BETA
This is a BETA experience. You may opt-out by clicking here

More From Forbes

Edit Story

How To Prepare For Big Tax Changes

Following
This article is more than 2 years old.

           The House reported out the “Build Back Better Act” late last month, closely following the proposed tax law changes by Senators Sanders and Van Hollen. Each makes somewhat different proposals, and the Act is far from finalized, what is clear is that any of these proposals, if enacted, will have significant impact on not only future plans but on existing plans involving trusts and annual gifts. 

Although most of the proposals are imposed prospectively, Senator Van Hollen and others have proposed making the changes effective from January 1, 2021. For estate planners, we cannot wait until the proposals are finalized, as that will be too late. We will need to act and act quickly when the legislation passes, both to execute on plans and to unravel existing plans that have negative tax consequences. In other words, we will need to make sure that our clients are prepared for all possible changes and have plans (and documents) ready to deal with those changes.

Here are some of the proposed changes and how they affect estate planning:

Reduction in the Estate and Gift Tax Credit: The temporary unified estate and gift tax credit, now equivalent to $11.7 million, is temporary because it is scheduled to revert in 2026 to the prior credit amount, adjusted for inflation, of $6 million.  The proposals are to make that drop to $6 million as of January 1, 2022. Using the full $11.7 million credit before 2022 requires that the client gift the full $11.7 million in 2021, since the measurement of the credit amount is cumulative, you do not get the additional credit over $6 million after the effective date. 

How to Prepare: Only a few very wealthy clients can afford to gift $11.7 million without having some way of being able to receive income from those assets. So it is best to draft trusts where a third party holds broad powers of appointment to make those assets available sometime down the road (what is commonly called a spousal limited access trust or “SLAT”). 

Changes to making Gifts in Trust: Although a gift can be made outright, with a gift as large as the current unified credit most clients will want to protect the assets from creditors, from mismanagement by beneficiaries who are inexperienced and to provide a certain safety net against future situations where the tax laws change again or the client’s situation changes. The proposals make significant changes in how gifts in trust are handled, both from a gift and estate tax perspective and from an income tax perspective. This is especially true in the proposed changes to the “Grantor Trust” rules.

The Grantor Trust rules were created in the late 1960’s to close a loophole in the tax law that allowed clients to use the (then) lower trust income tax rates for some of their income. This rule makes it so that a trust with certain characteristics is deemed to have been earned by the client, who created the trust, that is the Grantor. This loophole was closed, but it opened up other planning techniques, such as a client selling assets into a Grantor type trust, which are not recognized as income for tax purposes. Because the Grantor Trust rules apply only to income taxes, and not gift or estate taxes, such Trusts, where there is a sale, can be used to “freeze” the value of an asset for estate tax purposes. 

The proposals make a 180-degree shift in how the Grantor Trust rules are applied. Now, instead of being excluded from the client’s estate, Grantor Trusts will be included in their estate. Whereas now termination of Grantor Trust status or distributions to beneficiaries from a Grantor Trust are not a taxable Gift, the proposal is that these would trigger a gift tax. Existing Grantor Trust will be grandfathered in, but any contributions to the Trust after the effective date would be a taxable gift. 

How to Prepare: Trusts can be drafted so that they are not Grantor Trusts, but can become a Grantor Trust at a later date. Grantor Trusts can be converted into non-Grantor Trusts before the effective date of the legislation. Also, when the laws last reverted to the former credit amount (at that time from $5 million to $1 million), many clients found that they had funded trusts which, in hindsight, they need not have funded. There should be a mechanism that, if the proposed changes do not take effect the way we expect, you could unravel the transaction.

Another area where the Grantor trust rules will have an impact is on life insurance held in trust, (a “Crummy'' Trust). Now, the payment to the Trust for the premiums, if the amount is below $15,000 per beneficiary per year, is not a taxable gift. The proposed changes to the Grantor Trust rules will make these premium payments a taxable gift. Preparing for these changes includes prefunding the premiums now or entering into a split dollar agreement for the life insurance.

There are many other proposals which have direct or indirect impact on clients. For example, the extension of the Net Investment Income Tax (NIIT) to the non-FICA distributions to the shareholders of an S. Corporation will make clients reconsider whether it makes tax sense to convert the S. Corporation into an LLC or C. Corporation, which is taxable now, rather than wait for the higher tax rates after the first of the year. Additionally, there are major changes in the way that illiquid assets, such as closely held company stock, is valued; and, payments of an annuity payment from a Grantor Retained Annuity Trust will also be taxable. 

What to do? The answer is to track the proposals and be ready with a “Plan B” that can accommodate the changes in the tax laws. This may mean going as far as to draft completely different sets of documents, so that the documents can be signed and the transfers made in the interval between when the legislation is passed and the President signs it into law. This will require an open conversation with clients and keeping them educated about what is being proposed.

Follow me on LinkedInCheck out my website