Legislation has been proposed to change the estate, gift and generation-skipping tax system. There are numerous changes that we are anticipating will occur. Although we do not know the exact changes that will occur to the estate, gift and generation-skipping tax system until the law has been signed, it is fair to say that a change is highly likely to happen this year that will impact many tools that previously have been used to reduce estate taxes.
To begin with, the “For the 99.5% Act” which was introduced on March 25, 2021, into the US Senate, reduces the amount of the federal estate tax exemption to $3,500,000.00 (indexed for inflation) per person. This Act proposes that the amount exempt from lifetime gifts would be reduced to $1,000,000.00 (not indexed for inflation), which would also reduce the federal estate tax exemption amount. This is significantly less than the $11,700,000.00 amount currently exempt from gift and estate taxes.
For example, David has a $12,000,000.00 estate. He currently could gift $11,700,000.00 without incurring any gift or estate tax. If he died with an estate of $300,000.00, that amount would be subject to federal estate tax since he had previously utilized his whole amount exempt from gift and estate taxes.
Secondly, the deceased spouse’s unused exemption amounts are used before a donor’s exemption amount. There is a “use it or lose it” provision.
For example, David was married to Martha. Martha died in January 2020 when the amount exempt from estate taxes was $11,580,000.00. David elected portability so that he could use Martha’s amount exempt from estate taxes. If David made a $15,000,000.00 gift in 2021 before the new legislation was enacted, he would use up all the portability amount of $11,580,000.00, plus $3,420,000.00 of his amount exempt from gift and estate taxes. He would be left with a federal estate exemption of only $80,000.00 if the new amount exempt from federal estate taxes was reduced to $3,500,000.00.
In comparison, David was married to Martha. Martha died in January 2020 when the amount exempt from estate taxes was $11,580,000.00. David elected portability so that he could use Martha’s amount exempt from estate taxes. If David made a $20,000,000.00 gift in 2021 before the new legislation was enacted, he would use up all of the portability amount of $11,580,000.00, plus $8,420,000.00 of his amount exempt from gift and estate taxes. He would be left with no exemption for federal estate or gift purposes if the new amount exempt from federal estate taxes was reduced to $3,500,000.00.
In both scenarios, David would have no remaining amount of gift tax exemption if the amount exempt from gift taxes was reduced to $1,000,000.00.
The rate of the estate tax is also scheduled to change. For the amounts between $3,500,000.00 and $10,000,000.00, it will be taxed at 45%. For amounts between $10,000,000.00 and $50,000,000.00, they will be taxed at 50%. For amounts between $50,000,000.00 and $1,000,000,000.00, they will be taxed at 55%, and for amounts over $1,000,000,000.00, they will be taxed at 65%. It is currently proposed under the For the 99.5% Act that the exemption amounts and rate structures would apply to deaths, GST transfers and gifts made after December 31, 2021.
The For the 99.5% Act would also eliminate the step-up in tax basis for grantor trusts. Only grantor trusts created and fully funded before the date of enactment would be grandfathered in so that they were not included in the grantor’s estate. For individuals who have grantor trusts before the date of enactment, they will need to make sure that the grantor trust pays its own expenses and they do not personally write a check for a grantor trust expense, or they will be losing the grandfathered grantor trust status and part of the grantor trust will be included in the grantor’s estate.
For example, David set up a life insurance trust in 2011. David gifts $5,000.00 annually to the life insurance trust to pay the annual life insurance premiums on a $1,000,000.00 policy. The trust has a provision in it that taxes the income in the trust to David. David makes a transfer of $5,000.00 to the trust for 10 years after the For the 99.5% Act is passed and then dies. As David put $50,000.00 into the trust before the For the 99.5% Act was enacted and $50,000.00 after the Act was enacted, half of the $1,000,000.00 policy would be included in David’s estate.
In comparison, David set up a life insurance trust in 2011. David gifts $5,000.00 annually to the life insurance trust to pay the annual life insurance premiums on a $1,000,000.00 policy. The trust has a provision in it that taxes the income in the trust to David. David makes a gift of $200,000.00 to the life insurance trust before the For the 99.5% Act was enacted. David uses the money in the trust to pay the trust bills and makes no additional transfers to the trust before he dies. The trust is not included in David’s estate.
The For the 99.5% Act would eliminate commonly used valuation adjustments for marketability, minority interest, blockage and taxes on built-in gain. These discounts are used regularly to reduce the value of gifts of limited liability company interests to family members.
For example, David and Martha have two children that are both married with two children. They own rental real property worth $1,000,000.00 that they want to maintain in the family in a limited liability company. Due to transfer restrictions and lack of ability to control the limited liability company, an appraiser had stated that the financial units in the limited liability company were only worth 60% of the value of the underlying asset. So, instead of each financial unit having a value of $10.00 per unit, each financial unit is treated as having a value of $6.00 per unit. They previously had started gifting financial units to their two children, the spouses of the two children and the four grandchildren. They were gifting away $120,000.00 in LLC units each year. Therefore, David and Martha had gifted away 20,000 LLC units for the $120,000.00 annual gifts. If they have no valuation discounts, they would only be able to gift away 12,000 units for the same $120,000.00 gift under the For the 99.5% Act after the date of enactment. In addition, only $20,000.00 of the gift would be protected by the annual exclusion amount.
The rules regarding GST exempt trusts are also changing. Currently we have been able to allocate the generation-skipping tax exemption to a trust so that it was not included in the estate of beneficiaries who merely had the use of the money during their lifetime. The For the 99.5% Act would change this so that the trust that would otherwise be exempt from generation-skipping taxes must terminate within 50 years, or it would lose its generation-skipping tax exemption.
For example, currently, David could set up a trust for the benefit of his descendants for a period of 150 years. During that 150 year period, if this trust was exempt from estate taxes, all distribution from the trust would be exempt from generation skipping taxes. With the proposed For the 99.5% Act, any distributions to David’s grandchildren or lower generations that occur 50 years after the trust was created would be subject to the generation-skipping tax.
It also appears that the rules regarding step-up in tax basis at the time of death are also going to be changing. This may mean that we have carryover basis. With carryover basis, the person who inherits the property has the same basis in the property as the person who died.
For example, David has a stock that he paid $100.00. David wills the stock to his child, Chris. He dies when the stock is worth $200.00. Under the current rules, Chris would inherit the stock with a tax basis of $200.00. Under a carryover basis system, Chris inherits the stock with a tax basis of $100.00.
We could have a Canadian style system where the estate will pay the tax on the increase in property value at the time of death.
For example, David has a stock that he paid $100.00. David wills the stock to his child, Chris. He dies when the stock is worth $200.00. David would be treated as selling the stock at the time of his death. David’s estate would pay the tax on the difference between $200.00 and $100.00.
It has also been proposed that we could have a mark to market system that would tax the increase in value on assets annually.
For example, David has a stock that has a value of $100.00 on January 1. The stock has a value of $200.00 on December 31. David would pay income on the difference between $200.00 and $100.00.
Things to do as soon as possible:
- If you want to make ($15,000.00) annual gifts that are exempt from the gift and estate tax exclusion amounts, you need to do this before the enactment of this bill.
- If you have already consumed more than $3,500,000.00 of your exemption amount, you may want to consider if you have more gifts that you would like to make up to the $11,700,000.00 that is currently exempt from gift and estate taxes. You will not have any additional gift or estate tax exemption after the passage of the Act if the new amount exempt from estate taxes is only $3,500,000.00 and the gift tax exemption is only $1,000,000.00.
- If you have an irrevocable life insurance trust and are currently funding the trust each year with annual exclusion gifts, you may want to consider making a larger gift to the trust so that you no longer have to worry about making annual exclusion gifts or violating a grandfathered grantor trust which could cause part of the irrevocable life insurance trust to be included in your estate.
- If you have a spouse and your net worth is in excess of $7,000,000.00, you may want to consider creating a spousal lifetime annuity trust to utilize at least a portion of the $11,700,000.00 exemption while it is still available. Depending on the goals, the terms of the spousal lifetime annuity trust can be tailored for the situation.
For example, David and Martha own assets worth $15,000,000.00. David may want to consider creating a spousal lifetime annuity trust (SLT) for Martha. David could gift his $11,700,000.00 in assets to the SLT. Martha could be the trustee. Martha could receive trust income and principal for her maintenance, education, support and health. On Martha’s death, she could have a limited power of appointment that allowed her to change the ultimate beneficiary of the SLT to anyone excluding Martha, her estate, her creditors and the creditors of her estate. If Martha had not used any of her amount exempt from gift and estate taxes, then she would continue to have $3,500,000.00 exempt from estate taxes. Combined, David and Martha could protect $15,200,000.00 from estate taxes.
The bottom line is, if you have a taxable estate, you have a very short amount of time to make changes to your estate plan to utilize the current amount exempt from gift and estate taxes. If you would like to discuss your options, please call the office at (360) 715-3100 to set up an appointment.