The political classes in Washington D.C. continue to negotiate a final version of the budget reconciliation bill. The House version of the reconciliation bill has a public “sticker price” of $3.5T. That cost and some underlying elements are troublesome to a few Democratic senators, the most publicly to Senator Manchin (D - W.V.) and Senator Sinema (D - Ariz.). If you are even casually following the events, you know that to navigate the Senate successfully, all the senators in the Democratic caucus are required to vote yes on the final bill.
Given the scope of a potential $3.5T bill, it is impossible to concisely analyze its impact in quick posting (or possibly even a novel). Despite this, I will try to briefly summarize the publicly debated elements of the bill affecting estate planning. At the macro level, if enacted as written, House Bill (H.B. 5376) would:
Reduce the Federal estate exclusion (Estate, Gift and Generation-Skipping Transfer (GST) tax exemptions) from $11,700,000 to approximately $6,020,000 in 2022;
Eliminate the estate planning benefits of irrevocable grantor trusts; and
Revise how the estate and gift tax valuations are calculated for nonbusiness entities.
1. Decrease of the Basic Exclusion Amount
The basic estate tax exclusion amount and the applicable tax rates have varied since the modern estate tax was established in 1916. Looking at the two most recent significant changes, in 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, establishing a basic exclusion of $5,000,000, which was adjusted each year upward to account for inflation. Subsequently, the Tax Cuts and Jobs Act of 2017 temporarily doubled the exclusion for the tax years 2018-2025. The base amount would then return the 2010 act’s calculation of $5,000,000 adjusted for inflation.
The current draft of the budget reconciliation act moves forward the reset of the exclusion calculation to tax the year 2022. The change results in an exclusion amount of $6,020,000 for 2022 ($5,000,000 adjusted for inflation since 2010). Given that this provision (or one like it) is almost certainly going to survive any final bill negotiations, assuming you are not looking to similarly move up your death to take advantage of higher exclusions, what should you do?
For the vast majority of us, nothing. But it is possible to make gifts this year utilizing the higher estate tax exclusions for very high net worth individuals. Doing so is complex, and before making this decision, please explore your options and the ramifications of your choices with an appropriate tax attorney or account.
2. Loss of Benefits of Irrevocable Grantor Trusts
Under current law, an irrevocable grantor trust is a trust that has received a completed gift from an individual (the “grantor”) and is not includable in the grantor’s estate for estate tax purposes. However, the trust property is treated as owned by the grantor for income tax purposes.
Accordingly, a grantor may sell assets to an irrevocable grantor trust without realizing gain (or swapping assets with the trust) and may pay income taxes on trust income without making a gift to the trust.
As drafted, the House bill adds two new sections to the Internal Revenue Code significantly undermining the use of irrevocable grantor trusts in estate planning.
New § 2901 negates the estate tax benefits of irrevocable grantor trusts in the following ways:
The trust assets values are included in the grantor’s estate for federal estate tax purposes.
During the grantor’s lifetime, any trust distributions to anyone other than the grantor or the grantor’s spouse are treated as a gift by the grantor for estate tax purposes.
If the trust is dissolved during the grantor’s lifetime, any trust assets transferred are treated as a gift made by the grantor.
New § 1062 treats the sale or exchange of assets between the grantor and their irrevocable grantor trust as a taxable event for income tax purposes.
The draft bill provides that §§ 1062, 2901 apply to any trust created after the enactment of the bill and any portion of trusts funded by contributions made after the date of enactment. Furthermore, the language of the committee report indicates § 1062 applies to any transfers of property post-enactment, regardless of when the trust was funded.
If enacted as drafted, the bill eliminates much of, if not all of, estate planning benefit of creating new irrevocable grantor trusts. These provisions impact several common estate planning trust arrangements that utilize grantor trusts, including:
Grantor Retained Annuity Trusts (GRAT);
Qualified Personal Residence Trusts (QPRTs);
Irrevocable Life Insurance Trusts (ILIT);
Spousal Lifetime Access Trusts (SLATs);
Certain Grantor Charitable Lead Trusts (CLTs); and
Dynasty Trusts.
The impact of the bill on existing trusts is murkier. While it is clear that the new rules apply when an existing trust receives post-enactment contributions, the bill lacks a specific meaning of the term “contributions” and whether that is limited to actual gifts to the trust or whether it includes other events that may be deemed transfers. For example, if a grantor forms an ILIT, the annual gifts to the trust to pay the insurance premiums are certainly transfers for purposes of the bill, but the bill’s provisions can reasonably be, and probably should be, read to include the payout of the insurance proceeds following the grantor’s death as a transfer as well.
Whether you should take any action today is a difficult question to answer, given we do not know which provisions will survive the ongoing negotiations. You can still create new irrevocable grantor trusts or add to existing trusts to be “grandfathered.” But, if the new arrangements require future exchanges between the trust and its grantor (as with a GRAT), there is a substantial risk that such exchanges will be taxable. Similarly, if the arrangement will require additional contributions (as with an irrevocable life insurance trust), you should also consider the tax consequences of such contributions.
3. End of Gift and Estate Tax Discounts on Interests in Entities Holding Nonbusiness Assets
Transferring interests in entities like family limited partnerships and LLCs to family members has long been an effective estate planning strategy to move wealth to future generations while keeping the underlying investments pooled together. A significant advantage of this strategy is that the law permits applying discounts to the value of the transferred interests due to lack of marketability and lack of control.
The House Bill introduces new § 2031(d) eliminates these discounts to the extent an entity owns nonbusiness assets. The proposed statute requires the estate to value an entity without regard to any restrictions imposed by the entity itself.
Nonbusiness assets are defined broadly to include (i) any passive asset, (ii) held for the production of income, and (iii) not used in the active conduct of a trade or business. In most cases, this will include cash, real estate, financial investment assets, such as stocks, bonds, and derivatives, and economic interests, such as profits interests (including carried interests) and capital interests in partnerships and similar vehicles. The elimination of these valuation discounts applies to any made by the transferor or the transferor’s estate after the date of the enactment.
4. Noteworthy Omission, the Repeal of Stepped-up Basis
One widely discussed proposal was missing from the House Ways and Means Committee’s version of the bill. The proposed bill does not address eliminating a stepped-up basis. An asset with an appreciated value currently transfers to the heir at its value on the day the decedent died (or, in some cases, an alternate valuation date). The estate does not pay capital gains on past appreciation, and the heir only pays tax for future gains.
For instance, Wiley E Coyote owns 100 shares of Acme Explosives that he bought for $1000. If he sells it today for $10,000, he owes tax on a $9000 gain. But if Wiley dies in an explosion, the shares transfer to Wiley Jr. at the current value of $10,000, and he only pays tax on any gains above that basis when he sells in the future. The widely circulated change would have forced the estate to pay tax on gains of $9000 as if Wiley had sold the shares at the time of his demise. In addition to the tax on the gains, the entire $10,000 would be included in Wiley’s gross estate for estate tax purposes.
When the asset is a highly liquid, non-personal asset, there is some appeal to viewing the transfer in this light. When the asset is a generational family farm or business, the issues with this change become quickly apparent. A recent Wall Street Journal editorial by Democratic Senator Max Baucus illustrated the issues inherent in this provision and the difficulty the Democratic leadership would have in selling the provision to members of their party beyond just Senators Manchin and Sinema.
Interestingly, there is a way to eliminate stepped-up basis without the catastrophic consequences envisioned by those opposing it. The heir could merely take the asset with a basis equivalent to the decedent’s basis. Upon sale, the heir would owe all capital gains. Unfortunately, this solution does not accomplish what the more progressive supporters of the bill require: current tax income at the time of the death to offset the exorbitant costs of their proposals.
Right now, this proposal is “dead,” but given the ongoing negotiations and need to generate tax revenue in the bill, we should remain aware that it is out there.