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Retroactive Legislation: Advisors' Dilemma

With the potential for retroactive application of any basis step-up legislation, here are four options to consider when advising clients.

Tax bills have been introduced by U.S. Sens. Bernie Sanders, Chris Van Hollen and others that, when aggregated, essentially eliminate every significant estate-planning tool or advantage advisors and their clients currently possess, including an historically high estate and gift tax exemption, stepped-up income tax basis at death and minority interest discounts. And as part of his American Families Plan (AFP), President Joe Biden has proposed a substantial curtailment on stepped-up income tax basis at death. 

Although Biden introduced his proposal to eliminate income tax basis step-up at death several weeks ago, as of the date this article went to press, his administration had yet to release any actual bill language in this regard. As all advisors know, the devil is in the details. So, the question thus remains: without any details, and with the potential for retroactive application of any basis step-up legislation, how are advisors expected to advise their clients, today?

Retroactive Effective Date

One response might be to take a wait-and-see approach. The only problem with this plan is that the basis step-up bill that’s eventually passed by Congress may take effect on: (1) the date the bill is first introduced in Congress, (2) a date retroactive to the date Biden first proposed the AFP, or (3) worst of all, a retroactive date beginning on Jan. 1, 2021, similar to what’s provided in the Sensible Taxation and Equity Promotion Act of 2021 (the STEP Act), which was introduced by Van Hollen in late March 2021.

Herein lies the dilemma: Although Sanders’ “For the 99.5% Act,” doesn’t purport to be retroactive in nature, and would therefore appear to be constitutional, the STEP Act, which taxes transfers via gifts (including gifts to grantor trusts) as well as at death as deemed capital gains for income tax purposes, as though the transferor or decedent sold the transferred asset at the time of the transfer at its historical cost tax basis, purports to be retroactive to transfers on or after Jan. 1, 2021. Further, the proposed effective date of the basis step-up provisions to be included in the AFP may end up being: (1) Jan. 1, 2021, (2) the date Biden first proposed the legislation, or (3) the date the legislation is formally introduced into Congress. These dates will be important if Biden’s bill language ends up tracking the STEP Act, primarily because lifetime gifts are treated as sales under the STEP Act.

Here's the Catch-22 advisors find themselves in: Many attempts to grandfather various estate-planning techniques that would be eliminated by Sen. Sanders' “For the 99.5% Act,” by making irrevocable lifetime transfers today, such as transfers to an irrevocable grantor trust, could be hit by the retroactive provisions of the STEP Act or of Biden’s upcoming bill, and therefore be subject to income tax, potentially even at higher capital gains tax rates than exist today. 

Four Options to Consider

The estate planner’s job is to present the above analysis to the client and also explain that, once a statute is enacted, from that moment forward its application will almost certainly be constitutional. Within this general backdrop, here are some factors and options the client and the estate planner can examine, together:

            1. Consider waiting until Biden formulates his bill language and introduces his bill in Congress, because almost certainly, his bill will then supplant the current STEP Act. If Biden's bill doesn’t purport to be fully (that is, to the beginning of 2021) or partially (for example, to the date of its introduction in Congress) retroactive, the client can then make grandfathered transfers before the bill becomes law, using many of the estate-planning techniques Sanders attempts to eliminate. The obvious problem with this approach is that the time to make these lifetime transfers may be severely restricted. Some cushion may be provided, however, if the Senate needs to first debate the application of filibuster rules to Biden's bill, including potential reconciliation. Also, in recent years at least, it seems like it’s almost required that Congress wait until the last few weeks of the calendar year before taking final action on any significant tax bill. 

            2. If action is intentionally delayed until Biden’s bill is formally introduced in Congress, and if, similar to the STEP Act, Biden’s bill ends up being retroactive, in full or in part, the advisor and the client must then determine whether preenactment transfers should nevertheless be made, under a theory that the retroactive aspects of the law are unconstitutional. If Biden’s bill uses the date of introduction in Congress as the retroactive effective date, however, and if using this date is ultimately determined to be constitutional, the client may have been damaged by not making transfers before Biden formally introduced his bill.

            3. The ultimate decision whether to make preenactment transfers may depend on the dollar amounts involved. That is, if waiting until after Biden’s legislation is passed, including, potentially, until the client's passing, will mean the greater likelihood of a larger federal (and, potentially, state) capital gains tax liability coupled with a larger federal (and, potentially, state) estate tax liability (for example, because the current large federal estate tax exemption will have expired by then due to the existing sunset provision or otherwise), many clients may feel the risk is worth the reward and proceed with current transfers under a theory that any retroactive aspects of Biden’s bill will be ruled unconstitutional, and that, even if the provisions are ruled constitutional, under the worst case scenario, they would be potentially accelerating an income tax liability that will be payable eventually, anyway. By biting the bullet early, these clients hope that they’ll significantly lower, and potentially avoid, the eventual future total estate and income tax bill to their families.

            4. Finally, one option may be to assume none of the current and proposed estate planning related legislation in Congress will ever be passed, retain the status quo, and potentially use one or more of the techniques the For the 99.5% Act eliminates. The only problem with this approach is that the current large federal estate and gift tax exemptions will then not have been grandfathered, due to the existing sunset provision.

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