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:
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• 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:
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• 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.

​Conclusion

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.

In the recent November 2020 election, California voters narrowly approved Proposition 19, which makes the following two important changes to the California property tax rules:
 

1. Allows certain homeowners (over age 55, severely disabled, or victims of wildfire or other natural disaster) to move anywhere in the state up to three times to a home of equal or lesser value and bring their property tax assessment with them.  This rule takes effect on April 1, 2021.

 

1. Limits the availability of the parent-child exclusion for property tax reassessment purposes.  This rule takes effect on February 16, 2021.

 
Transferring Property Tax Basis of Primary Residence
 
Most homeowners in California know that their property taxes are based on the property’s assessed value, which can be significantly lower than the actual market value of the property.
 
Under existing law, homeowners over age 55 or certain disabled persons have a one-time opportunity to transfer their existing property tax assessed value to a replacement residence.
 
Proposition 19 expands the class of people who qualify for a transfer of their existing property tax assessed value, as follows:

• A qualifying homeowner is a person age 55 or older, a person who is severely disabled, or a victim of wildfire or other natural disaster.
• If the replacement property has a higher market value than the original home, Proposition 19 provides for the increased value to be added to the transferred assessed value.  For example, say a homeowner age 60 sells her home at $2 million.  The assessed value of the home she sold is $1 million.  She buys a new home in California for $4 million.  The assessed value of her new home will be $3 million.
• The replacement home may be in any county in California so long as it is purchased or built within two years of the sale of the original home.  
• A qualifying homeowner may apply the new transfer rules up to three separate times.

 
The above is a significant expansion over the current rules which allow for only a one-time opportunity to transfer a homeowner’s property tax assessed value, and only if (a) the fair market value of the replacement home is of equal or lesser value to the original home, (b) the replacement home is within the same county as the original home or is in one of ten counties in California which honors reciprocity, and (c) the replacement home is purchased or built within two years of the sale of the original home.
 
Significantly Limits Parent/Child Exclusion
 
By contrast, Proposition 19 effectively eliminates much of the prior parent-child exclusion available to homeowners under Proposition 58. 
 
Proposition 58 excludes from property tax reassessment the following transfers of real property between parent(s) and child(ren):

• Transfers of the principal residence (no value limit); and
• Transfers of the first $1 million of property tax assessed value (which can be much lower than the market value of other property).

 
Proposition 19 changes the above parent-child exclusions in the following ways:

• First, the $1 million exclusion for a non-principal residence is eliminated entirely. 
• Second, the parent-child exclusion for transfers of the principal residence will only apply if the child uses the home as the child’s own principal residence following the transfer.  Also, only the first $1 million of the market value in excess of the assessed value will escape reassessment.

 
For example, say child inherits a parent’s principal residence at death, and resides there as the child’s principal residence.  At the time of death, the home’s assessed value is $700,000, but its market value is $2.5 million.  Since the difference between the market value and the assessed value of the home is greater than $1 million, there will be a partial reassessment of the home to $1.5 million (or $2.5 million less $1 million).
 
However, say the home’s market value is instead $1.6 million.  Since the difference between the market value and the assessed value is less than $1 million, the home will not be reassessed when transferred to the child.
 
Things to Consider
 
In light of the significant change to the parent-child exclusion, for our clients owning California real properties, you might consider gifts using the existing parent-child exclusion before February 12, 2021[1], particularly under the following circumstances:
 

• If you own a vacation home or rental real property that you wish to be owned in the family for generations to come;
• If you own rental real properties with low assessed value and wish to preserve the current assessed value for your children;
• If you intend to gift real properties to your children in the near future;
• If you currently hold your residence in a qualified personal residence trust (QPRT) that has not terminated, there should be careful attention to any potential property tax reassessment on the residence.

 
 
 
[1] County Assessor offices are closed on Monday, February 15, 2021. 


 
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.
 

The Tax Cuts and Jobs Act (“Act”) was signed into law on December 22, 2017.  The Act made a number of changes to the income tax rules, as well as the estate, gift, and generation-skipping transfer (“GST”) tax rules.

In this publication, we discuss the changes to the estate, gift, and GST tax rules under the Act.  For the most part, we will not discuss the income tax law changes; you should discuss those changes with your accountant.

No Repeal; Exemption Limits Doubled Until End of 2025

The Act did not repeal the estate, gift, and GST taxes.  Instead, the Act temporarily doubled each person’s separate estate, gift, and GST tax exemption to $10 million per person, adjusted to the equivalent of 2011 dollars.  This means that effective January 1, 2018 each person’s tax exemption became approximately $11.2 million[1] reduced by any exemption amount the person previously used. 

The increase in the tax exemption amounts is scheduled to sunset after December 31, 2025.

The tax rate remains unchanged at 40%.

Claw Back

Prior to December 31, 2025, some donors will take advantage of the temporary increase in his or her lifetime gift tax exemption by making large gifts to children or other loved ones, either outright or in trust.  Most commentators believe that for donors who make large gifts between 2018 and 2025, but who die after 2025 (when each individual’s lifetime gift tax exemption reverts back to their pre-Act levels), those gifts in excess of the donor’s lifetime gift tax exemption amount in effect after 2025 will not be “clawed-back” to the donor’s taxable estate and made subject to federal estate tax.  However, we will not know for sure until the Treasury issues regulations.

No Changes to Portability Rules

Portability remains in effect under the Act.  With “portability,” if a deceased person is survived by a spouse, any remaining estate tax exemption that was not used by the deceased person’s estate may be transferred to his or her surviving spouse and added to the spouse’s exemption for estate tax purposes.

If death occurs between 2018 and 2025, it is unclear if the increased exemption amount under the Act would be portable if the surviving spouse dies after 2025 when the temporary increase to the tax exemption amounts under the Act sunsets.  We also expect the Treasury to issue regulations to clarify this issue.

Note that portability does not apply to a deceased person’s unused GST tax exemption.

No Changes to Income Tax Basis Rules for Lifetime Gifts or Basis Step-up on Death

The Act did not change the rules for an asset’s income tax basis (also known as its cost basis) transferred by the donor, either during lifetime or upon the donor’s death.  An asset’s income tax basis is used to determine the amount of any capital gain (or loss) upon any future sale of the asset. 
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Generally, the recipient of property transferred during a donor’s lifetime would receive the donor’s adjusted cost basis for the asset.  By contrast, when a beneficiary inherits property from a decedent, generally the cost basis of the asset is adjusted to equal its fair market value as of the decedent’s date of death.  If an asset has appreciated during the decedent donor’s lifetime, this will usually result in a “step-up” in the income tax basis of the property at death.  The above income tax basis rules should be considered prior to making gifts of appreciated property.

Pass-Through Entity Planning

Among other income tax changes, the Act creates a new income tax deduction of up to 20% for pass-through businesses – sole proprietorships, S-corporations, partnerships, or limited liability companies taxed as partnerships – on “qualified business income” (QBI).  The deduction is subject to certain limits and restrictions.  This new deduction creates a planning opportunity for clients who can qualify for the new deduction by establishing a pass-through entity. 

Our firm does not provide income tax advice of this nature.  You should consult with your accountant on whether or not to establish a limited liability company or other pass-through entity to qualify for the new deduction.

Conclusions and Planning Considerations

• This significant and temporary increase in each person’s lifetime gift tax and GST tax exemption amounts presents a unique opportunity for making lifetime gifts to children or other loved ones, either outright or to existing or new gift trusts.

 

• It is a good idea to review your estate plan to determine if it continues to accomplish your wishes. For example, if your current Revocable Living Trust calls for the size of your gift to be tied to the lifetime exemption in effect at the time of your death, you may wish to review and potentially change such gift formula in your trust.

 

• In some cases, one spouse owns significant separate property while the other spouse has comparatively less property.  Making a gift in the coming years to leverage the increased gift tax exemption possessed by the other spouse would be an excellent way to help the spouse with the larger estate transfer gifts to loved ones free of estate and gift tax.

 

• Those of you who might qualify for the new income tax deduction of up to 20% for pass-through businesses should speak to your accountant regarding that aspect of the Act, as well as any other income tax changes that may affect your personal income tax planning.

 
 
[1]   The Act changes the way inflation adjustment is calculated in the Internal Revenue Code, and each person’s estate, gift and GST tax exemption amounts will likely be $11.18 million in 2018.  However, this figure may not be finally determined until the end of 2018 or even early 2019.
 
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.