Ben Franklin famously said, “[O]ur new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” To which Will Rogers added, “Death doesn’t get worse every time Congress meets.” The recently released House Ways and Means Committee markup of the Build Back Better Act has only amplified the arguments, which have raged since the 2020 presidential campaign, over how to pay for President Biden’s agenda and who should bear the tax burden.
It is still not clear if all of these changes to the Internal Revenue Code will ultimately become law, but we thought you should at least have a clear idea of what’s currently on the table.
Increase in top marginal tax rate for non-grantor trusts and estates
For tax years beginning after December 31, 2021, the proposal increases the top marginal income tax rate of non-grantor trusts and estates from 37% to 39.6%.
For tax year 2022 and after, the top tax rate is projected to begin for non-grantor trusts and estates at income levels over $13,450.
Change in preferential rates on capital gain and qualified dividends
The proposal increases the top regular capital gain and qualified dividend rate for individuals, estates and trusts from 20% to 25%. The rate increase applies for both the regular tax and the alternative minimum tax (“AMT”). It is important to note the proposal to increase the top regular capital gains rate is effective for taxable years ending after the date the proposal was introduced – September 13, 2021. There is a transitional rule that allows gains and dividends earned on or before the effective date to be taxed at the 20% rate.
Surcharge on high-income individuals, trusts and estates
The proposal imposes (in addition to any other taxes) a 3% tax on the modified adjusted gross income of an individual, estate or trust that exceeds a certain amount.
The three-percent tax applies to modified adjusted gross income in excess of $5 million for single individuals, heads of households, married individuals filing joint returns and surviving spouses. For married individuals filing separate returns, the three-percent tax applies to modified adjusted gross income in excess of $2.5 million.
For estates and non-grantor trusts, the 3% tax applies to modified adjusted gross income that exceeds $100,000.
Keep in mind, the surtax is in addition to the proposed 39.6% top marginal tax rate of the trust and the 3.8% net investment income tax (if applicable).
Early termination of increased unified credit
The House Bill accelerates the expiration of the increase in the estate and gift tax exemption amount provided by the Tax Cuts and Jobs Act (“TCJA”). Currently, the estate and gift tax exemption is $11.7 million, but for decedents dying or making taxable transfers after December 31, 2021, the estate and gift tax exemption will be based on the pre-TCJA amount of $5 million adjusted for inflation. This is projected to provide an estate and gift tax exemption of approximately $6 million in 2022.
Since the amount of the taxpayers’ generation skipping transfer tax exemption follows the estate and gift tax exemption, taxpayers should also expect a reduction of the GST exemption to $6 million.
For purposes of the House Bill, a “deemed owner” is any person who is treated as an owner of a portion of a trust under the grantor trust rules.
The proposal impacts not only intentionally defective grantor trusts, but may also result in estate inclusion of part or all of irrevocable life insurance trusts, beneficiary defective trusts and qualified subchapter S trusts.
Current advice: Clients should make transfers they can afford to make to established grantor trusts ahead of enactment, which may come before December 31, 2021. If the proposals are enacted, the inclusion of a portion of the trust in the grantor’s estate not only eliminates moving appreciation out of the grantor’s estate but also makes an allocation of generation skipping transfer (“GST”) exemption to those transfers ineffective until the deemed owner’s passing or termination of the power creating grantor status; clients with aspirations of funding existing trusts for multiple generations should consider transfers they can afford to GST exempt grantor trusts prior to enactment. Finally, since Irrevocable Life Insurance Trusts (“ILIT”) may be subject to inclusion in the grantor’s estate under the proposal, grantors of ILITs, prior to the proposal enactment, may consider funding the trust with assets that will generate income needed to pay the premiums or fund the ILIT with enough assets to pay the premiums.
Changes for grantor trusts – sales to grantor trusts
The proposal would eliminate the non-recognition of gain on a sale transaction between the grantor and a trust of which the grantor is the deemed owner.
The proposal would also amend the related party rules to disallow losses on a sale between a grantor and their grantor trust.
The proposals are effective for (1) trusts created on or after the date of enactment and (2) any portion of a trust established before the date of enactment attributable to contribution made on or after the date of enactment.
Is the payment of the income tax an additional transfer to the trust? There is nothing in the bill indicating a reversal/termination of the Internal Revenue Service’s previous position that the tax liability of a grantor trust is that of the grantor. The payment of the grantor’s liability is not an additional gift to the trust. So far, there is nothing indicating this position will change. For clients who have existing grantor trusts, they should continue to retain grantor status and pay the income taxes to preserve existing trust assets.
Valuation rules for certain transfers of nonbusiness assets
For estate and gift tax purposes, the proposal would disallow the use of valuation discounts in valuing certain transfers of nonbusiness assets.
“Nonbusiness asset” means any passive asset held for the production or collection of income that is not used in the active conduct of a trade or business.
There is still a long way to go and there will be much wrangling on Capitol Hill before we know the impact of final legislation, but now would be a good time to contact your Friedman LLP advisor to see how these provisions might affect your income, estate and gift tax planning.