On March 28, the Biden administration released its second set of desired revenue raising proposals in General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals, (the 2023 Green Book.) These proposals represent the first comprehensive tax proposals from the administration since Build Back Better failed to advance in Congress late last year. For tax advisors, Green Book proposals are always interesting—both for what’s included and what isn’t. While these proposals may not advance, especially given the current Congress—it’s useful to see what topics are being considered and to be able to address client concerns regarding the proposals
In our previous article, we tackled the headline-grabbing Billionaire Tax, and in a subsequent piece, we’ll address some of the proposed trust and estate administration changes. In this piece, however, we’ll unpack the proposals related to a number of popular tax planning techniques used by high-net-worth (HNW) individuals, which are far more expansive compared with the first Biden Green Book.
Layering Income Taxes on Top of Transfer Taxes
The primary proposal aimed at estate planning in the 2022 Green Book reappears in the 2023 Green Book. In short, death, lifetime gifts and exceeding maximum holding periods for assets in trust would be recognition events for income tax purposes. The resulting income tax liability would be in addition to the potential gift, estate and generation-skipping transfer (GST) taxes imposed. The substance of the proposal is the same as last year’s. There were, however, two updates that addressed some of the criticisms of the initial proposal worth noting here. First, the exclusion on gain has been increased from $1 million per donor/decedent to $5 million, and it remains portable to a surviving spouse. This will remove most taxpayers from the application of this new double-taxation system. Second, the rules regarding valuation discounts have been relaxed somewhat. The original proposal stated that the value of a partial interest would simply be the proportional value of the entire interest. This means that noncontrolling interests in active businesses with third-party owners would be valued much higher for purposes of this tax than the fair market value (FMV) of the interest. This year’s proposal excludes “an interest in a trade or business to the extent its assets are actively used in the conduct of that trade or business” from the required disallowance of appropriate discounts replacing what had been a tax deferral in the 2022 Green Book to be paid on the sale of the business interest or on the business ceasing to be family owned.
The 2023 Green Book proposal would substantially limit the tax benefits of grantor-retained annuity trusts (GRATs) by calling for changes previously proposed by the Obama administration. In each of the Obama administration’s Green Books, there were proposals targeting the use of GRATs. The final two Obama Green Books, issued in 2015 and 2016, called for both the elimination of short-term GRATs and so called “zeroed-out” GRATs, where the value of the retained annuity interest was equal to the value of property transferred, resulting in a taxable gift at or near zero. The Obama Green Book proposals have appeared elsewhere including in both Sen. Sanders’ and Sen. Warren’s respective gift and estate tax proposed legislation,
While these proposals weren’t in the last year’s Green Book or Build Back Better legislation, they’re now back in the 2023 Green Book with this year’s edition. The proposal seeks to achieve this by requiring: (1) a GRAT to have a term of at least 10 years, (2) that a GRAT last no longer than the life expectancy of the grantor plus 10 years and (3) that the remainder interest (that is, the amount of the taxable gift) be the greater of (a) 25% of the value of the assets contributed or (b) $500,000 (however, that this latter amount be capped at the value of the gift). These proposals also would have transactions between the GRAT and the taxpayer be recognition events for income tax purposes.
The grantor trust rules, once an anti-abuse provision, have been one of the most used provisions of the Internal Revenue Code for estate planning by allowing the trust to grow income tax free with the grantor having to pay the income tax liability directly with funds that would have otherwise been included in the grantor’s gross estate and by enabling tax-free transactions between the grantor and grantor trust. Prior to Build Back Better, there were multiple legislative proposals that were modeled on Obama administration proposals to limit the use of the grantor trust rules for estate tax savings by having any asset sold or exchanged with a grantor trust be included in the taxpayer’s estate. Then, the House Ways and Means version of Build Back Better went a step further by including the assets at death, together with the 2022 Green Book proposal to treat the sale or exchange between a grantor and a grantor trust as an income tax recognition event notwithstanding the grantor trust status.
The 2023 Green Book’s proposals focus on the income tax nature of grantor trusts rather than the Obama administration–inspired proposals using the estate tax. What’s entirely new this year is that the income tax payments required to be made by the grantor under the grantor trust rules would be treated as gifts to the trust going forward. The value of the gift will be determined as of Dec. 31 of each year, where the gift will be the sum of all income taxes paid less any reimbursements made to the grantor by the trust. The proposal explicitly excludes revocable trusts from this regime and effectively ignores typical irrevocable life insurance trusts that hold only non-income-producing life insurance policies.
Promissory Note Valuation
A common estate-planning technique, especially in recent years due to low Internal Revenue Service prescribed interest rates, is intra-family loans and/or sales. In these transactions, a taxpayer provides assets to a related party (such as a family member but more often a trust for the benefit of a family member), in exchange for a promissory note that has the minimum interest rate required for the loan to not be treated as a below market loan under the Tax Code. As a result of the exchange of assets for a loan that isn’t treated as below market, the promissory note is valued at its face value for gift tax purposes, which keeps the assets from being transferred as a gift under IRC Section 2512 principles. If the promissory note is later gifted or included in the estate of the lending party, that promissory note must be valued again under the FMV standard. The Treasury Department has been concerned that some taxpayers take a position that “relies on the statutory rules to assert that the loan is not below market for gift tax purposes at the time of the transaction and relies on the underlying economic characteristics to assert the loan is below market for estate tax purposes later.” That is, the promissory note is valued at less than outstanding face value and accrued interest because of present value discounting and any increase in then applicable rates. The Treasury Department first proposed in its 2015–2016 Priority Guidance Plan, but has omitted since the 2017–2018 plan, regulatory action on the valuation of such noted.
While the Biden administration hasn’t returned the proposal to its Priority Guidance Plan, it added the proposal to its 2023 Green Book (potentially signaling a belief that a statutory change is required). The proposal states that if the promissory note was originally treated as having a sufficient interest rate to avoid having any foregone interest as income or any part of the transaction treated as a gift, then for future valuation purposes the interest rate from the loan will be the greater of: (1) the stated interest rate in the promissory note or (2) the applicable IRS published rate at the date of valuation. Further, for purposes of valuation, the loan must be assumed to be short term to further avoid the application of discounts. This proposal would take immediate effect applying to any valuation after the enactment date regardless of when the promissory note was issued.
Ending the Perpetually GST Exempt Trust
Trusts that can exist in perpetuity under local law and are GST exempt are often referred to as “dynastic trusts” because they allow family wealth to pass generation to generation free of transfer taxes. Past proposals from Democrats have sought to curtail these dynasty trusts by having the exempt status end after a set number of years from the creation of the trust. The Obama administration proposed the inclusion ratio of a trust would automatically become one 90 years after the trust was created. While not part of the Build Back Better proposals, other Democratic legislative proposals in 2021 called for the exempt status to end on the trust’s 50th anniversary. This year’s Biden administration proposal similarly seeks to change the inclusion ratio, but not with reference to when the trust was established, rather it’s with reference to the beneficiary. Under the Biden proposal, the GST tax-exempt status would apply only to “beneficiaries no more than two generations below the transferor, and to younger generation beneficiaries who were alive at the creation of the trust…” To put in vernacular, if you’re looking at the linear descendants of a donor, only transfers to the taxpayer’s children, grandchildren and those great-grandchildren (or younger) who were alive when the trust was created. This change would apply to both pre-enactment and post-enactment trusts. However, for purposes of this proposal, pre-enactment trusts will be treated as having been created on the enactment date in identifying what beneficiaries are alive.