In a recent speech, President Joe Biden characterized his “Build Back Better” agenda as “a long term investment in American families” that “will be fully paid for over the long term by having…the super wealthy begin to pay their fair share.”1 This statement may be debatable, but one thing is clear: proposals that are currently being negotiated in Congress would pay for its multi-trillion dollar price tag2 by eliminating many common estate planning strategies. Thankfully, steps can be taken now, before enactment of final negotiated provisions, to lessen or avoid the impact of these changes, but the window of opportunity may be rapidly closing.
The House Ways and Means Committee’s proposal for tax changes include the following key provisions that would affect estate planning strategies:
- Resets the estate tax exemption to the 2010 base of $5 million, as adjusted for inflation, which will be approximately $6 million in 2022. The current exemption amount is $11.7 million, per person, which is the total amount a person may give away or leave to heirs before having to pay a 40% tax.
- Converts irrevocable grantor trusts, trusts on which the “grantor” (the person who created and/or funded the trust) pays all the income taxes for the trust during his/her lifetime (e.g. many irrevocable life insurance trusts) from being nontaxable at the death of the grantor to being taxable at the grantor’s death for federal estate tax purposes. Grantor trusts established before enactment may be “grandfathered” and, thus, not impacted unless the trusts are modified or additional contributions are made to the trust after the date of enactment. Additionally, any termination of a grantor trust after the date of enactment will result in a gift for federal gift tax purposes.
- Converts distributions from a grantor trust to persons other than the grantor or his/her spouse from nontaxable to taxable for federal gift tax purposes and converts many transactions with a grantor trust (e.g. the sale or exchange of assets) from nontaxable to taxable for federal income tax purposes.
- Prohibits discounting the value of certain business entities that hold what are deemed to be “non-business assets,” for purposes of the federal estate and gift taxes. Non-business assets means any asset held for the production or collection of income and not used in the active conduct of a trade or business. Valuation discounts have been commonly applied to interests in family limited partnerships, family limited liability companies and other closely held family entities when transferring ownership interests in such an entity to several members of the same family either during the transferor’s life or upon the transferor’s death.
Many families have used the current (historically high) estate and gift tax exemption amount to implement estate planning strategies designed to minimize the transfer tax costs on the wealth they pass to future generations. Common strategies have included transactions with irrevocable grantor trusts; for example, gifting discounted business interests, selling assets for a note or exchanging high basis assets for low basis assets. If the Build Back Better agenda as outlined above is enacted into law, these strategies will come to an abrupt end. Accordingly, high-net-worth individuals should work with their tax advisors to determine whether additional estate planning should be implemented prior to enactment, including:
- Making additional gifts to utilize the full federal estate and gift tax exemption amount before it is significantly decreased. Any exemption above $5 million (indexed for inflation) that is used would essentially save a family 40 cents on the dollar in transfer tax.
- Establishing and fully funding a new grantor trust, which should maintain full grantor trust benefits post-enactment provided there are no subsequent modifications or additional contributions to the trust. The trust could potentially be structured to allow the grantor to continue to benefit from trust assets, e.g., by structuring it as a so-called domestic asset protection trust or spousal lifetime access trust.
- Evaluating existing grantor trusts. For example, providing sufficient liquidity to an insurance trust now to cover future premium payments and thereby avoiding the need to make contributions to the trust in the future. Additionally, terminating a grantor trust before the date of enactment should be considered when there is no promissory note from a sale or the note has been fully satisfied.
- Restructuring certain ownership interests in assets that currently qualify for valuation discounts but could be characterized as “non-business assets” under the new law.
In addition, the House Ways and Means Committee’s proposal includes several provisions that will affect high income earners from an income tax perspective, including:
- Adding a new high income taxpayer surcharge. The surcharge is to be equal to 3% of excessive Modified Adjusted Gross Income (MAGI). The MAGI threshold is set to be $5 million for taxpayers married filing jointly. The MAGI threshold is $100,000 for trusts and estates.
- Expanding the 3.8% net investment income tax to cover income derived in the ordinary course of a trade or business for high income taxpayers. This does not apply to income on which Federal Insurance Contributions Act is already imposed. This proposal will take away the advantage of S Corporations which pay low salaries.
- Creating a new Section 199A limitation, which imposes a maximum allowable deduction (i.e. a cap on the amount that may be claimed as a deduction).
- Raising the top capital gains tax rate from 20% to 25%.
- Restoring the top federal income tax bracket to 39.6%.
- Increasing the Internal Revenue Service’s budget by 90% and doubling staffing, which should enable the agency to more aggressively enforce current and new tax laws (e.g. more thorough examinations of returns, more audits, etc.).
One huge question still remains - what is the effective date of the legislation? There is no clear timeline on when the proposed bill will or could be passed as negotiations concerning its ultimate size and scope are still ongoing. However, under the current draft legislation, the effective date of many of the proposed provisions is the day of enactment of the bill (not the end of 2021), so the window of opportunity to put any planning in place may be rapidly closing.
Although there is still a lot of uncertainty about what tax reform measures, if any, will ultimately be passed by Congress, if the proposed legislation is adopted in its current form or a form close thereto, the changes will be significant. We recommend being proactive and speaking with your tax and financial advisors now to make sure you are not caught off guard.
- Remarks by President Biden, August 11, 2021, https://www.whitehouse.gov/briefing-room/speeches-remarks/2021/08/11/remarks-by-president-biden-on-the-build-back-better-agenda/.
- The actual cost of the agenda is uncertain. The Penn-Wharton Budget Model, which is one of the most skeptical of White House estimates, calculated that the agenda would spend $5.2 trillion and only raise $3.4 trillion in the first 10 years. Kessler, Glenn. “Fact Checker: Biden’s claim that his spending plan ‘costs zero dollars.’” The Washington Post 28 September 2021. Compare this skepticism to President Biden’s September 24, 2021 tweet, where he asserted that “My Build Back Better Agenda costs zero dollars.”