On September 12, 2021, the House Ways and Means Committee introduced proposed tax changes to be incorporated in the budget reconciliation bill known as the "Build America Back Better Act.” Included below are highlights of the proposed changes under the 881-page tax bill (the full text of which is located here and a summary of the text is located here):
Proposed Changes. The proposed bill provides major changes to the estate and gift tax rules that could reverse parts of the Tax Cuts and Jobs Act of 2017 and significantly limit opportunities for estate and tax planning. Such proposals include changes to the following:
- Reducing the Estate and Gift Tax Exemption. The proposed bill reduces the federal estate and gift tax exemption from $11.7 Million per person to $5 Million per person, indexed for inflation, prior to the scheduled sunset on January 1, 2026. The generation-skipping transfer tax (GST tax) exemption amount will also decrease from $11.7 Million per person to $5 Million per person. The proposed change would apply to estates of decedents dying, and gifts made, after December 31, 2021. Projections from the Joint Committee staff currently show that the exemption would be approximately $6.02 Million per person for 2022.
- Restricting Valuation Discounts. The proposed bill seeks to effectively eliminate discounts for transfers of certain closely held business interests. Specifically, the proposed change would apply to the transfer of “nonbusiness assets” held by an entity that is transferred on or after the date the proposal is enacted. Nonbusiness assets are generally defined as passive assets held to produce income and not used in the conduct of an active trade or business. This proposal applies to the valuation of entity interests owned at death and to entity interests transferred through gifting.
- Eliminating Gift Tax Advantage of Grantor Trusts. Under the proposed bill, assets held by grantor trusts would be included in a decedent’s taxable estate if the decedent is the “deemed owner” of the trusts. In addition, the proposed bill generally treats a distribution made from a grantor trust as a gift, unless (a) the distribution is made to a grantor’s spouse, or (b) the distribution discharges an obligation of the deemed owner. In the event that grantor trust status is terminated during the grantor’s lifetime, the assets will be treated as being gifted by the grantor at such time. This change would be effective for both trusts created, and transfers made after enactment of this proposal.
- Under current law, a grantor trust is a trust in which the trust creator retains certain powers over the trust so that he or she is liable for the income tax on the trust assets instead of the trust itself. By doing so, the creator effectively makes a tax-free gift to the trust beneficiaries because the trust income is not reduced by the payment of taxes (leaving more assets for beneficiaries and less in your estate). The proposals would eliminate this strategy by imposing gift tax consequences on a grantor’s payment of trust income taxes. In addition, through the proposed inclusion of assets of a grantor trust in the grantor’s taxable estate, the creation of irrevocable trusts, such as spousal lifetime access trusts, will be less valuable.
- Eliminating Advantages of Sales to Grantor Trusts. In addition, the proposed bill provides that grantor trust rules would be ignored in relation to any transfer of property between a trust and the deemed owner of such trust through a sale or exchange transaction (this rule does not apply to revocable living trusts). This proposed change would be effective as to sales to trusts created on or after the date of enactment.
- In a previous Client Alert, which can be found here (Planning with Low Interest Rates and Temporarily Reduced Asset Values), we discussed the benefit of selling assets to an intentionally defective grantor trust to exclude the trust assets from the estate of the individual who created the trust while simultaneously taxing trust income to such individual. Due to how grantor trusts are currently taxed, when a grantor sells assets to a grantor trust, no capital gain is triggered. However, the proposed bill significantly reduces the benefit of the “sale to defective trust” technique due to the gain that would be recognized on the sale.
- Restricting Exclusion Rates for Section 1202 stock. The proposed bill would provide that the 75% and 100% exclusion rates for gains realized from qualified small business stock (QSBS) would not apply to taxpayers with adjusted gross income equal to or over $400,000. The baseline 50% exclusion would remain available for all taxpayers. This would impact the QSBS exclusion for sales taking place after September 13, 2021, but an exception would exist for gain resulting from sales under binding contracts entered into prior to or on September 12, 2021.
- Increasing Tax Rates for Trusts and Estates. The proposed bill would increase the top marginal income tax rate to 39.6% for estates and trusts with taxable income over $12,500 (not including charitable trusts). In addition, the proposed bill provides that estates or trusts with income over $100,000 would be subject to an additional 3% tax on their modified adjusted gross income. This change would be effective for tax years after 2021.
- Increasing Tax Rates for Individuals. The proposed bill would increase the top marginal individual income tax rate to 39.6%, effective after December 31, 2021. This marginal rate would apply to: (a) married individuals filing jointly with taxable income exceeding $450,000; (b) heads of household with taxable income exceeding $425,000; (c) unmarried individuals with taxable income exceeding $400,000; and (d) married individuals filing separate returns with taxable income exceeding $225,000. Additionally, the proposal would apply a 3% surtax on modified adjusted gross income over $5,000,000, effective after December 31, 2021.
- Increasing Capital Gains Rates. The proposed bill seeks to increase the 20% tax rate on capital gains to 25%. The effective date for this increase would be September 13, 2021, but an exception would exist for gain recognized resulting from sales under binding contracts entered into prior to the effective date.
Notable Omitted Proposals. Many of the proposed changes above were previously mentioned in President Biden’s administration’s General Explanations of the Administration’s Fiscal Year 2022 (informally referred to as the “Green Book”), meaning many clients have begun to prepare for any changes needed under their respective planning. However, it is notable that certain items from the Green book were not provided for under the committee’s proposals, including:
- No Repeal of the Step-Up in Basis Rule. Under the Green Book, the proposals sought to eliminate the automatic adjustment of income tax basis of assets to the fair market value at death (erasing any capital gain on appreciated assets owned by a decedent). There is no mention of a repeal of the step-up in basis under the proposed bill.
- No Repeal of SALT Caps. In addition, there is no mention under the proposed bill of a full (or partial) repeal of the current $10,000 cap on state and local tax deductions.
- No Federal Rule Against Perpetuities for Dynasty Trusts. Past proposals sought to restrict the benefit of long-term trusts (i.e., a trust that will last 50 years or more), which can be used as an effective wealth-preservation tool to move assets from one generation to the next while avoiding estate and GST taxes at each generation. There is no mention of any limitation on such trusts under the proposed bill.
- No Increase in Estate Tax Rates. The proposed bill does not impact the annual exclusion amount for gifts (remains at $15,000 per year per donee), and the top estate tax bracket remains at 40%.
- No Added Limitations on GRATs. Past proposals have mentioned possible limitations on the use of Grantor Retained Annuity Trusts (GRATs), specifically seeking to impose longer minimum terms to limit their effectiveness. The proposed bill imposes no such limitations
- No Death Recognition Events. Under the Green Book, subject to specified exclusions and exemptions, all deathtime and lifetime transfers would be income tax realization events. These proposals were particularly troubling for nonmarketable property, such as businesses, because drastic measures (such as borrowing or forcing a sale) would often be necessary to pay taxes due. However, these death recognition events were not mentioned under the proposed bill.
Next Steps on the Legislation—A Long Way to Go Before it Becomes Law. The House of Representatives was the first to act on putting together the Reconciliation legislation in Committee. When all action is complete in the House it will be sent to the House Rules Committee where it will likely sit until an agreement is reached between House and Senate Democrats. The Senate has yet to act and they are not likely to have any committee markups, since Senate Republicans as a group have vowed to not support the bill in the Senate. They passed before the August recess, a bipartisan infrastructure bill that is sitting in the House awaiting action promised for September 27 by the Speaker. With only a few votes difference between the Democrat and Republican majority in the House, and a 50-50 breakdown between parties in the Senate where the Vice President has to break any tie, the extremes on both sides of the Democrat party in those bodies can influence the outcome. The Majority Leader Chuck Schumer (D-NY) and Speaker Nancy Pelosi (D-CA) will have to huddle internally to determine their next steps. Speaker Pelosi and Chairman Neal both want to avoid forcing Democrats to take a vote on any non-starter issues in the Senate. At this point, the House Rules Committee awaits the Budget Committee’s final package before turning to Speaker Pelosi for specific instructions regarding the timing of a full vote on the floor of the House. It is anyone’s guess if they can thread the needle to get passage of this mammoth proposal.
Recommended Actions for Clients. The proposed bill is merely a starting point for potential changes and represents a worst-case scenario in terms of sweeping changes. The proposals under the bill may change before it is brought to the House floor for a vote and, at that point, it still may be difficult to gather enough votes to move the bill along. However, even if all of the proposed changes do not pass, certain proposed changes (in one form or another) will most likely become reality.
With all that being said, what does this mean for you? Any single individual with an anticipated gross estate in excess of $5 Million and married couples with a combined anticipated gross estate in excess of $10 Million may want to consider estate planning techniques to take advantage of the higher gift and estate tax exemptions that are currently in place. Even if the proposed planning options do not come to fruition, current factors, like depreciated asset values as a result of the COVID-19 pandemic, record-low interest rates, and historically high estate and gift exemption amounts, provide unique opportunities to minimize your tax exposure. In a previous Client Alert, which can be found here (Planning with Low Interest Rates and Temporarily Reduced Asset Values) we discussed several tax-efficient strategies to consider, including: intra-family loans; Grantor Retained Annuity Trusts; sales to Intentionally Defective Grantor Trusts; and Charitable Lead Annuity Trusts. More information about these and other techniques can be found here.
Please contact one of Michael Best’s Wealth Planning attorneys if you would like to discuss opportunities and implications in light of the proposed tax law changes, especially if you are considering making lifetime gifts.