Making The Right Steps In View Of Yesterday’s Estate/Gift Tax Proposals

By Alan S. Gassman and Brandon Ketron

House Democrats provided a not so welcome distraction for high bracket and wealthy taxpayers from the ongoing pandemic and evacuation of Afghanistan this morning by releasing their plan to adjust how basic income and estate taxes will work for businesses and families, and the two certainties in life promised by Benjamin Franklin have never been more certain.

While no one can offer a comprehensive summary or analysis of what these 881 pages of proposed new laws entail, we can cover many primary changes, points of confusion, and also the effective dates provided in this proposed legislation.

Brandon Ketron and I will present a free Webinar on these new rules on Saturday at 11 a.m. (Eastern Standard Time). Please feel free to join us by e-mailing info@gassmanpa.com for an invite to the live presentation and the YouTube replay that will be set up shortly thereafter. Please also send us questions and suggestions for what you would like for us to cover.

Webinar attendees will receive easy-to-use spreadsheets that can help them see how taxpayers may come out under the new exemption amounts by putting present net worth, annual net savings and asset value growth rates for both single individuals and married couples, as well as a Qualified Personal Residence Trust (“QPRT”) Estate Tax Savings Calculation Spreadsheet that we have recently developed.

The good news is that only a few of the new rules would impact transactions or transfers that are made before the new Act would be passed, and many of the provisions would not take effect until January 1, 2022, but those who are being advised to transfer significant values to irrevocable trusts as gifts before their exemption amounts are cut in half must act by the day that the law is enacted, or must alternatively plan to gift the amounts to people or entities other than grantor trusts, if they do this after the date of enactment, and before year end, based upon how the bill was written.

Below is a section by section breakdown of major changes and effective dates, and thoughts relating to what to do and what not do while we wait to see what changes are made to the Bill, and if any substantial bill will be passed this year. All of this is subject to change as the Senate gets involved, but we should not see anything more severe or taxpayer unfriendly than what these rules are, and it could be a lot worse.

Tops on the list of action items for most wealthy American families is to get their houses into order in preparation for increased federal estate taxes. After months of being teased with the prospect of a lower estate tax exemption, and the possibility that the exemption would come down before there was time to make large gifts, the reality of what is proposed must now sink in for a few days, and then action may need to be taken.

Estate/Gift Tax Exemption Cut in Half Effective January 1, 2022 – Use It or Lose It

The good news on this arena is that the reduction of the estate and gift tax exemption from $10,000,000 as adjusted for inflation (presently $11,700,000 per person) will be intact through the end of 2021, but will be reduced to one half of the present amount effective January 1st, 2022. This means that the “use it or lose it” gifting decisions for wealthy individuals can be made up through the end of this year, but most well advised wealthy families will be better off making such gifts before such legislation is passed, because of the Grantor Trust and discount rules described below.

As an example for a person who will not use a Grantor Trust or discounts, Grandma has used $700,000 of her estate and gift tax exemption from prior gifting, and therefore has an $11,000,000 exemption remaining that she may wish to use prior to the end of the year. If she has a $21,000,000 estate and makes an $11,000,000 gift, this will reduce her estate to $10,000,000. If Grandma then dies in 2022, or thereafter, she would have no exemption remaining, and the estate tax will be $4,000,000 ($10,000,000 x 40% = $4,000,000). Fortunately, the proposed law does not increase the estate tax rate the way that the Bernie Sanders bill would have.

If Grandma does no gifting in 2021 and dies in 2022, or thereafter, when the exemption would be based upon one half of $11,700,000 ($5,850,000) adjusted for inflation to perhaps $6,000,000, then her estate will be $21,000,000 reduced by her remaining exemption amount of $5,300,000 ($6,000,000 less prior gifts of $700,000), and estate taxes of $6,280,000 ($15,700,000 x 40% = $6,280,000) will be owed to Uncle Sam 9 months after her death. It will not feel good to stroke that check for $6,280,000.

What if Grandma does not make the gift but is on her death bed on December 31st 2021 hoping for a miraculous recovery and a few more years in the very nice retirement home where she lives. Would you want her children or best friend to make her health care decisions at that time? One day of life could cost $2,280,000.

It is also important to note that there will be no “clawback” for use of the increased exclusion amount, meaning that Grandma will not be penalized for gifting $11,000,000 of assets if she passes away at a time when the applicable exclusion amount is $6,000,000.

Another factor to consider is that in order to use the temporary increased exemption, gifts must exceed what the exemption will be reduced to. For example, if Grandma were to gift $5,000,000 in 2021 when the applicable exclusion amount is $11,700,000 and then pass away in 2022, or thereafter, when the applicable exclusion amount is only $6,000,000, Grandma’s applicable exclusion amount would only be $1,000,000. Therefore, in order to take full advantage of the increased exemption, Grandma will need to gift all $11,000,000 of her remaining exclusion.

The fact that families will have until the end of this year to make large gifts if the law passes is the good news. The loss of very important vehicles that we commonly use for gifting and estate tax planning is the bad news. I may have to get a hobby besides planning estates and writing and giving webinars if this law passes. Please write to your congressman and ask them not to pass the proposed rules on Grantor Trusts and discounts, which would take effect upon the day that President Biden signs the new law effect, if this happens.

What Is the Big Deal About Grantor Trusts?

A Grantor Trust is a trust that can be separate and apart from the Grantor and contributor of the trust for estate tax purposes, but be considered as owned by the Grantor for income tax purposes. Since the Grantor is considered as the owner of the trust for income tax purposes, transactions between the trusts and the grantor are “disregarded” meaning that assets can be sold or exchanged with the trusts without triggering any income tax consequences.

The vast majority of well positioned wealthy clients who have engaged in planning have established these trusts, which allow the Grantor to pay the income tax on the trust assets on behalf of the beneficiaries, and also allow the Grantor to sell assets that may qualify for a discount, such as non voting LLC interests for long term low interest notes without paying any income taxes on the sale. The numbers can be very advantageous where instead of owning a valuable asset that may have income and growth at 7% or more the client has a note bearing interest at 2% that will not grow in value. Not only that, but the Grantor can continue to pay the income taxes associated with the Trust’s assets without the payment of income taxes being considered a gift to the trust, which allows the trust to grow income tax free and further reduce the Grantor’s estate.

In the above example, Grandma could put $14,000,000 of investments in an LLC and gift the 99% non voting membership interest in the LLC to a Grantor Trust for her descendants. Due to discounts associated with a non-controlling, non-marketable interest in the LLC allowed under present law, this might result in an $11,200,000 gift (assuming a 20% discount applies). Grandma can pay the income tax on the income from the investments for her remaining lifetime, which will further reduce estate taxes for her family upon death, but only if she acts before the date of enactment of the new bill.

Fortunately, Grantor Trusts established and funded before the enactment of the new law would be grandfathered, as would promissory notes in place at the time of enactment, so a great many estate tax planners expect to be very busy completing trusts and sale arrangements that are in progress now, and uncertain how many more they have the capacity to handle given the short time frame Congress is providing us with here.

Discounts and Other Estate Planning Tools May Also Be Impacted

The new bill would not only stop the use of Grantor Trusts, but it would also eliminate discounts unless the asset gifted or sold is an “active trade or business”. The new bill may also stop planners from being able to use irrevocable life insurance trusts, at least to some degree, and also Grantor Retained Annuity Trusts (GRATs), Qualified Personal Residence Trusts (QPRTs), and Grantor Charitable Lead Annuity Trusts (CLATs) depending upon how it is applied and interpreted.

What we do not know is whether the anti-Grantor Trust provisions would prevent or significantly hinder the use of other types of trusts that are specifically permitted under the Internal Revenue Code, but may have different and completely ineffective tax results if established or funded after the date that the bill is enacted.

Possible Impact on the Use of a Qualified Personal Residence Trust (QPRT)

For example, a Qualified Personal Residence Trust allows a homeowner to transfer his or her homestead or a vacation property into a Trust that permits the Grantor to make use of the property at no rent charge for a term of years, and considers the gift of the ownership interest in the home to be less than the full value of the home because of the discount attributable to the present value of the free use possessory term.

Nevertheless, after the death of the Grantor, the entire value of the property held under the Trust escapes estate tax, and the Grantor will pay rent after the possessory term of years expires, which further reduces the Grantor’s estate, and enables the Grantor to continue to use the property.

The QPRT can be drafted to be disregarded for income tax purposes, both during and after the possessory term, so that rent paid for use is not taxable to the Trust, and the property is considered to be owned by the taxpayer in the event of sale, to qualify for the $250,000 or $500,000 exclusion for the sale of a primary residence.

If the new proposed Act is read literally, then QPRTs that are entered into and funded by deed before the date of enactment will be grandfathered to receive the above benefits, but those that are executed and funded by deed after the date of enactment will cause the property to be considered to have been gifted in full when the trust is established, and then possibly again after the Grantor dies and the property is transferred to the beneficiaries, with a credit to be received for the initial transfer when the second transfer occurs.

What About Grantor Retained Annuity Trusts (GRATs)?

Likewise, a Grantor Retained Annuity Trust (“GRAT”) is an arrangement whereby an individual can transfer property to a trust which provides for payments back to the individual over a term of years in fixed dollar amounts that are sufficient to cause there to be no gift for gift tax purposes.

Nevertheless, if the assets in the GRAT grow in value above approximately 1.0% a year, based upon present rates for GRATs entered into this year, the excess value remaining after the term of years can pass estate and gift tax-free.

A GRAT is considered to be a Grantor Trust during the time that the Grantor receives annual payments, and can be considered to be a Grantor Trust thereafter, if drafted to facilitate that.

Under the new rules, the funding of a GRAT after the date that this law would be enacted could cause income tax on the excess of the fair market value of the assets placed into the GRAT over the tax basis of such assets, and the excess value remaining after the GRAT term may be considered a gift when distributed, notwithstanding that Internal Revenue Code Section 2702 provides under present law that no gift results when the actuarial value of the annual payments made to the Grantor equals the value of assets placed into the Trust.

Charitable Lead Annuity Trusts (CLATs)

A Charitable Lead Annuity Trust (“CLAT”) works in a way very similar to a GRAT, except that the fixed annual payments will go to a charity, with what remains after the term of years that payments are made to pass to family members without being considered to be a gift.

A Grantor CLAT is a CLAT that is drafted to be disregarded for income tax purposes, and therefore Grantor CLATs that are funded after the date of enactment may trigger income tax on the excess of the fair market value of the assets placed in the GRAT over the income tax basis, with the remainder interest passing to descendants being subject to federal gift tax when the payments to charity end.

The above discussion of QPRTs, GRATs and CLATs may not be accurate or what the Ways and Means Committee is intending, and guidance with respect to this will probably be forthcoming in any legislation that would pass, or before or immediately after passage, but individuals and families who are considering the use of QPRTs, GRATs or CLATs should proceed without delay.

While the loss of Grantor Trusts and discounting, not to mention Qualified Personal Residence Trusts, Grantor Retained Annuity Trusts and Charitable Lead Annuity Trusts would be formidable, other techniques will continue to exist. Nevertheless, estate tax planners will feel like carpenters who have lost their hammers, nails and pliers, and have significant construction to do somehow without them. The result for wealthy families will be exposure to pay significant income taxes upon many effective estate tax planning techniques, and to have a much higher risk and probability of paying estate tax on a larger part of a family’s assets.

Is There Any Good News?

We were pleased to see no mention of a number of things that had been tossed around by lawmakers, including the following:

1. No “capital gains tax on death” was included, or any rule that would detrimentally affect the present tax laws that permit the assets of a deceased individual to be considered to have been purchased for the fair market value thereof on the person’s date of death to eliminate capital gains taxes attributable to appreciation and depreciation taken up through the date of death.
2. Proposals that would have taxed placing appreciated assets into separately taxed trusts, or transferring appreciated assets out of separately taxed trusts are also thankfully not mentioned.
3. Proposals which would have reduced the amount of annual gifts that an individual or married couple could have made to irrevocable trusts or otherwise were not included.
4. Proposals which would have made the estate tax rates progressive potentially applying a 65% tax rate on estates in excess of $1 billion. Thankfully under the current proposal the estate tax remains at a flat rate of 40%.
5. Proposals to decrease lifetime gifting allowance to as low as $1,000,000. Under the current proposal the estate and gift tax exemption remains the same, although reduced to one-half of what would have otherwise applied.
6. Specific provisions that would eliminate a step up in basis for assets held by a Grantor Trust. While it is unclear under present law if a step up in basis applies to assets held by Grantor Trusts, many practitioners take the position that a step up in basis does apply since the grantor is considered to be the owner of the assets for income tax purposes.
7. Proposals to apply generation skipping taxes via a deemed termination of Generation Skipping dynasty trusts every 50 years.

The good news for estate tax advisors is that there are very few proposed new rules in this arena under the new bill. The bad news is that if our spouses were upset because we have been working late up until now, then they have not seen anything yet!