Taxation - Income, Estate, and Gift
By James M. Duggan, MBA, JD - Special guest author
In late March, the "For the 99.5% Act" (the Act) was introduced to Congress. The Act contains several additions, removals, and amendments to the Internal Revenue Code that could significantly alter your estate tax obligation and planning structure.
In addition, the Biden Administration has proposed various income tax law changes that also will impact high income and high net worth clients — purportedly only the top 1%.
The questions below will help you consider what these proposals might mean to you and provide guidance on what to do if the Act becomes law.
IS YOUR ESTATE WORTH MORE THAN $3.5 MILLION?
If your estate is worth more than $3.5M, under the Act you would now be subject to estate tax at death on all assets in excess of this amount. This is a significant change as the current law only taxes assets in excess of $11.7M. These amounts are "per taxpayer," so if you are married and have proper planning, you can double the amount of assets subject to this estate exemption. By reducing the exemption to $3.5M per taxpayer, it greatly increases the amount of estates that will potentially be subject to paying tax. Based on historical numbers published by the IRS, the amount of estate tax returns subject to estate tax would likely triple if the proposed reduction is enacted.
HOW MUCH OF YOUR ESTATE COULD YOU STAND TO LOSE DUE TO THE PROPOSED TAX LAW CHANGE?
Under the current federal estate tax structure, a flat 40% tax is imposed on all assets in your estate above the exemption amount. The proposed change would eliminate the 40% rate and replace it with the following progressive tax system:
|Estate assets||Tax Rate|
|Up to $3.5M||0%|
|In excess of $3.5M up to $10M||45%|
|In excess of $10M up to $50M||50%|
|In excess of $50M up to $1B||55%|
|Greater than $1B||65%|
CAN YOU STILL MAKE TAX-FREE GIFTS?
Yes, you can still make tax-free gifts — on an annual basis, as well as during your lifetime (in excess of the annual exclusion) — but the amounts are greatly reduced. In addition, the amount you can give away during your lifetime in excess of the annual exclusion is capped at $1M, which is a significant departure from current law. Under current law, your lifetime gifting exemption is the same as the estate tax exemption at death ($11.7M in 2021). The proposed law would divorce the two numbers so that you are more limited in what you can give away during your lifetime versus at death. This could create a large disparity in many estates and will make wealth transfer planning much more difficult.
ARE YOU STILL ABLE TO PLAN WITH TRUSTS THAT PROVIDE FOR MULTIPLE GENERATIONS?
Legally, yes, you will still be entitled to benefit from statutes that provide long or perpetual trust terms, but the tax benefits will be greatly diminished. Whereas today you can create trusts that will avoid estate tax and generation skipping tax into perpetuity for your future generations, the Act would require the imposition of a generation skipping tax every 50 years, and would impose the highest applicable tax rate at such time (65% under the current proposal). So, while the trust terms may go on into perpetuity, the tax benefits may not.
WHAT ABOUT THESE THINGS CALLED GRATS – ARE THEY FINALLY BEING ABOLISHED?
Under the current federal tax code, grantor retained annuity trusts (GRATs) can be utilized by individuals by transferring appreciating assets to their beneficiaries via a GRAT without the appreciation being subject to taxation. The typical GRAT is structured as a "zeroed out, two-year GRAT" to minimize possibility of taxation. The Act, however, includes a required minimum 10-year term for GRATs, and includes a prohibition of the "zeroing out" method, thereby ensuring some value is ascribed to the transfer.
If enacted, GRATs will become a far less desirable and utilized estate planning tool. GRATs have been attacked repeatedly in prior administrations' tax law proposals, but in the end, have somehow managed to prevail.
CAN YOU STILL USE VALUATION DISCOUNTS WHEN VALUING CERTAIN ASSETS YOU GIFT?
Similar to the longstanding attack on GRATs, the use of valuation discounts in wealth transfer planning has been the subject of attack and proposed legislation for decades. Most private clients own either private investments or interests in family limited liability companies or partnerships, which in turn own their more liquid assets. Rather than giving actual cash or marketable securities to the next generation when gifting, it is most often desirable to gift interests in these various companies instead. Determining the value of these interests is a difficult task, and the taxpayer is generally allowed to reduce the stated value of the gift by taking valuation discounts for:
- Lack of marketability, and
- Lack of control.
As a result of these combined discounts, the typical value of a gift can generally be reduced by 25%-35%. For example, while a gift of $1M in cash is equal to exactly that — $1M — for gift tax return reporting purposes, a gift of $1M of an entity subject to a combined valuation discount of say 33%, would only be reported as a $670K gift for tax purposes. Another way to look at it for gift maximization purposes is to work in reverse and gross-up the amount that can be gifted. For example, a $1.5M gift of interests in a family entity subject to a 33% discount would be reported as an actual gift of $1M, effectively allowing the taxpayer to give away 50% more value without paying tax.
To avoid this mismatch between liquid and illiquid asset valuation for tax purposes, the Act proposes to do away with valuation discounts on non-operating family enterprises altogether.
WILL INTENTIONALLY DEFECTIVE GRANTOR TRUSTS STILL BE A USEFUL TOOL?
As an alternative to using a GRAT to "freeze" the value of an asset and transfer all of the appreciation to the next generation, many have recently turned to a vehicle known as an intentionally defective grantor trust (IDGT). The IDGT is purposefully structured so that the income on the assets transferred to the trust remains taxable to the grantor, but the value of the underlying assets is excluded from the grantor’s estate for tax purposes. The benefit to this structure for the high net worth client is that the grantor is "forced" to pay the taxes on assets transferred to the next generation, and since it is required under the grantor trust rules, the payment of the income taxes is not viewed as an additional gift to the next generation. The ability to pay the taxes for the next generation and not have it be a taxable gift can be very compelling in the amount that can be transferred as well as allowing the principal of the trust to grow without depletion since no trust assets have to be used to pay a tax burden. In addition, under the current law, all appreciation of the assets in the IDGT are outside of the grantor’s estate and not subject to estate tax.
The Act proposes to eliminate the benefits of IDGT planning by:
- Including the entire value of the grantor trust (less the value of gifts made to the trust) to the decedent’s estate,
- Treating distributions from the trust as taxable gifts, and
- Creating a taxable gift of the assets if the grantor changes the status of the trust from a grantor trust to a non-grantor trust.
Although the proposal is that these law changes will only apply to trusts or transfers to trusts established after enactment, it will greatly curtail the effectiveness of IDGTs for wealth transfer planning purposes.
WILL MY INCOME TAXES BE GOING UP?
With all of the proposals in the first few months of this year, the result is going to be some form of tax increase. Corporate tax rates are proposed to increase from 21% to 28%, and the top marginal rate for individuals would increase from 37% to 39.6%.
WILL MY CAPITAL GAINS RATE BE GOING UP, TOO?
If your income exceeds $1M, you will also experience an increase in your capital gains tax. Specifically, your tax will be the same as the highest ordinary rate, or 39.6%, plus the 3.8% net investment income tax under Obamacare (which gets triggered for income over $250,000 (assuming joint filing)). Therefore, the effective rate will be 43.4% in the highest bracket.
This increase is critical for those with large portfolios or those intending to sell a business. For the sale of a business in excess of $1M, this could mean that the tax differential between an asset sale (that is primarily ordinary income) and a stock sale (capital gain) would be negligible, as both would be taxed at the highest rate.
WILL THE STEP-UP IN BASIS AT DEATH BE ELIMINATED?
The increase in the capital gains rate could have significant impact on inheritances as well. Under current law, all of the assets in one's estate get a "step-up" in basis at death. By increasing the tax basis of inherited assets to the amount equal to the fair market value of the assets at death, it means a beneficiary receives the assets with no inherent gain. Therefore, if the asset was immediately sold, there would be no capital gains tax to pay. If the asset is sold down the road after some appreciation, the gain is now calculated from the higher basis amount, resulting in less tax. That is the benefit of the step-up in basis at death.
Under Biden's proposal, he would eliminate the step-up in basis altogether. Rather, the beneficiary would receive what is called "carry-over basis" — which is generally the original cost of the decedent's investment, with some adjustments along the way. If the decedent would have gains to pay upon sale of the asset, so too will the beneficiary since the basis would not change. As a result, beneficiaries receiving assets in an estate administration, beyond a $1M exemption per person and $500K per couple for real estate, could ultimately be subject to capital gains tax at the 43.4% rate mentioned above if all of Biden's proposals are enacted.
SO, WILL ALL OF THESE CHANGES HAPPEN, AND IF SO, WHEN?
At this point, the changes to the law outlined herein are proposals and are not yet final. There will no doubt be some changes in the law that will be consistent with the proposals and will be to the detriment of the high income, high net worth client. It is good to prepare yourself for this eventuality. However, it is not likely that all of the foregoing will be enacted, and if enacted, it is possible/likely that the ultimate rates and thresholds will be lower numbers. The legislative process will surely run its course for better and for worse.
The good news from the Act as proposed is that there was no intent to "clawback" the effective date to January 1, 2021. Instead, it appears that most proposals would be intended to take effect on either the date of enactment or on January 1, 2022. This should afford taxpayers the opportunity to plan during this year to get ahead of any potentially adverse changes.
IF THE PROPOSED LAWS DO GO THROUGH IN ONE FORM OR ANOTHER, WHAT PLANNING CAN BE DONE THIS YEAR TO TAKE ADVANTAGE OF EXISTING LAWS?
Given the current favorable estate tax laws in effect, many taxpayers will want to consider leveraging those rules to accomplish the following this year:
- Make annual exclusion gifts at the current $15,000 level;
- Utilize their lifetime exemption gifts by making large gifts up to the $11.7M exemption level before it goes away;
- Maximize gifting by utilizing available valuation discounts in conjunction with family limited liability companies or partnerships; and
- Combine the discounted gift of interests with freeze techniques such as GRATs and IDGTs to be grandfathered.
With respect to income tax planning, for those who are considering the sale of a business or other capital assets in the short term, it would obviously be advantageous to sell prior to any change in the law to lock in the lower rates.
On a go-forward basis after the proposed income tax changes, taxpayers may wish to structure their investments in a more tax favorable manner, such as investing more of their wealth in qualified plans, individual retirement plans, annuities, and insurance vehicles. The insertion of the tax-free vehicle avoids any tax drag when selling the capital assets.
Please consult with your financial and other advisors to determine which, if any, of the strategies discussed herein may be beneficial for your planning purposes.
James M. Dugganis a founding principal of DUGGAN BERTSCH, LLC, a Chicago-based business, tax, estate and wealth planning firm comprised of attorneys and accountants. Jim's practice has concentrated principally on business and corporate law, and estate and wealth planning, primarily as they relate to closely held business interests and high net worth families. Jim's experience in the structuring and implementation of Family Offices, sophisticated tax planning, and asset protection planning strategies is nationally recognized, as is his role in the firm's development of a leading multidisciplinary planning protocol.
Joel M. Field III founded Field Financial Strategies, LLC as a boutique financial practice out of an overarching desire to help empower friends and clients to live life to its fullest and confidently pursue their goals, without worry about finances.
As a CERTIFIED FINANCIAL PLANNER™, Joel works extensively with business owners, professionals, entrepreneurs, and executives around the country. Joel's trademarked Financial Empowerment Process℠ is a comprehensive approach to developing a financial strategy that enables clients to work towards their financial goals. Joel is highly qualified to address the needs of clients in the areas of comprehensive financial planning, investment management, retirement planning, estate planning, insurance planning, and business planning.
Joel M. Field III, CFP®, CLU®, LUTCF®
Founder and Financial Planner