The House Ways and Means Committee recently released a draft proposal of new tax increases to help pay for the much anticipated $3.5 trillion House budget proposal. While this proposal will no doubt evolve as it moves through the political process, it gives us some idea of what the White House and Democrats are looking for. While there are many tax increases, the estate tax proposals may require the most immediate action for some.
Their proposal is to cut in half the current gift, estate and generation skipping tax (GST) exemption, diminish the value of the grantor trusts that are frequently used in estate planning, and dramatically restrict valuation discounts that have long been used to leverage gifts to beneficiaries.
Reduction in Gift, Estate and GST Exemptions
The gift/estate/GST exemption of $5 million was passed into law back in 2010 with a scheduled increase for inflation annually. Former President Trump doubled the exemption for 2018 to 2025 with the signing of the 2017 Tax Cut and Jobs Act. Even though the higher exemption was scheduled to revert to the $5 million adjusted for inflation in 2026, the new proposal accelerates that to January 1, 2022. Thus, the current gift/estate/GST exemption of $11.7 million would be reduced to roughly $6 million.
Grantor Trust Changes
Grantor trusts, which are frequently used in estate planning, are effectively being eliminated. Current law allows grantors to irrevocably transfer assets out of their estate but continue to pay income tax on the income from the trust. This income tax payment is in effect a gift to the beneficiaries without it being treated as a taxable gift. The current proposal requires that any assets held in a grantor trust be included in the grantor’s estate. Also, any transfers out of a grantor trust to anyone other than the grantor or spouse are treated as gifts, or if the trust’s grantor status is terminated during the grantor’s lifetime, the assets will be treated as a gift at that time. These provisions effectively have eliminated the common estate tax savings vehicles: Grantor Retained Annuity Trusts (GRATs), Spousal Lifetime Access Trusts (SLATs) and Qualified Personal Residence Trusts (QPRTs).
Another creative technique using grantor trusts involves the grantor selling assets to a grantor trust for a note at current interest rates, which are very low. This technique is called a Sale to an Intentionally Defective Grantor Trust (IDGT). Since the grantor and grantor trust are the same person for income tax purposes, the sale is disregarded for income tax purposes. This is an estate freeze technique that allows assets to appreciate, yet the trust only pays the grantor back the note plus interest at a much lower rate. If you happen to combine a sale of assets using discounted values (discussed below), then your gift is even further leveraged, and more wealth is transferred to beneficiaries. Their proposal makes this technique a taxable sale, which will certainly diminish the value of this structure. The effective date of this provision, as well as the valuation discount elimination provision explained below, is the date of enactment of the bill, which isn’t known at this point.
Valuation Discount Changes
As mentioned, valuation discounts are frequently used to transfer wealth to beneficiaries. Marketability discounts and minority interest discounts are commonly used to reduce the value of assets being gifted. For example, assume a family limited partnership is formed with contributions of marketable securities. Gifting non-controlling fractional interests of that partnership may reduce the value by 15-35% or more depending on the facts and type of assets gifted. Discounts make sense because you can’t immediately convert that gift to cash. As a minority owner, you can’t control the decisions of the majority owner, and most agreements won’t allow you to sell your interest to an outside party. Thus, the value of what you received is not worth the full value of the assets inside the entity. The current proposal eliminates these discounts for non-business assets transferred. Non-business assets include cash, marketable securities, and other assets not used in the active conduct of a business.
What Should Be Done Now?
Taxpayers that have assets over $11.7 million single, or $23.4 million married filing jointly, should consider using that exemption now. As mentioned above, most estate techniques involve grantor trusts and discounts, so we don’t know when this proposal will progress to a signed bill. However, the effective date of these provisions will be the date of enactment. This may be before the estate tax exemption decreases on January 1, 2022. Gifts made at or below the proposed exemption amounts will not help you avoid losing the exemption. For example, assume you were single now and made a gift of $6 million. In 2022, the exemption drops from $11.7 million to $6 million. With the $6 million gift, you’ve just used up your current exemption and can’t make additional non-taxable gifts. You’ve lost the opportunity to gift another $5.7 million. At a 40% estate tax rate, that will cost your heirs $5,700,000*40% = $2,280,000. This is doubled if you happen to be married and doesn’t even factor in future appreciation that will be subject to the estate tax.
The goal is to gift as much as you can up to the current exemption amounts noted above. You obviously need to factor in your lifestyle and what assets you need to maintain your lifestyle. For those that are concerned they may give away too much (and don’t want to ask their kids for money!), then a SLAT may be an answer for you if you are married. This vehicle allows for distributions back to your spouse in certain circumstances, which can alleviate some of your concerns.
The bottom line is this: if you want to take advantage of the larger gift/estate/GST exemption, please act now because the clock is ticking. You can reach out to us or your estate attorney to start the analysis and help you with your estate planning and goals.