Are Popular Estate and Gift Tax Planning Techniques Doomed?

In response to instructions under the budget resolution passed by the U.S. House of Representatives, Ways and Means Committee Chairman Richard Neal offered an amendment on September 13 that includes several tax changes in the area of estates, gifts, and trusts. Although the budget reconciliation package is still a work in process (yes, anticipate more changes), the amendment gives an indication of what provisions may have broad Democratic support in the House.

Whether you are currently contemplating when and how to transfer wealth or have a comprehensive wealth transfer plan in place, consider how the latest Congressional proposals may affect your strategy going forward.

Higher income tax rates

The highest tax bracket for trusts would increase from 37% to 39.6% for tax years 2022 and after. The top capital gains rate would increase from 20% to 25% for sales after September 13, 2021.

However, unlike the increase to individual tax rates that would only affect a portion of the population, the higher rates would affect substantially all trusts that pay an income or capital gains tax. Similar to current rules, trusts would pay tax at the highest bracket almost immediately (over $13,450 of income for 2022).

If passed into law, trustees would have a greater incentive to use any discretionary provisions under the governing document to regularly distribute income (and capital gains, if permitted) to pass the taxable income on to beneficiaries in lower income tax brackets.

Reduction in estate and gift tax exemption

Under the proposal, the estate and gift tax exemption would drop to roughly $6 million next year. Married couples could transfer double that amount during lifetime or at death before paying a transfer tax.

Under current rules, an estate and gift tax generally applies once combined transfers exceed $11.7 million ($23.4 million for couples) for 2021. This exemption amount was scheduled to drop after 2025. However, the proposal accelerates the lower exemption by four years.

Taxpayers should complete contemplated transfers by the end of the year. Also, if you are undecided about making major gifts before the exemption drops, talk with your advisors as soon as possible. It may take longer than you anticipate to finalize paperwork and transfer assets.

3% surtax

Many trusts would also get hit with a new surtax. Unlike an income tax that applies to taxable income (after you subtract allowable deductions), the surtax would apply to a higher amount (before some deductions). For example, a trust could deduct costs paid in connection with the administration of the trust (such as trustee fees and tax preparation costs) in calculating both the income tax and the surtax. It could also take into consideration any deduction for distributions to beneficiaries. However, it would not be able to subtract the deduction for qualified business income or other miscellaneous expenses treated as itemized deductions. (Under current law, miscellaneous itemized deductions such as appraisal fees; investment or management fees; and custodial fees in connection with property held for producing income are disallowed through 2025. Beginning in 2026, the expenses are deductible to the extent to the extent the total amount exceeds 2% of the taxpayer’s adjusted gross income (AGI).)

The dollar threshold for trusts is significantly lower than the proposal for individuals. Under the House Ways and Means package, a 3% surtax would not apply until an individual’s “modified adjusted gross income” exceeds $5 million. However, trusts would pay the extra tax on every dollar over $100,000. (Under the most recent draft of legislation, the surtax does not appear to apply to electing small business trusts (ESBTs). CLA will continue to monitor this issue as legislation evolves.)

As mentioned above, many trustees regularly distribute income to beneficiaries, since trusts are subject to the highest marginal income tax rate at a very low threshold. This approach allows the beneficiaries — who are often not earning significant amounts — to pay taxes at their marginal rate. Similar to higher income tax rates, the 3% surtax would provide a greater incentive for trustees to distribute income.

Intentionally defective grantor trusts

The primary tax benefits of intentionally defective grantor trusts (IDGTs) would effectively be repealed. 

The assets owned by these trusts are currently considered and valued as gifts upon the lifetime transfer to the trust (allowing for future appreciation of the property transferred to avoid estate tax). The proposal would delay the timing as to when the assets are valued for transfer tax purposes until death (or earlier if the person is no longer treated as the owner for income tax purposes). This change would prevent the “freezing” of an estate with an IDGT because any future appreciation would be taxed as though the decedent still owned the asset personally.

For example, if an individual transfers property worth $1 million to an IDGT today and it grows to $2 million at her death, she is only subject to transfer taxes on $1 million. However, under this new proposal, her estate would pay transfer taxes on the future value of $2 million.

Under current rules, another advantage is that IDGTs are disregarded for income tax purposes. The individuals establishing the trusts are permitted to report the trust’s income on their personal return. This treatment is beneficial since the payment of the tax (effectively paying someone else’s tax bill) is not considered a gift for a grantor trust. In addition, the overall tax burden is reduced if the individual is not in the highest tax bracket (trusts reach the highest tax bracket almost immediately). 

This treatment also allows for tax-free transactions between the taxpayer and the trust. A sale to an IDGT is a commonly used technique to shield future income from transfer taxes. The use of promissory notes in conjunction with sales provides additional leverage. Under the new proposal, these transfers could potentially trigger income recognition.

If enacted, changes to the rules for IDGTs would become effective for trusts created or contributions made on or after the date of enactment. As of the date of this article, nothing has been enacted — so there is no official date.

Valuation discounts

The proposal would repeal the use of valuation discounts (such as lack of control and lack of marketability) for certain nonbusiness assets. Such discounts are commonly taken into consideration in valuing interests — particularly minority interests — in closely held partnerships, limited liability companies, and S corporations.

The proposed rules are complicated and incomplete (Treasury would need to provide details in the form of regulations), but it essentially means passive assets (e.g., investments, nonbusiness real property assets) would generally be valued as though they are held outright by the owner. For transfer tax purposes, any sale, assignment, or market limitations on the nonbusiness interest would be disregarded. The valuation discounts would continue to be permitted for assets used in the active conduct of a trade or business. 

If enacted, changes to the valuation discount rules would become effective after date of enactment.

Special-use valuation for farms

One estate and gift tax proposal that is taxpayer-favorable involves the special-use valuation rules — commonly used for farms and certain other businesses upon their owner’s death. Under current law, the land is valued at its “current-use value” rather than its fair market value if it meets certain qualifications. 

Although helpful, this benefit is currently limited to the estate tax on $1,190,000 (the maximum amount by which you can reduce the land’s value). Under the proposal, the land’s value could be reduced by as much as $11,700,000, indexed for inflation, beginning in 2022. (That’s almost 10 times the current benefit.) The recapture rules would remain, though, if the heir does not continue to operate the farm or business.

Take an integrated approach

All aspects of a wealth transfer plan should be factored into your analysis and strategies before taking steps to implement. Given the potential for major tax changes, legislative proposals are also an important element of an integrated approach.

Our tax and wealth advisory professionals understand that legislative proposals evolve. We’ll watch for changes in thresholds, how assets in trusts may be treated, special rules for closely held businesses, and transition rules.

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