Yet Another Tax Proposal
The Biden administration released its budget and tax proposals on March 28, 2022. This is called the “General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals,” or more affectionately the Greenbook. Should you care? Honestly, who knows. Speakers at a major estate planning conference speculated that it was unlikely for any of this to get enacted. So, if the gurus suggest this is unlikely to be enacted why should you give it any attention? Cuz no one can predict what might happen in Washington. With so many serious issues such as Ukraine, inflation, perhaps another Covid surge, etc. etc. will Congress be able to focus on tax legislation that is similar to what was rejected previously? While the gurus might be right that it’s unlikely to happen, what if they are wrong? Predicting tax law changes is a bit less precise then predicting the weather.
Strategic Changes to the Tax Proposals Might Enhance Potential for Enactment
There have been a number of strategic changes made to the tax proposals which may have been made to address objections, e.g. from the life insurance lobby, so that the new proposals have a better shot to get passed. Some of these will be explained below. Also, there has been some “repackaging” of the proposals to perhaps make the proposals play better on Main Street. A major piece of the repackaging is the so-called “billionaire tax.” The Administration may be calculating that the public will view taxation of the bad billionaires as a good thing to do. After all those really rich billionaires don’t pay their fair share of tax, live in houses that are too big, and spend money on extravagances like rocket ships. While none of that may be true or reasonable, and the so-called billionaires’ tax really applies to people with net worth of $200 million, not the advertised $1 billion, it might sound good to some of the populace. The point is that these strategic changes might result is some portions of these changes actually getting enacted.
What Should Chicken Little Do
So what do you do? No question that us tax geeks have sounded like Chicken Little squealing for years now that “The estate tax sky is falling!” “The estate tax sky is falling!” So, what is the practical approach to address they latest in a seemingly endless series of harsh estate tax proposals? Ignoring the changes may be at your peril (or at least to the detriment of your heirs). Getting exercised about them doesn’t make much sense ‘cause nothing may happen. But prudent planning, taking steps that will protect your estate if any of the changes are enacted, that are reasonable for you even if nothing happens, seems to be the appropriate middle ground. The following discussion of some of the many changes proposed will also highlight practical steps and parameters that might help taxpayers work with their advisers to identify reasonable planning steps.
Income Tax Increases
Hey this is supposed to be an estate tax planning article, why mention income taxation? The reality is that income taxes have a profound impact on the size of estate you will be able to accumulate, the administration of trusts and estates, and more. Income and estate tax planning have become more interrelated and important to address as part of a holistic plan in recent years. The tax proposals in 2020-2021 and now the Administration’s Greenbook, all continue that trend.
Increase the top rate to 39.6% beginning in 2023. The top rate would apply to taxable income over $400,000 (single) or $450,000 (joint) in 2023. Note that the higher rates will apply at dramatically lower levels to complex or non-grantor trusts. Dividends and long term capital gains are proposed to be taxed at the highest ordinary tax rate rather than the favorable 20% rate under current law.
So-called carried interests that investment pros may earn on certain investment partnerships will be taxed on both income and sales proceeds as ordinary income. Under current law these often are taxed at more favorable capital gains rates. If the income tax are increased to 39.6% that could represent an almost doubling of tax costs. This will be further compounded by state income taxes as states generally pattern their tax systems after the federal rules. So in some instances the marginal tax rates on this income could more than double.
Real estate owners have benefited from the ability to exchange one real estate property for another and to defer any income tax. This rule has been under attack for years and the Greenbook proposes to cap this benefit at $500,000 per taxpayer. That would quash what has been a popular planning technique. While this change would not directly affect estate planning it could have a significant impact on overall planning for real estate developers. For example, a common planning technique for real estate developers has been to sell real estate entities to a grantor trust to lock in discounted values and shift substantial appreciation outside their estates. These interests generally cannot qualify for a step-up in income tax basis (the amount on which gain on sale is computed) unless the property interests are swapped back into the estate. After the developer dies these low basis real estate assets would be costly to sell. However, these real estate interests may then be exchanged in the future to retain tax deferred growth in these trusts. That exit strategy will essentially be eliminated for large property owners. This change may be exacerbated by proposed changes to depreciation recapture rules for real estate developers. This all may change the dynamic in planning approaches to be used.
The Supposed “Billionaires’” Tax
First, what was proposed is not a tax on Billionaires and is an unusual newfangled type of tax. The title of the tax certainly seems to be intended to play well with voters. The tax is also different than a wealth tax, like those proposed previously, perhaps because the Administration was concerned that a pure wealth tax might not pass a Constitutional challenge. Both aspects are part of what was referred to above as some of the strategic repackaging of the prior tax proposals (and perhaps a reason not to ignore them). This does not mean that there might not be a Constitutional challenge, but perhaps the Administration views that risk as reduced by the modifications as the tax is really an income tax on unrealized gain, not a tax on wealth.
Certainly, the headliner of the 2023 Green Book is the billionaire tax. This is a tax based on wealth, but isn’t a wealth tax as traditionally understood (that is, a tax computed as a percentage of a taxpayer’s total wealth). In contrast, the Biden proposal, while only applying to individuals meeting a threshold wealth, would impose a minimum tax rate on income, gains and unrealized gain rather than total wealth. That might make it more likely to withstand a Constitutional challenge then the wealth tax Senator Elizabeth Warren had proposed previously.
Rich folk, defined as those with more than $100 million in net worth could face a new type of income tax. Hey how did $1 billion become $100 million? Dunnoh! This proposed new tax would be at the rate of 20% of an expanded version of taxable income that includes unrealized appreciation. Unrealized appreciation is capital gain you have not triggered. For example, you hold $25 million of Apple stock that you purchased for $2 million, it would seem that you would have to pay a tax of 20% on the $23 million of appreciation. There would be an adjustment for the tax paid when you sell the stock to avoid taxing you on tax you paid. The tax would be phased in from $100 to $200 million of wealth. To administer this tax presumably anyone worth $100 million or more will have to file a new type of tax return reporting all of this. The compliance, calculating appreciation, valuing non-marketable assets like rental real estate, family business, collectibles, etc. will be costly and complicated. The proposals include mechanisms to estimate these values, subject to possible challenge or adjustment. None of this seems simple and implantation and enforcement will be costly for the IRS and taxpayers alike. This is especially likely given that this is a new type of tax that differs from the types of taxation that have previously existed. There is also concern that some rich folks may have liquidity issues in paying the tax.
While it is impossible to plan for a tax proposal that may never be enacted, or may morph in many ways before it may be enacted (and these caveats apply to any planning suggestions in this article), it might possibly prove advantageous to shift assets into irrevocable trusts now. Perhaps assets transferred into a trust might avoid being included in the calculation of net worth for the Billionaires’ tax.
Grantor Trusts Tax Payments
So harsh tax proposals that attacked grantor trusts were proposed by Senator Saunders and others. None passed. Word is that the powerful insurance lobby did all it could to impress on Congresspersons that the prior proposed changes would have undermined the common life insurance trust and that would have caused substantial harm to the life insurance industry. Life insurance is big business. There is about $100 billion of life insurance in force in the US. But since grantor trusts are a keystone of much of modern estate planning, the Administration strategically rethought changes to grantor trusts with the goal of hindering their use so rich folk could not as effectively transfer wealth, but to do so in a different way that didn’t upset the large insurance industry lobby. We don’t really know why the new proposal for grantor trusts, but like so many of the changes discussed in this article, the Administration seems like it was strategic in tweaking prior proposals to make them more palatable to Congress. That is why despite the tax gurus skepticism about the likelihood of enactment, caution is the wiser approach. The new attack on grantor trusts will treat the settlor (grantor or person setting up the trust) as having made a taxable gift to the trust every time the grantor pays the income tax on trust income. That mechanism, referred to as “tax burn” by tax folks, is one of the most powerful leveraging device in the estate planning arsenal. The “beauty” of this proposal is it has almost no impact on insurance trusts, hence defanging the insurance lobby, but will put significant pressure on the use and benefits of grantor trusts.
What might you do in light of this proposed change? If it happens you will have to reassess with your tax advisers whether your or your trust pays the income tax on trust income. That might require evaluating whether a grantor trust can be converted to a non-grantor trust. In some instances that might trigger an unacceptable tax cost. But paying income tax if you have no exemption left could prove costly as well. Certainly if you are creating new trusts include a tax reimbursement clause in the trust document, mechanisms to turn off grantor trust status, decanting provisions to facilitate modifying the trust for potential future tax law changes (that is actually a good idea for any trust just because of the ongoing tax uncertainty), etc.
Grantor Trusts and Sales/Repurchases
Under current law one of the more popular planning techniques (see the discussion about note valuations). You can sell an asset to a grantor trust and not trigger any gain. The trust can provide you a note for the purchase price so the value of the appreciating asset is frozen in your estate. The Greenbook proposes to eliminate the ability to sell assets to a grantor trust, unless it is revocable (meaning included in your estate), without gain. That would close down a major planning tool.
If your estate might benefit from a note sale transaction perhaps it is best to complete the transaction sooner than later in case this component of the proposal is enacted.
If assets are in a grantor trust, under current law, you can repurchase them without any income tax consequence. That can be used to bring assets that appreciated inside a trust back into your estate to obtain an income tax basis step up on death. Although, if death is a triggering event that will come at a substantial cost. The ability to repurchase assets at no tax cost has also provided flexibility to revise an estate plan. Suppose you sold interests in the family business to a trust for your son who was running the business. But since that time your son has become a full time surfer and your daughter has taken over the business. You can repurchase the business from the trust and bequeath it to your daughter. That flexibility could be eliminated with the proposed change. So while it is uncertain, and perhaps unlikely, that these changes may be enacted. Why take the risk? Evaluate all trust plans now and determine if shuffling of any assets may be advantageous. Better to complete these transactions while you know the law permits it.
Grantor Retained Annuity Trusts (GRATs)
GRATs are a technique wherein you gift assets, even appreciated assets, to a special trust. The Trust will pay you a calculated annuity amount for a specified number of years that approximately equals the value of the property and a mandated interest rate. If the property appreciates above that benchmark, the excess is removed from your estate without any gift tax consequences.
The attack on GRATs includes changes that have appeared in many prior proposals: Short term GRATs will be eliminated by a minimum term of 10-years for which a GRAT must last. GRATs won’t be able to continue for more than your life expectancy plus 10 years. Finally, GRATs that use little or no gift tax exemption will be proscribed by rules requiring a minimum gift be recognized on transfers to GRATs of 25% of the value of the gift or $500,000. These changes, and other proposals, would effectively zap the planning benefits of most GRATs.
What might this proposal mean? If GRATs make sense for you (that might be if you have a large estate and have used up all of your gift exemption) do them now if there is no downside (e.g., you’ll have enough assets to cover your lifestyle expenses for the rest of your life even if the GRATs succeed handsomely. If you have a family business you wat to shift out of your estate, if the proposed deemed realization taxation in the following paragraph is worrisome, GRATs might make sense. Since the proposals might eliminate exceptionally long term GRATs (e.g. 99-year GRATs have been used as an interest rate play. You won’t outlive the term of the GRAT but interest rates increase substantially from when you set up and funded the GRAT (e.g. in the current low interest rate environment) to the interest rates on your death, the GRAT formula for what portion is included in your estate may shift a substantial portion of that value out of your estate. If transfers of appreciated property from a GRAT back to you will trigger gain as proposed, then a very long term GRAT which will have a low annuity payment may result in an annual payment that might be small enough to pay from GRAT income and avoid the use of appreciated GRAT property that might trigger gain.
Trust Reporting
New reporting requirements will be imposed on trusts to provide information on the value of trust assets. This will affect trusts assets valued over $300,000 or income over $10,000. This will create additional administrative burdens and headaches for trusts and will also provide the IRS valuable information to identify trusts to audit. The income tax audit rate on trusts has been incredibly low. Perhaps this will signal an uptick on such audits. That will add further to the costs and administrative burdens on trustees. It may also change the calculus some taxpayers go through about taking aggressive or inappropriate positions on returns to play the audit lotter. That may change. Likely the data on these reports will provide the government generally with more information on the planning wealthy taxpayers pursue. That may lead to further law changes or enforcement policies in the future.
Note Valuation Consistency
The Greenbook will require that taxpayers be consistent when valuing promissory notes. A bit of a background will help understand what this change might mean. A common estate planning transaction is to sell appreciated assets (that it is anticipated will continue to appreciate) to a grantor trust for a note. Because the sale is to a grantor trust no income tax will generally be triggered on the sale. By the trust paying the seller/taxpayer with a note, the value of the appreciating assets is effectively frozen in the estate by the note and the interest on the note. If the appreciation of the asset, e.g. a family business, is substantially greater than the interest on the note, a significant wealth transfer might occur. Another common estate planning note transaction is for a senior generation, e.g. a parent, to loan money to a lower generation, e.g. a grandchild. The grandchild invests the money and if the earnings on those investments exceed the interest on the note, a wealth transfer occurs. In both transactions the interest rate on the note is set based on mandated federal interest rates. But here’s the deal, the interest rates mandated suffice to avoid the imputation of a gift on the above transaction (let’s call that the initial transaction). But those rates are almost assuredly less than what a third party would insist on for a similar loan. So, in a later situation (e.g. the death of the lender or a sale of the notes) the notes may be valued under the general gift and estate tax paradigm of “willing buyer and willing seller.” That independent standard of valuation might well discount the value of the note to much less than its face value. Effectively these two different valuations (the initial transaction valuing the note at face and the later transaction valuing the note as a third party would) whipsaw the government. You may remove assets from the estate for a note of $X but then when you die or sell the note it might be valued at .75 x $X. Although other changes in the Greenbook may change note sales this is a further effort to clampdown on common estate planning transactions.
What might this mean? Let’s say you’ve done several note sale transactions over the years. Perhaps you should evaluate with your advisers contributing those notes and other assets to an LLC and then valuing and either giving and/or selling that entity to different trusts than were involved in the transactions creating the notes. In other words, lock in the valuation position now before the law changes. While this might provide a means of locking in the valuation approaches before the law prohibits it, just keep in mind that there is no guarantee that it will fly. The IRS might still challenge the transaction even without a statutory change by Congress. If the note was created too close in time (and there is no way to measure how much time should pass) the IRS might argue that your positions are inconsistent, or that the various steps in your various plans (the initial transaction and the later transfer of the note) were really one integrated transaction.
Deemed Realization Events
Tax proposals in prior years introduced the concept of deemed realization events. These are circumstances that could trigger a tax on unrealized appreciation of assets. The Greenbook reintroduces a similar scheme of taxation. This change if enacted would have a profound, costly and new impact on wealth transfer and income tax planning for high net worth taxpayers. A key change, perhaps another one of the Administration’s strategic moves to enhance the potential for enactment, is that there a $5 million exemption up from the $1 million under some of the prior proposals. Spouses will be able to transfer (port) this $5 million figure to the survivor of them. Perhaps this was intended to limit the tax to higher wealth taxpayers and thereby lessen the objections by key Congresspersons required to approve a vote. A special rule is proposed for family business interests permitting deferral of the tax until the business is sold, tangible property and principal residences.
This change appears to affect three primary types of situations: (1) If you make a gift. This is a gratuitous transfer, e.g. to a trust. If that triggers gain then it will inhibit gifting to shift value, and especially appreciation, outside your estate; (2) when you die. If there is effectively a capital gains on death it will cause a reassessment of buy and hold investment philosophies, increase the need for life insurance, and other planning techniques; or (3) holding assets in trust past a specified time period of 90-years. If a tax will be assessed on any unrealized appreciation in these circumstances it will have a profound negative impact on planning.
With these changes possible (even if not likely) perhaps it might prove advantageous to shift assets into trust structures before the law changes. That might not avoid the 90-year trust tax realization rule if enacted but it may avoid the taxation on a post enactment gift transfer.
Dynastic Trusts Limited
So under current law the Trifecta of estate planning might be to get highly appreciating assets into a trust that lasts forever. That may enable the assets in the trust (i.e. those not distributed out to beneficiaries) to remain protected from creditors forever, and to remain outside the transfer tax system. That may mean no gift, estate or generation skipping transfer (GST) taxes, forever. That’s the gold to go for. Congress is well aware of this and there have been many past proposals to limit how long these trusts might last, or what happens after some specified number of years to the GST exemption status of the trust. So far, none of those proposals have been enacted. The Administration has made a new and different proposal to restrict these dynastic trusts. Perhaps the Administration proffered a new approach to win over Congresspersons who were reluctant to vote for prior variations of this type of change.
The Greenbook proposes limiting the duration of a trust’s GST exempt status no further than great-grandchildren alive when the trust is created, or for existing trusts, alive at the date of enactment.
What do you do now? Perhaps nothing solely because of this proposal because it will ensnare existing trusts as well. However, maybe the wiser course of action is shift as much wealth as appropriate and feasible into dynastic GST exempt trusts now. Perhaps the law will be modified in the sausage making legislative process so that pre-enactment trusts might be exempt or get more favorable treatment. If it makes sense to shift wealth to trusts, hey, why not just do it now.