President Biden issued his budget proposal on March 11, 2024. The document’s full title is “General Explanations of the Administration’s Fiscal Year 2025 Revenue Proposals.”
Transformative Tax Changes Will Redistribute Wealth
If even some of these proposals are enacted into law it could dramatically change taxation of the wealthiest Americans and substantially reduce the wealth that will be able to be passed to their future generations. Never say never. No one can predict what negotiations in Congress might result in. No one can predict the upcoming election. Many similar proposals have been floated by Democrats many times over many years. Some or all of these may, in fact, be enacted. Given how costly and impactful these provisions could be, the safer and wiser course of action for those who seek to preserve wealth and pass it on is to plan now. But the changes proposed so accurately zero in on many of the most common wealth transfer strategies that whether you planned years ago, plan now, or just wait, your options to shift wealth will be dramatically limited. Further, the proposals to increase income taxes on the wealthy will exacerbate the estate tax changes.
Ouija Board
Does your Ouija Board work? If not, perhaps you should immediately begin planning. If President Donald Trump wins a second term and controls the House and Senate, he may seek to extend the 2017 Tax Act breaks for the wealthy. He may seek to go further and perhaps (maybe likely) will seek to repeal the estate tax. If, but he wants to do more. If President Joe Biden wins a second term and control over both the House and Senate, he will likely seek to enact all of these proposed changes to force the wealthy to contribute more, tamp down on wealth inequality, and raise revenues to fund social programs. The election results could have one party controlling the House and the other the Senate with majorities that are so slim that perhaps little tax change might be enacted. Can you possibly plan with this dramatic uncertainty? You can, but carefully.
But isn’t the “wait and see” approach wiser? See what the election brings then try to predict? Unfortunately, as will become clear as you read on, waiting is not likely to be the prudent approach because many of the provisions are listed as becoming effective after December 31, 2024. Yes, this year! Sure that may never happen, but is that a gamble you want to take?
How to Plan NOW!
You should consider planning for all of the harsh Biden budget proposals being enacted. Perhaps, some or all might be. So, creating grantor, irrevocable, trusts, and making gifts to them before year end might be prudent. If you’re still a fence sitter set up the trust and put $1,000 in it. That way, if you get closer to any potential deadline (year-end 2024, the date of enactment of a new law, etc.), you will be in the batter’s box, ready to swing at your planning goals. If you do nothing but wait, you may not have time to contemplate or implement a trust plan properly. So, tee up your plan now.
If you pursue the above course of action, consider a couple of concepts that may serve as guiding principles. Given the incredible uncertainty, plan with flexibility. Incorporate into any planning documents mechanisms that give you flexibility to adjust to possible future developments. Also, in case you do transfer substantial wealth to one or more trusts, preserve reasonable access to trust assets. For example, instead of just setting up a trust for your descendants, perhaps your spouse can be named a beneficiary as well. That may still facilitate your achieving estate tax planning and asset protection (lawsuit protection) goals, but retaining more access.
You should not take any planning steps that you might regret if the estate tax is repealed. If you are really uncomfortable transferring significant wealth to irrevocable trusts and only would consider doing it in case the Biden tax proposals are actually enacted, they carefully weigh whether you should do anything. But, as explained above, if you can plan flexibly and with access, you may protect your assets from claimants which alone may be a sufficient planning benefit from planning even if the estate tax is repealed.
2026 Is Coming
When evaluating what planning steps to take in light of the Biden Budget proposal, consider that in 2026, many of the favorable tax changes enacted as part of the 2017 Tax Act will likely sunset. The gift, estate, and generation-skipping transfer (GST) tax exemption will come down by half. Some taxpayers should evaluate making gifts before the end of 2025 to secure the bonus exemption before it is lost on January 1, 2026. If a taxpayer is considering planning for the reduction in the exemption, why not try to complete that same planning before the end of 2024 just in case the Biden Budget gets enacted in 2025 and provisions in the proposal with a December 31, 2024, effective date actually become effective then?
Consider that we live in the most litigious society in history. That’s not going to change, regardless of what happens in Washington. So, planning to protect wealth from claimants remains a justification for planning. Right now, there are many planning techniques that advisers can use to help taxpayers accomplish their goals. So right now is a great time to pursue planning opportunities. Those tools can enhance flexibility. So why wait? Plan now, but plan prudently.
Consider the possible benefits of having as much of your wealth as reasonable held in flexible, long-term irrevocable trusts, with all the appropriate planning bells and whistles. With that approach, you may be better able to deal with any changes that occur. Also, so long as you preserve access to assets in the trust you create, perhaps you cannot hurt yourself too badly.
Capital Gains Tax Changes
Biden’s proposal would eliminate the preferential long-term capital gains rate when income exceeds $1 million. That would mean capital gains would be taxed at ordinary income tax rates instead of at more favorable lower capital gains tax rates. President Biden wants the tax rate to increase on top earners from 37% to 39.6%. That is almost double the 20% capital gains rate. Therefore, this change would have harsh tax consequences on some taxpayers. For example, if you sell a closely held family business the income from that once-in-a-lifetime sale could push you past the $1 million level and you would lose capital gains tax rates for that year. If this is enacted, it might be possible to complete transactions over time (e.g., sell 10% of the stock each year) to realize gains in lower income tax brackets over many years, or use the installment method of reporting to spread the gain out over many years and perhaps at lower rates.
What might this change trigger? You might hold investment assets for longer since the cost to sell will increase substantially. If you are anywhere near that $1 million threshold you’ll want to plan years in advance of a controllable sale to try to avoid hitting that million dollar figure if you can.
Realization on Gift or Death
Under current law you generally don’t recognize any taxable gain for income tax purposes when you make a gift of assets, or on death. The proposal would change this historic foundation of tax law and would tax a transfer property by gift or it death. These would be a realization of events. There will be a $5 million exclusion from this gain so it will only effect wealthier taxpayers. But those effected will face a costly sting that will change how they plan and what they do. If you want to gift appreciated assets to a trust to protect them from claimants, that could trigger an income tax cost to do so. If the 39.6% ordinary income tax rate applied it would make it impractical to do so as you would lose 40% (more if state or local income taxes also applied) of the value to taxes immediately. Many people will prefer to take the chance with a possible creditor in the future than to diminish their wealth by that much immediately.
If on your death your estate paid an income tax on appreciated assets, it would get an income tax deduction for the income tax paid in calculating the estate tax. But the overall tax burden would be very costly. If you live in a state like New York or Connecticut, where there is a state estate tax, the marginal overall tax rate at death could be 60-80% percent.
If this rule taxing appreciation on gifts is passed, many taxpayers will rush to make gifts, trying to beat the tax trigger. Having your plan in place and trusts already created might enable you to get the transfers done before the change is effective. But that is always a gamble trying to beat the effective date of a new law. So, some taxpayers should consider making gifts now for this reason as well as the reasons noted above.
Tangible Assets
Tangible personal property (e.g., furniture) is excluded from the realization proposals. Collectibles (e.g., artwork), however, are not excluded. Also the home exclusion of $500,000 for a married couple will remain available.
The Code Section 1202 $10 million exclusion for certain small business corporate stock will remain available.
These new rules, if enacted, could impact your choice of investments and assets.
How can you differentiate between personal effects and collectibles? Let’s say you have a very valuable art collection. If you want to transfer artwork to a child so the child can hang it in their home, it seems like that may trigger a gain on that gift of artwork. That could be a significant cash flow issue because you do not have anything that’s actually generating cash from the gift transaction with which to pay a tax. Does that mean that you loan the artwork to your child instead of gifting it? Is that going to be a way around this new tax rule? And then, if you loan it, what about insurance? If you continue to own the art, and your child has possession, that may complicate the insurance coverage you both may need. Contrast that with the simple gift where your child would insure it post-gift. Simple transactions that you wouldn’t put a lot of thought into under current law may become incredibly complex if gain recognition on gifts is enacted.
Gifts to a non-grantor trust (a trust that pays its own income tax) would trigger again.
Gifts of property to your spouse will not trigger gain under the proposed deemed realization rules. This could create even more complexity in planning for blended families. If you are in a second, third, fourth, or later marriage, and have highly appreciated assets there would be a significant tax incentive to bequeath those assets to your spouse to avoid gain on your death. If you bequeath the same assets to children from a prior marriage that will trigger gain. If you have both assets that are highly appreciated and assets that have not appreciated significantly, you could bequeath the appreciated assets to your spouse so gain is deferred, and non-appreciated assets to your children. That process, however, will make will drafting and planning more complex.
Transfers to charity would not generally be deemed a recognition event. Gifts to charity will not trigger any gain. So, if you gift appreciated stock to a public charity, there is no gain. If you gift assets to any type of split-interest trust, there’ll be realization on the non-charitable portion. That will reduce the benefit of a gift to a charitable lead trust (CLT) or a charitable remainder trust (CRT). Such transfers would trigger gain to the extent of the interests of the non-charitable beneficiary. A typical CRT is structured with the minimum tax law requirement of a 10% remainder interest to charity. That would mean that 90% of the gain would be realized as you receive payments out of the charitable trust. Hopefully there will be an exception for a split-interest charitable trust for a spouse and charity so that it would not be taxable. If you structure the split-interest trust to zero-out the value of the taxable (i.e., non-charitable) portion, that should avoid immediate gain.
Gain on Death
When someone dies the tax they pay on the appreciated assets under the Biden proposal would be a deduction on the estate tax return for the income tax paid by the estate. That would reduce the overall tax burden, but the overall cost would remain hefty. If President Biden succeeds in raising the income tax rate your estate could owe approximately 40% income tax on the gain realized on death and then a 40% estate tax on your assets reduced by the income tax paid. Estates must plan for the liquidity necessary to pay the new income and continuing estate tax costs. Also, don’t forget that if the other proposed changes are enacted, the estate tax will be much higher under the new tax system because of the myriad of restrictions on planning options, resulting in a larger taxable estate than under the current law. The overall tax burden for wealthy on death could be dramatically increased.
Gain on Distributions from or Gifts to Trusts
Under current law, no gain is realized if you transfer assets to a grantor trust. If a trust distributes property to you, e.g., you swap cash for property held by a grantor trust, no gain should be realized. Under the new proposal, contributions or gifts to and distributions from any irrevocable trust will be deemed income tax recognition events. This one change alone will eliminate the ability to use one of the most popular estate planning tools, a transfer to a grantor trust. This will end estate planning as we know it today.
Making distributions of appreciated property out of a trust, e.g. to the settlor of the trust, will eliminate your ability to complete swaps. Under current law, you could swap cash into an irrevocable trust and take back an appreciated asset of equivalent value with no adverse tax consequences. This technique could bring a highly appreciated asset back into your estate to obtain an income tax basis step up on death. If the asset remained in the trust, it would not gain that basis increase, and heirs would ultimately pay a capital gains tax. The new law’s deemed realization of gain on distributions of trust assets would eliminate this valuable and common planning tool, the swap (also referred to as a substitution of assets). Grantor trusts have been the keystone of most estate planning for decades. Critical to the use of grantor trusts was the ability to move assets into and out of the trust without any income tax consequences. That will be eliminated. This one change would alone decimate another popular planning technique, grantor retained annuity trusts (GRATs) (see below). That is because key to many GRATs has been the ability to shift appreciated assets into the GRAT without a tax cost, and for the GRAT to pay you as the settlor appreciated assets to satisfy the annuity that the trust owes you under this technique. That will be eliminated.
Gain On Death Deferral for Family Businesses
Family-owned businesses will be given a safety valve from the new tax on death. They will be permitted to elect to defer the tax on appreciation, with interest, until the business is sold or no longer family-operated. But to get this benefit the IRS can require security for the payment deferred. This appears to mean that the IRS could place a lien on business assets to secure the payment of both the income tax and estate tax due on death. Consider the possible adverse impact of such liens on financing family business operations, etc. These dual costs on death, especially for an illiquid asset like a family business, may create a significant incentive to use life insurance to provide liquidity. But even using life insurance could be more nettlesome then under current law. The many other restrictions in the Biden budget proposal will restrict if not undermine the use of life insurance trusts commonly used when insurance policies are purchased as part of an estate plan. Grantor trusts will be restricted, annual gifts (as discussed below will be capped at $50,000/year), and GRATs (which have been used to funnel assets into insurance trusts) will be impractical. The result of these and other changes is to make the traditional life insurance held in an insurance trust approach limited.
Periodic Gain Recognition for Trusts
The Biden proposal provides for a forced recognition event for property held in trust every 90 years. At year 90 any appreciation on the value of assets held in a trust will automatically have to be realized and income tax paid even if no sale or other transaction occurred. Transition rules have been provided for older trusts so that they will not be able to wait a full 90-years as new trusts will be able to do. For example, for trusts created before 1944, they will have to report gain in about nine years. The tax rate may be the new 39.6% maximum tax rate on individuals plus the 3.8% net investment income tax. That is almost 44%, and if there is state and local tax, the marginal overall rate could be 50%+. Most state income tax systems follow the federal rules. So if a gain is imputed in year 90 on a federal level, it will likely be deemed to have occurred from state income taxes as well. Some trustees may choose to move trusts out of high-tax states years before the gain-triggering event to at least try to avoid the state income tax even if they cannot mitigate the federal imputed income tax.
You should consider when creating a new trust that the it should be a trust that lasts as long as possible, that has situs in a trust and tax-friendly state, and that has domestic asset protection trust (DAPT). These states have more favorable laws, robust and flexible administrative trust companies, etc. Examples are Alaska, Nevada, South Dakota, Delaware, Tennessee, and New Hampshire. When preparing your estate plan as we advance, consider using a revocable trust instead of a will being your primary dispositive document. That may make moving a trust formed at your death (a testamentary trust) to a state with favorable trust income tax rules easier. This is because you should not need court approval to make any kind of change or change the trust’s situs. Note that retirement assets cannot be transferred to a revocable trust without triggering gain. Other assets, like professional corporations, may face legal restrictions on transfer to a trust.
With the prospect of an approximately 40% income tax on trust income, the ability to shift wealth down generations will be substantially limited. This will inhibit dynastic planning that has been one of the themes of estate planning for decades.
Who is an Executor
Under current law, gaps, confusion, and inconsistency can exist regarding who is the personal administrator or executor to take certain actions on behalf of an estate. That has created administrative difficulties for both taxpayers and the IRS. The new law would allow the executor to do anything regarding the decedent’s tax liability on behalf of the decedent.
Special Use Valuation
For farmland and certain real estate used in a closely held family business current law permits that property to be valued using special rules that will reduce the estate tax value. The purpose of this is to reduce the need to liquidate family farms or real estate used in a family business to pay estate tax. But under current law this benefit is capped at about $1.4 million of property. The new law, and this is one of the few favorable changes proposed in President Biden’s budget, will increase this amount to $14 million. That is $28 million for a married couple. There are strict and detailed requirements that have to be met to qualify for this opportunity. For example, it must actually be a working farm. This benefit may be so significant, especially if the estate tax exemption is cut in half in 2026 to about $7 million; anyone owning property that might qualify may focus on planning to qualify. Further, it may even become worthwhile for others to invest in such assets if they can realistically qualify for this enhanced tax break. Consider that the average value of a family farm might only be about $2.5 million.
Consider how the Biden budget proposal disparately affects different types of assets. Some asset classes are better, others not. Collectibles are going to be a real issue with the potential to trigger tax on gifts. Section 1202 corporate stock and farmland could be especially beneficial assets to own. This will make planning more nuanced and complicated, and in many cases unfair as between different taxpayers.
Trust Reporting
If you have more than $300,000 in a trust, or gross income in excess of $10,000, new trust reporting rules will apply. These thresholds are so modest that virtually every trust will be impacted. Trustees will have to report the value of trust assets to the IRS annually. Taxpayers, trustees, and beneficiaries are all going to be very uncomfortable having to disclose this information. The proposal requires that the trust’s generation skipping transfer (GST) tax inclusion ratio will also have to be reported. That is the portion of the trust that is exempt from generation-skipping transfer tax. For taxpayers who have had qualified advisers preparing proper gift tax returns (Form 709) every year they made gifts, and maintaining trust records, this may not be a significant complication. But for many trusts the trustees and even the CPAs helping with trust income tax returns may not have any idea what this figure will be. Reconstructing it for an old trust could be costly and complicated.
Also, consider that the new Corporate Transparency Act (CTA) has created new and burdensome reporting on entities and trusts that own certain interests in entities, or which have certain control over entities. This is going to be really invasive, and the term, beneficial owner, just like so many things that the government does, is incredibly misleading because it’s not just people who own 25% or more could be anyone who has substantial control, which is a very complex term. When it gets into the trust world, where the trust owns interests and entities, it could be every single person named in the trust or a very complex process trying to figure out who that is.
The CTA is focused on business entities (partnerships, corporations, limited liability companies, etc.), and trusts are only affected if they have interests in reporting entities. The Biden budget proposal would add another layer of reporting for almost all trusts on top of the CTA burden. The government is seeking to require the reporting of a lot of confidential and sensitive information, and no one will be comfortable with this.
The CTA will require that you use your home address, not a PO box, not your accountant’s office address. You will have to file a copy of your driver’s license or passport and disclose your Social Security number.
So, now trusts may have to report the assets/net worth, which was not required under the Corporate Transparency Act. How will the trustee value a piece of raw land or a vacation home that’s been in the family for decades or longer?
Valuation Adjustment Mechanisms
Much wealth, and hence the focus of much of estate planning, has been the transfer of hard to value assets like interests in a family business or real estate. An issue that occurs with all such property is what is the value? Even if you have your business appraised the IRS could challenge the appraisal of a gift of that business that you make as being wrong. An increase in the gift valuation could result in a 40% gift tax. Taxpayers have tried to avoid that risk but using special valuation mechanisms. Instead of transferring a percentage interest in a business entity, you transfer a fixed dollar amount. That way, if the IRS challenges the value you have only made a gift of that value, not a percentage interest. That should avoid any unintended gift tax. The IRS has long disfavored this mechanism as they assure that if the IRS is successful in an audit, no tax can be collected. The use of these mechanisms makes the administration of the tax system extremely difficult because they spend resources on audit to accomplish nothing. The Biden budget will eliminate the use of these mechanisms. This is all rather unfair as wealthy people transferring interests in marketable securities have no valuation risk. But those transferring interests in real estate or a closely held business do. This is similar to the comment made earlier that there is a considerable difference in how different assets will be treated under the Bide proposal. That will make planning less fair and more complex.
Thus, if you own hard to value assets you should plan before this law becomes effective, Which is the end of the year.
Annual Exclusion Gifts
You are allowed to give away each year $18,000 to as many people as you want. This is referred to as the annual exclusion. If you had 20 heirs you could gift $360,000/year. If you are married, you and your spouse can gift $720,000. If all your heirs are named as beneficiaries of a trust, you can gift the trust that amount, and the trustee can give the beneficiaries notice that they can withdraw the money if they wish. That way, assuming the beneficiaries do not withdraw the money, all of it remains in the trust, and you face no gift tax consequence. The Biden budget will cap annual gifts at no more than $50,000 per donor. So you and your spouse will be limited to giving away $100,000/year or using whatever remains of your lifetime exemption. When that is exhausted future gifts above the $50,000 cap will trigger gift tax. If you have a large insurance plan, it could be difficult to gift enough cash into a trust to pay the premiums after this law change. You should plan for this possibility now. Consider creating Grantor Retained Annuity Trusts (GRATs) that can flow assets into your insurance trust. The Biden proposal will emasculate GRATs so now may be the last time you can use that technique to leverage gifts. Plan on funding any large insurance plans now, because the law will make it very difficult to do it if enacted.
Restriction on Duration of GST Exemption
In the old days (and still in some states), a trust could only last for a limited period of time, for example, 21 years past the death of the last beneficiary alive when the trust was created. However, many states have modernized their trust laws, permitting trusts to last for a very long time. If you create a trust in those states and allocate Generation-Skipping Transfer (GST) tax exemption to that trust equal to the gift amount, the trust can remain outside of the gift, estate, and GST tax systems, perhaps forever.
The Biden budget proposal will limit the duration of a trust GST exemption to, generally, no more than two generations below the transferor (i.e., your grandchild) unless younger generations (e.g., your great-grandchild) are alive at the time of the trust’s creation. This will greatly limit dynastic planning. Existing plans will be substantially altered. There is no grandfathering for pre-existing plans. So, even if you created a trust a decade ago believing it should be outside the estate tax system forever, that just won’t happen. That is because the effective date of this change is the date the new law is enacted.
You might need to revise your will and revocable trust. If those documents pour assets into existing irrevocable trusts they may have a shorter duration than if new trusts are created which may then include heirs born after the lifetime irrevocable trusts were created. That could require your heirs to maintain double the number of trusts adding to costs and complexity.
Also, consider the aggregate impact of the various Biden proposals. GST can only last two generations, distributions from or gifts to trusts will be income tax realization events, and assets you manage to shoehorn into trust with all these limitations will be subjected to a deemed realization and income tax every 90-years. Overall, the Biden proposal will substantially hinder the ability of the wealthy to transmit wealth down the generations. And that no doubt is one of the goals. The government is clearly saying we were not interested in dynastic planning.
Grantor Retained Annuity Trusts (GRATs)
GRATs are an estate planning mechanism that can facilitate your shifting appreciation out of your taxable estate, without incurring gift tax and with limited downside risk if the plan fails. For almost all cases, the Biden proposal will eliminate the use of this technique with various harsh new restrictions. It will require the remainder interest to have a minimum gift tax value equal to the greater of 25% of the value of the assets transferred by you to the GRAT (trust), or $500,000 (but not more than the amount transferred). That alone will make GRATs impractical in most situations. But the proposal goes further. It would also prohibit a GRAT duration or term shorter than 10 years, a term greater than your life expectancy as the annuitant, plus 10 years. Further, there could not be any decrease in the annuity amount paid. Income tax-free exchanges with the trust would trigger income tax. Thus, GRATs will effectively be eliminated for unusual situations. If you could benefit from GRATs (e.g., to leverage value into an insurance trust to meet future premiums because of the restrictions on annual gifts discussed above), you need to complete them before the date of enactment. Since no one can predict that it is basically the sooner, the better. Also, you should plan cash flow to avoid the need to pay annuity in kind.
CCA said that the valuation adjustment mechanism wouldn’t work because the taxpayer was in bad faith because they didn’t have the appraisal recognize offers that were on the table.
Swap or Substitution of Assets
A hallmark of most grantor trusts is a right given to the person creating the trust to swap assets with the trust. As the grantor to the trust and its deemed owner, this allows you to swap assets of equal value (typically cash) tax-free for trust assets (usually appreciated assets). This puts appreciated assets back into your estate and thereby maximize the value of the “step-up” in basis at death.
For any grantor trust that is not fully revocable, the Biden proposal would treat an asset transfer between the trust and you as the grantor as regarded for income tax purposes. That means taxable. That will make a basis step up on assets inside trusts impossible to achieve. Also, swapping to revise or restructure your estate plan will be impossible. For example, you may have put a business asset into a trust and named certain beneficiaries, the son running the business. Years later, your son changed his mind and wanted to do something completely different. Your daughter, who had nothing to do with the business when the trust was created, is now running the business. Under current law, you can swap the business outside of the trust back into your name, and put different assets in the trust. Then you can do a new plan to get the business to your daughter. You lose a lot of flexibility for personal planning reasons, not just the basic step up with the Biden change.
Review all trusts before enactment and consummate swaps before then.
Again, the big-picture theme of the Biden budget proposal is to restrict almost every technique that estate planners use, indirectly restricting many others, to prevent wealth transmission.
Tax “Burn”
Most trusts created for estate planning purposes are grantor trusts. That means the person who created the trust, not the trust, pays income tax on trust income. That odd-sounding consequence is one of the most powerful wealth-shifting devices. It allows a deemed owner of a grantor trust to pay the income tax attributable to trust assets without incurring gift tax. Biden’s proposal provides that your payment of the income taxes on income earned by an irrevocable grantor trust is a gift deemed to occur on December 31 of the year in which the income tax is paid (or earlier if grantor status terminates). This is yet another restriction/cost that is being created to restrict current estate planning strategies. So in addition to the income tax burn on trust income, you’re going to pay a gift tax at 40% on top of that.
Since this new rule only applies to trusts created after the new law is enacted, you should create a grantor trust you might need sooner rather than later.
You could include a tax reimbursement clause in the trust in case the tax costs gets too much for you to bear. But based on a recent IRS ruling, you’d better put that in at inception because if you try to add it later, the IRS will argue that such a step will trigger adverse tax consequences. One of the key problems that produce tax reimbursement is even if you include the clause properly in the beginning of the trust, if you use it too often (which no one can define) the IRS can argue that you had an implied agreement with the trustee to reimburse you, therefore you retain an interest the whole of the trust is back in your estate. Consider using an institutional trustee as that may reduce the risk of this tax problem.
GST Transactions Between Trusts
Say you have a trust that is not GST-exempt. That means that when that trust passes to your grandchildren (skip persons in tax jargon), a Generation-Skipping Transfer (GST) tax could be triggered. But if you can shift the value of a non-GST-exempt trust into a GST-exempt trust, that tax cost might be avoided. How might you do that? The trustee of the non-GST-exempt trust could sell assets it owns to another trust that is GST-exempt for a note. If both trusts are grantor as to you, or the buying trust is grantor as to the selling trust, no income tax should be trigged on the sale. Thereafter, any increase in value of the asset (e.g. a family business) above the interest rate the buying trusts pays the selling trust, could be outside the tax system forever.
This proposal would treat this type of transaction as some type of GST transfer and you would have to re compute the inclusion ratio. This is effective the date of the new law’s enactment. That might suggest completing any such transactions now.
Loans to Trust Beneficiaries
Loans have been a very flexible trust administration tool. It has been common for trusts to loan beneficiaries money for several reasons. In many cases, loaning money can have a tax advantage. For example, if you have a non-GST exempt trust, and you want to provide economic benefit to a lower generation person, a distribution could trigger a GST tax. If the trustee instead loans money to the beneficiary or perhaps buys a personal use asset like a house and lets the beneficiary use it, the tax might be avoided or deferred. It’s also been common for a trust that’s in a favorable no tax state that wants to provide money to a beneficiary in a high-tax state to loan money to the beneficiary instead of making a distribution.
The Biden proposals will eliminate the above. It will treat loans in the same manner as a distribution so that a portion of trust income based on the value of the amount of all loans and distributions. Once the law is enacted, the trustee can no longer loan a beneficiary without an income tax consequence identical to that of a distribution. The new rule will require that a loan pass out distributable net income (DNI). Since most states follow federal tax law, that may also create taxable income in the state where the beneficiary lives. This will complicate trust administration. Since a loan may also trigger income tax to the beneficiary, if the trustee is trying to get specific funds to a beneficiary the amount loaned or distributed (since they will be treated the same) may have to be increased (grossed-up) to provide the beneficiary enough money to pay the new income tax cost and leave them with enough net funds for the intended purpose (e.g., a down payment on a house). What if a trust has three beneficiaries? One beneficiary wants to buy a home, and the trustee wants to give her a million dollars to buy the home. The other beneficiaries are younger, and the trustee is obviously, logically, concerned about maintaining equality between the various beneficiaries of this pot or sprinkle trust. The trustee might prefer to loan the money to the beneficiary being helped because then if that loan has to come back even with interest, then, in effect, the trustee has arguably not been unfair to the other beneficiaries. But now that the loan will create a negative income tax cost, which has to be factored into the planning as well, maintaining parity between beneficiaries may be more difficult.
Discounts
Under current law, if you make a gift of a non-controlling portion of a business entity or assets, the interest or asset given may be valued at a fraction of the total value. These valuation discounts have been the fuel of much of estate planning. Discounts (and the tax burn discussed above) have been fundamental to how wealthy people have shifted value out of their estates and outside of the estate tax system. The Biden proposal will revise Code Section 2704(b) to provide that the value of any partial interest in closely held business transferred to a family member must be the pro-rata share of the aggregate fair market value. In other words, no more discounts. This restriction will apply to intrafamily transfers of partial interests in property in which the family collectively has an interest of at least 25% of the whole. For purposes of this new rule, family members would include the transferor, the transferor’s ancestors and descendants, and the spouse of each.
If your estate plan might benefit from valuation discounts, you should evaluate consummated that plan before the Biden proposal is enacted.
Conclusion
There is simply no way to guess what, if any, of the Biden proposals will be enacted, and if so, when. It is clear that the Democrats have been proposing similar harsh tax changes for a long time, and at some point, some or many of these proposals may be enacted. With that risk, wealthy taxpayers should plan now. The planning should be structured to be as flexible as possible (without jeopardizing your goals). Any asset transfers, presumably to trusts, should be planned to give you sufficient access so that you aren’t harmed economically. Regardless of the tax changes that may occur, you may benefit from asset protection benefits. So, plan while you can. Right now, we know what tax planning techniques we have.