House Ways and Means Committee Tax Plan Proposes Changes to Estate Planning

The House Committee on Ways and Means has proposed a tax plan intended to fund President Joe Biden's "Build Back Better" $3.5 trillion infrastructure program. Among the many changes in this proposed tax plan are three that will significantly impact estate planning opportunities: 1) changes to the grantor trust rules, 2) elimination of valuation discounts for interests in passive entities, and 3) reduction in the gift and estate tax exemption. These potential changes could make year-end planning especially important this year.

Grantor Trusts

Grantor trusts, the income of which is taxed to the grantor instead of the trust, have been an important estate planning tool since income tax brackets for trusts became more compressed than those for individuals. Additionally, the grantor trust rules allow the grantor to retain some control over an irrevocable trust, such as the carefully limited ability to change the trust's assets and beneficiaries. Under the current rules, there are several commonly used estate planning structures that rely upon the grantor trust rules, including grantor retained annuity trusts (GRATs), spousal lifetime access trusts (SLATs), intentionally defective grantor trusts (IDGTs) and irrevocable life insurance trusts (ILITs).

GRATs are used to transfer appreciated assets without incurring gift and estate taxes. Under a typical GRAT, the grantor will receive an annuity for a term of years and the remainder will be distributed to a continuing trust, usually for the benefit of the grantor's descendants. The annuity payments are structured so that the value of the remainder is zero or close to zero, which results in the initial transfer to the trust being nontaxable. While the annuity payments will be included in the grantor's estate, the appreciation of the assets during the term of the GRAT will pass to the continuing trust tax-free. With rapidly appreciating assets, this can result in the transfer of significant wealth without incurring any gift tax.

A SLAT is used to provide support to the grantor's spouse while moving assets by gift out of the grantor's estate. These are a good tool to remove appreciation of the assets from the grantor's estate while continuing to allow the grantor's spouse to benefit from those assets. The distributions from the SLAT to the spouse will be included in the spouse's estate, but the remaining assets will not be included in either spouse's estate.

IDGTs are a similar concept to SLATs, except that they completely remove all of the assets from the grantor's and spouse's estates. This is because IDGTs are for the benefit of someone other than the grantor or the grantor's spouse, so distributions from the IDGT are not included in either estate. IDGTs are attractive for two reasons. First, the grantor can continue to pay the income tax liability of the IDGT, allowing the assets of the trust to grow tax-free without additional taxable gifts from the grantor. Second, the grantor can sell assets to the IDGT without any income tax consequences, thus freezing the value of the transferred assets in the grantor's estate and moving the appreciation from those assets to the IDGT.

ILITs are used to provide life insurance to a beneficiary tax-free. The grantor can make annual contributions to the ILIT to pay insurance premiums. ILITs can take advantage of the annual exclusion so that these contributions do not incur any gift tax. By definition, ILITs are grantor trusts.

Although the assets of a grantor trust are deemed to be owned by the grantor for federal income tax purposes, until now they have not necessarily been included in the grantor's taxable estate for federal estate tax purposes, and that mismatch has allowed taxpayers to engage in the planning techniques described above.

The Ways and Means Committee proposal would end this mismatch by treating all assets of any grantor trust as includible in the grantor's gross estate for estate tax purposes. Additionally, under the Ways and Means Committee proposal, distributions from a grantor trust will be taxable gifts. Under current law, there is a taxable gift only upon creation of the grantor trust and distributions are gift tax free. These changes would apply to trusts created on or after the enactment date and contributions to any trusts if the contribution occurs on or after the date of enactment, even if the trust was created prior to the enactment date.

Finally, sales between the trust and the grantor will be fully taxable, and in-kind distributions will be treated as realization events that trigger capital gain. Currently, these sales are tax-free, because the grantor and the trust are considered the same taxpayer, so the sale is a nontaxable event. Additionally, in-kind distributions are not a recognition event under current law. Both of these changes apply to all trusts, regardless of when they were created. The current language of the proposed bill states that these changes apply only to trusts created on or after the effective date, but the Ways and Means Committee has clarified their intent to cover trusts created before the effective date as well, and it is likely that change will be in a new iteration of the bill.

The Ways and Means Committee's grantor trust estate inclusion rule would effectively end planning with SLATs and IDGTs. Because the rules apply to transfers made after the effective date, ILITs will also be problematic as ILITs sometimes require ongoing contributions to the trust to facilitate payment of the insurance premiums. GRATs might be impacted if the new rules would treat distributions of assets in kind to satisfy the annuity as a sale or exchange for income tax purposes. Additionally, the language of the proposal is so broad, it could create other unanticipated consequences for GRATs.

Disallowance of Valuation Discounts for Interests in Passive Entities

The Ways and Means Committee proposal also changes the use of valuation discounts for transfers of ownership interests in passive entities. Under current law, lack of marketability and minority interest discounts are appropriate when valuing closely held entities for gift and estate tax purposes. Under the new tax proposal, these common discounts are eliminated for entities that hold nonbusiness assets. The definition of nonbusiness assets appears to include marketable securities and real estate, unless the donor or the decedent actively managed the real estate. These changes will apply to transfers made after the date of enactment.

Estate and Gift Tax Exemption

The current gift and estate tax exemption is $11.7 million per person, which shelters the vast majority of estates from estate tax. This amount is adjusted annually for inflation. Under current law, if Congress does nothing, the exemption will revert to $5 million per person, indexed for inflation ($5.85 million) in 2026. The House Ways and Means Committee proposal would accelerate this reversion, making it effective for estates of decedents dying and gifts made after Dec. 31, 2021.

Any exemption above $5.85 million not used will be "lost" on Jan. 1, 2022, so taxpayers should consider transferring as much of their exemption amount as possible before the end of the year.

Conclusion

The House Ways and Means Committee proposal could make many commonly used estate planning tools far less effective than they have been. Of course, the Senate is expected to amend this proposal, and the end result may be quite different. Additionally, there is no guarantee that the legislation as a whole will be passed by the closely divided Congress.

Given the uncertainty surrounding these proposals and the potentially short time frame for acting, interested parties should consult with estate planning and tax advisors as soon as possible to determine if action should be taken now. For more information or additional guidance on the proposed tax plan, contact the authors or a member of Holland & Knight's Private Wealth Services Group.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.