The media has reported widely upon the need to provide funding for governmental programs, whether those stemming from the COVID pandemic, those needed to address climate change, or those focused on improving our nation’s aging infrastructure. Washington is actively seeking ways to pay for such programs, and to reduce (or at least not increase) the size of the alarming federal deficit. President Biden, Senator Sanders, and Senator Van Hollen have all introduced legislative proposals that include dramatic tax changes. Any of these proposals, if passed into law, could be imposed retroactively, with capital gains tax increases effective as of dates as early as April 2021. Even if you do not consider yourself wealthy, these proposals, if they become law, could affect both your income taxes and your existing estate plan (or your future estate plan if you do not have one in place). If you are in fact wealthy, these proposals pose significant challenges.
This letter is intended as a courtesy to keep you abreast of current and potential changes, and is not intended to establish or re-establish an attorney-client relationship.
In the discussion below, we will provide:
- Summaries of the Proposals and Their Consequences
- Steps to Consider Taking Now
- The Uncertainty We Face
 Treasury Secretary Janet Yellen suggested this recently in remarks before a Senate panel.
- President Biden’s Proposal- The American Families Plan
Ordinary income tax rates apply to IRA distributions, wages, and interest income. Capital gains rates apply to gain from transfers of capital assets held for longer than one year. Typically, capital assets are investment assets. Ordinary income has traditionally been taxed at higher rates than capital gains, a policy designed to stimulate taxpayers’ investment in long term capital assets. President Biden’s proposals include taxing capital gains (now taxed at 15-20%) at higher, ordinary income tax rates (as high as 40%), once adjusted gross income exceeds $1 million. That means that when real estate, investments, business interests, or other valuable assets are sold, 40% of gain on the sale could be taxed. In addition, the 3.8 % net investment tax (NIIT) would still be imposed. The income tax rate increase would be effective as of a date as early as April 2021, so it would be retroactive.
President Biden’s proposal also includes imposing capital gains tax on assets held in a trust, partnership, or other non-corporate business entity if the assets have been held in the entity for ninety years, even if those assets are not transferred by gift, sale or otherwise. The asset is “deemed” to have been transferred, for income tax purposes. That means all of the appreciation that has built up inside that asset for the preceding ninety years without being taxed, would have to be recognized on a tax return by the trust, partnership, or other non-corporate entity, and capital gains tax would be imposed (unless tax has already been imposed on a prior recognition event).
The “deemed” recognition event described here would be based on a ninety-year period beginning on January 1, 1940, meaning the first recognition period could be deemed to occur in 2030. Therefore, if an estate plan includes an irrevocable trust created on or before January 1, 1940, the appreciation on trust assets left in the trust could be subjected to capital gains tax in the near future.
Note that the first $100,000 of gains resulting from transfer of gifted property would be exempt from capital gains tax.
The President’s proposal also separates the unified system of estate and gift tax, limiting the amount that can be transferred by gift during an individual’s lifetime to $1 million. Notably, the proposal does not include any retroactive “recapture” or “claw back” of previously used gift tax exemption.
- Senator Sanders’s Proposal- The 99.5% Act
Senator Sanders’s proposal has a different focus. He would change the rules applicable to gift, estate and generation skipping transfer (“GST”) tax. The estate tax exemption amount would be reduced from the current $11.7 million per individual to $3.5 million. As a result, many of you who have estate plans designed for a non-taxable estate would suddenly be catapulted into the realm of potentially taxable estates. Existing plans would have to be reviewed and likely revised. The gift tax exemption would be reduced to $1 million. This change is designed to tax the transfer of wealth to succeeding generations. Note that gifts transferred outright would not be subject to gift tax, only gifts to entities and trusts.
The Sanders plan would limit annual exclusion gifts (currently $15,000 per individual to an unlimited number of donees) to $30,000 per year. Many plans include Irrevocable life insurance trusts (ILITs) that receive annual gifts to pay for premiums on the policy assets; these plans would no longer work.
Dynasty trusts would no longer be allowed to escape GST tax and/or estate tax for longer than fifty years.
Sanders’s proposal also calls for an increase in estate, gift, and GST tax rates from 40% to as much as 65%.
High net worth individuals and business owners often benefit from “valuation discounts” when their closely-held business interests are transferred into trusts or business entities as part of their estate planning. These discounts on the value of the transferred assets can range from 20% to 40% based on lack of marketability, minority voting power, or liquidation restrictions. Sanders’s proposal would reduce the availability of these discounts on intra-family gifts. Many business succession plans are designed around intra-family gifts, meaning all of these plans would be adversely affected.
The benefits of Grantor Retained Annuity Trusts (GRATs) and Irrevocable Grantors’ Trusts would also be negatively affected by Sanders’s proposed legislation.
- Senator Van Hollen’s Proposal- The STEP Act
Senator Van Hollen’s proposal would affect certain transactions which were not previously subject to any income tax, making those transactions gain-recognition events. His proposal would be retroactive to January 1, 2021.
Steps taken in 2021 to minimize estate tax would no longer work as they were designed to. Most gifts during lifetime and at death would be treated as a sale of property, subject to capital gains tax (subject to an exemption amount).
Many estate plans involve transfers into grantor trusts, which are trusts that are treated as owned by the grantor for income tax purposes, but not for estate and gift tax purposes; the grantor remains responsible for paying tax on trust income during his or her lifetime, but the property is removed from his or her estate for estate tax purposes. Under Senator Van Hollen’s proposal, these transfers to grantor trusts would be subject to capital gains tax at death if the assets in the trust are not included in the grantor-decedent’s estate for estate tax purposes. Moreover, every twenty-one years, the trust would have a deemed recognition event and have to pay capital gains on built-in appreciation. Because the property in the trust is not actually sold, the trust may not have sufficient cash to pay such a tax.
Senator Hollen’s proposal also would eliminate a step-up in basis on assets transferred at death, excluding the first $100,000 in gain for assets transferred during life, and $1 million for assets transferred at death. The person who receives the inherited property would inherit the decedent’s basis in the property. A practical problem with this idea is that many people do not have records or knowledge of the basis of an asset they, themselves, inherited. Exceptions would be made for family-owned businesses and farms when the assets are given to persons who continue to run the business. Property donated to charity would also be excluded.
Steps to Consider Taking Now
Many advisors anticipate significant tax changes will be enacted. However, the nature, extent, and impact of those changes cannot be ascertained at present and the effective dates are unknown. Among advisors who are recommending taking proactive tax planning steps now, a wide and disparate spectrum of measures are being suggested. Although attendant risks cannot be fully ascertained at this time, a basic understanding of these risks, the issues, and the options, are important to understand.
Many of the recommended actions that could prove to be beneficial under one legislative proposal could actually prove to be harmful under a different legislative scheme. That said, ignoring the situation could result in worse consequences. Even in the face of so much uncertainty, an understanding of the options available and the accompanying pros and cons, is essential to making informed decisions about whether, and how, to take action.
Here are some of the planning steps you should consider:
- Steps to take RIGHT NOW:
- Review your existing estate plan with your attorney. Do you need to add formula clauses to your trust documents? Do you need to add decanting provisions? Some recommend adding disclaimer provisions to a trust agreement. Creating an irrevocable trust now, in 2021, may be advisable because the exemption amounts could be lowered soon.
- If you are discussing creation of an irrevocable trust, consider acting quickly. Discuss with your attorney what options are available now that could disappear in the future. For example, a grantor trust has been one of the most popular devices used in estate planning to avoid estate tax inclusion. This strategy may no longer be available if grantor trusts will be included in the decedent’s estate once legislation is enacted. Similarly, President Biden’s proposal imposes a maximum ten-year term for grantor retained annuity trusts (GRATs), and a minimum gift of twenty-five percent of the value or $500,000. Creating a GRAT now, before any proposals are enacted, could be advantageous, especially if the legislation is not retroactive. Some clients are creating SLATs and ILITs now.
- Review the option to transfer assets to a trust or a business entity right away, in order to avoid triggering capital gains tax if the transfer is made after the effective date of President Biden’s plan, should it be adopted. In addition, transferring assets now could take advantage of the existing valuation discounts for intra-family gifts. However, remember that if Van Hollen’s proposal becomes law, it will be retroactively effective to January 1, 2021, meaning those transfers will be retroactively subject to capital gains tax. Likewise, if deemed realization events become part of the law, those transfers will be taxed whenever the holding period expires (twenty-one years or ninety years).
- Review and update your beneficiary designation forms.
- Make sure you and your advisors all have copies of fully executed instruments.
- If your estate plan involves the transfer of notes or business interests, review record-keeping. You may have to prove that payments were timely made and properly accounted for. You may have to prove a legitimate business purpose for the arrangement.
- If your estate plan involves the transfer of business interests to a trust, you may have to establish an actual, legitimate business purpose for all transactions should the IRS challenge your arrangement. Again, recordkeeping is key.
- With regard to entities, be sure all business formalities have been observed, including the holding of annual meetings, and keeping records to document them.
- If your estate plan includes Crummey notices, be sure all records are in order.
- Review the type and basis of assets held in trust. Do any assets have significant built-in appreciation? Should you, and can you, exchange these for high-basis assets?
- Consider whether assets should be moved from a trust to a business entity.
- With any option, consider whether the tax benefits are outweighed by other priorities, including asset protection.
- Review your plans for your retirement assets in light of the new SECURE Act income tax rules.
- Steps to take in light of a possible reduction of the exemption amounts for estate, gift, and GST tax:
- If your existing plan was based upon your having a non-taxable estate, but now, with a lower exemption amount, your estate could become taxable (due to its value above the exemption amount), discuss options with your attorney. You will likely have to revise your plan.
- If President Biden’s proposal becomes law, any unused gift tax exemption over $1 million will be lost following the effective date. It may be wise to make lifetime gifts now, and use (or lose) your existing exemption. For example, consider bunching together planned annual exclusion gifts and making them now, as a single, reportable gift.
- Make annual exclusion gifts to as many donees as possible now, before the exclusion amount is capped at $30,000 per donor. Also, plan to make payments directly to medical or educational institutions to move assets out of your estate, because these types of gifts do not count against the gift tax lifetime exemption or the exclusion amounts.
- On your beneficiary designation forms, you could name a charity as a contingent beneficiary, so the primary beneficiary has the flexibility to decide whether to disclaim the gift and reduce the size of your estate by the value of the charitable gift.
- Steps to take in the face of deemed capital gains recognition events: If the capital gains rate is increased to the level of the tax rate applied to ordinary income, the income from all of your investments, and the proceeds of a sale of capital assets, will be taxed more highly. If “deemed” sales are going to force gain recognition, what can you do now to minimize tax?
- Consider whether to own assets outright, in order to avoid “deemed” transfers. However, keeping assets in trust may be required for asset protection or other purposes.
- Re-examine existing trust documents with your attorney. Consider whether the trust’s assets should be decanted into a new trust designed to avoid adverse effects of some of these proposals.
- Many financial advisors are recommending creation and funding of spousal lifetime asset trusts (SLATs) in 2021, because the estate and gift tax exemption amount could drop from $11.7 million per individual to an amount as low as (or possibly even lower than) $3.5 million per individual. A SLAT is an irrevocable trust strategy designed to reduce the size of an estate subject to estate taxes, by removing post-gift appreciation and dividing it amongst the children and/or grandchildren. One spouse makes a gift of assets to a trust for the benefit of the other spouse and gives up access and control of the trust’s assets, thereby removing assets from their combined taxable estates. If an estate plan strategy includes a SLAT, it is essential to ensure that the transferor cannot reach or control the trust assets. With this in mind, review your business operating agreements and trust provisions respecting distribution and liquidation powers.
- Any transfers should be considered from the standpoint of whether the IRS could collapse a series of transfers into one taxable event or unravel a series of transactions on the theory that the transfers lack any legitimate business purpose. Transferors must be able to demonstrate a legitimate business purpose; otherwise, the risks may prove too high.
- Some commentators have expressed concern that if an irrevocable trust, such as a SLAT, is designed to divide into separate sub-trusts for children upon the death of the Grantor, the division could be a taxable event under Biden’s proposal. It might be worth considering decanting into a new trust that does not provide for such sub-trusts. You should discuss with your tax attorney whether decanting the trust to avoid this triggering event is worth the effort and expense.
- Instead of transferring appreciated assets into a trust, consider borrowing money and transferring the borrowed funds to a trust, so as to avoid future capital gains.
- Some are recommending a disclaimer provision be included in new trusts, to provide a possible mechanism for unwinding transfers if new tax legislation is retroactive.
- Consider using life insurance products as wealth replacement if you transfer low basis assets now.
- If the estate tax exemption amount is lowered, in future years you can minimize your taxable estate by making gifts to charities, and simultaneously receive an income tax deduction at the new, higher rates.
- Steps to Take in the Face of Elimination of GST exempt status after a period of years:
- If your plan includes a dynasty trust, or depends on the current GST exemption amount, revisit the plan with your attorney in light of the proposed changes to the GST tax.
- Steps to Take Considering Elimination of the Step Up in Basis:
- Assets held in an irrevocable trust do not qualify for basis step-up on death, because they do not pass through the transferor’s estate, so assets held in those trusts would not be affected by this change.
- Talk to your attorney about whether it is possible to swap out low basis assets or discuss what provisions in your revocable trust or business succession plan may need to be revised in order to allow substitution of assets. Swapping out assets in 2021 may avoid a non-retroactive taxable event. Keep in mind that hard-to-value-assets may complicate and delay the exercise of a timely swap. On the other hand, if the transfer is later taxed retroactively, the transfer may prove to have been a poor decision.
- Your existing plan may include the option to have an independent trustee or trust protector choose to place certain assets in a marital trust or put them into to a family trust. This flexibility is key when trying to minimize income taxes. Assets in the marital trust currently receive a second step up in basis upon the death of the second spouse to die. However, the assets in the family trust do not receive a second basis step up upon the death of the second spouse. Your plan may have been created partly to obtain this second basis step up. Those decisions could now become irrelevant if the step up in basis upon death is eliminated; providing for separate marital and family trusts may no longer be necessary.
- Steps to Take in Case of Reduction of the Annual Gift Tax Exclusion Amount:
- Make gifts now.
- If your plan includes an ILIT or any type of trust where an insurance policy premium or other costs are paid for by annual gifting, discuss your options with your attorney.
- Effective dates of new laws and possible retroactive effects on plans:
- Unfortunately, some of the actions taken in 2021 may be affected by new tax laws, if they are enforced retroactively. All you can do is make the most informed decisions possible based on what you know now.
The Uncertainty Advisors Face
Tax lawyers are developing strategies to provide some buffer to potential changes and to build flexibility into every estate plan. If you have an existing estate plan, review it with your attorney as soon as possible; once any laws are passed, there could be a crush of clients trying to make appointments before year-end. You may need to act especially quickly if you have an irrevocable trust. Every taxpayer will have to assess the alternatives and make his or her own decisions regarding how much risk is acceptable, considering the cost and complexity of actions to be taken. Doing nothing might pose the greatest risk!
As is made clear in the discussion above, advisors are faced with a conundrum. Suggestions that could turn out to be advantageous could also prove to be irrelevant, or even harmful, to clients. Without the benefit of a crystal ball, no one knows which proposals, if any, will be enacted. Congress has surprised the public and the experts before, as it did with the Tax Cuts and Jobs Act (TCJA) in 2017. Of course, with the mood in Washington being highly adversarial, it is possible that no legislation will pass. Moreover, even if the Internal Revenue Code is amended, those same amendments could be reversed in one of the next administrations.
The suspense of not knowing what the future holds has been agonizing enough throughout the pandemic. Americans want certainty and predictability, so their financial and estate plans can be created and relied upon. Even when there are no guarantees of outcome, however, we, your tax attorneys, are here to help you identify your options, appreciate the possibilities, and make informed decisions. We recognize that your legacy and your present financial circumstances are of the utmost concern. We are here to assist you.