Proposed Changes to Federal Tax Laws Affecting Estate Planning | Davis Wright Tremaine LLP
The House Ways and Means Committee recently released its plan to pay for President Biden’s proposed Build Back Better Act. Many of the Internal Revenue Code changes proposed by this plan would have a direct impact on gift and estate tax planning.
Although the plan is still under negotiation and changes to legislation are likely, the impact of the proposed changes on common estate planning strategies is worth considering now.
Reduction of the tax exemption on inheritances and gifts
The proposed law would reduce the federal gift and estate tax exemption from the current $10 million exemption (indexed for inflation to $11.7 million for 2021) to $5 million ( indexed to inflation at approximately $6.2 million) beginning January 1, 2022. Under current law, the current $10 million exemption would revert to the $5 million exemption amount on January 1, 2026.
The proposal aims to accelerate this reduction. If such a proposal passes, the resulting federal gift and estate tax exemption would be reduced to just over $6 million effective January 1, 2022. For this reason, individuals may consider using any remaining gift tax exemptions before the end of 2021. .
Changes to Grantor Trust Rules
The proposal would make major changes to significantly reduce the ability to use grantor trusts as an effective technique for estate planning.
Grantor trusts are a popular estate planning technique that allows assets to be transferred out of a grantor’s estate for estate tax purposes, while leaving the grantor to retain ownership for estate tax purposes. Income. This offered the advantage of allowing transactions between a grantor and their grantor trust to occur without tax ramifications (sales, loans, leases, etc.).
It also allowed a settlor to continue to pay income tax attributable to transferred property without such payments being considered additional gifts, and further preserving the corpus of trust for beneficiaries. The bill would reverse this structure in several ways:
- Firstthe proposed legislation would require inclusion in the settlor’s estate of the value of all assets held in a settlor’s trust as of the date of the settlor’s death.
- Secondany sale transaction between a grantor and a grantor trust would be subject to income tax as if entered into between the grantor and a third party.
- The thirdall distributions from a grantor trust to a beneficiary other than the grantor or his or her spouse will be treated as a taxable gift from the grantor to the beneficiary of the distribution.
- ultimatelyIf a settlor elects to “turn off” the settlor’s trust power during their lifetime, thereby turning the trust into a non-settlor trust, the proposed legislation would treat that action as a further gift of trust assets to the trust beneficiaries, valued at the date of the renunciation of power.
These amendments would apply only to trusts established on or after the date of enactment of the proposed legislation, and to any contributions to grandfathered grantor trusts made on or after the date of enactment. Although the date of promulgation is most likely in the future, it is possible that such a change could be made retroactively.
Further, it is unclear whether post-enactment transactions between a settlor and its pre-enactment grantor trust (such as the payment of income taxes by the grantor, lease payments by the grantor or “deactivation” of the grantor trust status) will be subject to these new rules and the various negative consequences (including, for example, partial inclusion in a settlor’s estate or additional tax consequences on gifts) that result.
In particular, the proposed changes to the settlor trust rules will affect several popular grantor trust planning strategies, as described below.
Spousal Lifetime Access Trusts
A Spousal Lifetime Access Trust (SLAT) is a trust created by a settlor for the benefit of their spouse and descendants. It is difficult to structure an SLAT as a non-settlor trust since the settlor’s spouse is the primary beneficiary.
If an SLAT is established after the date of enactment of the proposed law, it will likely be included in the settlor’s estate upon death.
Irrevocable Life Insurance Trusts
Irrevocable life insurance trusts are most often established to hold life insurance on the life of the settlor in a manner that excludes the death benefit from the settlor’s estate. Some life insurance trusts are structured as grantor trusts. Under the proposed law, this would result in the value of the death benefit being included in the settlor’s estate upon death.
Although grandfathered insurance trusts are exempt from this inclusion, care should be taken in the future regarding the source of funds for future premium payments. Annual premiums are often funded by the grantor through annual donations to the trust. If the proposed amendments are successful, these additional contributions to otherwise grandfathered grantor trusts would result in some of the assets of the insurance trust being included in the grantor’s estate.
Clients with existing life insurance trusts may want to explore options to pre-fund all future premium payments to avoid this outcome. Alternatively, clients with existing constituent life insurance trusts may seek to amend those trusts to become non-constituent trusts, if possible, before the date of enactment of the proposed law.
Annuity trusts retained by the settlor
The effectiveness of Grantor Retained Annuity Trusts (GRATs) in transferring wealth to beneficiaries could be significantly reduced. Under the current proposal, distribution of assets to beneficiaries (or non-granting trusts for the benefit of the beneficiaries of the trust) at the end of the term of the GRAT will result in a gift by the grantor to those beneficiaries calculated on the fair market value of those assets. at the time of broadcast. If a donor does not have sufficient gift tax exemption at that time to fully cover the gift upon termination, gift tax may be due at that time.
The proposed change effectively renders the GRAT worthless as a leveraged asset transfer mechanism – the settlor is no better off than if it transferred the assets directly to its chosen beneficiary. Additionally, if a GRAT uses appreciated assets to pay the annuity payment due to the settlor during the term of the trust, that payment will be considered a sale for which income tax is recognized.
Clients who have funded GRATs with highly valued assets may consider swapping these low-base assets with high-base assets to reduce the possibility of gain from paying the annuity.
Qualifying Personal Residence Trusts
It also appears that Qualified Personal Residence Trusts (QPRTs) may similarly be rendered redundant under the new legislation for the same reason applicable to GRATs. If the distribution to the beneficiaries at the end of the QPRT term is subject to gift tax on the fair market value of the asset at that time, the benefit of the QPRT is eliminated.
Non-trading asset valuation rules
A common estate planning strategy has been to transfer marketable securities or non-commercial real estate to a family limited partnership or family limited liability company, and then to transfer by gift or sale fractional or minority interests in the entity. . The fractional and/or minority nature of the transferred shares has generally resulted in significant valuation discounts, allowing the transferor to donate or sell the interests at a much lower value than the simple direct transfer of the interests, outside of an entity .
The proposed legislation would eliminate the use of valuation discounts when valuing non-trading assets held in an entity. Non-trading assets would likely include assets not used in the active conduct of business – cash, marketable securities, triple net leased assets, etc., although the specific definition of “non-trading assets” is still unclear.