Proposed legislation significantly changes estate and gift tax rules

| 9/30/2021
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The Build Back Better bill passed by the House Ways and Means Committee significantly increases taxes on high-income individuals and wealthy families. In addition to proposals to increase income taxes for individuals, estates, and trusts, the bill includes numerous proposals that could affect current estate plans. Following are highlights of these proposals.

Reduction of the estate and gift tax exemption

The Tax Cuts and Jobs Act of 2017 (TCJA) doubled the estate and gift tax exemption for decedents dying and gifts made after Dec. 31, 2017, and before Jan. 1, 2026. A provision of the proposed legislation that would become effective Jan. 1, 2022, would reduce the estate and gift tax exemption back to the pre-TCJA amount, indexed for inflation. If enacted, the current $11.7 million per person estate and gift tax exemption would be reduced to $6.02 million for 2022 based on current estimates.

Because the current exemption will remain intact through the end of calendar year 2021, the “use it or lose it” strategy can be implemented by individuals who wish to make gifts before the end of this year. However, it might be better to make gifts before the legislation is passed because the proposed legislation also makes changes to the grantor trust rules and rules regarding valuation discounts that would change as of the date of enactment of the bill.

Changes to grantor trust rules

A trust is considered to be a grantor trust when the grantor has not relinquished all powers over the trust principal or income. The grantor is treated as the owner of all or some trust assets for income tax purposes.

One common estate planning technique used by high net worth individuals as part of their estate planning is the intentionally defective grantor trust (IDIT), which involves creating an irrevocable trust that is disregarded for income tax purposes, meaning it is treated as a grantor trust to the donor who pays the income tax on the trust’s income. However, for estate and gift tax purposes, the IRS will treat the trust as if it does exist, which makes the trust assets not includible in the donor’s estate and allows the trust to grow tax-free. Because the donor does not pay tax on this income, the donor avoids making an additional taxable gift.

The proposal would affect IDITs by including in the grantor’s estate any assets considered owned by a grantor trust and subject the trust to estate tax. In addition, distributions from grantor trusts during the grantor’s lifetime generally would be treated as taxable gifts. More importantly, if grantor trust status is terminated and the trust becomes a separate entity subject to tax, the grantor would be deemed to have made a taxable gift of the trust assets.

Also, under the proposal, transfers of property between a grantor trust and anyone who is an owner of the trust under the IRC’s trust rules would be treated as a sale or exchange and subject to income tax. Sale or exchange treatment would not apply if the trust is fully revocable by the deemed owner.

These grantor trust changes would become effective as of the date of enactment and could also affect qualified personal residence trusts, grantor retained annuity trusts, and charitable lead annuity trusts, by subjecting remainder interests to gift tax and the excess of the fair market value of the assets to income tax.

The good news is that the proposed legislation would allow grantor trusts created and funded before the date of enactment of the new law to be grandfathered. Many individuals, therefore, are considering establishing and funding grantor trusts now, before the law changes.

Elimination of valuation discounts

The proposed legislation would eliminate valuation discounts after the date of enactment unless the asset gifted or sold is an active trade or business. Therefore, the new rules would apply to gifts of nonbusiness assets such as closely held stocks or real property. Because any applicable discounts (for lack of marketability and lack of control) would be eliminated, the assets would be valued at full fair market value. This change would interfere with another common estate planning technique of contributing assets to a family limited partnership and then gifting partnership interests.
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Looking ahead

It is unclear whether these provisions will remain in the bill as it makes its way through the House and Senate or whether additional estate and gift tax provisions will be included in the final legislation. For instance, even though the bill that was passed by the House Ways and Means Committee did not include an administration proposal to eliminate stepped-up basis for capital gains, such a provision could be included in the bill as it works its way through the legislative process.

To manage this uncertainty, taxpayers should monitor the changes and consult with their tax advisers as soon as possible to determine the best way to prepare for possible law changes.

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Sally E. Day
Sally Day
Managing Director
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Lauren Shapiro
Washington National Tax