In September 2021, the House Ways and Means Committee released legislation named the Build Back Better Act (the “Act”). The Act, also known as the human infrastructure bill proposed $3.5 trillion of new expenditures and also contains revenue raising measures to pay for a portion of these new expenditures. It is unclear whether all the expenditures will be approved, but it can be expected that if the Act becomes law, most of the tax proposals will be adopted in some form.
Decrease to the Current Estate Tax Exemption
The 2021 exemption for the federal estate, gift, and generation-skipping transfer tax is $11.7 million per individual. Under the law adopted in 2017, the exemption is scheduled to increase annually for inflation until 2025. On January 1, 2026 the exemption is scheduled to revert to $5 million, as adjusted for inflation from 2010. Under the Act, these transfer tax exemptions would decrease effective January 1, 2022.
Valuation of Nonbusiness Assets
In valuing certain assets for gift and estate tax purposes, a common technique is to take advantage of IRS sanctioned discounts when the transferred asset is not publicly traded or is otherwise hard to value. The Act targets this valuation strategy by disallowing a valuation discount for the transfer of nonbusiness assets. Nonbusiness assets are passive assets that are held for the production of income or for appreciation and not used in the active conduct of a trade or business, e.g., marketable securities held by family entities. There are exceptions for assets used in hedging transactions or as working capital of a business. This new valuation approach would apply to transfers after the date of enactment of the Act.
Changes to Grantor Trust Rules
A grantor trust is a legal entity apart from its creator for gift and estate tax purposes, yet it is ignored for income tax purposes. These characteristics have provided an opportunity to gift assets in a manner where the transfer for gift tax purposes is the present value of the future gift, and the gifted assets can grow in value in the Trust estate, gift and income tax free to the next generation (but not skipped generations). As a grantor trust, the income and deductions of the trust flow through to the grantor for a defined period when the trust terminates and the assets are owned by the named beneficiaries. So long as the grantor’s interest in the income ceases prior to their death, the assets will not be included in the grantor’s estate for Federal estate tax purposes.
Because there are no income tax consequences on transactions between the grantor and the trust, a planning strategy allows the grantor to sell assets to the trust in exchange for a low-interest rate promissory note. The sale would not trigger capital gain and as long as the assets sold to the trust appreciated by more than the interest rate on the note, the sale of such assets removed value from the grantor’s estate for estate tax purposes. Further, the interest payments on the note from the trust to the grantor would be free of income tax.
The Act makes several significant changes to the taxation of grantor trusts:
The Act would make these sales between grantor trusts and their deemed owners equivalent to sales between the grantor and a third party.
At the grantor’s death, a grantor trust would be pulled into the grantor’s taxable estate.
Any distribution from a grantor trust to someone other than the grantor or the grantor’s spouse will be treated as a taxable gift from the grantor.
If the trust ceases to be a grantor trust during the grantor’s life, it will be treated as a gift by the grantor of all trust assets.
The Act would apply to grantor trusts created on or after the date of enactment and would apply to any contribution to an existing grantor trust thereafter. These changes to the grantor trust rules would have significant impacts on several common estate planning techniques including grantor retained annuity trusts, qualified personal residence trusts, and trusts created for the benefit of the grantor’s spouse. Insurance trusts, which are designed to keep the life insurance proceeds out of the grantor’s estate, are almost always grantor trusts. Existing insurance trusts would be grandfathered. However, premium payments are generally funded via ongoing gifts to the trust which could result in some of the death benefit being subject to estate tax.
Although we do not know what the final legislation will look like, the Act provides a view into the current proposals. While there is still time to do “traditional” estate planning, it should be undertaken quickly. Since several of the Act’s provisions become effective when the final legislation is enacted, the window may close sooner than year-end.
The information contained above has been prepared by the Law Offices of Lawrence Pohly for general informational purposes and is not intended to constitute a legal opinion or provide legal advice, which is provided only to clients of the Firm who have a retainer relationship with the Firm. The Law Offices of Lawrence Pohly disclaims all liability to any person who relies to their detriment on the information contained herein. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.