Prioritizing Estate Plans: Proposed Tax Law Changes
By Marissa Pepe Turrell, ASA, CVA, Director, Advisory Services
On September 13, 2021, the House Ways and Means Committee released its proposal for funding the $3.5 trillion reconciliation package (“Build Back Better Act”), detailing multiple changes to current tax law in order to increase tax revenue. Among these changes are proposals that could significantly modify planning for individuals looking to transfer assets out of their estates.
The proposed changes are not definite, and further revisions are likely to occur if and when the bill makes its way through the reconciliation process. However, some aspects of the proposal are significant enough that individuals may want to seriously consider accelerating transfers they may have been contemplating.
First and foremost, the proposal moves up the timeline for the reduction in the federal estate and gift tax exemption, from 2026 to 2022. The current $11.7 million exemption would drop to approximately $6 million. Individuals with estates expected to exceed the proposed $6 million exemption, who have not already used up their current $11.7 million exemption, have the opportunity until the end of 2021 to make additional gifts.
Individuals who had previously planned to gift assets in the next few years may want to do this now.
Certain types of grantor trusts allow the grantor to place assets in the trust, considered a gift when funded, with the grantor paying the income tax on taxable income generated by the trust. This allows the assets in the trust to grow outside of the grantor’s estate and for the assets held by the trust to increase in value without a reduction for taxes. The payment by the grantor of the income taxes on the trust’s taxable income is currently not considered an additional gift to the trust.
Another popular estate and gift planning technique affected by the House bill involves sales to grantor trusts. Under this technique, the grantor can sell property to a grantor trust for a promissory note. Since, under current law, the trust is not treated as a taxpayer separate from the grantor, there is no taxable gain or interest income recognized on payments received by the grantor. Any growth in the value of the transferred property in excess of the payments of principal and interest paid on the promissory note to the grantor remains in the trust for the benefit of its beneficiaries. The proposed change would cause the assets of a grantor trust to be includible in the grantor’s estate. Distributions from a grantor trust to trust beneficiaries other than the grantor’s spouse would be treated as a gift made by the grantor to the distributees.
The sale to a grantor trust would be curtailed by a new rule which would treat such sales as being between the grantor and a third party, resulting in taxable gain and interest to the grantor. The assets held by the grantor trust would still be includible in the grantor’s federal taxable estate under the rule discussed above.
Importantly, this change would be effective immediately at the enactment of the bill. Existing grantor trusts would be grandfathered in and allowed to remain outside of the estate. However, future contributions to the trust would be subject to the new rules and this would cause a portion of the trust to be includible in the grantor’s taxable estate. This can apply to pre-enactment date insurance trusts structured as grantor trusts where new contributions are made for the payment of insurance premiums.
Anyone considering a grantor trust should consider funding it now. For existing trusts that hold life insurance policies, donors should consider contributing to the trust for the payment of the insurance premiums before the law becomes effective. Additionally transfers to a Grantor Retained Annuity Trust, Grantor Retained Unitrust or regular grantor trust should be accelerated.
Lack of Control and Marketability
Finally, the bill proposes eliminating discounts for lack of control and lack of marketability on transfers of interest in entities with non-business assets. Currently, when an interest in an entity such as a partnership or LLC is transferred as a gift or is included in an estate, that interest is valued at its fair market value, a term defined by U.S. Treasury regulations. Under the fair market value standard, appraisers look at the rights of the interest being transferred and consider whether the pro rata value of the interest should be reduced or discounted because it lacks control of the entity and is not liquid. If a holder cannot exercise control over the timing and amount of distributions, or cannot sell or liquidate their interest quickly, various studies prove that a buyer would not pay a full pro rata value for such an interest, and therefore appraisers apply discounts to determine the fair market value.
The House proposal would effectively ignore the structure, rights and regulations of entities holding non-business assets. The proposal defines non-business assets as passive assets held for the production of income and not used in the active conduct of business. The proposal states that in order for real property to meet the criteria of being used in the active conduct of business, it must be used in defined capacities such as real property development, rental, operation or leasing, and importantly, the transferor must be actively involved in the business and the interest may not be a limited partner interest. The list of passive assets in the bill includes cash, stock, debt, real property, annuities, certain assets producing royalty income, foreign currency, precious metals, and personal property.
It is important to note that the inability to apply discounts applies even if passive assets happen to be held in entities that would be considered operating businesses. The rule would exempt certain assets used in the operation of a business, such as inventory and accounts receivable, and specifically says reasonable required working capital would not be considered a passive asset. However, because the wording specifies “reasonably required working capital,” it stands to reason that excess working capital in operating companies (as well as other passive assets sometimes owned by operating companies) will need to be bifurcated and treated separately from an interest in an operating company that could still be discounted.
This is a significant change in the valuation of gifts of interests in entities holding such assets. The change is effective immediately at the passage of the bill.
Individuals planning to gift such interests or in the process of structuring entities to hold assets to facilitate such a gift should do so as soon as possible.
While the proposed changes to tax law were not completely unexpected, the reality is they may change further or not pass at all. However, the details released by the House provide enough incentive for individuals to accelerate plans already in process. Hasty planning is not recommended, but for individuals who have been intending to transfer wealth through gifts in the near term, now may be the time to reach out to your Marcum professional or estate planning attorney for advice on how to proceed.