Tax Changes Proposed by House Ways and Means Committee
On September 12, 2021, the House Ways and Means Committee unveiled draft legislation as part of Congress’ $3.5 trillion budget reconciliation process. The legislation includes a list of tax hikes and reforms to help fund new government programs as part of the Build Back Better Agenda (BBBA). The tax proposals, if passed, will dramatically change tax and wealth transfer planning for high income and high net worth individuals.
In this publication, we discuss the proposed changes to the federal estate, gift, and generation skipping transfer tax (GST tax) rules. The proposed legislation also includes significant changes to the income tax rules. However, we do not discuss the income tax law changes here; you should discuss those changes with your accountant and other income tax advisers.
Termination of Temporary Increase in the Federal Estate, Gift and GST Tax Exemption.
The bill proposes to reduce by 50% each person’s estate, gift and GST tax exemption from $10.0 million per person to $5.0 million per person, in each case adjusted to the equivalent of 2011 dollars. This reduction is already scheduled to occur in 2026 under the Tax Cuts and Jobs Act of 2017. The bill would accelerate the reduction to begin four years earlier on January 1, 2022. If passed, each person’s estate and gift tax exemption would decrease from $11.7 million in 2021 to $6.02 million beginning in 2022.
Assuming the new rules take effect on January 1, 2022, the following illustrates how the estate and gift tax exemption would be calculated for a taxpayer who makes a current gift prior to the enactment date:
- Example 1. Taxpayer gives away $5.0 million cumulatively over his or her lifetime before 2022. In 2022, that person’s remaining lifetime gift tax exemption will be $1.02 million (or $6.02 million less the $5.0 million previously used).
- Example 2. Taxpayer gives away $10.0 million cumulatively over his or her lifetime before 2022. In 2022, that person’s remaining lifetime gift tax exemption will be $0; it will not be a negative amount. Following the 2017 Tax Cuts and Jobs Act, the IRS published final regulations that made clear the Treasury will not seek to “claw back” into a donor’s gross estate gifts made by the donor during years when the estate and gift tax exemption was at the increased levels.
In light of the above, if a person seeks to “take advantage” of the current (higher) lifetime gift tax exemption, that person must be willing to give away more than $6.02 million before the new tax laws are enacted.
Elimination of Grantor Trust Benefits
The bill also proposes to eliminate the estate planning benefits of irrevocable gift trusts structured as “grantor trusts.” Grantor trusts are trusts where the trust creator (the grantor) retains one or more powers over the trust that result in the trust’s income being taxable to the grantor.
Under current tax rules, an irrevocable gift trust may be structured as a “grantor trust” for income tax purposes, but such trust may nevertheless be considered outside of the grantor’s estate for estate tax purposes. This means a grantor’s sale of appreciated assets to the “grantor trust” does not trigger income tax to the grantor, as such a transaction would be deemed a sale by the grantor to himself or herself. Other transactions between the grantor and the “grantor trust” would similarly be invisible for income tax purposes.
The bill proposes to make the following significant changes to grantor trusts created on or after the date of enactment, or in the case of pre-existing grantor trusts, to that portion of the pre-existing grantor trust attributable to a contribution made on or after the date of enactment:
- Estate Tax Inclusion. When the grantor of the grantor trust dies, the assets of the grantor trust are includable in the grantor’s gross estate.
- Distributions Are Gifts. Distributions from the grantor trust to someone other than the grantor is a gift unless (a) the distribution is to a grantor’s spouse, or (b) the distribution discharges an obligation of the grantor.
- Taxation Upon Termination of Grantor Trust Status. If the trust ceases to be a grantor trust during the grantor’s lifetime, it will be treated as a taxable gift by the grantor of all of the trust’s assets.
- Adjustment. An adjustment will be made to amounts included in the grantor’s gross estate or treated as transferred by gift to account for amounts previously treated as taxable gifts by the grantor to the trust.
- Gain Recognized Upon Sale to Grantor Trust. With respect to grantor trusts created or funded after the date of enactment, sales between a grantor trust and its grantor would be subject to income tax. An exception is provided for grantor trusts that are revocable by the grantor.
Elimination of valuation discounts for transfers of nonbusiness assets
The proposed legislation would also disallow valuation discounts for entities that own "nonbusiness assets." These nonbusiness assets are defined as any passive asset which is held for the production or collection of income, and is not used in the conduct of an active trade or business. Specifically listed passive assets include cash, stocks, bonds, and real property, with exceptions for real property assets used in the active conduct of real property trade or businesses in which the transferor materially participates. This proposal is effective for transfers after the date of enactment.
Things to Consider
In light of the above tax proposals, please consider the following:
- For those considering making cumulative lifetime gifts in excess of $6.02 million, you should consider making those gifts by the end of 2021. If the gift is to be made to a grantor trust, it must be completed before the enactment date.
- The bill would seem to eliminate the tax benefits of Grantor Retained Annuity Trusts (GRATs) or Qualified Purchase Residence Trusts (QPRTs) created after the date of enactment.
- Most irrevocable life insurance trusts (ILITs) are grantor trusts because trust income can be used to pay insurance premiums. If grantor trusts become includible in the grantor’s taxable estate, new ILITs would likely need to prohibit payment of premiums from trust income, and only from trust principal. In addition, the “grantor trust” status for pe-existing ILITs that are expected to receive ongoing contributions after the effective date should be turned off.
- Sales of appreciated assets to a grantor trust created after the enactment date will give rise to capital gains tax. In addition, it is possible a subsequent revision of the proposed tax rule changes will make a sale to any grantor trust, whether created before or after the enactment date, to be a realization event. Similarly it is possible the House Ways and Means Committee will amend the proposed legislation to make other transactions between the grantor and any grantor trust, whether or not it is a pre-existing grantor trust, to be a realization event.
The draft legislation does not include many proposals previously contemplated, including repeal of the income tax basis step-up at death, the imposition of capital gains tax at death or upon a gift, increasing estate and gift tax rates, capping total aggregate annual gifts per individual donor, among other changes.
The final tax proposal from the House Ways and Means Committee will inevitably include proposals on other elements of the Build Back Better Agenda currently being marked up in other committees. What will actually be enacted is still very much in question. It is anticipated that at least some of the tax proposals will be cut from the final version.
If you have questions or wish to complete additional gifts before the end of 2021, please contact us immediately. We anticipate we will not have enough time to accommodate everyone, so we will need to hear from you right away if you want to take any action in anticipation of these changes.
This alert should not be construed as legal advice or a legal opinion on any specific facts or circumstances. This alert is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concern any particular situation and any specific legal question you may have.