Action Steps in a Pre-Budget Reconciliation World

Take-Away: While we are all standing around waiting for Congress to act on various revenue enhancing proposals there are a couple of steps that can, or should be taken, while the future remains uncertain.

Background: We are all acutely aware that Congress is on the verge of adopting legislation that might radically alter the face of conventional estate planning. I was asked by a trust officer today what they should be talking to their clients about, now, on the eve of benignly phrased tax reform. My terse answer, which you have all heard from me before, follows.

Lifetime Gifts: Whether or not the unified estate and gift tax exemption is reduced by 50%, from $11.7 million to around $6.0 million (the 2017 exemption amount adjusted by inflation to 2022] it is better to use it now, while grantor trusts and valuation discounts are still available.

Gifts of Nonbusiness Entities to Grantor Trusts: While the House Ways and Means Committee proposal is for the reduced transfer tax exemption amount to fall and become January 1, 2022, the proposed effective dates for changes to the grantor trust rules and the prohibition of valuation discounts on the transfer of interests in intra-family nonbusiness entities is the date of the legislation’s enactment. Consequently, waiting until the end of 2021 to make large gifts to use the donor’s available transfer tax credit might miss out on exploiting valuation discounts and the use of grantor trusts. Making large taxable gifts now to grantor trusts and using valuation discounts for the gift of nonbusiness entities, like family limited partnerships that hold marketable securities, would make the most sense.
No Clawback: So far, (as we know, anyway) the Committee has not proposed a reversal of the IRS’s formal position (announced in a Revenue Ruling) that there will be no clawback when currently using the larger transfer tax exemption amount when the transfer tax exemption subsequently falls to a lower amount. Yet there are rumors starting to circulate that Congress might reverse that formal position of ‘no clawback’ of lifetime gifts when using a formerly larger transfer tax exemption. That Revenue Ruling was primarily directed at the scheduled sunset of the transfer tax exemption starting in January 1, 2026, when the topic of clawback was a major concern to making lifetime gift.
Practical Reality: In order to effectively use the currently available high transfer tax exemption, a lifetime gift will have to exceed the amount that the gift tax exemption might ultimately fall to with the pending tax reform. That reality might deter donors from making very large gifts. Probably only the very wealthy will feel comfortable gifting more than $6.0 million before the end of 2021.

Create Grandfathered Grantor Trusts and Use Valuation Discounts: As noted, the proposed effective dates for changes to the grantor trust rules and the prohibition of valuation discounts is the effective date of the tax reform legislation, which could come earlier than January 1, 2022. While that proposal sounds harmless, consider what are grantor trusts, and thus what type of conventional planning will be impacted by that tax reform, if adopted. Or, the other way to look at the proposed legislation is that existing grantor will be grandfathered from most of the proposed law changes, so having a grandfathered grantor trust in place avoids many of these tax traps. Accordingly, in to attain this grandfathered status, the grantor trust will have to be in place prior to the effective date of the proposed tax reform legislation.

Grantor Trust Benefits Reduced: Recall that the use of a grantor trust, either to receive a gift [removing the appreciating asset completely from the grantor’s taxable estate] or as a sale to an intentionally defective grantor trust (IDGT), [which provides not only an estate freeze if the asset is sold (swapping an appreciating asset for a fixed-interest promissory note) but also the estate burn, since the grantor’s taxable estate is reduced by the payment of the trust’s income tax liability] will be lost for new grantor trusts.
QPRTs: While adopting a QPRT in a low interest-rate environment is not normally recommended, a QPRT is a grantor trust. If the law change comes to pass, funding a future QPRT will cause gain to be recognized by the donor when the residence is transferred to the trust; the transfer will be taxed as a sale to the QPRT, and a taxable gift when the grantor’s retained exclusive use term comes to an end. However, there ‘might’ be a credit for the gift tax that was assessed on the grantor’s initial transfer of the remainder interest in the residence.
GRATs: The proposed tax reform changes would cause a capital gains tax to be incurred on funding the GRAT, which greatly diminishes the wealth shifting feature of a GRAT. Creating a GRAT now achieves grandfathered status for the GRAT.
ILITs: Most ILITs are grantor trusts because the trust’s income can be used to pay the insurance premiums on the life of the insured-grantor. Creating an ILIT now achieves grandfathered status for the ILIT, in order to avoid including the value of the death benefit in the grantor-insured’s taxable estate.
CLAT: Creating a CLAT now preserves the grandfathered status of the CLAT, in order to avoid incurring a capital gain on funding the CLAT and also avoid a taxable gift when the CLAT’s remainder interest is distributed to the grantor’s descendants.

Conclusion: In sum, the advice to consider is pretty simple: (i) make large gifts now while you can, before the end of the year; (ii) create and fund grantor trusts now, before any new tax reform legislation is passed; and (iii) transfer family-owned and controlled entities among generations now, so that valuation discounts can still be claimed. Any client who was even thinking about adopting a GRAT, CLAT, QPRT, or who was considering a sale of an appreciating asset to an IDGT should accelerate their planning timetable if they believe that Congress will enact these pending tax reforms proposed by the House Ways and Means Committee.