Overview
The House Ways and Means Committee recently proposed new draft
federal tax legislation that would dramatically affect the Private
Wealth area. Many of the changes are time sensitive. Thankfully,
unlike previously publicized tax reform proposals, the existing
"step-up" in basis rules that apply at the time of a
decedent's death are not being altered by the new draft
legislation. A summary of the proposed changes follows. Please note
that the proposals discussed below are subject to further revision,
perhaps significantly so, as the draft legislation works its way
through Congressional committees in the different houses of
Congress and toward enactment.
Estate/Gift/GST Tax
Currently, the exemption against estate, gift and
generation-skipping transfer (GST) tax, as a result of the Tax Cuts
and Jobs Act of 2017, is $10 million per person, indexed for
inflation (i.e., $11.7 million for 2021). This increased exemption
amount is set to sunset after December 31, 2025. The current
proposals, however, would reduce the exemption amount to $5
million, indexed for inflation using a base year of 2010, beginning
on January 1, 2022 (i.e., approximately $6,020,000 for 2022).
Clients who wish to take advantage of the current $11.7 million
exemption before the end of 2021 may do so by accelerating their
estate planning goals and making lifetime gifts before the
year's end to use up remaining exemption amounts, as this
change would be effective next year.
Grantor Trusts
Under current law, a donor can establish a so-called
"grantor trust," with trust property treated as being
owned by the grantor for income tax purposes, but with trust
property outside of the grantor's estate for estate tax
purposes. As a common estate planning technique, a grantor will
often sell or exchange assets to or with a grantor trust with no
income tax consequence.
The new proposals would eliminate many of the tax benefits of
establishing grantor trusts. For example, under the draft
legislation, if a grantor is treated as the owner of a trust for
income tax purposes, the trust property would now be included in
the grantor's estate for estate tax purposes. This would
include any appreciation on the trust's assets in the
grantor's estate as well. The new legislation would also
classify distributions during the grantor's lifetime from a
grantor trust to a trust beneficiary, other than the grantor or the
grantor's spouse, as a gift to the beneficiary by the grantor,
with an offset for the grantor's initial gift to the trust. In
other words, the distribution from a grantor trust to a trust
beneficiary would be treated as a gift to the beneficiary by the
grantor. Additionally, sales and exchanges with a grantor trust by
a grantor would no longer be disregarded for income tax
purposes.
This potential change would apply to grantor trusts that are
settled after enactment (as opposed to after the end of the year)
of the legislation and to post-enactment contributions to and
transactions with existing grantor trusts. This could largely
eliminate the benefit of common estate planning techniques such as
grantor retained annuity trusts (GRATs), sales to grantor trusts,
spousal lifetime access trusts (SLATs), qualified personal
residence trusts (QPRTs) and irrevocable life insurance trusts
(ILITs).
ILITs are estate planning vehicles that are usually grantor
trusts. Typically, an ILIT holds life insurance policies and gifts
are made to the ILIT each year in order to pay the annual life
insurance premiums. Clients with ILITs may wish to pre-fund their
ILIT with multiple years' worth of life insurance premiums to
avoid having such contributions included in the grantor's
estate for estate tax purposes (if the current draft legislation
shows signs of being enacted in its current form) before the
enactment of draft legislation.
In addition to the above considerations regarding ILITs, clients
may want to consider creating and funding certain grantor trusts
prior to the enactment of the new tax legislation in order to
preserve favorable tax status.
Valuation Discounts
The new tax proposals also take aim at valuation discounts for
non-business assets (e.g., cash, publicly traded stocks and bonds,
debt instruments, etc.) that are held in limited liability
companies (LLCs), partnerships and other private entities.
Presently, if a donor makes a gift of a minority or non-controlling
interest in a private entity, the value of the gift is arguably
less than the value of the proportional amount of the entity being
transferred due to discounts for lack of marketability and lack of
control. The new tax proposals would eradicate these discounts for
transfers on or after the date of enactment if the entity's
assets include publicly-traded securities, non-operating cash or
other passive, non-business assets. For example, under current law,
a transfer of 20 percent of an LLC to a non-managing member would
likely be considered a transfer of less than 20 percent of the
value of the LLC due to discounts for lack of marketability and
lack of control. The new legislation would result in the transfer
of 20 percent of an LLC being considered a transfer of 20 percent
of the value of the LLC, increasing the amount of the gift being
made.
Clients who want to make lifetime gifts utilizing valuation
discounts with interests in entities holding non-business assets
may wish to do so before enactment of any tax legislation in order
to take advantage of these discounts for lack of marketability and
lack of control.
Retirement Accounts
The new tax proposals would prevent certain high-income earners
(generally, single taxpayers exceeding $400,000 in income and joint
filers exceeding $450,000 in income) from converting pre-tax
employee contributions to a qualified retirement plan to a Roth
account and from converting pre-tax IRA balances into Roth IRAs. If
enacted, all taxpayers, regardless of income, would not be able to
convert any after-tax contributions made to qualified retirement
plans or IRAs to a Roth account or Roth IRA, effective for tax
years beginning January 1, 2022.
There also are proposed significant changes for large retirement
accounts. Beginning in 2022, regardless of a taxpayer's age,
taxpayers earning more than $400,000 (or $450,000 for joint filers)
with a combined traditional IRA, Roth IRA and defined contribution
retirement account balance exceeding $10 million would be required
to withdraw 50 percent of the balance over $10 million. For any
aggregate traditional IRA, Roth IRA and defined contribution
retirement plan balance over $20 million, 100 percent of the excess
over $20 million must be withdrawn from Roth accounts up to the
lesser of (1) the amount needed to bring the total balance of such
accounts below $20 million and (2) the aggregate balance of the
taxpayer's Roth accounts. The taxpayer will also have to pay
income tax on such withdrawn amounts on an annual basis.
Additionally, for high-income taxpayers, the new provisions would
prohibit any additional contributions to traditional and Roth IRAs
if the aggregate balance of a taxpayer's retirement accounts
exceeds $10 million.
Conclusion
The above proposals make significant changes to the estate
planning landscape for all high-net-worth individuals, including
the potential termination of many estate planning methods that
advisors have traditionally recommended. While there has been
political momentum to pass tax legislation that will increase
federal revenue, these tax proposals may very well not be enacted,
if at all, without further amendment. Due to the effective dates
for many of the proposed changes, however, you should consider how
such variations to existing legislation may affect your estate
planning prior to the final enactment of new legislation.
We encourage you to get in touch with us regarding your estate
plan so that we can review it and make recommendations regarding
the potential impact of the draft legislation on your estate
planning goals.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.