Take-Away: A week or so ago a short summary of Bernie Sander’s proposed Bill, “For the 99.5 Percent Act” was provided. Some of its proposals are covered in a bit more depth.

Background: The proposed “For the 99.5 Percent Act” is clearly an effort to eliminate many conventional estate planning strategies and principles that have been used over the past decade to shift wealth outside the U.S. transfer tax system. A review of the proposed changes and their possible impact on some estate planning techniques follow.

Federal Estate Tax Exemption: The proposed Bill would reduce the present federal estate tax exemption of an individual from $11.7 million to $3.5 million. The effective date would be at, or after, enactment of the Bill.

The $3.5 million amount would not be adjusted by cost-of-living escalators. [IRC 2010 (c) drops subsection (B), the COLA escalator provision.]

With the escalated applicable exemption amount in recent years, there was a fair amount of upstream planning, where gifts were made to parents with the expectation that the parent’s own large applicable exemption amount would be able shelter the gifted assets from any estate taxation while exposing the gifted assets to an income tax basis adjustment on the parent’s death. That planning may no longer work with a much lower $3.5 million estate tax exemption available to the parent’s estate.

With the lower applicable exemption amount married clients may well go back to the credit shelter trust planning of the past, where the appreciation in the credit shelter assets will escape estate taxation on the survivor’s death. Joint trusts may be less frequently used for this reason, although married couples like their simplicity

Perhaps more QTIP trusts will funded on a spouse’s death, but probably with  no Claytonlike QTIP election made by the independent trustee.

Portability of the deceased spouse’s unused applicable exemption amount would continue between the spouses  but that may not work if the survivor’s exemption is not adjusted upward by inflation, but the assets sheltered by the portability election continue to grow in the survivor’s estate.

Federal Transfer Tax Rates: The current flat transfer tax rate of 40% would become progressive, going from 45% to 65%. [Note, in Senator Sander’s proposal of over a year ago, he had proposed taxing estates in excess of $1.0 billion at a 77% rate. That was dropped in the current Bill after his discussions with members of the Democratic caucus.)

A $25 million dollar estate under the existing transfer tax regime would be taxed at $5,320,000 on the owner’s death. Under the proposed Bill, the estate tax would be $11,745,000 million on a $25 million dollar estate at the owner’s death.

Federal Gift Tax Exemption: The proposed Bill would end the present unified federal gift and estate tax exemptions. The federal gift tax applicable exemption amount would drop from $11.7 million to $1.0 million per individual. The effective date would be after December 31, 2021, which gives some donors a relatively short window of opportunity in which to exploit their large applicable exemption amount with lifetime gifts during this calendar year.

Like the federal estate tax exemption amount of $3.5 million, the $1.0 million federal gift tax exemption amount would not be adjusted by cost-of-living escalators.

Split-gifts between spouses would continue to be available to a married couple.

With the prospective effective date for this possible legislative change, previously suggested techniques like coupling gifts made in 2021 with defined value formula gifts, with the excess  gift passing to QTIPs or donor advised funds under valuation adjustment clauses, or anticipated disclaimers by trustees or donees may longer be required to hedge against a retroactive reduction in the donor’s gift tax applicable exemption amount.

An individual using a Michigan Qualified Dispositions in Trust in anticipation of marriage, i.e. the Qualified Dispositions Trust is intended to serve as an alternative to a prenuptial agreement, may no longer find it as a viable alternative, unless the lifetime transfers to the Qualified Dispositions Trust are structured as incomplete gifts.

The much lower federal gift tax exemption would dramatically curb the use of grantor retained annuity trusts (GRATs are covered below) as an effective way to circumvent federal gift taxation on lifetime transfers.

Valuation Discounts: The proposed Bill eliminates valuation discounts for nonbusiness assets, which are defined as “any asset which is not used in the active conduct of one or more trades or businesses.” The Bill also carves out what it describes as “working capital reasonably required by the business” but does not provide much in the way of helpful descriptions of what that working capital ‘carve out’ actually means.

The Bill expressly targets minority discounts and marketability discounts, but appears to preserve blockage or saturation valuation discounts.

The Bill creates restrictions that apply if an entity is controlled by members of the same family, including ancestors, spouses, lineal descendants of such individuals, individual’s spouses, parents, or the spouse of any lineal descendant.

The Bill also creates a ‘look through’ rule that is intended to prevent tiered entities from still claiming some valuation discounts for lower tiered entities controlled by parent entities.

The Bill essentially abandons the standard “willing buyer-willing seller” test [Regulation 20.2031-1(b)]  in family controlled business entities.

With this change,  the value of a gift would be the fair market value of the entire asset that is the subject of the gift, multiplied by the percentage that is transferred.

This change would effectively eliminate the use of family limited partnerships or family limited liability entities in estate planning if an non-operating business is the owned by the entity. In other words, using an FLP or FLLC as a ‘wrapper’ for a marketable stock portfolio would probably come to an end, as would transfers of FLPs or FLLCs to a grantor retained annuity trust.

Example: Martha wants to make a gift of her interests in a real estate LLC that owns a shopping center. Martha’s interest in the LLC is restricted by the LLC Operating Agreement that limits her ability to sell her LLC membership interest or to control the LLC. Martha’s interest in the LLC is non-controlling. An appraiser value’s Martha’s membership interest at $11 million. That is derived by valuing the shopping center asset at $16.0 million, and applying a discount for lack of marketability of 28% [$4,400,000] and a lack of control discount of 5% [$580,000] finding a fair market value for Martha’s interest in the shopping center at $11,020,000. Under the proposed Bill, Martha’s interest in the LLC would be valued at $16 million, despite her inability to sell or exercise any control over the LLC or its shopping center.

Grantor Retained Annuity Trust: The Bill proposes several changes to GRATs that would be effective after the enactment of the Bill into law. As a broad generalization, GRATs may no longer be an effective estate planning strategy to pursue.

Zeroed-out GRATs, the most popular form of GRAT since it normally results in no taxable gift made on its formation, would be eliminated. Any new GRATs would be required to have a minimum 10-year duration. This 10-year rule dramatically reduces the efficacy of A GRAT because if the grantor does not outlive the GRAT’s annuity term, some or all of the GRAT’s assets are included in the grantor’s taxable estate.

Yet another rule would specify a minimum gift amount (of the remainder interest) that it be not less than an amount equal to the greater of 25% of the fair market value of the property transferred to the GRAT or $500,000.

Another technique often used with GRATs, called rolling GRATs, where the annuity received from a short, 2-year GRAT is promptly transferred to another short-term GRAT, is also eliminated.

When coupled with the drop in the grantor’s federal gift tax exemption to $1.0 million, it is easy to see why GRATs may become a planning technique of the past. It is probably that a gift tax will be due on funding the GRAT, with the $1.0 million gift tax exemption, with no assurance that there will be any wealth transferred to the GRAT’s beneficiaries at the end of the annuity payment period.

If longer term GRATs are to be required, thus increasing the mortality risk that the grantor will not outlive the annuity payment period, then it might make sense to mitigate that risk that the GRAT acquire life insurance on the grantor’s life- only the assets needed to pay the annuity stream for the balance of the annuity payment period would be included in the grantor’s estate, not necessarily the life insurance proceeds.

Conclusion: In some upcoming missives I will try to address the impact of the “For the 99.5 Percent Act” on irrevocable life insurance trusts and grantor trusts.