The Estate Planning & Probate Litigation Blog
In August, the U.S. House of Representatives and U.S. Senate passed a $3.5 trillion budget resolution and assigned the House Ways and Means Committee and the Senate Finance Committee with the task of coming up with enough tax increases to cover the total cost. On Sept. 13, the House Ways and Means Committee Chair Richard Neal (D-MA) introduced the committee’s budget reconciliation recommendations. On Sept. 15, in a largely party-line vote, the House Ways and Means Committee approved the recommendations and they now go to the House Budget Committee to be added to the rest of a $3.5 trillion reconciliation bill. It is important to remember that these recommendations may never become law in their proposed form. The Senate will have its version of the reconciliation bill which will include tax increases proposed by the Senate Finance Committee and the Biden administration has already begun to weigh in. Nevertheless, tax changes are expected to be enacted this year and the recommendations by the House Ways and Means Committee have laid the groundwork for possible tax reforms to be on the lookout for as the legislative process moves forward. Those who anticipate the tax changes and are prepared to take action to take advantage of existing tax laws before they are modified or eliminated may achieve significant tax savings. This alert highlights some of the estate and gift tax and income tax changes in the House Ways and Means Committee recommendations.
ESTATE AND GIFT TAX RELATED PROPOSALS
Estate, Gift and Generation-Skipping Transfer Tax Exemptions
The basic exclusion amount would be reduced to $5,000,000 adjusted for inflation with the base year being 2010. This proposal would be effective for gifts and estates of decedents dying after Dec. 31, 2021. The effect of this proposal is to accelerate the reduction in the exemption amounts which is currently scheduled to occur on Jan. 1, 2026. This proposal would result in a basic exclusion amount (and GST exemption) of approximately $6,000,000 (after the inflation adjustment) per taxpayer or $12,000,000 per married couple as of Jan. 1, 2022. Currently, the basic exclusion amount (and GST exemption) is $11,700,000 per taxpayer or $23,400,000 per married couple.
There is no mention of eliminating or modifying portability under the proposal, so one would assume the portability rules will remain intact under this proposal. There is also no mention of the elimination of the step up in basis above a $1 million threshold proposed by President Biden. President Biden, however, as already made note of the fact that his proposal is missing and reiterated his desire to see the proposal added to future legislation.
Increase in Estate Tax Valuation Reduction for Real Property Used in Farming
Currently, in certain instances, a decedent’s estate may reduce the value of farmland by $750,000 for purposes of determining the value of the land for estate tax purposes. The recommendations propose an increase in the adjustment amount to $11,700,000. This proposal would be effective for the estates of decedents dying after Dec. 31, 2021.
Changes to Grantor Trust Rules
The recommendations contain several proposed changes to the taxation of grantor trusts. For transfer tax purposes, (i) upon the death of a deemed owner of a grantor trust (or any portion of such trust), the assets of the grantor trust (or the applicable portion) will be included in the gross estate of the deemed owner, (ii) if a distribution is made from a grantor trust (or the applicable portion), such distribution will be treated as a gift for gift tax purposes unless the distribution is to the deemed owner or the deemed owner’s spouse or discharges an obligation of the deemed owner, and (iii) if the grantor trust status is terminated during the deemed owner’s lifetime, the deemed owner will be treated as having made a gift of the assets of the grantor trust (or the applicable portion). If assets of a grantor trust are included in the deemed owner’s estate or are treated as a gift from the deemed owner, an adjustment will be made to account for amounts transferred to the trust by the deemed owner that were previously treated as taxable gifts. The effect of this proposal appears to subject the appreciation of any asset transferred to the grantor trust to estate and/or gift tax, as applicable. Note that this proposal applies only to grantor trusts where the grantor is treated as the deemed owner, not to grantor trusts where another person, such as a beneficiary, is treated as the deemed owner.
For income tax purposes, where there is a transfer of property between the grantor trust and the deemed owner, unless the trust is fully revocable by the deemed owner, the grantor trust rules are ignored in determining whether the transfer is a sale or exchange for income tax purposes. Also, under this proposal, a deemed owner and the grantor trust will be considered related parties which would disallow any loss resulting from a sale or exchange between the deemed owner and the grantor trust. This proposal would apply even where a person other than the grantor, such as a beneficiary, is treated as the deemed owner. Note that these rules only apply to sale or exchanges between the deemed owner and the grantor trust. Thus, it appears that a deemed owner and a grantor trust can enter into other transactions such as a rental arrangement or a loan that will continue to be disregarded for income tax purposes.
One of the more popular estate planning techniques is a sale by a grantor to a grantor trust in which the grantor is the deemed owner of the underlying assets of the trust. A sale to an intentionally defective grantor trust is an estate freeze technique that allows a taxpayer to sell an asset to his or her trust without having to recognize any gain from such sale, while removing all appreciation with respect to such asset from his or her estate. These proposals effectively eliminate that planning technique.
These proposals are to apply (i) to any trusts created on or after the date of enactment of the new tax law by the House and the Senate or (ii) to any portion of a trust established before the date of enactment which is attributable to a contribution to such trust on or after the date of enactment. Grantor trusts created on or after the date of enactment and transfers to grantor trusts after the date of enactment will be subject to the these unfavorable gift and estate tax consequences. Thus, the window of opportunity to do certain planning under the current law is probably smaller than the window of opportunity to take advantage of the higher exemption amounts before they are decreased. In other words, taxpayers likely do not have until year-end before they are negatively impacted by these grantor trust proposals. It should be noted that these proposals apply to trusts created and contributions made after the date of enactment. Accordingly, a sale to a grantor trust occurring after the date of enactment to a trust formed prior to the date of enactment should not trigger the application of these proposed rules. We will follow up with another post to discuss in more detail some of the potential implications of these rules on existing trusts and planning going forward.
Valuation Rules for Certain Transfers of Nonbusiness Assets
Under this recommendation, the methodology for valuing an ownership interest in a privately-held entity for transfer tax purposes will be modified so that (i) any nonbusiness assets owned by the entity will be disregarded in valuing the ownership interest in the entity, (ii) the nonbusiness assets will be valued separately as if the transferor had transferred such assets directly to the transferee and (iii) no valuation discount will apply when valuing the nonbusiness assets. For purposes of this proposal, nonbusiness assets are any passive asset which is held for the production or collection of income and is not used in the active conduct of a trade or business. There are exceptions for real property used in the active conduct of a real property trade or business in which the transferor materially participates and passive assets held as a part of the reasonably required working capital of a trade or business. If a passive asset is an ownership interest of 10% or more in another entity, these rules shall be applied by disregarding the 10% interest and by treating the owner-entity as directly holding its ratable share of the assets of the subsidiary-entity. This proposal effectively eliminates the ability to transfer passive assets to an entity and obtain valuation discounts with respect to ownership interests in such entity. This proposal shall apply to transfers after the date of enactment.
INCOME TAX PROPOSALS
Top Marginal Income Tax Rate
The top marginal income tax rate for individuals, estates and trusts would increase to 39.6% and apply to taxable income in excess of $450,000 (married filing jointly or surviving spouse), $425,000 (head of household), $400,000 (single), $225,000 (married filing separately) and $12,500 (trusts and estates). These changes would be effective for tax years beginning after Dec. 31, 2021. Currently, the top marginal income tax rate is 37% and applies to adjusted gross income in excess of $628,300 (married filing jointly or surviving spouse), $523,600 (head of household), $523,600 (single), $314,150 (married filing separately) and $13,050 (trusts and estates).
Capital Gains Rate
The top long-term capital gains rate would increase to 25% from 20%.
The 25% top rate would be effective for long-term capital gains recognized after Sept. 13, 2021. Any long-term capital gains recognized before that date would be subject to the lower top rate of 20%. If a long-term capital gain occurs after Sept. 13, 2021 but before Jan. 1, 2022 and results from a transaction which occurs pursuant to a written binding contract entered into on or before Sept. 13, 2021 and which is not modified thereafter in any material respect, such gain would be subject to the lower top rate of 20%. In applying these rules with respect to a pass-through entity (e.g., entity taxed as a partnership or S corporation), the determination of when gains and losses are properly taken into account will be made at the entity level.
The existing thresholds of taxable income of $501,600 (married filing jointly or surviving spouse), $445,850 (head of household), $448,450 (single), $250,800 (married filing separately) and $13,050 (trusts and estates) will continue to apply to all long-term capital gains recognized during 2021 regardless of which top rate (20% or 25%) is applicable. For long-term capital gains recognized after Dec. 31, 2021, the thresholds for the top rate will equal the thresholds for the highest marginal income tax rate.
This proposal will also impact the taxation of qualified dividends as qualified dividends are taxed at the top rate applicable to long-term capital gains.
The 3.8% Net Investment Income Tax and Business Income
For individual taxpayers with modified adjusted gross incomes in excess of $500,000 (married filing jointly or surviving spouse), $250,000 (married filing separately) or $400,000 (single or head of household), the application of the 3.8% net investment income tax is expanded to apply to income of the taxpayer derived in the ordinary course of a trade or business (referred to as “specified net income”), regardless of whether such taxpayer materially participates in such trade or business, unless that income is already subject to FICA or self-employment taxes. This expansion also applies to trusts and estates at certain income levels. This change will impact taxpayers who own interests in pass-through entities, including S corporation shareholders materially participating in the business. This proposal applies to tax years beginning after Dec. 31, 2021.
Surcharge on High Income Individuals
Individual taxpayers would be subject to a 3% tax on modified adjusted gross income (“MAGI”) in excess of $5,000,000 for all individuals other than those filing married filing separately in which case the threshold is MAGI of $2,500,000. Trusts and estates would be subject to the 3% tax on MAGI in excess of $100,000. This proposal applies to tax years beginning after Dec. 31, 2021.
Section 199A Deduction
The maximum deduction allowed under Section 199A would be limited to $500,000 (married filing jointly or surviving spouse), $400,000 (single or head of household), $250,000 (married filing separately) or $10,000 (trust or estate). This change will impact taxpayers who own interests in pass-through entities. This proposal applies to tax years beginning after Dec. 31, 2021.
Roth IRA Conversions
Taxpayers (regardless of income level) would not be able to convert any after-tax contributions made to qualified plans or traditional IRAs to a Roth account or a Roth IRA. This change would eliminate the so-called “backdoor Roth IRA”. This change would apply to tax years beginning after Dec. 31, 2021.
Taxpayers with adjusted taxable income exceeding $450,000 (married filing jointly or surviving spouse), $425,000 (head of household), or $400,000 (single or married filing separately) will be prohibited from converting pre-tax employee contributions to a qualified retirement plan to a Roth account and pre-tax IRA balances into Roth IRAs. This change would apply to tax years beginning after Dec. 31, 2031.