We have written this newsletter to update existing and prospective clients and colleagues regarding potential gift and estate tax law changes and proactive steps that should be considered.
2021 Planning: As we had discussed in our last newsletter, President Biden has introduced a budget proposal. The Greenbook for that proposal includes a host of dramatic tax changes. Senator Sanders has also introduced proposals many of which were introduced in several versions of President Obama's Greenbook. Senator Van Hollen has introduced a proposal that would tax transfers retroactively back to January 1, 2021. Treasury Secretary Janet Yellen recently suggested, in remarks before a Senate panel, that if Congress were to pass a capital gains tax increase effective as of April 2021, that would not count as a retroactive increase.
While many advisers anticipate significant tax change may be enacted, the nature and effective dates of those tax changes are uncertain. Many advisers recommend taking proactive tax planning now. However, there is a wide and disparate spectrum of suggested steps and precautionary measures that are being suggested. Tremendous uncertainty exists as to what income and estate tax law changes might be enacted. While all attendant risks cannot be predicted or ascertained, it remains important to have a basic understanding of some of the reasonably foreseeable and predictable risks, issues and options. Therefore, the following discussion is intended to provide a broad overview of a few aspects of some of the proposals, and some of the planning steps one might consider.
Sanders Proposal: The Sanders proposal, in contrast to the Van Hollen and Biden proposals discussed below, focuses on changes to the gift, estate and generation skipping transfer (GST) tax rules. The exemption amounts will be reduced from the current $11.7 million to $3.5 million for estate and GST taxes, but down to a mere $1 million for gift tax. Valuation discounts may be reduced or, in some instances, eliminated. Tax rates could increase from 40% to as high as 65%. These proposal have driven many taxpayers to shift substantial wealth to trusts prior to a potential date of enactment. Nonetheless, caution on how to proceed may be in order as provisions in the Van Hollen proposal could adversely impact planning intended to avoid the consequences of the Sanders proposal. Some contemplate completing large note sale transactions to grantor trusts in order to lock in what might be prohibited later (e.g. discounts). However, this type of plan could trigger massive capital gains if the Van Hollen proposal is enacted with its retroactive effective date.
If the Sanders proposal is enacted, it could limit annual exclusion gifts made to trusts to twice the annual gift tax exclusion, or $30,000. Such a limitation could wreak havoc on many plans, including common life insurance trusts. In response, some are making gifts, or other transfers now, in order to sufficiently fund such trusts before changes might be enacted. Grantor retained annuity trusts (GRATs) could be so restricted that the historical rolling GRAT approach might be eliminated if the Sanders proposal is enacted. This is spurring some taxpayers (likely those who have already used their exemptions) to complete GRATs now. Because of limitations on GRATs included in the Sanders proposal, GRATs structured in 2021 may be very different than historically utilized. These are but a few of the many changes proposed by Senator Sanders.
Van Hollen Proposal: The Van Hollen bill calls for capital gains to be assessed on transfers to grantor trusts that are not included in the donor's estate and on transfers to non-grantor trusts. This could trigger capital gains tax on transfers made on January 1, 2021 or later. Thus, steps taken in 2021 to save estate tax, and avoid the restrictions of the Sanders estate tax proposal, could trigger capital gains tax. The Van Hollen proposal calls for taxing all appreciation on trust assets every 21 years. While some dismiss the proposal as too harsh, consider that President Biden's proposal (see below) also includes similar deemed realization events. As a result, some are transferring non-appreciated assets, or borrowing to fund gifts with cash instead of appreciated assets. While such steps might preserve exemption if a Sanders proposal is enacted, and not trigger capital gain if the Van Hollen proposal is enacted, they will not avoid harsh deemed realization events that could occur every 21 years with regard to assets held in trusts.
Biden's Budget Proposals: President Biden's proposals include taxing capital gains at ordinary income rates if adjusted gross income exceeds $1 million. This could result in approximately 40% federal taxation on the sale of a business, real estate or other valuable asset. In addition, that rate might be increased by the 3.8% net investment income tax, in addition to the imposition of state and local taxation. The Biden proposal also includes gain realization on gift or death, and even on certain funding of partnerships, LLCs and other entities. Thus, instead of a step up in income tax basis on death, all appreciation, above an exclusion amount, could be subject to capital gains tax. The capital gains tax (at federal rates reaching 40%) would be in addition to the estate tax (although a credit may offset some of the double taxation that would otherwise occur). President Biden's proposal also includes a 90-year deemed realization rule. Gain on unrealized appreciation would be recognized by a trust, partnership, or other non-corporate entity on property for which a recognition event has not occurred within the prior 90 years, with such "testing" period beginning on January 1, 1940. Consequently, the first recognition tax period could be deemed to have occurred in 2030. While certain exclusions would apply, it is not clear what those might be. So, as of January 1, 2030, irrevocable trusts created on or before January 1, 1940 could be subject to gain realization, meaning all unrealized appreciation would be taxed.
Some interpret the Biden proposals as triggering a gain realization event when trusts terminate. For example, you created a spousal lifetime access trust (SLAT) naming your spouse and descendants as beneficiaries in an effort to protect your $11.7 million exemption. On your spouse’s death the trust is to divide into separate trusts, one for each of your children. This may be construed to be a triggering event under the Biden proposal causing imposition of a capital gains tax. You might decant (merge) the existing SLAT into a new trust that keeps all trust assets in the same trust even after the death of your spouse. While many prefer separate trusts for each child (family line), is this worth doing to possibly avoid a proposed realization event if such a proposal is enacted?
Steps You Might Consider: No one can predict effective dates, or even what might be enacted. Previously it seemed prudent to plan now and hope planning completed before the effective date of a change would be grandfathered (exempted) from new changes. Now such planning may come with the added risk of possible capital gains tax consequences (unless unappreciated assets or cash is transferred). It is possible that if a trust is funded now it may escape proposed tough rules on grantor trusts being included in your estate, the application of a GST tax every 50 or 90 years, and more. However, it is also possible that these proposed changes might be made applicable to all trusts, even trusts completed before 2021. In fact, the Sanders bill proposes that all trusts lose GST exempt status after 50 years. The Van Hollen and Pascrell proposals would actually tax unrealized appreciation in trusts every 21 or 30 years, respectively. Those changes might make it preferable to transfer assets outside of trust. There is simply no certainty. Moreover, no adviser can guarantee the results of any plan or, at this juncture, the ability to complete the planning before any changes are enacted. Thus, even logical well-intentioned planning could prove harmful.
Protective Steps that Might Help: There are steps that might safeguard planning. Consider borrowing money and transferring the borrowed funds to a trust instead of transferring appreciated assets, in an attempt to avoid triggering capital gains. Some recommend inclusion of a disclaimer provision in new trusts that are to receive gifts and other transfers. Such a provision might provide a mechanism to unwind the transfers if adverse, and especially retroactive, tax law changes are enacted. But there are differences in opinion as to how such a disclaimer provision might be structured and its effectiveness. Transfer documents (e.g. an assignment of an LLC membership interest to a trust by gift) might utilize formula clauses limiting the amount transferred to your exemption amount in the event that exemption amounts are retroactively changed (although at present there are no proposals do to that). Consider contributing trust assets, and even many non-trust assets (excluding retirement plans and certain other assets) to partnerships or limited liability companies now in an attempt to avoid a tax that might be triggered on that type of transfer under a Biden proposal. Perhaps new trusts should include a mechanism to permit retaining assets in a single trust and negate provisions that would otherwise divide trusts on the death of a senior family member/beneficiary. Review existing trusts to evaluate whether it might be prudent to decant a trust into new trusts that incorporate provisions discussed above as well as other safeguards (e.g. the ability to distribute all trust assets to the lowest generation beneficiary prior to a new law resetting a trust’s GST inclusion ratio from zero to one).
Unfortunately, every plan faces a conundrum. The concern with all of these suggestions is that without knowing what will actually be enacted, such steps might prove irrelevant, or worse, harmful. On the other hand, waiting to know what is enacted, may eliminate the availability of any or all such options.
More to Consider: Planning relating to these significant tax proposals must also consider a myriad of other tax, asset protection, legal and other factors. Meaning that the complexities and uncertainties described above are not the only hurdles you face in deciding what planning steps you might pursue. As an example, several significant tax cases (Powell and recently Moore) suggest that planning may have to be carefully structured to remove from the transferor’s reach of control over distributions, liquidation and perhaps other key entity matters. This might suggest revisions to governing documents (e.g. operating agreement for an LLC), segregating distribution and liquidation powers (and the rights to change the documentation controlling those matters) into separate trusts, etc. Perhaps revising trust document to prohibit modifications of these steps may be prudent. As with so much of complex estate and related planning, there are a wide variety of opinions as to what steps might or should be taken and what might be effective.
Income Tax Basis Considerations: It may be prudent to review the type and basis of assets held in irrevocable trusts. Assets held in an irrevocable trust (other than a QTIP trusts) will not qualify for basis step-up on death. If the trust is a grantor trust, and includes a power to substitute, you may be able to swap assets into the trust in exchange for the appreciated trust assets. For irrevocable grantor trusts, consider the potential benefits of swapping appreciated assets so that they will be included in the settlor's estate to gain a basis step-up on death. There is uncertainty as to whether the exercise of a swap power now may trigger gain under some of the tax proposals being considered in Washington, so caution is in order. In addition, hard to value assets may add an additional level of uncertainty and/or complicate the ability to exercise a timely swap. Additionally, if the trust's status is changed from grantor to non-grantor status, gain could be triggered if the Van Hollen or a similar proposal is enacted. Moreover, Van Hollen and President Biden's proposals might trigger taxation on the appreciation of trust assets every 21 or 90 years, respectively. While it is impossible to predict what might be enacted or when, these proposals may completely change the types of planning advice that have historically been provided as well as the potential impact of transferring and holding assets in trust. While trusts will likely continue to provide valuable asset protection advantages, the use of trusts may be disadvantaged by these deemed realization events as contrasted to owning assets outright.
Follow Up on Prior Planning: For prior planning, it remains important to confirm you and all advisers have copies of fully executed instruments. In addition, document and calendar any outstanding follow up and administrative steps: such as dates note and annuity payments have to be made, annual meetings/consents for entities, formalities of proper distributions from entities and trusts, gift tax and income tax compliance deadlines, etc.
Secure Act: Review beneficiary designations for IRAs and other plans, as well as any trusts named as beneficiaries. The Secure Act generally eliminated the so-called “stretch-IRA” that had been the core of many plans and may adversely impact an intention to keep retirement proceeds in trust when a conduit trust (as opposed to an accumulation trust provision) was utilized for many classes of beneficiaries.
Potential Lessons from Morrissette: A recent case is yet another example of how the tax environment constantly changes, and how new court decisions (and other developments) continue to transform the planning environment. Morrissette v. Commission, T.C. Memo 2021-60 (May 13, 2021) provided the IRS with a victory that essentially put the kibosh on certain complex insurance tax planning. A 40% gross valuation misstatement penalty was assessed against the taxpayer in Morrissette II. In that case, the Court found that the taxpayer did not act with the “reasonable cause” or in “good faith” that would be necessary to avoid the imposition of harsh penalties assessed by the IRS. The Court found that the appraised value of an approximately $30 million insurance payment, claimed by the taxpayer to be worth about $7.5 million, was not reasonable and that the taxpayer knew as much. Some commentators question the appropriateness of the Court applying this standard to valuation. Nonetheless, following this decision, might it be prudent to exercise a greater degree of caution with respect to valuation matters? Might this case also herald a greater potential for assessment of valuation understatement penalties in future cases? Regardless of the differing views, caution may be in order. While the taxpayer in Morrissette was successful in deflecting certain estate tax inclusion challenges by the IRS, this was based on the Court finding the existence of a significant business purpose and substantial family disputes in Morrissette. These factors do not always exist and even if they do may be difficult to corroborate. One might therefore wish to carefully evaluate whether a business purpose for a transaction exists. If it does exist, steps might be taken to corroborate such purposes. If a business purpose does not exist, or cannot be demonstrated, a taxpayer might wish to reassess the risks and advisability of a particular plan.
Bottom Line: While it seems prudent to plan now, every taxpayer will have to assess and make their own decisions regarding how much risk they are willing to accept, what they anticipate might occur with respect to law changes (or not), and the cost and complexity they are willing to incur in light of such uncertainty. Bear in mind, opting to do nothing in light of the uncertainty might prove to be the greatest risk. Accordingly, we are advising clients to schedule a meeting with us so that we can identify potential changes that are needed in their estate plans, particularly if they have any irrevocable trusts. We may not have a crystal ball, but we are quickly developing some strategies to at least try to provide some buffer to some of these potential changes. Clients may need to act very quickly, definitely before December 31, 2021. If any legislation is enacted this year, we will be incredibly busy, so waiting is not in a client's best interests.
DISCLAIMER: We provide the information in this article for general information purposes only, and these materials do not constitute legal or other professional advice. We do not accept any responsibility for any loss that may arise from reliance on the information contained herein. No reader should act or refrain from acting based on information contained in this article without seeking advice of counsel.