I thank my partner Brandon Ketron, CPA, JD, LLM for his assistance with this post.
The estate tax revisions released by the Ways and Means Committee of the House of Representatives on September 13th have our full attention for very good reason, given that the effective date of significant changes would be the date that President Biden signs the bill, assuming that it is passed by the House of Representatives and the Senate.
Many taxpayers and their advisors have been rushing to establish or fully fund special irrevocable trusts that can both avoid federal estate tax and purchase from or exchange assets with the Grantor at no income tax cost.
These “Defective Grantor Trusts” can pay for appreciating assets by giving long-term low interest promissory notes, while the Grantor/contributor pays the income tax attributable to the trust income.
All of those features will not be possible with respect to trusts that are formed or to the extent funded after the date of enactment, but the legislation would grandfather trusts, to the extent funded, up through the date of enactment.
We have therefore been operating under the assumption that such grandfathered trusts would be able to swap assets tax-free after the date of enactment, or purchase more assets for low-interest promissory notes – – – but that has turned out to be too good to be true, at least according to the House Report No 117-130 that was released on September 28th.
This Report indicates that the language of the proposed new statute was intended to provide that such sales or exchanges that take place after the date of enactment will be taxable, as if the sale were to a separate taxpayer. The Report did recognize that the current language of the proposed bill does not provide for this, but that it would need to be amended to reflect what the Committee intended.
As a result of this individuals and families that have set up and are maintaining trusts that are disregarded for income taxes, including most “dynasty trusts” and Grantor Retained Annuity Trusts should look at what assets they have in and outside of these trusts, and consider whether to swap assets, sell assets or otherwise reconfigure arrangements or change trusts themselves before this new law would take effect.
This issue is discussed in a YouTube video posted last Saturday that can be seen HERE.
For example, I may have established a trust that has $2,000,000 worth of appreciated stock that I would like to buy back from the trust before my death, so that the stock can get a new fair market value income tax basis when I die. I therefore give the trust $2,000,000 cash or other high basis assets, and the trust transfers the stock to me.
Under present law, this can be accomplished income tax free; however if the new law is amended to provide for the above then after the date of enactment of the new law, this will be treated as if I sold the stock for $2,000,000 at the time of the sale.
As a second example, I may own 49% of an LLC that owns $2,000,000 worth of appreciated stocks.
I might sell the 49% ownership interest in the LLC to the same trust for $980,000 (49% of $2,000,000), and because I will not be able to take a discount under the new law, I could receive a promissory note payable interest only for up to my life expectancy, at the present applicable federal rate, which is only 1.74% per year.
This sale will be taxable to the extent that my tax basis in 49% of the LLC is less than $980,000, but fortunately it appears that the sale would be eligible to be reported under the installment method and taxed as payments are received on the note.
If my tax basis is higher than $980,000, then the loss that I experience will not be considered to have occurred as grantor trusts will be considered a related party for purposes of IRC Section 267 which disallows losses on sales or exchanges between related taxpayers. There are different rules that apply with respect to subsequent sales depending on whether the subsequent sale is for a gain or loss. If the subsequent sale is for a gain, then the trust will effectively take a basis in an amount equal to my higher basis by reason of being allowed to offset any gain by the previously disallowed loss.
For example, if Bob sells property that he bought for $100,000 to a grantor trust for $70,000, Bob will not be allowed to recognize the $30,000 loss. If the trust later sells the property for $110,000, the trust can offset the gain with the $30,000 previously disallowed loss and only pay tax on a $10,000 gain, as though its basis in the property at the time of the sale was $100,000.
However, assuming the same facts as above, if the trust later sells the property for $50,000 ($20,000 less than the trust paid for it) it will only be able to realize a loss of $20,000, making it as though the trust’s basis in the property was what the trust paid Bob for it.
This new revelation from the Ways and Means Committee has many tax advisors in the position of having to explain to clients who have established Defective Grantor Trusts in the past of the possible short window of opportunity to swap or sell assets that may be coming to a close in a few weeks, if not days.
While we can be sure that the eventual tax law changes will be somewhat different than what has been proposed, the effective dates of such changes can be expected to be as early as the date of enactment for the items described above.
Other changes are set to be effective for transactions occurring on or after September 13, 2021, including a 25% capital gains rate, and having the sales of Section 1202 company stock, also known as Qualified Small Business Stock (“QSBS”), subject to income tax on up to 50% of the gain thereon, instead of being completely tax sheltered as applies under the law as presently written.
Many taxpayers have established Grantor Retained Annuity Trusts (“GRATs”), which receive a gift of assets from a Grantor, and then make a stream of payments back. What remains under the GRAT after the stream of payments can pass estate tax-free for the Grantor’s descendants or others.
Many GRATs do not have sufficient cash to make the required payments, and therefore satisfy the payments by transferring appreciated assets such as stock that may be held and publicly traded or closely held corporations or LLC interests.
Such transfers could trigger income tax after the date of enactment, if the income tax basis of the assets transferred back to the Grantor will be less than the fair market value thereof.
Grantors of GRATs may therefore want to consider exchanging the GRAT assets now for cash before the new law would apply.
It is difficult to predict what new tax legislation may bring in the estate and gift tax arena, but individuals and families that have appreciated assets and Defective Grantor Trusts or GRATs should consider determining whether to swap assets or to purchase or sell them in exchange for notes, after consultation with their tax advisors, who may already be completely booked, at least through October 15th, as they prepare extended tax returns and advise their clients on PPP loans, ERC credits, and other unique situations that have arisen as the result of COVID 19.
The above and more will be discussed by me with Brandon Ketron on Saturday at 11am EDT. For free admission to the webinar or a replay you can e-mail info@gassmanpa.com.