House Tax Proposal: Let the Estate Planning Begin


RINA Alert - September 20, 2021 | Volume 19, Issue 18

House Ways & Means Committee Tax Proposal: 
Let the Estate Planning Begin

President Biden and the Congressional Democrats have been working on a $3.5 T tax and spending package. On September 12, the House Ways & Means Committee released its proposal that would significantly raise taxes on the wealthy. This proposal will likely be voted on in the House by the end of September. For those taxpayers considering transferring their estate in a tax-efficient manner, this proposal, if enacted in whole or part, would substantially reduce the amount their heirs would receive unless immediate planning is done. 

Maybe the most important aspect of this proposal would be its effective dates. Most of those dates would be the start of 2022, but the proposals dealing with what the Congress considers to be loopholes would be effective upon enactment. 

Removal of the Temporary Increase in the Applicable Exclusion Amount

The proposal would eliminate the temporary increase in the Applicable Exclusion Amount, which was scheduled to expire in 2026. In its place the exemption for estate, gift, and generation skipping tax would be approximately $6 M on January 1, 2022. The loss of the approximately $6 M exemption would be a “use it or lose it” situation. Those who make gifts which are outside of the estate by the end of the year would save $2.4 M (individually) or $4.8 M (per couple), plus the growth of the gifted assets would also be outside of the estate and not subject to estate tax. In addition, if the gifts are made with assets that received substantial discounts (if still allowed) could remove substantially more from the estate. 

Now for the Good News -- Section 2032A 

Now for the good news. Generally, property is valued for estate tax purposes at fair market value at its highest and best use. Many years ago, 2032A was enacted to allow farms to be valued as farms rather than the often higher “highest and best use” level. The problem is the amount allowed for reduction of the value has been frozen at $750,000 for many years. The House proposal would increase the reduction amount to a maximum of $11.7 M, and index it for inflation.

Here's an example that illustrates the power of this proposal. Joe Merlot owns a vineyard when valued for commercial property would be worth $30 M, but as a vineyard its value would be calculated at $20 M. Since the $10 M reduction is less than $11.7 M, the value for estate tax purposes would be $20 M, giving him $4 M in estate taxes. The problem with 2032A is that it is a very complex code section and that not all will qualify. With planning, the full benefits can be ensured saving significant amounts for the heirs. 

The proposal would also significantly change the estate taxation of grantor trusts. 

The typical irrevocable grantor trust used in estate planning allows the grantor to be the income taxpayer on trust income, but if also done correctly allows the entire trust value to be removed from the estate. The immense power of using this strategy is the payment of income taxes by the grantor is not a taxable gift, causing a much greater amount to be transferred to the trust beneficiaries. 

The House proposal would have assets in the grantor’s estate be subject to estate tax unless the trusts are grandfathered. Grandfathered trusts are those created and funded prior to the enactment of the new law. In addition, distributions from the grantor trust to a beneficiary during the life of the deemed owner of the trust (grantor) are taxable gifts. This would effectively destroy the use of Grantor Retained Annuity Trusts (GRATS) and Intentionally Defective Grantor Trusts (IDGTS). The most important aspect of the House proposal on grantor trusts are that these rules would be effective on date of enactment rather than on January 1, 2022. Planning and implementation must be done immediately if one wishes to take advantage of these planning strategies associated with grantor trusts.

Proposal would eliminate IDGT sale estate planning strategy  

A very powerful current estate planning leveraging strategy is the sale to an IDGT. Because the grantor and the IDGT are the same taxpayer, no taxable gain is recognized. The terms of the sale are generally interest only followed by a balloon payment. If the asset being sold produces significant cash flow, it is possible to have significant amounts available to make the annual interest payments and create a side fund to pay off the balloon. All this is done without changing the grantor’s income situation in any way. The proposal would disregard the deemed ownership of the trust by the grantor and force an income realization event upon the sale. This would effectively destroy this planning strategy. This change is effective upon enactment as well as the other grantor trust provision.Those who could benefit from this strategy need to start planning yesterday. 

Rrestriction of the use of valuation discounts

Another important aspect of the House proposal is the restriction of the use of valuation discounts. For transfer tax purposes, assets are valued at their fair market value, which is defined as “…what a willing buyer would pay to a willing seller, neither being under compulsion to buy or sell, and both being aware of all relevant facts.” Valuation discounts allow the reduction of the fair market value, perhaps significantly, allowing substantial savings of transfer taxes. The three most typical transfer tax discounts are:1) lack of marketability, 2) minority interest, and 3) unrealized taxes on built-in gain. Typically, a person will transfer their marketable securities and investment real estate into a limited partnership or an LLC.They will then make gifts of either limited partnership interest or non-managing member LLC interests and receive substantial discounts in making these gifts. This allows one to transfer a much greater amount of assets than the value of the gift. This is especially useful when the gifts qualify for an annual exclusion. At death, the value of the limited partnership retained by the person creating the partnership would receive another substantial discount, especially if it is less than 50% of the entity interest.

The House proposal would disallow valuation discounts for an entity transferring non-business assets. Non-business assets refer to any assets not used in an active trader business, but certain passive assets can be treated as business assets if they are used in the active trader business. Generally, this is going to be real property, in which the transferor actively participates. (These restrictions only apply to entities, not to the business itself.) It is therefore possible that a fractional interest can be given in the asset and still receive a substantial discount. 

Lastly, there is a proposal to disallow any discount held in a lower-tiered entity. If an upper-tiered entity owns 10% of a lower-tiered entity, the upper-tiered entity will be treated as owning directly its ratable share of the lower-tiered entity’s assets. This will effectively destroy a transferor from using a lower-tiered entity to receive valuation discounts of non-business assets. If this or any like proposal passes, the use of valuation discounts in family-limited partnerships that are non- trade or business assets will be eliminated. The proposal dealing with valuation discounts like the grantor trust provision will be effective on date of enactment. 

Planning must be done immediately to get the benefit of their use. Valuations can take a significant amount of time, and if a transferor waits, this may not be accomplished prior to enactment. 
Here's an example to show the benefit of planning immediately. Joe and Sharon have a net worth of $25 M, $18 M of which is in marketable securities and real estate subject to a triple-net lease, neither of which are trade or business assets. Joe is age 75 and in marginal health; Sharon is age 65 and in good health. Neither of them has used any of their applicable exclusion amount. They take their entire $18 M of assets (which are marketable securities or real estate) and contribute them to a family-limited partnership, in which an LLC controlled by them is the general partner and they own a 98% limited-partnership interest. Joe then creates a Spousal Lifetime Access Trust (SLAT), in which Sharon is a discretionary beneficiary and their children are remainder beneficiaries. The trust will qualify for Joe’s $11.7 M exclusion amount (if this is done by the end of the year), and since this is a grantor trust, the full value of the assets will be outside of the estate if created and funded prior to the date of enactment of the new bill. Since Joe is married to Sharon, he will have indirect access to the assets inside the SLAT. If Sharon lives to age 85 and the SLAT doubles in value, then $46.8 M will be outside the estate. The remainder of the estate will be subject to estate taxes, unless covered by Sharon’s applicable exclusion amount. Generally, it would make more sense to spend the assets that are not in the SLAT first, to minimize the growth of the estate. If, on the other hand, no planning is done and the estate doubles in size, then $75 M would be included in the estate which reduced only by both spouses’ applicable exclusion amount available at each of their deaths. The discounts available for funding the SLAT, just like the grandfathering of the grantor trust, would only apply if done before date of enactment. This strategy could be very powerful, especially with assets that appreciate substantially, but again it must be completed prior to the date of enactment.

Act now – make sure your estate plan is in order

If anything like the House Ways & Means bill is passed, big changes will occur in estate planning, leading to the possibility of a significant increase in estate taxes. Planning and implementation of creative estate plans done immediately can greatly minimize this possibility. The problem is that the time horizon may be very short. It is recommended that everyone contact their estate planning professional immediately after reading this article.

This content is prepared solely to provide general information to our clients and community.

This content does not constitute accounting, tax, or legal advice, nor is it intended to convey a thorough treatment of the subject matter.

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