As of this writing, Democrats in Congress are negotiating the so-called Build Back Better bill. Utilizing their bare majority, Senate Democrats hope to pass the legislation via the reconciliation process, relying solely on the votes of the fifty Democratic senators. The effort to get all fifty Democratic senators on board, however, continues.
It is unclear how this process will end and what, if anything, Congress will send to President Biden’s desk for signature. What is clear, however, is that if something passes, it will likely contain numerous tax increases that will primarily impact high-net-worth individuals. The best evidence of what those changes might be is the tax law proposal released by the House Ways and Means Committee on September 13, 2021 (House Committee Proposal).
A full summary of the 800-plus-page House Committee Proposal is beyond the scope of this article. This article contains only a high-level overview of key takeaways from the House Committee Proposal that impact estate and gift tax planning. Implementing changes to clients’ estate plans will require a keen understanding of the legislation that passes. To date, the legislative proposals primarily impact high-net-worth individuals who either currently have a federal estate tax issue or will have one as a result of the changes in the law. They also greatly impact clients who have established intentionally defective grantor trusts as an estate and gift tax reduction device.
Here are the significant changes contained in the House Committee Proposal (interspersed with some notes on what will not change):
1. The proposed change: Reduce the current $11,700,000 per person gift and estate tax exemption (the unified exemption) by approximately one half. This proposal, if enacted, will take effect January 1, 2022. It is estimated that the unified exemption, adjusted for inflation, would be approximately $6,030,000 in 2022. The unified exemption would continue to be indexed to inflation and would increase each year. It is important to note that the portability of an individual’s unified exemption to a surviving spouse is unchanged by the House Committee Proposal. Therefore, a deceased spouse’s estate may still port that spouse’s remaining exemption at death to a surviving spouse.
What it means: First, the number of individuals impacted by the federal estate tax will increase significantly under this proposal, although the vast majority of Americans will continue to be free of estate tax consequences. With portability maintained, married couples will still be able to pass approximately $12,120,000 free of federal estate taxes after 2022. As mentioned, this number will rise with inflation. Nevertheless, any clients with assets approaching the reduced $6,030,000 individual shelter should seriously consider reevaluating their estate plans to determine if additional steps should be taken.
Second, individuals or married couples whose assets exceed the unified exemption may want to lock in the current shelter by giving away assets to use the full amount of the unified exemption that they enjoy. For example, assume a client has assets valued at $25 million and has made no previous taxable gifts. If the client does nothing and dies in 2022 with a $6,030,000 unified exemption, the total gross estate tax incurred would be $7,588,000. If, on the other hand, the client takes advantage of the current $11,700,000 unified exemption in 2021 by giving away that amount this year, and then dies in 2022 with a remaining estate of $13,300,000, the total gross estate tax incurred would be $5,320,000—a savings of $2,268,000! There are numerous considerations in planning for such a gift—not least being whether the client actually wants to (or can) give away the entire current exemption amount. The types of assets to give away and the method of doing so should be closely examined. The loss of a step up in income tax basis at death for the gifted assets would also be a factor. This would all need to be considered, planned for, and enacted prior to January 1, 2022—and for now, that planning would be based only on the House Committee Proposal, not a bill signed into law.
2. The proposed change: Limit the use of so-called grantor trusts. 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.
3. Other proposed changes: While items 1 and 2 explain the most significant changes to estate and gift tax planning within the House Committee Proposal, there are some other items that planners should consider:
A. 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.
B. 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.
Importantly, and despite the chatter surrounding this issue, the House Committee Proposal leaves the step up in income tax basis at death untouched. Estates of decedents and their beneficiaries will continue to enjoy this favorable income tax outcome under the current version of the House Committee Proposal.
As noted, the estate and gift tax provisions of the House Committee Proposal mainly impact high-net-worth individuals. Whether and to what extent the House Committee Proposal will be incorporated into legislation passed by both houses of Congress remain unknown. As of now, however, the House Committee Proposal provides the best evidence of changes to federal estate and gift tax laws that could be enacted prior to January 1, 2022.