On September 13, The Ways and Means Committee of the House of Representatives released sweeping tax proposals affecting both businesses and individuals. Some of these proposals would have a significant impact on estate tax planning strategies if enacted.
Proposed tax law changes in the draft legislation that could affect clients’ estate planning include:
Estate and Gift Tax Exemption Decreases
- Lower the gift tax and estate tax exemption from the current $11.7 million per person ($23.4 million per married couple) to the 2010 level of $5 million per person, adjusted for inflation.
- The reduction in the gift and estate tax exemption also will reduce the generation skipping transfer tax exemption from $11.7 million per person to $5 million per person, also adjusted for inflation.
- The decreases would take effect for gifts made, and for estates of persons dying after, December 31, 2021.
- Early estimates are that these inflation-adjusted exemptions will be approximately $6.02 million.
Changes to Treatment of Grantor Trusts
Grantor trusts – trusts whose taxable activity and income are reported on the income tax returns of the persons who created the trusts – have been a widely-used and popular planning technique for many years. The proposed legislation would significantly restrict their use in the future. Among the planning techniques that would be impacted are:
- Grantor retained annuity trusts (GRATs).
- Qualified personal residence trusts (QPRTs).
- Intentionally defective grantor trusts (IDGTs).
- Spousal lifetime access trusts (SLATs).
- Irrevocable life insurance trusts (ILITs).
Grantor trusts would be subject to four specific changes:
- Grantor trusts would be included in the grantor’s taxable estate for estate tax purposes when the grantor dies.
- Distributions from grantor trusts during the lifetime of the grantor, except for distributions to the grantor or the grantor’s spouse, would be treated as taxable gifts for gift tax purposes.
- “Turning off” the grantor trust treatment of grantor trusts during the lifetime of the grantor also would be treated as taxable gifts for gift tax purposes.
- “Transfers” between a grantor trust and the grantor would be treated as sales between the owner and a third party, making it a taxable event. Regulations will be required to clarify what constitutes a “transfer,” but most expect that it will encompass, at a minimum, sales of assets by grantors to their grantor trusts, which has been a widely-used planning technique.
These changes would apply to new grantor trusts created after the date of enactment (when the President signs any legislation passed by both houses of Congress). These changes also would apply to portions of trusts to which contributions are made after the date of enactment. Grantor trusts that are created and funded before the enactment date would remain subject to the current tax laws as long as no future contributions are made to the trusts.
Should this tax proposal be enacted, ILITs would become especially problematic. The premiums on life insurance policies held in ILITs are often funded through gifts to the ILIT that qualify for the annual exclusion from the gift tax. Making these contributions to the trust after the date of enactment of the proposed changes would cause at least partial inclusion of the insurance in the settlor’s estate, which would defeat the purpose of establishing the ILIT. Some commentators expect the life insurance industry to mount a vigorous campaign to exempt ILITs from these new rules. In the meantime, individuals who have ILITs that are funded with annual gifts to pay the policy premiums may wish to consult with us and their insurance agents to consider whether to pre-fund their ILITs and/or their life insurance policies held in ILITs.
Changes in Valuation Rules
The proposed legislation would affect valuation and:
- Disallow valuation discounts in connection with transfers of entities holding significant nonbusiness (passive) assets that are held for the production of income and not used in the active conduct of a trade or business. Examples of “passive assets” include cash, marketable securities and investments, real estate, promissory notes and partnership interests. This would affect gifts or intra-family sales of family limited partnerships and LLCs that are funded with investment portfolios and/or operating companies with cash or other assets in excess of the normal working capital needs of the business. A look through rule would be applied to a passive asset that consists of a 10% interest in another entity, treating the holder of the passive asset as holding its ratable share of the assets of the other entity directly. The changes related to passive assets would apply to transfers made after the legislation’s date of enactment.
- Increase the value of property eligible for special use valuation for estate tax purposes from $750,000 to $11,700,000. This primarily affects property used in family farms and family businesses by allowing the property to be valued based on its current use rather than its highest and best use. This is the only pro-taxpayer provision in the draft legislation that affects estate planning.
What Is Not Included in This Proposed Legislation
Perhaps as noteworthy is what was not included:
- Most notably, there is no provision to eliminate the “step up in basis” that occurs upon an individual’s death. Current law allows assets included in a decedent’s gross estate for estate tax purposes to receive an adjustment to their income tax basis equal to fair market value at the date of death. This has the effect of wiping out unrealized gains and preserving more of a decedent’s assets for transmission to heirs and beneficiaries.
- Limitations on the number and size of the annual exclusions from the gift tax were not included.
- Except for reducing the generation skipping transfer tax (GSTT) exemption amount, the GSTT would be left unchanged. Proposals to limit the duration of dynastic-style trusts had been proposed earlier this year by some lawmakers.
- The proposed changes in the laws related to estate tax planning would not be retroactive as some congressmen and senators have proposed.
Negotiations Are in Full Swing
As of our publication date, this legislation is still being debated and has not yet passed the full House of Representatives. Of course, even if this legislation is passed by the House, passage by the Senate will be necessary, and we can expect that senators will have their own proposals. As with any proposed legislation, we cannot predict what will be added, modified or deleted in regards to these proposals as they move through Congress.
Clients who have delayed making gifts or finalizing plans for new trusts may have only a short time (weeks or at most a few months) to finalize and implement their plans and should not delay action any further.
If you have questions about any of the proposals mentioned above, please contact your Warner estate planning attorney.