This article contains a high-level overview of the House Committee Proposal for the Build Back Better bill that impacts the use of Irrevocable Life Insurance Trusts, other Grantor Trusts, and Family Limited Partnerships. Please see my earlier blog on the impact of the proposed 50% reduction of the Gift and Estate Exemption. To date, the legislative proposals primarily impact high-net-worth individuals.
The proposed change: Limit the use of so-called grantor trusts, including Irrevocable Life Insurance Trusts (ILITS). Simply put, grantor trusts are trusts that are designed to be outside of the grantor’s estate for estate and gift tax purposes but still owned by the grantor for income tax purposes. Any income earned by the trust is taxable to the grantor, providing an additional means for the grantor to make a contribution to the trust free of transfer tax consequences. Many irrevocable life insurance trusts are set up as grantor trusts. Under the House Committee Proposal, however, this bifurcation would no longer be possible, as any assets in a grantor trust would be pulled back into the grantor’s estate at death for federal estate tax purposes. Further, any gifts out of a grantor trust (with very limited exceptions, including for a gift to a spouse) would be deemed a taxable gift.
What it means: This change is significant for two reasons. First, after the effective date of the House Committee Proposal, the creation of new grantor trusts will no longer be a viable strategy. Second, grandfathered grantor trusts—that is, grantor trusts enacted prior to the effective date of the House Committee Proposal—will need to be carefully evaluated. Any contributions made to grandfathered grantor trusts after the date of enactment of the House Committee Proposal (if it is actually enacted!) will cause partial inclusion of that grantor trust in the grantor’s federal taxable estate. Therefore, any grantor trusts that are currently funded with yearly gifts will need to be reevaluated, and the possibility of fully funding such trusts now, prior to the enactment date, must be considered.
Other proposed changes:
- Limits on valuation discounts for nonbusiness assets. The House Committee Proposal would impact the efficacy of gifts of limited liability company or family limited partnership interests holding nonbusiness assets, as it would eliminate the ability to take a discount on the value of those assets. For example, prior to this change, a parent could transfer $5 million of marketable securities to a family limited partnership and then give away a minority share in that partnership to a child at, for example, a 30 percent discount. The House Committee Proposal eliminates that type of planning for nonbusiness assets.
- Increase in capital gains tax rate. If enacted, the House Committee Proposal would increase the maximum capital gains tax rate from 20 percent to 25 percent for sales occurring on or after September 13, 2021.
Conclusion
You should have your estate planning evaluated if: you are a high net worth individual with a partially funded irrevocable life insurance trust, other grantor trust, limited liability company or family limited partnership holding nonbusiness assets, or capital appreciation in excess of $1M.