Tax and Estate Planning Client Alert

The proposed legislation currently being deliberated1 in Congress, contains several changes to the current income and estate tax laws. These proposed changes, if and when enacted, will dramatically affect future estate tax planning for high-net-worth individuals, wealthy families, and business succession planning. Many of the primary strategies we have used to achieve transfer tax (estate, gift and generation skipping transfer taxes) and income tax minimization for our clients will be rendered ineffective.  The most significant measures affecting estate planning opportunities are:

1. Changes to the Grantor Trust Rules

2. Reduction in the Gift and Estate Tax Exemption Amounts

3. Elimination of Valuation Discounts for Closely Held Businesses

4. Increase in the Capital Gains Rates

If enacted into law, some of the proposals would affect existing plans, as well. 

The purpose of this alert is to recommend you review your existing plans with your tax attorney, financial advisor, and CPA. While we continue to review the proposed changes, in anticipation of the possibility of passage, we are discussing with clients various strategies to consider in order to mitigate the effects of the new laws upon existing and future plans.

Changes to the Grantor Trust Rules

Many of the strategies estate planning and tax attorneys have traditionally utilized revolve around the use of irrevocable grantor trusts. Intentionally Defective Grantor Trusts (IDGTs), Grantor Retained Annuity Trusts (GRATs), Qualified Personal Residence Trusts (QPRTs), Spousal Lifetime Access Trusts (SLATs), and Irrevocable Life Insurance Trusts (ILITs) are all typically structured as irrevocable grantor trusts. The current tax code treats such irrevocable trusts as separate taxable entities for gift and estate tax purposes, but treats the grantor and the trust as one and the same for income tax purposes. As a result of this disparity:

• The grantor can remove the assets and future appreciation from his or her gross estate, while continuing to pay the trust’s income taxes, payment of which is not deemed to be a taxable gift.
• A sale or a loan between a grantor trust and a grantor do not create any income tax liabilities.

Under the proposed law, the date of death value of the assets owned by a grantor trust would be included in the grantor’s estate, for estate tax purposes, upon the death of the grantor. Distributions to non-spouse beneficiaries would be treated as taxable gifts by the grantor to the beneficiaries. Transfers of assets between the grantor trust and its grantor would no longer go unrecognized for tax purposes. The grantor or the trust would be forced to recognize gain or loss, or incur transfer tax, on the transaction. Conversion of existing grantor trusts to non-grantor trusts will trigger tax consequences. Taxable income retained by a non-grantor trust above $13,050 will be subject to an income tax rate of 39.6%. Modified adjusted gross income of a non-grantor trust above $100,000 will subject to a 3% surcharge, as well as the 3.8% net investment income tax.

The proposed laws would only affect irrevocable grantor trusts funded after the date of enactment, meaning irrevocable grantor trusts created and fully funded before the date of enactment will be grandfathered in.

After enactment, ILITs, IDGTs, QPRTs, GRATs, and most SLATs, likely will not be viable planning strategies post-enactment. because the death benefit of any insurance policy owned by the trust will be subject to estate tax. Discuss with your tax attorney whether an ILIT could be designed as a non-grantor trust or non-grantor SLATs could  present a future option for your family.

With regard to existing ILITs, the change in the law could prove problematic to existing plans. Many ILITs are set up in such a way that the grantor, on an annual basis, transfers funds into the trust to pay the premiums on policies held in the trust. Some split-dollar and third-party premium financing arrangements call for the employer or a third party to advance annual premiums to the trust and subsequently be repaid, or indirectly gift the funds to the ILIT. Once this legislation is enacted, transfers of funds to pay annual premiums will be subject to gift tax and could trigger estate inclusion of the insurance proceeds. And unless an ILIT has liquid assets available to pay premiums, the policies will lapse.

What to Do Now

With regard to ILITs, consider pre-funding the ILIT now, before the date of enactment, with liquid assets sufficient to pay all, or multiple years’ worth, of future premiums. Using the higher gift tax exemption amount now is beneficial. However, not all clients are in a position, financially, to exercise this option. Funding the ILIT with income-producing property will result in taxable income to the trust (at high rates).  Depending on future guidance from the IRS, a loan to the trust could be an option, as long as it is properly structured and documented, so as not to be recharacterized as a gift. Loans between family members may be subject to higher scrutiny by the IRS, who will examine whether the terms of the loan are commercially reasonable. If a client wants to transfer a policy to the ILIT now, perhaps a bona fide sale of the policy before the date of enactment is an option.

Reduction in the Gift and Estate Tax Exemption Amounts

Currently, the gift and estate tax exemption amount is $11,700,000 per person or $23,400,000 per couple. That means  you (and/or your spouse) may give away up to those amounts during life or at death without incurring federal gift or estate tax. Currently, the estate tax rate is 40%. The proposed legislation would reduce that amount to $6,025,000 per individual or $12,050,000 per couple.  In addition, the generation-skipping transfer tax exemption amount, currently 40%, will be correspondingly reduced.

What to Do Now

The current exemption amount is “use it or lose it.” If you are a client with a net worth (or anticipated net worth) in excess of the new exemption amount, you may want to consider making large gifts to an existing irrevocable grantor trust prior to the date of the enactment of the bill. No claw-backs for use of your current exemption amount before the date of enactment will occur. Discuss with your attorney whether to allocate your remaining GST exemption to trust assets that are not already GST-exempt.

Valuation Discounts Eradicated

Most business succession plans or estate plans transferring wealth from one generation to the next involve planning around valuation discounts. A frequent strategy is use of an intentionally defective grantor trust (IDGT) to transfer closely held business ownership interests to the trust in return for a note. The grantor sells non-voting shares or units to the trust at the appraised fair market value. The fair market value of the shares will be appraised at a discount for lack of control and for lack of marketability. In return the grantor will receive a note equal to the discounted value of the interests transferred plus interest at the AFR. For example, assume the grantor transfers 50 % of the nonvoting shares in an LLC valued at $100 million. If the value of this portion of the LLC were directly proportional to the percentage of the entity, the shares would be valued at $50 million. However, discounts will be taken for lack of marketability and lack of control. Generally, valuation discounts fall in the 30% range. Therefore, the fair market value of the interests transferred to the IDGT will be $35 million, rather than $50 million. This amounts to an instant tax-free gift of the discounted value to the beneficiaries. The note will be for $35 million rather than $50 million, so payments on the note will be lower. The difference between the AFR and the interest rate on the note will permit interest rate arbitrage as well. The grantor is nevertheless able to retain control of the entity until death because he still possesses the voting shares in the entity.

The proposed legislation would eliminate these valuation discounts for transfers occurring after the date of enactment, if the business assets include publicly-traded securities, non-operating cash, or other passive investment assets unrelated to the business.

What to Do Now

Consider making transfers of interests in family business entities that would now reflect these valuation discounts before the enactment of the legislation. Tax attorneys may be able to assist with post-enactment strategies for such transfers, but be sure to involve your attorney, as this requires careful planning.

Increase in the Capital Gains Rates

The proposals in Congress increase the highest capital gains tax rate from 20% to 25%. The new rate would apply to contractual transactions occurring after September 13, 2021. Trusts are taxed at the highest rates on MAGI 2 exceeding $13,050, while individuals are taxed at the top rate on MAGI exceeding $400,000 for single filers, $425,000 for head of household filers, and $450,000 for joint filers. A 3% surcharge on modified adjusted gross income (MAGI) over certain limits would also go into effect for 2022 and would apply at lower thresholds to estates and  trusts ($100,000) than to individuals ($5 million). Dividends will also be affected by the proposal.

What to Do Now

Talk with your tax lawyer, financial advisor, and CPA. It may be prudent to sell highly appreciated assets now. On the other hand, if you are not likely to need the money over the next ten years, perhaps it would be wise to hold the assets and wait for future changes to the law. Focus investments on those that are likely to appreciate over time rather than those that generate sizeable dividends. Examine the assets held by existing trusts within the family with these same issues in mind.

1 The Build Back Better Act, released on September 13, 2021 by the House Ways and Means Committee.
2 Modified Adjusted Gross Income