A number of tax proposals have been released this year to raise taxes on ultra-high-net-worth (UHNW) individuals. While some may be tempted to react to every proposed change, the reality is that whether any proposals will be enacted, which proposals will be passed, when they will be passed, and when they will become effective is still tremendously uncertain. Altering planning every time a new tax proposal is released may quickly resemble a futile and potentially detrimental game of “whack-a-mole” and lead to adverse long-term outcomes.
Making drastic changes to a client’s investment strategy based on political predictions can be risky, so the right response for some clients may be to wait until the legislative environment/outcome is clearer. Another defensible strategy may be to focus on planning that clients intend to do in the future but that may need to be accelerated or modified due to potential tax changes.
Use remaining gift and estate tax exemption
The Tax Cuts and Jobs Act1 (TCJA) doubled the gift and estate tax exemption for transfers made after 2017. However, after 2025, many of the individual provisions of the TCJA are scheduled to sunset, and the gift and estate tax exemption will be reduced to $5 million, adjusted for inflation. Individuals who take advantage of the TJCA’s increased gift tax exemption will not be adversely impacted after 2025 when the exemption amount is scheduled to decrease.2
Recent House Ways and Means (HW&M) Committee tax proposals3 would accelerate this change to 2022. After accounting for inflation, the exemption amount would be reduced from the current $11.7 million level down to approximately $6 million next year, thus accelerating the “use it or lose it” opportunity.
Donors with the means and intent to use the full $11.7 million exemption should consider doing so now. Given that the exemption would be reduced from the top but is used up from the bottom as gifts are made, only individuals who make cumulative gifts in excess of $6 million before the end of this year would derive any benefit from the currently elevated exemption amount.
Married couples who are unable to fully use the exemptions of both spouses may benefit from exhausting one spouse’s exemption rather than using equal amounts of both exemptions.
Although under the HW&M proposals individuals may technically have until the end of this year to take advantage of the historically high exemption amount in effect, the available window of time may be smaller if the donor wishes to take advantage of grantor trust strategies that may enhance overall wealth transfer benefits.
Create and fund grantor trusts
A grantor trust is a trust that is disregarded for income tax purposes. Trust income and deductions are generally reported on the grantor’s personal income tax return. Even though the trust is ignored for income tax purposes, transfers to the trust may be respected for gift and estate tax purposes.
Assets transferred to the grantor trust can be excluded from the grantor’s gross estate, and the income taxes paid on the trust income can further reduce the grantor’s future estate tax exposure.
The grantor’s payment of income tax on behalf of the trust results in a tax-free gift to the trust beneficiaries, allowing trust assets to grow undiminished by income taxes. The grantor may also be able to “turn off” the grantor trust status if paying taxes on behalf of the trust becomes too cumbersome.
The HW&M proposals would make several important changes to current favorable grantor trust rules:
- Grantor trust assets would be included in the grantor’s gross estate
- Grantor trust distributions would be treated as deemed gifts
- Grantor trust assets would be treated as a deemed gift when the grantor trust status is “turned off”
- Sales between the grantor and grantor trust would be treated the same as sales between the grantor and a third party
If enacted, these proposed changes would adversely impact, if not eliminate, the benefits of certain powerful estate planning strategies that rely on the grantor trust rules, such as the following:
- Grantor retained annuity trusts
- Intentionally defective grantor trusts
- Irrevocable life insurance trusts
- Spousal lifetime access trusts
Under the HW&M bill, these changes would take effect on the date of enactment. Grantor trusts created and trust contributions made prior to the date of enactment would be grandfathered under existing rules.
Accordingly, UHNW individuals may have a small window of time to create, fund, or sell assets to a grantor trust prior to the date of enactment. So, if an UHNW individual is otherwise considering making gifts and the use of grantor trusts, acceleration of such actions might be prudent.
Incorporate flexibility and urgency
Due to pending status of the HW&M bill, UHNW individuals may benefit from making large gifts by the end of this year to fully use up their current gift and estate tax exemption. An even earlier deadline may apply if gifting strategies involve the use of grantor trusts.
Despite the fact that the HW&M bill provides important clues as to which provisions might be included in a final tax bill and the applicable effective dates, uncertainty remains.
Therefore, to the extent possible, integrating flexibility and building in mechanisms to unwind or modify planning in the future, if necessary, may be advisable. In an estate planning context, contingency planning might include the use of strategies such as formula clauses, qualified disclaimers, rescission, or decanting provisions. An estate planning attorney can help determine what options may exist and how to effect them.
Although “whack-a-mole” is an arcade classic, more effective tax planning strategies exist.
Other Tax Regime Blogs
- Steps Advisors Could Take Ahead of Potential Changes in Capital Gains Tax Law
- Impact of Green Book Capital Gains Proposals on Loss-Harvesting Strategies
- Repeal of Basis Step-Up: Third Time’s the Charm?
- Tax Planning Under Election Uncertainty
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