Senator Bernie Sanders released his proposed estate and gift tax reform legislation on Thursday, March 25, to the displeasure of a great many American families and their advisors. Senators Kirsten Gillibrand, Jack Reed and Chris Van Hollen reportedly co-sponsored this plan, and Representative Jimmy Gomez will reportedly introduce a version of the bill in the House of Representatives.
This 18-page bill is devilishly powerful from a financial standpoint, but relatively simple from a technical standpoint with reference to what it seeks to achieve.
Besides a reduction of the $11,700,000 estate tax exemption to $3,500,000 and reduction of the gifting exemption to only $1,000,000 in 2022, many very important planning techniques and structures will not be possible after enactment.
On the other hand, the good news is that most arrangements that are entered into before enactment of the law will be grandfathered in from an estate and gift tax standpoint. This is very good news for those who have already acted, or who act without delay.
Here is an explanation of the new rules, along with planning pointers and practical observations.
1. Yes, the Exemption Would Be Only $3,500,000, Minus Past Reportable Gifts!
Effective beginning January 1, 2022, the estate tax exemption amount would be only $3,500,000, instead of the present level of $11,700,000 per person, thus being $7,000,000 in total for a married couple. After 2022, the exemption will continue to rise with inflation.
This will cause many individuals to gift a large portion of whatever remains of their $11,700,000 each exemptions before year end, but lifetime reportable gifting of less than $3,500,000 does not increase the amount of exemption that can be used.
For example, an individual who has made $2,000,000 of taxable gifts in the past now has a $9,700,000 exemption. This person may be encouraged to use at least $6,200,000 of exemption before the end of 2021, so as not to lose the exemption amount. If she uses only another $1,500,000, then she will have zero exemption in 2022 if the new Act is passed, so she needs to have given more than a total of $3,500,000 to be able to have given more than $3,500,000 during her lifetime without paying gift tax.
The transfer may be made to an irrevocable trust for a spouse and descendants, and such a trust may also benefit the donor in the event of financial hardship, if the trust is properly formed in a jurisdiction that has laws that prevent creditors from reaching into the trust.
Many married couples will respond to this proposed rule by having one spouse establish a trust for the benefit of the other spouse and descendants, while the second spouse funds a trust benefitting descendants only because of something known as the “Reciprocal Trust Doctrine.”
Year end 2021 will not be a good time for wealthy individuals to be in intensive care–the family will have an incentive to pull the plug to save significant estate taxes.
Those surviving spouses who have received a “portability allowance” from a deceased spouse of unused estate tax exemption will be relieved to know that this will not be reduced by the new rules. For example, if one spouse dies in 2021 and leaves all assets to the surviving spouse, then the surviving spouse will have an $11,700,000 portability allowance plus a $3,500,000 estate tax exemption and can therefore pass $15,200,000, unless he or she remarries and the new spouse dies before her, in which event the new spouse’s portability allowance will be substituted for the old ones.
2. The gift tax exemption will be limited to $1,000,000 beginning on January 1, 2022.
Presently, the estate tax and gift tax exemptions are both set at $11,700,000, less whatever taxable gifts an individual has made in the past. The exemption is reduced when the taxpayer makes gifts to individuals that exceed $15,000 in a given year.
In the example above, the individual who has a $9,700,000 exemption and makes a $6,200,000 gift will be reducing her estate and gift tax exemption to $3,500,000 in 2021, but then her gift tax exemption will go down to $1,000,000 in 2022, if this Act passes.
After that, she will be able to gift only the $15,000 per year/per person, plus $1,000,000 of assets without paying gift tax. This will encourage many families to gift everything but the $1,000,000 exemption that will be remaining after 2021, if the Act passes.
While it can make sense to gift the entire exemption amount, many individuals who engage in estate tax planning transactions prefer to leave some exemption in place in case there is a gift tax audit and the IRS claims that transfers made constituted larger gifts than were reported.
For example, an individual may own 49% of a company worth $20,000,000. The 49% ownership of a $20,000,000 company will typically be worth significantly less than $10,000,000 because of valuation discounts that are generally permitted for lack of control and lack of marketability. Court decisions are far from uniform as to what percentage discount will apply, and the results can vary based upon facts and circumstances. A taxpayer may claim a 40% discount, reporting the transfer of 49% ownership of the company as being worth approximately $6,000,000 for gift tax purposes, and an IRS auditor may offer to allow a 20% discount, for example. Typically, a compromise is struck somewhere between the above two numbers, which are mentioned, for example purposes only.
3. A Significant Rate Increase
The estate tax rate will go up on January 1, 2022 from a flat rate of 40% to a progressive rate that will be based upon 45% for the first $6,500,000 of taxable estate, and then 50% on the next $40 million worth of taxable assets, 55% for the next $50 million of taxable assets and 65% on everything over that.
For example, if an individual dies with a $2 billion estate in 2022 and has never made a taxable gift, then the tax rates will be as follows:
- 45% on the excess of $3,500,000 up to the first $10 million of assets,
- 50% on the next $40 million worth of assets (from $10 million to $50 million),
- 55% on the next $50 million worth of assets (from $50 million to $1 billion), and
- 65% on everything over $1 billion of assets.
Many charities will benefit from these increased rates, as taxpayers may decide to donate money during their lifetime to get both an income tax deduction and reduce their estate tax exposure. Many families establish their own private foundations that can qualify for these deductions and allow for family members to control the foundations and even receive compensation for services rendered, as long as the charitable foundation rules are followed. This should increase if this Act is passed. IRA’s can pass to such foundations to avoid both income tax on withdrawal and estate taxes, where the combined tax rate can exceed 75%, or more.
It is noteworthy that the above changes would not take effect until January 1, 2022, giving taxpayers approximately eight months to make gifting decisions, or die early if that is the best strategy.
Unfortunately, for those who do not move fast, most gifting strategies involve the use irrevocable trusts and discounts that are presently available for estate tax planning, and these structures will not be available once this Act passes, as described below.
Many planning techniques will still be available after the Act, including low interest rate notes, installment sales between family members or trusts that are separately taxable from their Grantors, notes that may terminate on death (“self-cancelling installment notes”) and Charitable Lead Annuity Trusts, but none of these hold a close second to the three primary techniques that will be greatly curtailed as soon as the new act passes: Grantor Retained Annuity Trusts, Grantor Trusts, and family entity discounts.
If and when the Act passes, the following structures and techniques will not be available:
1. DISCOUNTS FOR NON-BUSINESS ASSETS AND ENTITIES WILL BE ELIMINATED
Presently, a married couple could place $15 million worth of assets into a limited liability company, and then each spouse might sell 49% ownership in the limited liability company to an irrevocable trust for descendants in exchange for a note that might be in the amount of $5,000,000, assuming a 33 1/3% valuation discount.
The new Act would amend the Internal Revenue Code to require that the valuation of most family entities would have to be based upon the pro-rata percentage of ownership multiplied by the value of the underlying assets, with very few exceptions.
The new law includes “look-through rules,” which provide that even a 10% ownership interest held by one entity in another entity will be considered to be worth the value of 10% of the assets that are owned by the separate entity. The five pages of legislation known as Section 6 of the Act will be the subject of close review and discussion, but the bottom line is that the types of discounts that have been taken routinely for most families will simply not be available once the Act passes.
2. GRANTOR TRUSTS WILL BE TREATED AS OWNED BY THE GRANTOR
Striking near and dear to the hearts of dedicated estate tax planning professionals is a new Section 2901 that would be added to the Internal Revenue Code to provide that a trust which is funded or transacted with after the date of enactment of the law and is considered to be owned by the Grantor for income tax purposes, or by a person that exchanges assets with such trust, will be subject to federal estate tax on the death of the Grantor, as if the Grantor owned the assets of the trust.
This provision will eliminate any future use of “Defective Grantor Trusts” in estate tax planning, making it essential that any such trusts be established and fully funded before the Act becomes law.
For those not familiar with these rules, or who need a recharge, under the present trust tax law, an individual can establish a trust that will not be subject to federal estate tax, but will be considered as owned by the individual for income tax purposes.
This enables the individual Grantor to pay the income tax on the earnings of the trust without this being considered to be a gift, and to exchange assets with the trust, which can include selling assets for long-term low interest rate promissory notes, special notes that may vanish on death, or special arrangements called “Private Annuity Sales.”
The ability to do this on an income tax-free basis will be eliminated under the new Act, and time is growing very short for individuals who have established or will establish such trusts to “freeze” future appreciation out of their estate by selling assets in exchange for long-term low interest notes.
This technique is discussed in my Forbes article entitled Biden Estate Tax Implications and When to Unplug Great Grandpa, which was posted on October 27, 2020.
The use of installment sales and Grantor Trusts can be seen on a YouTube video that was recorded with Professor Jerry Hesch and estate tax planning lawyer Marty Shenkman in September of 2020. This is a pretty deep dive that is mostly for tax advisors and those who like technical and mathematical discussions or have trouble sleeping.
3. NO NEW INCOME TAX BASIS FOR GRANTOR TRUST ASSETS ON DEATH
One item of good news is that the Act does not prevent the avoidance of capital gains taxes when the estate of a recently deceased person dies. The Tax Code will continue to provide that assets owned by a person are considered to have been purchased for their “fair market value date of death” amount. For example, if James owns stock worth $100,000 on death that cost him $10,000 and his family sells the stock later for $110,000, then only $10,000 is taxed as a capital gain.
But what if James donated this stock before he died to an irrevocable trust that was outside of his estate for estate tax purposes, but considered to be owned by him for income tax purposes?
In conjunction with the curtailment of the formation or funding of Defective Grantor Trusts, as discussed above, the new law also provides that when the Grantor of such a trust dies, there will not be a new fair market value income tax basis for the assets of the trust. This will work a hardship on those Grantor Trusts that already exist and can continue to exist for estate and gift tax avoidance purposes.
Presently, the law is not clear on whether a new fair market value income tax basis is received when the Grantor of a trust that is disregarded for income tax purposes dies. Many advisors do not believe that there is a step up in income tax basis on the death of the Grantor, although some of us believe that there is. This law change is evidence that those who die before the law is enacted should get the step up in tax basis.
This provision would apply for all irrevocable trusts that are treated as owned by the Grantor of the trust, including those that have been formed and funded before this new Act is passed.
4. BYE-BYE GRATS
The new law will severely reduce the utility of an important planning structure known as the Grantor Retained Annuity Trust.
Under a Grantor Retained Annuity Trust (“GRAT”), an individual can place assets in the trust and have all growth in the assets exceeding a fairly low rate of return (presently based upon only 4/10ths of 1% per annum) pass for the benefit of family members without this being considered to be a gift for gift tax purposes.
The Walton family made the GRAT more famous by winning an IRS Tax Court case that challenged the ability to set up a short-term GRAT.
Under a “Walton GRAT,” a person could put $10 million worth of stock in a trust that pays her back just over $5 million at the end of the first year and just over $5 million at the end of the 2nd year, and anything in the GRAT after the 2nd year can benefit children and pass free of estate tax. The funding of such a GRAT is not considered to be a gift under the “zeroed-out GRAT” rule that was blessed in the Walton case.
The “anti-Walton” GRAT provision would require GRATs to have a minimum term of ten years, and for there to be a minimum gift considered to have been made on the funding of the GRAT that would have to be at least equal to either (1) 25% of the fair market value of the property placed in the GRAT, or (2) $500,000, depending upon the circumstances.
This will cause GRATs to be much less attractive as an estate tax avoidance technique, and will cause a great many families to enter into GRAT transactions immediately so as to be grandfathered in before the Act is passed.
5. AN EVERY 50 YEAR TAX ON LONG TERM TRUSTS
A very bold step in the Sanders plan is to require long-term trusts held for multiple generations to be subject to federal estate tax as generations die, and the trust continues.
Presently, trusts can be established to be held for the “health, education, maintenance and support” of multiple generations without ever being subject to federal estate tax, even as one generation dies and the next generation becomes the primary beneficiaries.
The new Act would require that there be no greater than a 50-year deemed term for a trust that would otherwise be “generation-skipping tax exempt,” and will require pre-existing trusts to be deemed to terminate for estate tax purposes 50 years after the date that the Act passes.
There will be significant complexity and analysis with respect to what this new law will mean for pre-funded Dynasty Trusts, but the intention of the law is clear, and the law provides that the IRS will have the power to prescribe regulations as necessary to carry out the intentions of the law change.
6. ANNUAL GIFTING TECHNIQUES CURTAILED
Another change, which will be effective January 1, 2022, will be that the $15,000 per donee gift tax exemption will be limited to $30,000 per donor with respect to certain transfers.
The $15,000 per year annual gift tax exclusion goes up with inflation in increments of $1,000, so when this goes up to $16,000 a year, the annual maximum per donor will be $32,000 with reference to the “limitation transfers” provided in the law.
These limitation transfers are as follows:
- A transfer into a trust.
- A transfer of an interest in certain family entities.
- A transfer of an interest in an asset that is subject to a prohibition on sale.
- A transfer of an asset that cannot be immediately liquidated by the donee.
This will make it more difficult to transfer wealth to the younger generation, while having some degree of control over spending or use of what is gifted.
For example, a married couple with four children can presently gift $120,000 of money or other assets into trusts, based upon $15,000 per parent/per child.
Now, they will be able to transfer only $60,000 ($30,000 from each parent) into trusts for their children, and the other $60,000 each would have to go directly to the children, or may pass to 529 plans and other vehicles that are not subject to the limitation described above.
7. DID THEY GIVE AWAY THE FARM?
The final changes are with reference to farms and conservation easements.
In these areas, the Act will provide greater benefits for estates that consist of “qualified real property,” which is used for farming, or a trade or business other than farming that will keep the property and the trade or business in the family for at least eight years after death.
Under the present law, this can enable a family to reduce the value to be applicable for estate tax purposes to take into account that the property is worth less if it is limited to such historical use, based upon $1,190,000, as the indexed amount for 2021 as a maximum differential. The Act increases this to $3 million, and provides that the $3 million amount will be increased with inflation in the future.
In addition, the maximum estate tax exclusion for conservation easements was increased from $500,000 to $2,000,000.
These changes were made effective for decedents dying and gifts made in 2022 and thereafter.
The proposed For The 99.5% Act will have a profound impact for a good many American families who may have been assuming or hoping that no significant estate tax increase would occur. Those families will need to act immediately to preserve their wealth in the face of a significant estate tax increase that involves not only rates in exemption amounts, but also elimination of the most prevalent tools and structures now being used.
This article originally appeared on Forbes.