With the Sept. 27 deadline approaching for the House of Representatives to mark up President Joe Biden's proposed Build Back Better Act, estate planners need to keep on their toes. Many of the changes being discussed, if eventually passed into law, could drastically impact clients' plans; therefore, planners should consider immediate action.
Here's a brief summary of relevant provisions and some important effective dates:
1. The Act reduces the federal estate, gift and generation-skipping transfer tax exemption to $5 million, adjusted for inflation, beginning for estates of decedents dying and gifts made after December 31, 2021.
2. The Act increases the limitation on the estate tax valuation reduction for certain real property used in farming or other trades or businesses to $11.7 million, effective for estates of decedents dying after December 31, 2021.
3. Effective for trusts created on or after the date of enactment of the Act, the Act would cause trusts to be included in the grantor's gross estate for federal estate tax purposes to the extent the grantor is treated as the deemed owner of the trust for income tax purposes at the time of his death.
4. Distributions from the same portion of trusts described in paragraph 3, above, during the lifetime of the deemed owner (other than to the deemed owner or to the deemed owner's spouse) would generally "be treated as a transfer by gift [by the deemed owner] for purposes of chapter 12," with "proper adjustment" made "to account for amounts treated previously as taxable gifts under chapter 12 with respect to previous transfers to the trust by the deemed owner."
5. Except in the case of revocable trusts, the Act would also cause sales to trusts described in paragraph 3, above, by a deemed owner to be recognized for federal income tax purposes to the extent of the deemed owner's portion of the trust, effective for trusts created on or after the date of enactment of the Act.
6. To the extent that the grantor is no longer treated as the deemed owner of any portion of a trust described in paragraph 3, above, the Act provides that "all assets attributable to such portion at such time shall be treated for purposes of chapter 12 as a transfer by gift made by the [former] deemed owner."
7. The provisions described in paragraphs 3 through 6, above, would also apply to the portion of like trusts established before the date of enactment of the Act which is attributable to property contributed to the trust by the deemed owner on or after such date.
8. The Act eliminates valuation discounts for transfers of interests in entities owning nonbusiness assets, effective for transfers (including, presumably, transfers at death) after the date of enactment of the Act.
Immediate Planning Considerations
Trusts Established and Fully Funded Prior to the Effective Date. Obviously any new planning techniques involving significant gifting should be accomplished as soon as possible. If the intent is to make use of the current $11.7 million estate, gift and generation-skipping transfer tax exemption, the gifts must be completed prior to January 1, 2022. If the intent is also to make the gift to a so-called "grantor trust" for federal income tax purposes (which is a trust wherein the grantor is treated as the owner of the trust for income tax purposes), the gifts should be made before the date of enactment of the Act, i.e., the date the President signs the Act into law. The same "prior to date of enactment" principle applies to gifts of interests in so-called "marketable security entities" (including but not limited to family limited partnerships and limited liability companies), where the intent is to achieve a gift tax valuation discount when the gifts are made. The estate planner's principal concern, of course, is that the date of enactment of the Act could turn out to be sooner, rather than later.
For new irrevocable trusts which the estate planner is establishing for clients, even ones which will predate the yet-to-be-determined date of enactment of the Act, it must be remembered that the Act will apply to the portion of the trust attributable to property contributed to the trust on or after the date of enactment, even if the trust itself predates the date of enactment. This situation is addressed below.
Trusts Established or Funded on or After the Effective Date. For trusts established on or after the date of enactment of the Act, to the extent the grantor is no longer treated as the owner of any portion of a trust, "all assets attributable to such portion at such time shall be treated for purposes of chapter 12 as a transfer by gift made by the deemed owner." A similar rule applies to distributions from such trusts during the deemed owner's lifetime. The Act then provides that "proper adjustment shall be made . . . to account for amounts treated previously as taxable gifts under chapter 12 with respect to previous transfers to the trust by the deemed owner."
Although, at first blush, this "proper adjustment" provision may appear agreeable, there are problems and ambiguities associated with it. In the first instance, the adjustment only applies to prior "taxable" gifts. It thus appears that there will be no adjustment for annual exclusion gifts to a trust which are covered by Crummey powers, for example. Thus, if all contributions to the trust over the years were covered by the annual gift tax exclusion, but the gift tax value of the trust's assets is now $500,000, there will be a $500,000 taxable gift (presumably not covered at all by annual gift tax exclusions, unless "deemed gifts" are covered by the Crummey withdrawal language) if the trust assets are distributed to one or more beneficiaries during the deemed owner's lifetime, with no adjustment for the fact that all contributions to the trust were covered by the annual gift tax exclusion.
It is likewise not clear how the "to account for amounts treated previously as taxable gifts" language will apply if there are other taxable gifts by the grantor to the same persons during the previous years. For example, what if the grantor made a $15,000 annual exclusion amount outright gift and a $15,000 annual exclusion amount Crummey gift to the same person during a previous year? Will the grantor be able to treat the annual exclusion amount as applying to the outright gift, and thereby receive a greater "proper adjustment" when the distribution from the trust is made? Presumably there will be some apportioning of the annual gift tax exclusion between the two previous gifts, based on the relative value of the gifts, but it would be much preferable if Congress would simply clarify this situation now with appropriate language, prior to voting on the Act.
The Act also infers that the deemed gifts would not be subject to the Section 2035 gifts within three years of death rules. This is because the Act employs the phrase, "for purposes of chapter 12," whereas Section 2035 is not based on transfers "for purposes of chapter 12," but is rather based on actual (i.e., not deemed) transfers, and the Act does not appear to change this basis. A proper understanding of this situation will be crucial if a life insurance policy is distributed out of the trust within three years of the deemed owner's death.
For grantor trusts established on or after the date of enactment of the Act, as well as for grantor trusts established before date of enactment of the Act which are added to later, the applicable portion will be includible in the grantor's gross estate at death, presumably using an approach similar to current IRC Section 2035 and following. The Act provides that "proper adjustment shall be made with respect to the amounts so included in the gross estate . . . to account for amounts treated previously as taxable gifts under chapter 12 with respect to previous transfers to the trust by the deemed owner." This bill language is somewhat confusing, as IRC Section 2001(b)(2) would already remove this portion of the decedent's prior taxable gifts from the term "adjusted taxable gifts."
Minimizing the Effect of the New Grantor Trust Rules
For new arrangements established on after the date of enactment of the Act, as well as for arrangements established before date of enactment of the Act which will require future contributions, the goal will often now be to eliminate or at least minimize the extent to which the trust will be treated as a grantor trust under the Internal Revenue Code ("the Code"). In the case of a so-called "spousal access trust," for example, grantor trust status can be minimized by placing a limit on the percentage of the trust income or principal which the spouse may receive each year, e.g., to five percent. Under new Section 2901(a)(1) of the Code, as proposed, this should mean that only five percent of the trust principal would be includible in the grantor's gross estate at death. The trust instrument could then call for the removal of the five percent limitation after the grantor's death. [Note that, unlike IRC Section 678(a)(2), there is no argument under IRC Section 677 that an annual "release or modification" of a spouse's discretionary income or principal right increases the portion of the trust of which the grantor would be considered the deemed owner.] For irrevocable life insurance trusts, the trust can be drafted to disallow the use of trust "income" (as that term is construed for purposes of IRC Section 677) to pay premiums, and otherwise ensure that the grantor will not be treated as a deemed owner of the trust, e.g., by excluding a power to substitute and the ability of the grantor's spouse to receive income or principal from the trust during the grantor's lifetime. A power in an independent trustee to lend funds to the grantor, with adequate interest and security, should also be permissible.
If the client has previously established and funded an irrevocable grantor trust where future contributions are anticipated, one obvious alternative would be to establish a second, non-grantor trust, to be used for future contributions. In certain situations this alternative may not be practical, however, for example where the existing grantor trust consists of a life insurance policy with a considerable cash surrender value. In this latter case consideration should be given to taking immediate steps to eliminate any powers or rights which are causing the grantor trust status of the trust, but without causing adverse transfer tax consequences in the process. For example, decanting can be used to eliminate the ability of the trustee to use trust income to pay premiums. If these steps are taken before the Act is enacted into law, there should not be a deemed gift by the grantor of the assets of the trust at the time the trust is no longer regarded as a grantor trust, and future contributions to the trust should not create an estate tax inclusion problem.
The problem is that eliminating grantor trust status without causing other adverse transfer tax consequences, even through trust decanting, may be easier said than done. For example, in the case of a spousal access trust, if the spouse renounces an income or principal interest in the trust, or allows the trustee to decant to a trust which eliminates the interest, this may be treated as a taxable gift by the spouse.
One option for dealing with this situation would be to consider having the grantor loan funds to the existing trust to pay future premiums, which loan would be repaid out of the policy's cash surrender value or proceeds. Provided that the policy's cash surrender value and other trust assets are sufficient enough to be considered an appropriate "liquid seed," this trust should retain its "grandfathered" status, even if funds will be needed by the trustee for future premiums. If the trust is funded exclusively with term policies, however, such that there is no sufficient liquid seed, the grantor may need to "pre-fund" the trust with additional assets, prior to the date of enactment of the Act.
The only disadvantage to this approach is that the value of the note or notes receivable will be includible in the grantor's gross estate at death. The grantor would retain the ability to make annual exclusion gifts in other fashions, however, including potentially even making annual gifts of interests in the promissory note or notes.
Note that in some situations the loan option will not be available, e.g., where premiums are directly paid by the insured's employer. In these situations, if it is not possible to decant or otherwise eliminate powers and interests which are causing the grantor to be treated as the deemed owner of the trust, without running the risk of adverse transfer tax consequences to the grantor's spouse, and the client is also unwilling to risk violating the three-year rule by purchasing the policy directly and transferring it to a new, non-grantor trust, it may be necessary to immediately establish and fund a new grantor trust to purchase the group policy, and include in the trust the ability in the trustee to later eliminate the power to substitute or other power which is causing the grantor to be treated as the deemed owner of the trust. Even if the new tax laws are already in place at the time the trustee eliminates the violating powers, the worst case scenario would be that the grantor will be deemed to have made an additional taxable gift at that time, but this gift should be offset by the value of the gift the grantor made to the new trust, at least to the extent the gift was considered a taxable gift, and as discussed above there should no risk of running afoul of IRC Section 2035.
Effect of Protective Clauses. Interesting issues may arise if an irrevocable grantor trust agreement executed and funded prior to the date of enactment of the Act includes a provision to the effect that "no person shall possess any power or interest in the trust which would cause any portion of the trust to be includible in the grantor's gross estate for federal estate tax purposes, and to the extent any such power or interest would otherwise exist, it shall be deemed void and of no effect." If funds are added to this existing grantor trust after the date of enactment of the Act, presumably any provisions of the existing trust agreement which would cause estate tax inclusion in the grantor's gross estate would be simultaneously voided, though only to the extent of the applicable portion of the trust which is attributable to the subsequent contributions. Thus, for example, the applicable portion of any interest of the grantor's spouse in the trust during the grantor's lifetime would be immediately voided, as would the applicable portion of a power to substitute principal in the grantor and the ability of a trustee to use trust income to pay premiums. If the client is ok with all of this in a particular case, then it will not be necessary to go to any other trouble to ensure that the trust corpus is not included in the grantor's gross estate at death.
Presumably the provision of the Act which causes taxable gift treatment if the grantor "ceases" to be treated as owner of any portion of the trust should not apply, because the trust was not a grantor trust as to the applicable portion at the moment the Act first applied to it, i.e,, when it was first funded with additional assets after the date of enactment of the Act. Congress should clarify this significant point, nevertheless.
Finally, because there is no assurance that the Act will ever become law, or even if enacted that it may not some day later be repealed, in drafting new trust documents for clients, including trust instruments created via decanting, consideration should be given to including a clause in the trust document which would allow someone other than the grantor or the grantor's spouse to add a power of substitution or other power to the trust instrument which would cause the non-grantor trust to become a full grantor trust as to the grantor.