Tax Planning

Construct higher impression on property tax planning

Tuesday, September 14, 2021

On September 13, the House Ways and Means Committee, headed by Chairman Richard E. Neal (D-MA), released its plan to pay for the $ 3.5 trillion Build Back Better Act (the “Act”). The legislation includes a variety of changes throughout the tax code, but the following summary focuses on the provisions that most directly affect inheritance tax planning. We stress that this remains a bill that will inevitably undergo further revisions before it is passed by the House of Representatives and taken up by the Senate. Note that some of the provisions discussed below will take effect as soon as the legislation goes into effect, so taxpayers may not have all of 2021 to respond.

Reduction in gift and inheritance tax exemptions[1]

The Tax Cuts and Jobs Act (TCJA), signed by President Trump in 2017, temporarily doubled transfer tax exemptions to $ 10 million, adjusted for inflation. As a result, the gift, inheritance, and GST tax exemptions are all $ 11.7 million per person in 2021. According to the TCJA, the tax exemption will be reduced to $ 5 million on January 1, 2026, adjusted for inflation. The proposal expedites this to 2022, which means transfer tax exemptions will be roughly halved from January 1, 2022. Those looking to take advantage of the current higher exemptions should give gifts before the end of the year or assign the GST exemption to existing trusts that are not currently GST exempt.

Valuation of non-business assets[2]

A common estate planning strategy is to transfer unlisted or other difficult-to-value assets and have those assets valued at the lowest reasonable value. Under the proposed law, this approach will continue to be available for equity interests in operating companies, but not for family businesses financed with marketable securities.

Under the proposed law, a stake in a company must be assessed in two steps upon transfer. First, all “non-business assets” owned by the company are valued as if they had been transferred directly from the transferor. Therefore, no valuation discount is permitted. Second, the stake in the business to be transferred is assessed using the traditional “buyer-will-seller” analysis, but the value of the non-business assets is ignored. This new valuation approach applies to transfers after the law comes into force.

For example, if Operating LLC makes widgets and also owns $ 3 million in publicly traded stocks, a gift of a 33 percent interest in Operating LLC to a child would be considered a (1) $ 1 million publicly traded stock gift and (2) a Donated a 33 percent stake in Operating LLC that is valued as if it did not own any publicly traded shares.

Income taxation on sales to grantor trusts[3]

For income tax purposes, a grantor trust is essentially treated as the grantor’s alter ego. As a result, the income and deductions associated with the giver’s trust assets are reported in the giver’s tax return. For many years, estate planners have used the unique nature of a grantor trust to transfer assets into trusts, often by selling assets to the trust in exchange for a low-interest note. As long as the assets sold to the trust have increased by more than the interest rate on the note, this strategy for tax-free asset transfers has proven its worth.

Due to the taxation of grantor trusts, no capital gain is triggered when a grantor sells valued assets to a grantor trust. Any interest payments on the associated promissory note are also exempt from income tax. The proposed legislation would add a new section 1062 requiring that profits from such sales be recorded, but would refuse to record a loss. It appears that the treatment of loan interest between a grantor and a grantor would still be income tax exempt.

It is also common for a grantor to “trade” assets of equal value with a grantor trust. A concessionaire may do this to bring high base assets into the trust in exchange for low base assets, to help diversify the trust’s investment portfolio, to gain access to cash or other liquid assets of the trust, or for a number of other reasons. This transaction, too, has historically been free of capital gains tax consequences, but that would apparently no longer be the case if the proposed law were passed in its current form.

The proposed legislation would apply to grantor trusts, with the exception of revocable trusts formed on or after the effective date of the law. Existing irrevocable trusts would be considered “grandfathered”, but if a “contribution” is made to a grandfathered trust, part of that trust would be subject to these new rules. The term “contribution” is not defined.

Estate taxation of grantor trusts[4]

Perhaps the change with the greatest impact on traditional estate planning strategy would be the new section 2901. Again, these provisions apply to trusts formed on or after the effective date of the law, with the exception of revocable trusts, or to that part of a grandfather Trust assets attributable to contributions made after that date. The section contains three main provisions:

  1. If the presumed owner of a grantor trust dies, the assets of that grantor trust will be part of the gross assets of the presumed owner.

  2. Any distribution made by a grantor to a person other than the grantor, the grantor’s spouse or to settle a debt of the grantor will be treated as a taxable gift from the grantor to the person receiving the distribution.

  3. If the trust ceases to be a grantor trust during the grantor’s lifetime, it will be treated by the grantor as a gift of all trust assets.

Perhaps the best way to understand how disruptive the proposed 2901 section would be is to examine how it would affect several common estate planning strategies.

Grantor Retained Annuity Trusts

Founded in 1990, GRATs are perhaps the most widely used advanced estate planning technique. The taxpayer transfers assets to a trust and the taxpayer is entitled to a series of payments approximately equal to the value of the assets brought in over the next two or more years. As a result, the taxpayer has made a net gift of almost zero (these are sometimes referred to as “zeroed out GRATs”). As assets increase, essentially all of the increase in value can be passed on to future generations tax-free, provided the giver survives the GRAT annuity term.

Once section 2901 is codified, GRATs no longer appear to be beneficial. If a GRAT transfers assets to a Continuing Grantor Trust at the end of the annuity term, the assets will remain subject to inheritance tax. If assets are transferred to a non-gifting trust or children, the transferor will be treated as a gift equal to the value of the assets transferred. In either case, there is no benefit in creating a GRAT. The taxpayer would be better off simply giving a gift of any size. Additionally, if valued assets were used to make the required annuity payment to the grantor, that payment would trigger an assumed sale and undesirable capital gain event, as per proposed Section 1062.

Insurance trusts

Insurance trusts are almost always grantor trusts. They are designed to ensure that the insurance death benefit is not subject to inheritance tax. The premium payments owed from the insurance policy are usually settled through annual donations to the foundation.

Existing insurance trusts will continue, but the insured’s payment of future insurance premiums is an additional contribution to the trust, which means that part of the insurance death benefit will be subject to inheritance tax. Keeping track of this part will be a challenge for many taxpayers. If the insurance trust is a grantor trust, the death benefit of a trust’s own insurance is now subject to inheritance tax. It will be difficult to build an insurance trust that is not considered a grantor trust with respect to the insured or the trust beneficiaries.

Lifelong access for spouses

A SLAT is a trust for your spouse and descendants. In general, designating your spouse as a trust beneficiary will result in that trust being classified as a grantor trust. As a result, it will be very difficult in the future to set up an irrevocable trust in favor of your spouse without making the property of that trust subject to inheritance tax.

Increased relief for certain properties used in agriculture or other trades or businesses[5]

In certain circumstances, applicable Section 2032A permits agricultural property to be used in any trade or business based on that use rather than the actual market value of that property. Effective January 1, 2022, the maximum depreciation of this property will increase from $ 750,000 adjusted for inflation since 1997 to $ 11.7 million adjusted for inflation. There are a number of technical requirements under Section 2032A, but for those who qualify, this proposal will provide significant inheritance tax relief.

What’s not included

As important as the proposed changes are, there are a number of other changes that the estate planning community expected that were not included in the bill at this point. The maximum tax rate remains at 40 percent. There are no proposed changes to the generation skip tax or the treatment of dynasty trusts. There have been some concerns that the gift tax exemption would drop to just $ 1 million, but it remains united with the inheritance tax exemption. No changes will be made to the annual gift tax exclusion. Perhaps most importantly, contrary to Biden’s original suggestion[6] There are no provisions in this Act that give rise to capital gains tax when a gift or death of a taxpayer occurs, and there are no changes to the base top-up rule.

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While the current proposal will certainly change as the legislative process progresses, for the first time we have specific legislation on which to base our year-end planning. Some of the changes are significant and would affect the estate planning strategies that have been in place for decades. However, none of these changes would take effect until final legislation is passed. As a result, there is still time to review your specific circumstances and take the actions that best serve your overall planning goals.

[1] Section 138207 of the Act. Please note that all section references are dated September 13, 2021 and are subject to change due to the legislative process.

[2] Section 138210 of the Act.

[3] Section 138209 of the Act.

[4] ID card.

[5] Section 138208 of the Act.

[6] Fact Sheet: The American Families Plan, published April 28, 2021.

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