Planning in a World of Tax Reform

Take-Away: No one knows what tax reform will ultimately look like later this year, but that is not a good reason to ignore some planning steps that can be taken now to mitigate the increase in taxes that can be expected from that tax reform. All planning steps embrace the use-it-or-lose-it principle.

Background: In March, Bernie Sanders’ Bill, “For the 99.5% Act” was filed. In April, Senator Chris Van Hollen filed his Bill “Sensible Taxation and Equity Promotion”, or the STEP Act. President Biden just reported his proposal to fund the massive infrastructure tBill with a 39.6% capital gains tax on those who earn more than $1.0 million in a year. While no one knows what will become of these tax ‘reform’ proposals, it is probable that we will see later this year [probably in October with the Budget Reconciliation efforts] some form of tax reform legislation which will increase tax revenues. Rather than summarize (again!) all of these legislative proposals, what follows instead is a list of things that we should be talking to clients about now.

1. Annual Exclusion Gifts: Do not wait until the end of 2021 to make annual exclusion gifts, as annual exclusion gifts might be reduced both in number ( to 2) and amounts ($10,000 each.)
2. Lifetime Gifts: Use applicable exemption amounts now to shelter lifetime gifts, using whatever of the donor’s $11.7 million exemption is still available, in light of the pending proposal to reduce the donor’s gift tax exemption to $1.0 million (the level it was back in 2009.)
3. ILITs: Use available applicable exemption amounts now to prefund any existing crummey trusts, like an ILIT, if annual exclusion gifts are limited to 2 per donor, and no more than $20,000 in the aggregate. Similarly, large loans to existing ILITs would help to maintain large premium policies held in the ILIT, if crummey gifts become a thing of the past. New life insurance policy acquisitions might be the fully paid-up variety that did not require additional premium payments. Also, split-dollar arrangements might be considered as an alternative funding source.
4. GRATs: Existing GRATs would be grandfathered under the proposed Bill. Consequently, now would be a good time to create and fund a zeroed-out, short-term GRAT, before proposed changes would require a minimum GRAT  term of 10 years and a minimum GRAT remainder value of 25% of the property transferred. Creating a GRAT now would also exploit the low IRC 7520 interest rate now in effect.
5. Grantor Trusts: With the proposed elimination of grantor trusts, now would be a good time to create such a trust, as existing grantor trusts would be grandfathered, other than post-law change transfers to an existing grantor trust. Thus, post-transfer appreciation on the transferred assets would escape estate and gift taxation.
6. IDGTs: The proposed Bills effectively eliminate any benefit to a lifetime sale to a intentionally defective grantor trust. A sale to an IDGT of an appreciated asset now would make sense, as existing grantor trusts, as noted, would be grandfathered.
7. Dynasty Trusts: If an existing GST exempt trust was created prior to 1995, it might face paying automatic GST taxes beginning in 2026. Some existing GST exempt trusts might need to be decanted to give the trust trustee the ability to confer general powers of appointment, e.g. withdrawal rights, to non-skip persons in order to avoid the automatic imposition of a GST tax in 2026.
8. Sale of Appreciated Assets: If owners of certain assets or businesses are contemplating a sale in the near term, now would be a good time to accelerate and close on that transaction prior to the end of 2021, before higher capital gains rates come into effect. Current sales would also avoid future deemed sale rules now proposed on the transfer of appreciated assets, e.g. by gift or bequest.
9. Social Security Taxes: Owners of closely held businesses who perform compensation-based services may want to consider an S-corporation (if eligible) to mitigate exposure to the proposed additional payroll Social Security tax on earned income above $400,000.
10. Qualified Business Deduction: Owners of businesses and pass-through business entities whose income exceeds $400,000 may want to consider if ownership among different owners (or trusts) would mitigate exposure to the proposed reduction of the qualified business income deduction, i.e. IRC 199A.
11. Late GST Exemption Allocations: A donor may want to consider making late GST exemption allocations to non-exempt trusts, before the donor’s GST exemption is reduced to $1.0 million. In addition, it may make more sense to delay using a donor’s available GST exemption on lifetime gifts and preserve that exemption and use it against higher GST taxes imposed at death.
12. Partial QTIP Elections: With a looming reduction in the applicable exemption amount to $3.5 million, married individuals might consider using QTIP trusts, where a partial QTIP election can be made, so that possibly some federal estate taxes would actually be paid on the first spouse’s death, but at lower federal estate tax marginal rates. The QTIP election would also exploit the previously taxed property tax credit on the survivor’s death related to the survivor’s income interest in the non-QTIP trust, e.g. a 5+5 withdrawal power.
13. Transfer Fractional Real Estate Interests:  While most valuation discounts would be eliminated in intra-family transfers, e.g. limited partnerships or LLCs, the elimination of valuation discounts would not apply to the transfer of partial interests in real estate that is not held in an entity. Accordingly, the transfer of a tenant-in-common fractional interests in a parcel would still be eligible for valuation discounts.
14. Life Insurance: With deemed sales on death, lower estate tax exemptions, and higher estate tax rates, the need for liquidity has just increased. There might also be more occasions where the unlimited marital deduction is not relied upon, i.e. the payment of estate taxes on the first spouse’s death, to take advantage of the lower proposed federal estate tax rates. Life insurance may provide a hedge to address those additional liquidity needs. It looks like the life insurance industry will be the real ‘winner’ with this possible tax ‘reform’ legislation.

Conclusion: These are just some preliminary observations of where some planning today might help to avoid income and transfer taxes tomorrow. As noted, no one knows what the final legislation will look like after Congress gets through debated it to death, but taking some steps now can help to reduce taxes that are certain to increase.