On September 21, 2021, the House Ways and Means Committee (the “House”) released a comprehensive draft of the proposed statutory tax language (the “House Proposal”), which, if enacted could take effect by January 1, 2022 or theoretically earlier and have a major impact on future estate planning.
This post focuses on the proposed estate planning changes, and suggests steps to reduce the impact of these changes.
Estate Tax Proposal 1 – Reduction of the Lifetime Estate and Gift Tax Exemption
Currently, the lifetime Estate and Gift Tax exemption is at $11.7 million, but will revert back to approximately $6.2 million by 2026. The House estate tax proposal is to accelerate the 2026 reduction to 2022. This means, if an individual dies in 2022, and his or her lifetime gift and estate assets add up to be greater than $6.2 million, their estate could incur taxes.
To avoid estate taxes and to preserve the higher exemption amount, an individual will need to use up the exemption before January 1, 2022 (if the proposed law is enacted) or before January 1, 2026. The individual will need to remove assets and/or cash from his or her name valued at greater than $6.2 million to take advantage of the higher exemption.
One way to use the exemption is to gift assets. Gifts can be outright or in Trust. Outright gifts may not be favorable as the individual will lose all control over the gifted assets/cash, and these gifts will be exposed to an heir’s creditors, potential divorce (if commingled) and irresponsibility. Lastly, the individual might not have that much liquidity on hand to make an out right gift.
A better method would be, e.g., to place assets in an irrevocable trust to retain some control and interest, while delaying heirs from receiving the assets and protecting it from their creditors. A certain irrevocable trust — the grantor trust — is commonly used for this purpose. Below are somes examples and brief descriptions of each type of grantor trust.
It should be noted that the the House Proposal aims to eliminate the use of grantor trusts by the date of enactment, but will grandfather existing trusts and trusts created prior to enactment.
Grantor Trust – ILIT, SLATs, GRATs, GRUTs and QPRTs
A Grantor Trust is a useful estate planning tool to help reduce, and for some even eliminate, estate taxes. Assets placed in a grantor trust are excluded from the taxable estate, but the grantor continues paying income taxes incurred by these assets. This last bit is particularly useful as (1) trust income taxes are typically much higher and (2) taxes paid by the grantor further reduce the taxable estate. If the House Proposal becomes law, it might eliminate the use of grantor trusts.
Following are examples of commonly use grantor trusts:
- Irrevocable Life Insurance Trust or “ILIT” is typically funded by the grantor to purchase a life insurance policy on the grantor’s life. The proceeds are payable to the Trust and excluded from the grantor’s estate, making the proceeds free of taxation. For an estate that will definitely incur estate taxes, a life insurance trust provides liquidity for beneficiaries to pay estate taxes. If the House Proposal becomes law, new ILITs would need to be a non-grantor trusts in order for the proceeds to be excluded from the grantor’s estate.
- Spousal Lifetime Access Grantor Trust or “SLAT” is a trust that gives income to the grantor’s spouse for life, and excludes the trust assets from both the grantor and grantor spouse’s estate. Thus, grantor will continue to have indirect access to the funds AND RETAIN the higher tax exemption that is would be eliminated by January 1, 2022 (if the proposed law is enacted) or by January 1, 2026. If the House Proposal becomes law, new SLATs would become includable in the grantor’s estate and thus, eliminating its use.
For those who want to take advantage of the SLAT, there is still time. Existing SLATs or SLATs created before the enactment date will be grandfathered in, meaning it won’t be affected by the new law. However, some urgency in planning might be needed to ensure proper planning before the enactment date.
- Grantor Retained Annuity Trust or “GRAT”, Grantor Retained Unitrust or “GRUT” and the Qualified Personal Residence Trust or “QPRT” all function similarly where grantors retain an interest (e.g. payment of principal and interest, or a right to live in the residence) in the property they place inside the trust. The trust assets reduces in value and thereby reduce estate taxes. The grantors retain an interest for a predetermined period of time, and the longer the grantors retain the interest the greater the tax benefits. If the Grantors outlive the predetermined time period, the entire trust property will be excluded from their estates.
For those who want to take advantage of the GRAT, GRUT or QPRT, there is still time. Existing GRAT, GRUT and QPRT or ones created before the enactment date will be grandfathered in, meaning it won’t be affected by the new law, so long as the grantor outlives the predetermined time period. However, some urgency in planning might be needed to ensure proper planning before the enactment date.
Estate Tax Proposal 2 – Increase in Income Tax Rates
For those who want to take advantage of the ILIT, there is still time. Existing ILITs or ILITS created before the enactment date will be grandfathered in, meaning it won’t be affected by the new law. However, some urgency in planning might be needed to ensure proper planning. Trusts with particularly high premiums should consider pre-funding the trust with enough cash (which would reduce the grantor’s lifetime gift and estate tax exemption) to pay for all future premiums as any new contributions to the trust after enactment date might pull some trust assets back into the Estate.
Besides the capital gains tax increase from 20%-25%, the House Proposal will increase the highest or “marginal” individual income tax to 39.6% for the individual who makes over $400,000, the married couple filing jointly who makes over $450,000, and trusts and estates that make $13,050. Additionally there will be a 3% high income surcharge for married couples filing jointly with a modified adjusted gross income in excess of $5 million, and trusts and estates with a modified adjusted gross income in excess of $100,000.
Individuals intending to do a Roth conversion, might consider doing it before the end of the year to avoid being taxed at a higher rate. There should also be a review of existing trusts to determine whether accumulation of income (which can incur substantial income taxes) or distributions to beneficiaries might be more beneficial.
Estate Tax Proposal 3 – Valuation Rules for Nonbusiness Assets
The House Proposal also aims to eliminate the use of valuation discounting for non-businesses, which includes passive assets held for the production of income such as cash, marketable securities, and other assets not used in active conduct of a business. This could eliminate the use of family limited partnerships or family limited liability companies, where a gift or sale of non-controlling fractional interests are made to various trusts to receive a decrease in value of the business or a “discount” on the trust assets. This discount in turn lowers the estate taxes.
This blog post was guest written by Ada Chan, Esq. Please learn more about her here.
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