On September 13, 2021, the House Ways and Means Committee Chairman announced the Committee’s plan to pay for the $3.5 trillion Build Back Better Act (the “Act”). The Act has measures to combat the climate crisis, create jobs, encourage economic and affordable housing development, and lower health care costs. To pay for these measures, the legislation contains a variety of changes, some of which are expected to become effective as soon as the legislation becomes law.
Decrease to the Gift and Estate Tax Exemption
Valuation of Nonbusiness Assets
In valuing assets for gift and estate tax purposes, a common technique is to take advantage of appropriate discounts when the transferred asset is not publicly traded or otherwise hard to value. The Act targets this valuation strategy by disallowing a valuation discount for the transfer of nonbusiness assets. Nonbusiness assets are passive assets that are held for the production of income and not used in the active conduct of a trade or business, e.g., marketable securities held by family entities. There are exceptions for assets used in hedging transactions or as working capital of a business. This new valuation approach would apply to transfers after the date of enactment of the Act.
Changes to Grantor Trust Rules
A grantor trust is respected as a viable legal entity apart from its creator for gift and estate tax purposes, yet it is ignored for income tax purposes. These characteristics have provided an opportunity to transfer assets estate, gift, and income tax efficiently to the next generation. As a grantor trust, the income and deductions of the trust flow through to the grantor and are reported on the grantor’s income tax return and the grantor is responsible for the trust’s income tax. The payment of the income tax is not considered a gift. The trust thus grows free of income tax.
Because there are no income tax consequences on transactions between the grantor and the trust, a planning strategy allows the grantor to sell assets to the trust in exchange for a low-interest rate promissory note. The sale would not trigger capital gain and as long as the assets sold to the trust appreciated by more than the interest rate on the note, the sale of such assets removed value from the grantor’s estate for estate tax purposes. Further, the interest payments on the note from the trust to the grantor would be free of income tax.
- The Act would make these sales between grantor trusts and their deemed owners equivalent to sales between the grantor and a third party.
- At the grantor’s death, a grantor trust would be pulled into the grantor’s taxable estate.
- Any distribution from a grantor trust to someone other than the grantor or the grantor’s spouse will be treated as a taxable gift from the grantor.
- If the trust ceases to be a grantor trust during the grantor’s life, it will be treated as a gift by the grantor of all trust assets.
The Act would apply to grantor trusts created on or after the date of enactment and would apply to any contribution to an existing grantor trust.
These changes to the grantor trust rules would have significant impacts on several common estate planning techniques including grantor retained annuity trusts, qualified personal residence trusts, and trusts created for the benefit of the grantor’s spouse. Insurance trusts, which are designed to keep the life insurance proceeds out of the grantor’s estate, are almost always grantor trusts. Existing insurance trusts would be grandfathered. However, premium payments are generally funded via ongoing gifts to the trust which could result in some of the death benefit being subject to estate tax.
Although we do not know what the final legislation will look like, the Act provides a view into the current proposals. While there is still time to do “traditional” estate planning, it should be undertaken quickly. Since several of the Act’s provisions become effective when the final legislation is enacted, the window may close sooner than year-end.
If you have any questions about this alert, please contact your SGR Private Wealth counsel.