Something Big is Coming

Provision: Transfer Tax Rates

Currently, the gift and estate rate is, effectively, 40%.

99.5% Act: New marginal tax brackets and an increase in rates. The proposed brackets and rates are:

• $3.5mm – $10mm = 45%
• $10mm – $50mm = 50%
• $50mm – $1B = 55%
• $1B+ = 65%

STEP ACT and American Families Plan: There is no separate estate and gift tax rates as a transfer during life or at death is treated as a sale of the asset.  Appropriate income or capital gains tax applies. There are special rules for transfers to grantor and non-grantor trusts – see below.

Comment: Adding new tax  brackets with increasing tax rates, particularly when viewed in conjunction with some of the other proposed changes, will increase the gift and estate tax liability for many individuals. Estate planners will begin to look at “bracket planning.” For married couples, the plan may be to expose some of the estate to taxes in the estate of the first spouse to die – assuming this will take advantage of a lower tax rate.  The  use of second to die insurance will likely be one of the key means to pay the increased taxes on a  cost effective basis. In addition, the use of single life insurance to cover costs at a first death may also become an important part of the planning. 

Provision: The Basic Exclusion Amount/AKA the Lifetime Exemption

Currently, the inflation adjusted amount per individual is $11.7 mm.  The exemption is subject to a sunset provision and would return the exclusion amount to $5mm (adjusted for inflation) on 1/1/2026.

99.5% Act: Reduced to $3.5mm for the estate tax. During life, only $1mm of the $3.5 may be used. No adjustment for inflation.

STEP ACT and American Families Plan: $1mm exclusion from unrealized gains at death. In the STEP Act, for gifts, the taxpayer may draw down $100k of the $1mm on an annual basis. Amount will be adjusted for inflation. Awaiting details on AFP.

Comment: Under the 99.5% Act the dramatic decrease in the exemption will increase the number of taxpayers exposed to the estate and gift tax and will increase the tax payable by high net worth individuals. For clients who have significant wealth and are comfortable making current gifts, using up all or some of the larger current exemption amount is worth exploring. Making a current gift can involve the purchase of life insurance – generally to be owned by an irrevocable life insurance trust. Using a one pay premium design may be beneficial. Yes, this will be a MEC, but if death benefit is the key element in these situations, then MEC status is not a significant issue. By one paying the policy, you also may avoid some of the tax traps for trusts that are built into the 99.5% Act and STEP Act (which are explored below).

Provision: Gift Tax Annual Exclusion

The gift tax annual exclusion is $15,000 for tax year 2021. That means a donor may gift $15,000 a year to as many donees as they like (provided the gift is one of a present interest).

99.5% Act: Reduced to $10,000 per year per donee for gifts to individuals. For gifts to irrevocable trusts or involving pass thru entities or other non-liquid assets, the donor is limited to 2x the annual exclusion rate.  For example, for gifts subject to the 2x limit, the donor could make no more than a $20,000 gift annually in total.

STEP ACT and American Families Plan: Nothing similar. But see, the lifetime exemption which permits the donor to drawdown against the $1mm exemption amount. The drawdown is limited to $100,000 annually until the $1mm exemption is exhausted. Awaiting details on the AFP.

Comment: Under the 99.5% Act the limit on the gift to trusts is a direct attack against common place planning tools such as the ILIT using Crummey provisions. When combined with the proposed $1mm exemption for lifetime transfers, conventional planning may become difficult to accomplish. Programs involving premium finance may become more popular under this scenario.  As noted earlier, having the policy funded in 2021 may become an optimal plan. The same situation may be true if STEP is enacted.

Provision: Unlimited Marital Deduction

99.5% Act: Will still be available.

STEP ACT and American Families Plan: A Spousal exception will apply if spouse is a US citizen and long term resident.

Comment: There will be planning situations where it makes sense not to use the unlimited marital deduction and lifetime exclusion to shelter the estate of the first spouse to die. With new brackets and rates increasing, there may be situations where the math suggests paying a tax early but in a lower bracket will make sense.  In these cases, having single life coverage (perhaps in addition to second to die coverage) will help pay for the tax due on the first death.

Provision: Unlimited Marital Deduction

99.5% Act: Will still be available.

STEP ACT and American Families Plan: Will be available.

Comment: Charitable giving will continue to be driven by a client’s charitable intent and whether the tax benefit of certain plans causes charitable giving to become a lynch pin of estate planning.  However, much more needs to be known about the tax proposals.

Provision: Adjustment in Basis at Death
IRC Section 1014 permits an adjustment in basis for the beneficiary equal to the fair market value of the asset on the decedent’s date of death (or alternate valuation date).  This is the so called, step up in basis rule.  There is no basis adjustment for lifetime gifts.

99.5% Act: No change. Adjustment in basis available to beneficiaries when the transfer is at death. There is no adjustment in basis for gifts – the carry over basis rules apply for lifetime transfers.  Clarifies that property in a grantor that is not included in the grantor’s estate does not get a step up in basis.

STEP ACT and American Families Plan: Generally, property transferred during life or at death will trigger sales treatment. For the beneficiary, their basis will be equal to the value of the property that was subject to tax. However, there is carryover basis for transfers to a spouse and to charities (as those transfers will not be treated as a sale of the asset). There may also be some exceptions for transfers to and from Grantor trusts.

Comment: The 99.5% Acts continuation of the basis adjustment is good news. Its main change is to codify generally accepted treatment of grantor trust assets.

Provision: Qualified Plan/IRA Inclusion

99.5% Act: No change. The fair market value is included in the decedent’s gross estate.

STEP ACT and American Families Plan: Not impacted by the bill as the funds when received by the beneficiary will be taxed as ordinary income.

Comment: It’s interesting that the two proposals did not make changes to qualified plans and IRAs and their inclusion in the estate tax. That confirms what we already know – Qualified plan / IRA funds are often the most highly taxed asset in an individuals’ possession. The plan value may be subject to an estate tax and an income tax – greatly reducing its value to the beneficiaries. It may make sense to review the Legacy IRA strategy available from National Life Group to see if moving funds from the plan and using after tax amounts to purchase a life insurance policy to deliver income tax free death benefits to the family makes economic sense.

99.5% Act: Eliminates discounts for lack of control and lack of marketability for transfers of entity interests that consist of non-business assets.

Provision: Limits on Discounts
Discounts on the value of an asset helps reduce transfer tax costs. For instance, if the underlying asset is worth $1mm but a discount of 30% is applied, then only $700,000 would be included as the taxable transfer.

STEP ACT and American Families Plan: Not specifically addressed in the bill although will likely be impacted due to Grantor Trust rules. See below.

Comment: Discounts on the transfer of certain assets has been the stock and trade of estate planners and are often subject to IRS scrutiny. The 99.5% act takes direct aim at perceived abuses of this concept.  The Act does not seem to negate all discounting and has some exceptions built in – however transfers of limited partnership interests where the partnership assets include cash/cash equivalents, business interests, etc. may no longer use discounts to value the transfer.

99.5% Act: Minimum GRAT term of 10 years and a maximum term of the Grantor’s life plus 10 years. Remainder interest must be no less than 25% of the FMV of the gift or the greater of $500,000 and not greater than the FMV of the property in the trust.

Provision: GRAT Rules
The Grantor Retained Annuity Trust allows the grantor to transfer an asset, retain a stream of payments for the term of the trust with the remainder being paid to named beneficiaries (often family members or a family trust).  It is possible to set up the plan so that the transfer tax value of the remainder is near zero. This has been very effective for the gifting of discounted and/or highly appreciating assets.

STEP ACT and American Families Plan: Not specifically addressed in the bill although will likely be impacted due to Grantor Trust rules. See below.

Comment: Most GRAT planning relies on the use of a short term with so called zeroed out valuations. The 99.5% Act eliminates the short term GRAT as a planning tool.  With longer terms required planners will have to consider the mortality risks of the increased term. If the Grantor dies during the GRAT term the assets in the trust will be included in the Grantor’s estate.  With discounting on the assets transferred to the GRAT limited and the increased GRAT term, this kind of planning may fall out of favor. However, if the GRAT is attractive because the underlying asset may be rapidly appreciating, using a life insurance policy to defray the costs of the assets being include in the estate may become a standard practice. 

99.5% Act: Sale of property to an intentionally defective grantor trust (IDIT) is effectively eliminated. Assets held in an IDIT will be included in the Grantors gross estate. Distributions to beneficiaries will be treated as a gift.

Provision: Sale/Gifts to Grantor Trusts
An IDIT is treated as owned, for income tax purposes, by the Grantor. If the Grantor sells as asset to the trust, the sale is ignored for income tax purposes and no taxable gain occurs.  This transaction may reduce the taxable estate while allowing the Grantor to retain a stream of payments for a set term.

STEP ACT and American Families Plan: Property transferred to a grantor trust will not automatically be treated as sold. However, property will be deemed sold if property is no longer included in the grantors’ estate, is transferred to another person, at the grantor’s death or if the grantor is no longer treated as the owner of the trust.

Comment: Sales to IDITs has become a popular tool among estate planners. It potentially allows assets to be transferred in such a way that does not have adverse current income tax results and efficiently moves appreciation out of the estate.  When tied to discounting techniques, this plan can save a family significant gift and estate taxes. The two proposed tax acts eliminates this tool.  This will likely expose estates to more estate taxes.

99.5% Act: Transfer from a trust more than 50 years after it is created will be subject to a transfer tax.

Provision: Dynasty Trusts
Dynasty trusts are irrevocable trusts designed to stay in place thru a number of generations.

STEP ACT and American Families Plan: While not specifically addressed, the impact of the changes on transfers to and from Grantor trusts and non-Grantor trusts will curtail the benefits of the Dynasty Trust. Awaiting details related to the AFP.

Comment: Dynasty trusts are trusts that are set up in such a way that the assets held in the trust avoid inclusion in the gift and estate tax system for a number of generations. By keeping the assets out of the transfer tax system, families could accumulate significant wealth.  Both of the tax proposals will put a stop to the multi generation avoidance of transfer taxes.