House Ways and Means Committee Estate, Gift and Trust Proposals

Take-Away: The House Ways and Means Committee’s  recent tax proposals should probably be looked at as a worst case scenario when it comes to possible changes in the Tax Code in the near future. Equally surprising, however, are some of the topics that were not covered in the Committee’s tax proposals.

Topics Not Covered in the Committee’s Proposal: Some previously covered possible tax law changes which are not included in the Committee’s proposal released this week include:

• No ‘deemed disposition’ of assets on an owner’s death;
• No elimination of an income tax basis ‘step-up’ on the owner’s death;
• Some previously discussed limitations on GRATs were omitted, e.g. a minimum GRAT 10-year duration; a minimum 25% value of the GRAT’s remainder interest when the GRAT is funded, i.e. a gift of 25% of the transferred assets’ value; 
• No ‘federal’ rule against perpetuities to eliminate long-term ‘dynasty’ trust planning or impose a maximum 50-year GST exclusion ratio; 
• No increase in the federal estate and gift tax rate; and
• No proposed federal estate tax surcharge on billionaires.

Digging Deeper into the Committee’s Proposal: Taking a closer look at some of the Committee’s proposed tax law changes that affect estate planning strategies and trusts and estates-

1. Reduction in the Basic Exclusion Amount: An indvidual’s applicable exemption amount would be reduced from $11.7 million to the 2017 level of $5.0 million, adjusted for inflation. The inflation adjusted exemption starting in 2022 will be $6,020,000. Note that this change to the estate and gift tax applicable exemption amount will also apply to the generation skipping transfer tax exemption, so the GST exemption will also be $6,020,000 starting in 2022. [IRC 2631(c).] Effective: January 1, 2022.

Observation: Make large gifts before the end of 2021 in order to utilize the donor’s larger applicable exemption amount.                       

2. Farmland Valuation Reduction: Under the current Tax Code the decedent’s estate which holds farmland is entitled to claim a valuation adjustment (down) to reduce the farmland’s highest and best use value by $750,000. [IRC 2032(A)(2).] The Committee’s proposal is to increase the permissible reduction in the decedent’s farmland highest and best use value by “up to $11,700,000.” Farmers win big if this becomes the law. Effective: January 1, 2022.
3. Grantor Trusts: Many changes are proposed with regard to grantor trusts:

Estate Inclusion: A new provision would be added to the Tax Code which would require the inclusion in the grantor’s taxable estate of the value of the grantor trust’s assets. [New IRC 2901.] Excluded from this estate inclusion rule would be transfers of the trust assets to the grantor’s surviving spouse.

Gift Tax Set-0ff: The Committee proposes that a proper adjustment will be made if the value of the grantor trust assets are included in the grantor’s taxable estate to account for previously taxed gifts made by the grantor to the grantor trust.

Taxation of Distributions: In addition, the Committee proposes that any distribution from a grantor trust to a nonspouse beneficiary will be a taxable gift.

Taxation on Termination of Grantor Trust Status: Also, if the grantor trust. status terminates, e.g. the grantor releases the right to exchange assets of equivalent value, the termination of that grantor trust status will also be treated as a taxable gift of the grantor trust’s assets.

Existing Grantor Trusts ‘Grandfathered:’ These new rules would not apply to an existing grantor trust, unless the grantor added additional assets to the ‘grandfathered’ grantor trust after the effective date.

Effective Date: Date Of Enactment of the Legislation

Observations: Many trusts used in estate planning, including SLATs, GRATs, QPRT’s, and ILITs are all grantor trusts for one technical reason or another. Arguably all of these trusts will be impacted in some manner by the proposed taxation changes to grantor trusts. 

GRATs and QPRTs:  If the intent of the Committee was to prohibit the use of GRATs or QPRTs, it would have been much easier to just proposed the repeal those existing Tax Code sections that authorize GRATs and QPRTs.

SLATs: As for SLATs,  now would be a good time to create the SLAT and fund the SLAT asap.

Decanting: If a trustee is contemplating a trust decanting, now would be the time to complete that decanting to avoid the transfer of the assets being treated as a gain recognition event.

Fund Existing Grantor Trusts Now: Since existing grantor trusts are ‘grandfathered’ they should be funded now with with gifts or by sales in exchange for installment notes.

Avoid Future Gifts to ‘Grandfathered’ Trusts: It might not be a good idea to make gifts to that ‘grandfathered’ grantor trust after the new taxlaw becomes effective, since that ‘post-enactment’ gift will still be included in the grantor’s taxable estate.Consequently, future gifts might better be made to non-grantor trusts.

*ILITs:  It might be wise to await further Regulations to see how the ‘estate inclusion’ rule for grantor trusts will impact an ILIT. Or, simply avoid the ILIT being classified as a grantor trust to begin with, e.g. the ILIT should be created by an individual whose life is not insured under the life insurance policy held in the ILIT, or the ILIT should require that all insurance premiums paid by the trustee cannot be paid using ILIT income, only the ILIT’s principal.

4. Intentionally Defective Grantor Trusts: The Committee proposes to add a new Tax Code section [IRC 1062] which would cause the gain on the sale of an appreciated asset to a newintentionally defective grantor trust (IDGT) to be immediately recognized. This rule would apply to sales to trusts created on or after the date of enactment, or to any portion of a trust that was created before the date of enactment which is attributable to a contribution made on or after the date of enactment. Effective: Date of Enactment of the Legislation.

Observation: If an individual seriously contemplates the sale of appreciated assets to a intentionally defective grantor trust to implement an estate planning ‘freeze’ strategy, now would be the time to create that grantor trust and ‘seed’ that trust with 10% of the value of the appreciated asset to be sold to that trust.

5. Valuation Discounts: The Committee proposes to renumber a Tax Code section [from IRC 2031(d) to IRC 2031(f)] to eliminate the use of valuation discounts when nonbusiness entities which own passive or income generating assets are transferred to family members, e.g. limited partnership interests in a family limited partnership which owns marketable securities are gifted to younger family members. A comprehensive definition is used to describe nonbusiness assets. The transfer of an interest in an active trade or business would presumably still be subject to valuation discounts for lack of control and lack of marketability. Effective: Date of Enactment.

Observation: The language used by the Committee only refers to the transfer of entities or interests in entities. For example, if a parent titled real estate in an LLC and then proceeded to transfer LLC units to the parent’s children, the LLC units (an entity) would be denied the use of any valuation discounts associated with the non-controlling and non-marketable LLC membership interests. In contrast, if the parent simply conveyed tenant-in-common interests in the real estate to his children, it would seem that the parent could still claim valuation discounts associated with those fractional interests, as no entity is involved in the gift of fractional interests.

6. Trust and Estate Income Tax Surcharge: The Committee proposes that estates and trusts with annual income in excess of $100,000 in a year will pay an additional 3% taxon the estate or trust’s modified adjusted gross income. [IRC 67(c).] The 3% tax would be added to the estate or trust’s marginal income tax rate, which has been proposed to be increased to 39.6%. Charitable trusts would not be subject to this additional tax. Trusts are at the highest marginal federal income tax bracket when the trust accumulates income in excess of $13,050. Accordingly,  a trust that accumulated income in excess of $100,000 would pay an effective federal income tax rate of 42.6%. Effective: January 1, 2022.

Observation: The way this proposal reads it is possible that the additional 3% income tax would also apply to split interest trusts, such as charitable remainder trusts and charitable lead trusts.

7. Qualifed Small Business Stock: The Tax Code currently excludes from gain recognition the sale of qualified small business stock, up to $10 million per shareholder. [IRC 1202.] A new provision would be added to the Tax Code that would ‘cap’ the amount of the gain that can be excluded for trusts and estates that sell qualified small business stock, at 50% of what would otherwise have been excluded under this Tax Code section. Effective: Sales of QSBS made after September 13, 2021, except for gains that result from sales of QSBS under binding contracts that existed on September 12, 2021.

Observation: This proposed change targets a ‘stacking’ strategy often exploited by shareholders of qualified small business stock (QSBS). The way IRC 1202 reads, each shareholder is entitled to exclude up to $10 million in gain on the sale of their  QSBS. Accordingly,  the ‘stacking’ strategy was for the QSB shareholder to fund multiple non-grantor trusts using the QSB stock. Then each shareholder, i.e. the original shareholder and each non-grantor trust that holds the QSB stock,  would each be eligible to exclude up to $10 million on their sales of the QBS stock to third parties.

What the Future Might Look Like: If these proposed changes are passed by Congress and the President signs them into law, the face of conventional estate planning will dramatically change. We might then expect to see:

Use Of Non-Grantor Trusts: The creation of non-grantor trusts for the benefit of children and grandchildren, (to avoid gain recognition on funding if the trusts were grantor trusts.)

Non-Grantor Trusts as Investors:  Rather than rely on lifetime gifts of investment interests to children or grandchildren, or to trusts created for their benefit, non-grantor trusts will become ‘initial’ investors along with the parents or grandparents, so that there is no need to make lifetime gifts of those interests.

Loans, Not Gifts: A parent or grandparent will make loans, not gifts, to non-grantor trusts for their children or grandchildren.

Gifts of Fractional Interests: Rather than ‘wrap’ an investment or asset in an LLC or FLP, the donor will make a fractional interest gift in the underlying asset or investment, e.g. gifts of tenant-in-common interests in real estate.

Conclusion: This is just the beginning. Many of these proposals, if they become law, will not look much like when they were initially proposed. Some of the proposals will not make they way into the final bill that Congress votes on. Probably what is most important is that for those individuals who are in the process of adopting some of the estate planning trusts identified, like grantor trusts, now is the time to accelerate the completion of that planning before the tax legislation is enacted.