Impact of President Biden's Tax Plan on Estate Planning
With Democratic control of the White House and Congress, there has been much speculation on what President Biden’s tax proposal will look like, as well as the likelihood that President Biden’s tax plan will be enacted into law. In April 2021, the Biden Administration announced the American Families Plan, which proposed significant tax law changes to increase taxes on both corporations and high-net-worth individuals and to provide more resources to enhance IRS tax enforcement efforts. On May 28, 2021, the United States Department of Treasury issued a report entitled “General Explanation of the Administration’s Fiscal 2022 Revenue Proposals” (generally referred to as the Green Book) which included more details on the tax law changes previously proposed in the American Families Plan. The purpose of this memorandum is to provide a brief overview of some of these proposed changes and to focus on how those potential changes may impact estate planning.
Long-Term Capital Gain Recognition
In general, the current tax laws provide that the recipient’s basis of property acquired at death is the fair market value of those assets as of the decedent’s date of death. The recipient’s basis of property acquired by gift is the same as the donor’s basis as of the date of such gift. There is no realization event when property is acquired at death or via gift, unless and until that property is subsequently sold (and any gain would be determined based on the recipient’s adjusted basis).
Under the current proposal outlined in the Green Book, there will be a realization of capital gains to the extent such gains are in excess of a $1 million exclusion per person, upon the transfer of appreciated assets at death or by a gift, including transfers to and distributions from irrevocable trusts and partnerships. The proposal would provide various exclusions and exceptions for certain family-owned and operated businesses.
In addition, gains on unrealized appreciation will be recognized by a trust, partnership or other noncorporate entity at the end of an applicable 90-year “testing period” if that property has not been the subject of a recognition event during that testing period. The 90-year testing period for property begins on the later of January 1, 1940 or the date the property was originally acquired, with the first possible recognition event to take place on December 31, 2030. Under the proposal outlined in the Green Book, realized gains at death could be paid over 15 years (unless the gains are from liquid assets such as publicly-traded securities). There would be no gain recognition for transfers to U.S. spouses or charities at death. The Green Book states the above-referenced changes would be effective for property transferred by gift, and property owned at death by decedents dying, after December 31, 2021.
Potential Transfer Tax Provisions and Retroactivity
Noticeably absent from the Green Book are any changes to the federal estate, gift and generation skipping transfer (GST) tax system that President Biden proposed during his campaign. Currently, the exemptions for the federal estate, gift and GST tax are $10 million per individual (indexed for inflation). After taking into account inflation in 2021, the exemption is $11.7 million per individual (or $23.4 million for married couples). President Biden had proposed to broaden the impact of transfer taxes through some combination of lowering the estate tax exemption from their current levels to a base of $3.5 million per individual and increasing the estate tax rate from 40% to 45%. The absence of any proposed changes to the transfer tax system currently does not mean that such changes will not be proposed by the Biden Administration at a later date.
Additional Transfer Tax Proposals
There have been additional bills targeting high-net-worth individuals which have been proposed by legislators (although not the Biden administration) in March of this year, including the Ultra-Millionaire Tax Act, the For the 99.5% Act, and the Sensible Taxation and Equity Promotion (STEP) Act.
The Ultra-Millionaire Tax Act was introduced by Senator Elizabeth Warren on March 1, 2021, and would create an annual tax of 2% on the net wealth of households and trusts valued at over $50 million to $1 billion and an additional 1% annual surtax on households and trusts above $1 billion.
On March 25, 2021, Senator Bernie Sanders introduced the For the 99.5% Act, which is the most comprehensive of any of the proposed bills. Included in the proposal are the following changes that would affect estate planning: (i) reduction of the estate tax exemption amount to $3.5 million and the gift tax exemption amount to $1 million; (ii) a graduated increase to estate tax rates ranging from 45% up to 65%; (iii) elimination of certain discounts for family-owned entities; (iv) requiring Grantor Retained Annuity Trusts (GRATs) to have a 10-year minimum term and a minimum remainder interest of the greater of $500,000 or 25% of the amount contributed; (v) requiring GST tax-exempt trusts to terminate after 50 years; and (vi) changing the annual gift tax exclusion, which is currently $15,000 per individual, to limit each donor to a cumulative $30,000 annual gift tax exclusion regardless of the number of individuals for certain transfers. In addition, the For the 99.5% Act would significantly impact grantor trusts commonly used in estate planning by requiring that (i) assets in a grantor trust be included in the grantor’s estate; (ii) treating distributions from a grantor trust as gifts from the grantor, and (iii) treating the entire trust as a gift from the grantor if grantor trust status is “turned off” during the life of the grantor.
The STEP Act was introduced by Senator Chris Van Hollen on March 29, 2021. The STEP Act targets basis step-up by treating property transferred by gift, in trust or upon death as sold for its fair market value and triggering immediate capital gains taxes. The exemption for any such gain would be $1 million. In addition, all “non-grantor” trusts would have to pay tax on unrealized gains every 21 years.
There has been some concern among practitioners regarding the potential effective date of any new transfer tax laws. In the past, tax legislation has generally been prospective in nature. For example, the effective date of many of the Green Book proposals, if passed, will be after December 31, 2021. There is some precedent, however, that suggests a new tax law could be retroactive in its effective date. A retroactive date means the date of the introduction of the legislation or an even earlier date could be the effective date of any new transfer tax laws. For example, the proposed STEP Act discussed above would apply retroactively, effective starting January 1, 2021. Most commentators believe a retroactive date is unlikely given the punitive effect on taxpayers who make planning decisions based on current tax law, and the limited precedent for making such meaningful tax law changes retroactive.
Sunset of Current Increased Transfer Tax Exemptions
Even if the proposed changes to the transfer taxes above do not become part of any new tax law, the current increased exemptions for the federal estate, gift and GST tax will automatically expire at the end of 2025, at which time the exemptions will revert to a base of $5,000,000 per individual (indexed for inflation). The indexed exemption at that time (2026) is expected to be around $6,400,000 per individual.
Given the uncertainty of the new tax laws, high-net-worth individuals with estate tax concerns should consider taking advantage of the current heightened exemptions by implementing wealth transfer strategies, such as the following:
Intentionally Defective Grantor Trust (IDGT). An IDGT is a type of irrevocable trust that takes advantage of the disparity between income tax and estate tax rules, allowing you to transfer assets in trust for the benefit of your family during your lifetime, thus removing those assets from your taxable estate. An IDGT is structured to cause the trust income to be taxed as a “grantor trust,” so that the income is taxed to you rather than to the trust beneficiaries. This tax payment becomes a gift tax-free benefit to the beneficiaries, which further augments the ultimate value of the transfer because your beneficiaries avoid income tax. This allows the principal of the trust to grow without reduction by income taxes, while your payment of the income taxes further reduces the value of your taxable estate. The IDGT can be structured so that the “grantor trust” status for income tax purposes can be switched off at any time, thereby causing the trust to become a separate taxpayer for income tax purposes. Another benefit is that you can sell assets to the IDGT to freeze the value of those assets for estate tax purposes. The “freeze” occurs because once the assets are sold any subsequent appreciation of those assets will escape the estate tax.
Spousal Lifetime Access Trust (SLAT). A SLAT is an irrevocable trust created by you for the benefit of your spouse but the trust terms can also be drafted to provide benefits for your children or other descendants during your spouse’s lifetime. A SLAT is designed so that assets gifted or sold to the trust will be not be includable as part of either your or your spouse’s estate for federal estate tax purposes. Because the assets will not be taxable at you or your spouse’s death, the amount of assets passing to your children or other descendants will be significantly greater, assuming that the assets appreciate in value. A SLAT is almost always structured as an IDGT, so the benefits of “grantor trust” status are realized with a SLAT as well.
Grantor Retained Annuity Trust (GRAT). Given the historically low-interest rates, a GRAT is particularly beneficial. A GRAT is an irrevocable trust that you create and fund with assets that are expected to appreciate over time. You retain the right to receive an annuity from the GRAT for a term of years, which is computed by applying the IRS rate of return to the value of the assets transferred to the GRAT. At the end of the GRAT term, the trust’s remaining assets will pass to your family members or trusts for their benefit. If the contributed property appreciates or produces income that outpaces the IRS rate of return, that growth or appreciation will pass to those family members or trusts transfer tax-free.
Charitable Lead Annuity Trust (CLAT). If you have charitable inclinations, you may also want to consider a CLAT, which is favorable under the current conditions for similar reasons as described above with respect to a GRAT. A CLAT is an irrevocable trust you fund with assets that are expected to appreciate over time. A charity receives an annuity from the CLAT for a term of years, which is determined by applying the applicable IRS rate of return to the value of the assets transferred to the CLAT. In addition, you receive an immediate income tax charitable deduction equal to the calculated value of the annuity payments. At the end of the CLAT term, the remaining assets will pass to your family members or trusts for their benefit. If the contributed property appreciates at a rate that outpaces the applicable IRS rate of return, that growth or appreciation can pass to those family members (or trusts for their benefit) transfer tax-free.
Annual Gifts. You can make an annual tax-free gift of $15,000 per individual (indexed for inflation) that does not count against your lifetime gift tax exclusion. Any amount you give annually above $15,000 counts toward your lifetime gift tax exclusion. If you are able and have sufficient cash flow, consider giving gifts sooner rather than later to help keep future appreciation and subsequent income out of your estate.
These are just a few potential techniques to consider but there may be other beneficial strategies that apply depending on your particular circumstances. Although there are still a number of unknowns, it is important to plan and evaluate your options, especially while the transfer tax exemptions remain at record highs. We cannot predict the actions of Congress but there does appear to be Democratic party momentum to at least implement these changes.