Recently, the House Ways and Means Committee released long-awaited details on Democrats’ proposed funding for the $3.5 trillion Build Back Better Act agenda. The draft bill includes several important tax provisions that would considerably restrict certain commonly used wealth transfer strategies. While it’s still early in the legislative process, those who have postponed the implementation of lifetime wealth transfer strategies should execute those plans as soon as possible. It’s not clear whether proposed changes in the House bill will become law, but one thing is certain: Future tax laws are unlikely to become more favorable than they are right now. Investors who can afford to act should act now.
The Short List
Which strategies should you favor? In short, (i) large gifts (ii) to irrevocable (“intentionally defective”) grantor trusts (IGTs), (iii) that take advantage of valuation discounts, when appropriate. All three would be substantially limited under the proposed House rules.
- Large gifts, for those who can afford them. Under current law, the gift and estate tax exclusion stands at $11.7 million per person; the House proposal would halve that amount to about $6 million (inflation-adjusted), effective in 2022. If enacted, the new, lower exclusion would be further reduced by any prior taxable gifts. That means an individual who uses $6 million of her exclusion prior to 2022 would have zero exclusion remaining next year. To take advantage of the current elevated exclusion amount, an individual would have to give away more than $6 million prior to the end of this year. Ideally, she would give away the full $11.7 million, if she safely can afford to do so. For this reason, married couples should not necessarily “split” the gift; instead, consider using one spouse’s exclusion in its entirety first to take full advantage of that spouse’s enhanced exclusion as it now stands. Bernstein can quickly assess how much an individual or couple safely can afford to give away, given their own unique circumstances, without adversely affecting lifestyle spending and other personal financial goals.
- To maximize the benefit, make those gifts to IGTs. Under current law, gifts to a properly structured IGT—including the post-transfer growth of those assets—avoid estate tax upon the grantor’s death. In the meantime, the grantor, as “deemed owner” of the IGT’s assets for income tax purposes under the grantor trust rules, pays income taxes each year on behalf of the trust and its beneficiaries. Given the powerful nature of this estate planning strategy, it’s not unusual for an IGT to accumulate 25 to 50 percent more wealth at the grantor’s death than a comparable trust that bears its own income tax burden during the grantor’s lifetime. Yet the House proposal would effectively eliminate this path by including an IGT’s assets in the grantor’s estate for estate tax purposes. The new law is scheduled to take effect on the date of enactment (essentially when the President signs the bill). So, while taxpayers needn’t contend with a potential decrease to the gift and estate tax exclusion until next year, the loss of IGTs as a planning strategy could occur prior to year-end. IGTs established and funded prior to the date of enactment would still avoid inclusion upon the grantor’s death (provided no further gifts are made). Families who want to take advantage of wealth transfer planning using IGTs may have weeks, not months, to complete those transfers. Importantly, the permissible beneficiaries of an IGT include the grantor’s spouse; such a trust often is referred to as a “spousal lifetime access trust” (SLAT). This approach may prove valuable for married couples who are uncomfortable giving away $11.7 million of assets to a trust solely for the benefit of the grantor’s descendants. A SLAT provides a path to bring wealth back onto the marital balance sheet, if needed, by having assets distributed to the grantor’s spouse.
- Cramming 15 lbs. of groceries into an 11.7 lb. bag. Should those who can afford to give away more than $11.7 million before the end of 2021 do so? It would require paying gift tax at a rate of 40 percent on any excess. And although paying gift tax may be beneficial in certain cases, most families seek to avoid it. Under current law, those families have options.
- Installment sale. First, in addition to an $11.7 million “seed” gift, a grantor may sell assets—up to nine times that amount, or more than $100 million, according to most estate practitioners—to an IGT in exchange for a low-interest-rate promissory note.1 In return, the IGT is typically required to pay the grantor just annual interest during the note term, with repayment of principal postponed until maturity. Further, in today’s landscape, the seller (i.e., the grantor) does not recognize capital gain upon such a sale. That’s because, as the deemed owner of the IGT’s assets for income tax purposes, she is deemed to have sold the assets to herself. The House proposal would eliminate such “nonrecognition,” effective as of the date of enactment, treating the transaction as a taxable sale or exchange. However, an installment sale completed prior to that date would not be subject to these parameters.
- Valuation discount. Second, prior to giving or selling assets to an IGT, a transferor first may contribute those assets to an entity—such as a limited liability company (LLC)—in exchange for ownership interests, and then give and/or sell nonvoting interests to an IGT. Using an LLC or other entity in this fashion has many potential nontax benefits, including consolidation of asset management and economies of scale, especially when investing in nontraditional asset classes. In addition, a nonvoting interest in an LLC or other entity should not be worth a proportionate share of the liquidation value of assets held by the entity. The reason? The holder of such interest (i) typically cannot sell that interest to a third party without the permission of the entity’s manager; and (ii) cannot compel a distribution from or otherwise control the entity. Given these constraints, a discount in the value of the interest may result due to a lack of marketability and lack of control. In fact, it’s not unusual to see a 20- to 30-percent reduction below the liquidation value of the holder’s proportionate share of the entity’s assets.2 As it now stands, the Internal Revenue Service often contests such a discount, but in many cases, taxpayers have successfully defended it in court. The House proposal would eliminate valuation discounts for nonbusiness assets, effective as of the date of enactment.
A Need for Speed
Taxpayers who have been considering wealth transfer strategies—especially those involving big gifts and/or sales of discounted assets to IGTs—should act swiftly. Strategies other than a simple gift of the $11.7 million gift and estate tax exclusion to one or more individuals and taxable trusts could be impacted by the new House rules before the end of the year. Professional advisors, especially estate planning attorneys, and independent appraisers, already have full plates and are likely to remain busy for the remainder of 2021. Leverage your Bernstein advisor and the firm’s resources to help quantify the wealth transfer opportunity and coordinate with your professional team. You can also count on Bernstein for further insights as Congress’ plans become clearer in the coming weeks.
- Thomas Pauloski
- Senior National Director, Institute for Trust and Estate Planning—Wealth Strategies Group
- Robert Dietz
- National Director, Tax Research—Wealth Strategies Group
- Tara Thompson Popernik
- Senior National Director, UHNW Services—Wealth Strategies Group
1 For instance, a nine-year note issued in October 2021 may bear interest at the mid-term applicable federal rate of 0.91 percent per year.
2 Notably, an independent appraisal of fair market value for transfer tax purposes is essential.