion at $15,000 (still indexed for inflation). However, the annual exclusion has new limits for certain transfers, including a cap of twice the annual exclusion amount ($30,000) per donor for transfers to trusts regardless of the number of beneficiaries. These changes reduce options to transfer assets during life to avoid estate taxes at death.
De Facto Duration Limit on New and Existing GST Trusts
GST trusts are typically funded using a grantor’s GST exemption so distributions to a generation skipping person (typically, grandchildren or lower generations) are exempt from the onerous GST tax for as long as the trust may run (150 years in Washington State). The Act seeks to limit the duration of the dynastic trusts through nullifying the GST exemption after 50 years. For trusts created after enactment, any distribution to a skip person after 50 years is subject to GST tax. For all trusts created before enactment, any distribution to a skip person 50 years after enactment will be subject to GST tax. To illustrate the change, a $1 million distribution to a grandchild in 2073 would result in $650,000 in GST taxes, meaning it costs $1.65 million in trust assets to make a $1 million distribution to a skip person. The nullification of the GST exemption effectively forces trusts to make distributions to non-skip persons after 50 years or, if none are available, to consider terminating distributions to skip persons shortly before the 50 year deadline to avoid substantial GST taxes.
Grantor Trust Utility Changes Dramatically
The Act also imposes new rules on grantor trusts. Among several key features, grantor trusts allows trust assets to grow tax free through the grantor’s gift-tax free payment of the trust’s income taxes. The Act takes direct aim at grantor trusts by imposing a new requirement that the assets of grantor trusts established after it is enacted be included in the grantor’s gross estate, less any gift tax paid upon transfer into the trust. This revision pulls the value of the appreciated assets back into the estate, which eviscerates one of the main reason to use a trust. The Act also impacts current grantor trust by requiring the inclusion assets contributed after the enactment in the grantor’s gross estate. Many irrevocable life insurance trusts (“ILITs”) are grantor trusts. This change, along with the proposed revision to the annual exclusion, may create the pre-enactment need to transfer assets into ILITs to fund or prepay policy premiums to avoid assets being pulled back into estates.
No Valuation Discounts for Nonbusiness Assets
One other impactful change is the Act disallows minority discounts for lack of marketability and lack of control for nonbusiness assets, i.e., assets not used to conduct a trade or business. The value of those types of assets will be gross value, with no valuation discount available.
Planning in Uncertain Times
The United States Congress is divided and partisan. If it passes, the dramatic changes discussed above likely will be smoothed around the edges as the Act progresses through the legislative process. However, the Act provides new clarity on potential near-term revisions to the federal estate tax. It is likely still too early to know the exact steps taxpayers should take ameliorate the potential revisions to the estate tax. While the Act takes aim at lifetime gifting through various means, taxpayers with the ability to make sizable gifts now may, after discussions with their estate planning team, elect to utilize the higher federal exemption before it changes. In addition, currently established inter vivos trusts may benefit from a review by an estate planning attorney to assess options to mitigate the potential adverse changes.