November 12, 2021
UPDATE: The BBB draft legislation has been revised and updated, most recently (as of this writing) as of November 4. The newer draft takes several of the proposed changes off the table. Significantly, this version does not include the reduction in the estate tax exemption (and corresponding gift and generation-skipping transfer tax exemptions). If left unchanged, the existing inflation adjustment will increase the exemption from 11,700,000 to $12,060,000 in 2022. The changes to valuation discounts and treatment of grantor trusts are also absent from this version.
The bill does include a couple of new surtaxes for estates and trusts as follows:
* A 5% surtax on the modified adjusted gross income of a trust or estate above $200,000
* An additional 3% surtax on the MAGI of a trust or estate above $500,000
The good news is that the modified AGI is determined after deductions for charitable contributions.
This continues to be a moving target for families and planners. It remains to be seen whether the provisions originally appearing in this bill will stay out, or whether some of the provisions will make their way back into the final version. While hard to predict, at this point it seems less likely there will be sweeping changes to the status quo vis a vis estate, gift and GST planning. Regardless, there remains a risk that these changes reappear, or that they are passed in later legislation, perhaps in 2022 retroactively. For many families, continuing to plan with a sense of urgency (but not panic) may be the most risk averse approach.
Yogi Berra famously said, “when you come to a fork in the road, take it.” The “Build Back Better” Act (BBB) was introduced in the House on September 13. Among hundreds of pages of legislation, many of which are tax related, are some important proposed changes in the estate and trust arena which represent tax increases for high net worth families.
At this point, these are just proposals; a version of the bill from the Senate hasn’t yet been introduced, and what happens in Washington is frustratingly difficult to predict. Nevertheless, the BBB’s introduction signals that some of the favored tools of the estate planner may be legislated out of existence starting on January 1, 2022. Between now and then is a short window of opportunity to capture significant tax benefits. In other words, we believe this may be the proverbial “fork in the road.” Mark Twain lamented that he “was seldom able to see an opportunity until it had ceased to be one.” This message is designed to alert you to the potential issues and opportunities, and allow you to take the action you deem prudent.
ESTATE TAX INCREASE
The 2017 Tax Cuts and Jobs Act doubled the then-existing estate tax exemption. The proposed BBB halves it back to pre-2017 levels. Using round numbers, this means a decrease in the estate tax exemption from $12MM to $6MM per person. For a married couple, this means a $12MM reduction in estate tax exemption. For individuals with an estate of $12MM+, this is a tax increase of $2.4MM. For a married couple with $24MM+ the tax increase is $4.8MM.
The current gift and estate tax exemptions are unified. A taxpayer can use this exemption during life, or at death, so there is an opportunity to gift assets out of one’s estate and utilize the higher exemption levels until December 31. This is most advantageous when the gift(s) are large enough to use the disappearing exemption. Gifts up to ~$6MM use the exemption that will otherwise remain after January 1. Any gifts over that will take advantage of the exemption that disappears on that date.
GRANTOR TRUST ELIMINATION
As alluded to earlier, Grantor Trusts (sometimes also called Intentionally Defective Grantor Trusts, Defective Grantor Trusts, or if the beneficiary is a spouse, a Spousal Lifetime Access Trust or SLAT) are one of the favorite tools of estate planners for mitigating the impact of estate taxes. And they are on the BBB’s chopping block. The existing Grantor Trust rules are a “best of both worlds” from an income and estate tax perspective. Assets can be gifted out of one’s estate (sheltering the growth from future estate taxes), and income taxes can be paid by the grantor and not the trust. In effect allowing income tax to be paid as additional tax free gifts to the beneficiaries, perhaps at a better rate compared to the trust, and further reducing the Grantor’s taxable estate.
For ultra-high-net worth individuals and couples, assets can be sold tax-free to the trust where exemption has been used. Under the BBB’s rules, assets in Grantor Trusts created in 2022 or later (or asset contributed in 2022 or later) would be included in the estate of the Grantor, and sales of assets to a Grantor Trust would no longer be tax free. If taxable sales occur in the future, capital gains would be realized, and the new top capital gains rate is raised to 25%. Furthermore, the ability to recognize valuation discounts for gifts or sales is somewhat limited, depending on the type of assets involved. Existing Grantor Trusts would be grandfathered, which means there’s a limited time opportunity to create and fund a Grantor Trust. Any additional gifts to Grantor Trusts after January 1, 2022 would result in some portion of the Trust’s assets being included in the Grantor’s estate.
These proposed changes to the Grantor Trust rules are also problematic when contributions will be made to an Irrevocable Life Insurance Trust (ILIT) after 2021 to fund the payment of life insurance premiums. Under current law, ILITs are treated as Grantor Trusts. This is a difficult issue to remedy. The trust may need a provision which prohibits payment of insurance premiums to qualify as a non-grantor trust, but this leaves the problem of how premiums will be paid. The grantor could commit to pay the premiums directly as an indirect gift to the trust (for gift tax purposes), but the trust would not have actually paid the insurance premiums and should thus avoid Grantor Trust status. Crummey beneficiaries must still be notified of their rights to withdraw, and the trust must have a cash reserve available from which to satisfy any exercised withdrawal rights. Another option is to fund the ILIT with an income producing asset sufficient to fund future premiums. This funding must take place before December 31.
William Arther Ward said, “opportunities are like sunrises. If you wait too long, you miss them.” To modify his analogy, if these changes impact you, don’t let this opportunity sunset.