Planning for Future Tax Law Changes Today

Take-Away: With the Presidential campaign soon, to take center stage this year, individuals might consider adopting some estate planning steps or trusts before the election is final and the possible change in the White House and composition of Congress.

Background: Senators Warren and Sanders recently gained our attention renewing their proposed tax law changes that would radically alter the estate-planning world. Their campaign proposals would: (i) annually tax wealth of the uber-wealthy; (ii) limit a donor to $20,000 in annual exclusion gifts during a calendar year: (iii) reduce the donor’s lifetime gift tax exemption to $1.0 million; (iv) limit a decedent’s estate tax exemption to $3.5 million; (v) limit the duration of generation-skipping trusts to 50 years; and (vi) eliminate many valuation discounts when assets are transferred. Their other proposals would negatively affect GRATs and ILITs. With these possible tax law changes on the horizon, now may be the time to take some pro-active steps, especially if some of the existing traditional estate planning strategies are grandfathered despite dramatic tax law changes. Consider the following:

Inter-spousal Gifts and Step Transaction Doctrine: The the federal gift tax unlimited marital deduction would arguably survive under the proposed tax law changes. Transfers between spouses are normally free from federal gift taxation. Less apparent is the IRS’s ability to impose its step-transaction doctrine to gifts by the donee-spouse. Suppose the law is changed and a donor is limited to making a total of $20,000 a year in annual exclusion gifts. A father may make gifts of $20,000 to his son, and the mother may make gifts totaling $20,000 to the same son. On its face, both gifts to their son should pass muster if the law changed. However, if the assets gifted by the mother initially came from the father, the IRS could argue that it was a step-transaction transfer by the father of $40,000 to his son, using the mother as the father’s agent, as an intermediary. In order to avoid even the appearance of a step-transaction a significant period needs to pass between the gift from the husband to his wife and the subsequent gift by the wife-mother to her son. Consequently, now might be a good time to transfer assets from the titleholder spouse to the non-titleholder spouse, so that the transferred asset can be gifted in a following year by the recipient spouse without fear of triggering the step-transaction doctrine.

Non-reciprocal Spousal Lifetime Access Trusts and Reciprocal Trust Doctrine: Along the same lines, one popular estate planning technique these days in light of the large, albeit temporary, federal gift tax exemption amounts, is for each spouse to create and fund an irrevocable trust for the lifetime benefit of their spouse, commonly known as a spousal lifetime access trust, or SLAT. These trusts are not intended to qualify for the unlimited federal gift tax exemption. Instead, the transfer of assets to the SLAT is a taxable gift, but a gift that is entirely sheltered from gift tax by virtue of the transferor-spouse’s large lifetime federal gift tax exemption (currently over $11 million.) SLATs work so well that spouses are tempted to create a SLAT for each other, in effect moving $22+ million from their marital estate, while still enjoying the income generated by the $22+ million for the rest of their lives. In addition, those trust-held assets are also protected from the spouses’ creditor claims. The problem is that if the two SLATs are mirror images of each other, then the IRS will assert its reciprocal trust doctrine, effectively uncrossing the two SLATs and treating each SLAT as having been created by the settlor for the settlor’s own lifetime benefit. With the uncrossing of the two SLATs, the value of the assets held one trust would be included in the taxable estate of its settlor. [IRC 2036.] One way to avoid the IRS’s reciprocal trust doctrine is to have the two trusts (i) be as dissimilar as possible in their terms (and sometimes assets), and (ii) not be created and funded at roughly the same time. Once again, the timing of the transfer of assets to the two SLATs will be a critical factor that the IRS will look to in deciding whether (or not) to apply its reciprocal trust doctrine. If the wife establishes a SLAT for her husband in 2020, and the husband creates a SLAT for his wife in 2021, there is far less of a chance that the IRS will succeed in applying its reciprocal trust doctrine to the two SLATs. While it is best to have the terms of the two SLATs be as dissimilar as possible, the timing of their creation and funding is equally as important as the trusts’ terms. Now would be a good time for one spouse to create and fund a SLAT for their spouse.

Intentionally Defective Trusts and Repeal of Valuation Discounts:  One popular estate planning technique is to sell an interest in a closely held business to an irrevocable trust that is taxed as a grantor trust for income tax reporting purposes. Often critical to exploiting this strategy is to claim valuation discounts with regard to the asset or business interest that is sold to the trust in exchange for a promissory note. This sale transaction is, in effect, an estate freeze, with the conversion of an appreciating asset into a non-appreciating promissory note, without recognizing any capital gain. Sometimes the valuation discounts claimed for the asset that is sold might be as high as 40%. The campaign proposals made by some of the candidates would eliminate the use of many valuation discounts. The ‘sale’ of family business interests to an intentionally defective grantor trust, or IDGT, at the present time should be considered in light of their current utility and effectiveness which might justify the sale-to-an-IDGT being grandfathered  if subsequently eliminated with a tax overhaul by Congress. This is especially the case if the asset sold to the IDGT is stock in an S corporation, in light of last year’s Tax Court decision that recognizes a third valuation discount, to go along with the lack of control and lack of marketability discounts, for the ‘tax affecting’ of an S corporation.

Dynasty Trusts and Limitation on GST ‘Grandfathering:’  The Generation Skipping Transfer Tax (GST), a flat 40% tax that is imposed in addition to the federal estate tax,  is often avoided through the use of the $11+ million GST exemption. By exploiting their GST exemptions, parents could transfer up to $22+ million to a GST exempt trust, to shelter those transferred assets from the GST tax, and thereafter to provide lifetime benefits from the GST exempt trust to their children and grandchildren without any tax. In addition, this dynasty-type of trust would provide lifetime benefits to multiple generations of the family without any of the trust assets either being taxed in the child’s estate, or the grandchild’s estate, or the great-grandchild’s estate, et seq. In addition, the assets held in this long-term dynasty trust would be protected from the beneficiary’s creditors. However, one of the candidate’s proposals would be to limit a dynasty-trust that is GST exempt to 50 years, after which the GST tax would be imposed on each distribution from the trust. Again, a dynasty- trust put in place today which permitted by the current tax law may be grandfathered, even if the law subsequently changes to limit the duration of a GST exempt trust.

Insurance Trusts and Limitations on Annual Exclusion Gifts:  Many irrevocable life insurance trusts (ILITs) have their premiums paid though annual exclusion gifts made to the trust by the settlor-insured. The trustee then uses the cash payments, after crummey notices are sent to the trust’s beneficiaries, to pay the annual premium to sustain the life insurance policy held in the ILIT. Often these annual exclusion gifts have to be ‘stacked’ on top of each other to create sufficient funds to pay the large life insurance premium each year. If the law changes and the settlor of the trust is limited to annual exclusion gifts of no more than $20,000 in a calendar year, then there either may not be enough cash to pay the policy premium, or the settlor will have to consume some of his/her $1.0 million lifetime gift exemption to contribute the additional cash to pay the policy premium in full. With that $20,000 per year annual exclusion gift limitation lurking, or a $1.0 million lifetime gift tax exemption, now might be the time for the settlor to pre-fund enough assets into the ILIT now, using his/her existing $11+ million gift tax exemption, so that the trustee can pay the insurance premium for several additional years, especially if the dollar limit on annual exclusion gifts comes to pass.

Grantor Retained Annuity Trusts and Minimum Duration and Fixed Remainder Interests:  One planning technique legitimized in the current Tax Code is the use of a Grantor Retained Annuity Trust (or GRAT.) The Tax Code permits an individual to transfer assets to an irrevocable trust, which, in turn, pays an annuity stream back to the grantor-settlor. The gift of the remainder interest in the GRAT is usually ‘zeroed out’ by the size of the annuity that the grantor-settlor retains, which means virtually no taxable gift is made when the GRAT is funded. If the assets transferred to the GRAT, grow faster than the presumed growth rate when the GRAT was established that is used to value the annuity interest, the assets remaining in the GRAT when the annuity period comes to a close pass to the GRAT’s remainder beneficiaries gift-tax-free. Usually a very short term is set for the annuity period, like 2-3 years. One of the proposals being tossed around by the candidates would be to authorize a GRAT only if its duration is at least 10 years, which may make it more difficult to shift appreciation in the GRAT assets to the trust’s remainder beneficiary gift-tax-free. In addition, instead of permitting the current ‘zeroed out GRAT,’ the proposal would require a minimum present value of the GRAT remainder to be 10% of the value of the asset transferred to the GRAT (which is similar to the current rule with regard to charitable remainder trusts.) Add to these GRAT restrictions the possible elimination of valuation discounts of hard-to-value assets, e.g. real estate; minerals; closely held business interests used to fund the GRAT, and not to many GRATs will be created if these changes come about. Setting up a GRAT now, permissible under the current law, (IRC 2702) makes some sense, while the rules are clear.

Conclusion: No one knows if any of these tax law proposals will happen. They may only be campaign rhetoric that panders to voters who do not perceive themselves to be in the 1% who are vilified by Senators Sanders and Warren. However, we all know that Congress is always on the look-out for revenues (as demonstrated by the recent 10-year distribution rule for inherited IRAs under the SECURE Act) so nothing is not out of the realm of possibility when it comes to tax law changes. Acting now with some simple estate planning moves might prove to be prescient.