How To Protect Your Wealth From The Lions, Tigers And Bears Waiting To Pounce In The Washington Tax Forest

While walking through the dark tax forest, are you scared from the noises coming from Washington? Are any taxing animals out there who might be interested in eating things like, um, your income, your assets, your life insurance, and more? Yeah, there are probably taxing lions, and taxing tigers, and taxing bears out there. They are waiting to pounce! But can you do more than say “Oh my?” Yes. You should consider planning options that might deflect some of that threat.

2021 Planning Is Complicated But Important

There are a number of significant tax proposals that have been floated in Washington, and more may well be proposed. The range of possible outcomes is nothing may get enacted or some combination of the costly elements of all proposals might be enacted in some form. But while no one can predict the outcome of any of this, inaction may prove to be the costliest option you can take right now.

President Bident has introduced a budget proposal. The Greenbook for that proposal includes a host of dramatic income tax changes that could remake significant aspects of the tax system and change tax planning. Senator Sanders proposal reflects changes the estate and transfer tax system with modifications that were introduced in President Obama’s Greenbook over many years. Senator Van Hollen has introduced an income tax proposal that would tax transfers retroactively back to January 1, 2021.

While most if not all advisers anticipate significant tax change may be enacted, the nature and effective dates of those tax changes is uncertain. Many advisers recommend that proactive tax planning action be taken now, but there is a wide spectrum of suggested steps, and precautionary measures, that are being suggested. There is tremendous uncertainty as to what might occur with income and estate tax law changes. So while it may be worth taking aggressive tax action now, be certain you understand the risks, issues and options before proceeding. The following discussion is a brief overview of a few aspects of some of the proposals to help you identify how current planning has to steer around the landmines each creates for tax planning. The discussion will also highlight some of the specific planning steps and strategies that you might consider with your advisory team.

Sanders Proposal

The Sanders proposal, in contrast to the Van Hollen and Biden proposals discussed below, focuses on changes to the gift, estate and generation skipping transfer (“GST”) tax rules. The exemption amount will be reduced from the current $11.7 million to $3.5 million for estate and GST tax, but only $1 million for gift tax. Valuation discounts may be reduced or in some instances eliminated. Tax rates could be increased from 40% to 65%. These proposal have driven many taxpayers to shift substantial wealth to trusts prior to the date of enactment.

Some folks have speculated that the Dems may make a reduction in the gift tax exemption retroactive to an earlier date. That may not be unfounded as the Van Hollen bill is retroactive to January 1, 2021 and the Biden capital gains changes to April. So what if you make a gift to use exemption before Sanders might be enacted and Congress retroactively reduces it?

Planning Idea: Talk to your advisers about two possible approaches. First, use a formula clause in the legal documentation assigning the assets to the trust as a gift that incorporates a limitation based on the gift tax exclusion in effect on the date of the transfer. If you like a “belt and suspenders” you might include in the trust that will receive the gift a disclaimer provision so that one or more beneficiaries can disclaim the gifts and unwind the transfer. Talk to your advisers about this as there are several different views on how to structure a disclaimer. That way, if there is a retroactive reduction the trustee or beneficiaries can disclaim the gift down the reduce exemption level and avoid a tax.

Caution is in order with planning to avoid the Sanders estate tax proposal because under the Van Hollen and Biden proposals, as noted below, you could trigger tax in doing so. For example if you gift millions to a trust or family to avoid the possible reduction in the gift tax exemption to $1 million, you might trigger capital gains on those transfers if the Van Hollen proposal is enacted with its retroactive effective date.

Planning Idea: You might gift non-appreciated assets (cherry pick those out of your portfolio) or borrow on assets and gift the cash you borrowed. Those transfers could help safeguard exemption before from the Sanders proposal but avoid triggering gain under Van Hollen (discussed below).

Planning Idea: You might use the idea above of incorporating a disclaimer provision into the trust receiving the gift. That way, if the gift triggers income tax under Van Hollen the trustee or beneficiaries can disclaim and unwind the gift. Some tax gurus suggest this doesn’t work because disclaimers are a transfer tax mechanism that won’t be effective for income tax purposes. Other tax folks take the opposite view that it does work because if the disclaimer is valid under state law then a state law disclaimer would control property rights and hence income tax rights.

Some  taxpayers are completing large note sale transactions to grantor trusts to lock in what might be prohibited later, discounts that may be eliminated, and more. However, those transfers could trigger massive capital gains if the Van Hollen proposal is enacted. Some experts suggest that note sales for adequate consideration would not be taxed under Van Hollen’s proposals, others suggest that result might not be certain.

Planning Idea: You might be able to rescind or unwind such a transaction later in the same tax year, although the ability to do so is not assured.

Annual exclusion gifts to trusts will be limited to twice the annual gift tax exclusion, or $30,000. That could wreak havoc with many gift plans, including common life insurance trust planning.

Planning Idea: You should evaluate making gifts or other transfers to fund trusts before changes might be enacted.

Grantor retained annuity trusts (“GRATs”) will be so restricted that they might not be used if the Sanders proposal is enacted. That is spurring some taxpayers (likely those who have already used their exemptions) to complete GRATs now. The structure of current GRATs may be very different then the historic application of that technique. Many other changes have been proposed.

Planning Idea: If you have used your entire exemption and want to make more transfers you might fund a ladder of GRATs now since rolling them in the future may not be possible. However, it is not clear that GRATs will past muster under Van Hollen so if Van Hollen is enacted, along with its retroactive effective date, transferring appreciated assets to a GRAT might trigger capital gains tax.

Van Hollen Proposal

The Van Hollen bill calls for capital gains to be assessed on transfers to grantor trusts that are not included in the donor’s estate and on transfers to non-grantor trusts. This could trigger capital gains tax on transfers made on January 1, 2021 or later. Thus, steps you take in 2021 (or have taken) to save estate tax and avoid the restrictions of the Sanders estate tax proposal (discussed above) could trigger capital gains tax.

Planning Idea: You might discuss the likelihood of a retroactive effective date being enacted for this. Some advisers suggest (but have no real basis to do so unless they have a crystal ball) that this type of change is unlikely to be enacted by such a divided Congress. But if you opt to proceed ignoring the potential for Van Hollen being enacted you do so at your own risk.

The Van Hollen proposal calls for taxing all appreciation on trust assets every 21 years. While some have dismissed the proposal as too harsh consider that President Biden’s proposal (see below) has adopted deemed realization events included in the Van Hollen proposal. Some are transferring non-appreciated assets or even borrowing to fund gifts with cash instead of appreciated assets, as noted above. While those steps might preserve exemption if a Sanders proposal is enacted, and not trigger capital gain if the Van Hollen proposal is enacted, they will not avoid the harsh deemed realization event every 21 years that may affect trusts that have been ubiquitous in estate planning.

Planning Idea: You might evaluate making gifts outside of trust to potentially avoid the 21 year tax. For example, if you put assets in an family limited partnership (“FLP”) and make gifts of the FLP direct to heirs, perhaps the 21 year capital gains can be avoided. Using the FLP might provide some control and asset protection in the absence of a trust. However, Bill Pascrell, Jr. has a proposal that calls for taxes every 30 years, and President Biden’s is every 90 years. Is it worth doing this? Might it be better to make transfers to trusts as has commonly been done in planning?

Biden Proposal

President Biden’s proposals include taxing capital gains at ordinary income rates if adjusted gross income exceeds $1 million. That could mean about a 40% tax on the sale of a business, real estate or other valuable asset. That rate might be increased by the 3.8% net investment income tax and state and local taxation.  

Planning Idea: You might have read about some big deals going on to beat the tax changes. Well, if President Biden’s plan is enacted with the effective date of the capital gains changes the date of announcement (back in April!) those folks trying to beat the tax changes will have missed the boat and face about a 40% capital gains tax. You might use the installment sale method or charitable remainder trusts to manage your overall adjusted gross income to be under the $1 million to avoid the about doubled capital gains tax. If there is no April effective date you might opt out of installment sale treatment. Talk to your CPA about the details and planning to see if this might work for you.

President Biden’s proposal also includes, similar to Van Hollen, gain realization on gift or death. But the President’s proposal goes further and even includes gain recognition on the funding of partnerships, LLCs and other entities. Thus, instead of a step up in income tax basis on death, all appreciation, above an exclusion amount, could be subject to capital gains tax. And that tax could be about 40%. That may be in addition to the estate tax (although a credit may offset some of the double taxation that would otherwise occur).

Planning Idea: You might evaluate with your advisor team intentionally selling assets now to trigger capital gains and managing your income to be below the $1 million level where the higher, almost double, capital gains tax kicks in. Next year do the same. If you are quite elderly income tax planning may take on a very new approach. You might intentionally want to trigger as much gain every year before you die as you can while still being in the lower 20% capital gains rate. This can be used over years to reduce the gain that will be triggered at death at a 40% rate. This is a very different view of planning and might best be accompanied by your wealth adviser and CPA collaborating on multi-year forecasts to manage income and tax brackets.

President Biden’s proposal also includes 90-year rule. Gain on unrealized appreciation also would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years, with such testing period beginning on January 1, 1940. The first possible recognition event for any taxpayer under this provision could thus be December 31, 2030. Certain exclusions would apply. It is not clear what those might be. So, January 1, 2030, many irrevocable trusts would be subject to gain realization (all unrealized appreciation taxed). Some interpret the proposals to include triggering tax when trusts terminate. For example, you created a spousal lifetime access trust (“SLAT”) naming your spouse and descendants as beneficiaries to try to protect your $11.7 million exemption. On your spouse’s death the trust may divide into three trusts, one for each of your children. That might be a triggering event under the Biden proposal causing a capital gains tax.

Planning Idea: You might decant (merge) the existing SLAT into a new trust that keeps all trust assets in the same trust even after the death of your spouse. While many prefer separate trusts for each child (family line) is this worth doing to possibly avoid a tax that might be enacted?  Perhaps you add a power to a trust protector to defer transfers to successor trusts under a trust instrument if it will trigger taxable income that is contrary to the settlor’s intent.

What Estate Planning Steps You Might Consider Now

Obviously, no one can predict effective dates or what will be enacted. It had seemed that the prudent course of action was to plan now and hope that your planning is completed before the effective date of a change, and that existing planning is grandfathered (exempted) from new changes. However, that planning may now come with the added risk of possible capital gains tax (unless you transfer unappreciated assets or cash). It is possible if you fund a trust now that it may escape tough new rules on grantor trusts being included in your estate, the application of a GST tax every 50 or 90 years, and more. It is also possible that these changes could be made applicable to all trusts, even trusts completed in 2020 or earlier. In fact the Sanders bill proposes that all trust lose GST exempt status after 50 years. The Van Hollen and Pascrell proposals would actually tax unrealized appreciation in trusts every 21 or 30 years respectfully. There is simply no certainty. Also, understand that no adviser can guarantee the results of any particular plan, or at this juncture the ability to complete the planning before new laws are enacted. Thus, well intentioned planning that seems logical, could prove harmful.

Protective Steps that Might Help

There are steps you might take to safeguard planning. Borrow money and transfer the borrowed funds to a trust instead of transferring appreciated assets, to avoid triggering capital gains. Include a disclaimer provision in new trusts that are the recipients of gifts and other transfers. That might provide a mechanism to unwind the transfers if adverse, and especially retroactive, tax law changes are enacted. But there are differences in opinion as to how such a disclaimer provision might be structured and its effectiveness. Transfer documents (e.g. an assignment of an LLC membership interest to a trust by gift) might include formula clauses limiting the amount transferred to the exemption amount you have in the event that exemption amounts are retroactively changed (although at present there are no proposals do to that). Perhaps all trust assets, and even many non-trust assets (excluding retirement plans, and certain other assets) might be contributed to partnerships or limited liability companies now to avoid a tax that might be triggered on that type of transfer under a Biden proposal. Perhaps new trusts should include a mechanism to permit retaining a single trust and negate provisions that would otherwise divide trusts on the death of a senior family member/beneficiary. Perhaps existing trusts might be decanted into new trusts that incorporate the provision above as well as other safeguards, e.g. the ability to distribute all trust assets to the lowest generation beneficiary prior to a new law resetting a trusts GST inclusion ratio from zero to one.

Scylla and Charybdis

A concern with all of this is that without knowing the law these steps might prove irrelevant, or worse, harmful. On the other hand, waiting to know what is enacted, may be too late. Tax planning today is certainly as challenging as traversing between the rock and whirlpool of Greek mythology. Whatever options you consider, there are going to be risks associated with it. And you will not know the right option until some future date when new tax laws are enacted.

Using some of the techniques (and there are others) noted in this article may reduce risks, but it will assuredly not eliminate them.

Another concept to consider is try to only do planning that has benefits apart from whatever tax law changes occur in Washington. If a plan has helpful implications to business succession planning and asset protection benefits, you might not feel as bad if the law doesn’t change, or the change is different then what you anticipated.

Planning Idea: Unless you are so very wealthy it doesn’t matter, be certain that whatever you do you have sufficient access to assets transferred and other sources of cash flow that your lifestyle is not restricted as a result of the planning.

There is More To Consider

Planning for the significant tax proposals must also consider a myriad of other tax, asset protection, legal and other factors. As but one example, several significant tax cases (Powell and Moore) suggest that planning may have to be carefully structured to remove control over distributions, liquidation and perhaps other key entity matters, from the transferor’s reach. This might suggest revisions to governing documents (e.g. operating agreement for an LLC), segregating distribution and liquidation powers (and the rights to change the documentation controlling those matters) into separate trusts, etc. Trust documents may need to be revised to prohibit modifications of these steps. As with so much of complex estate and related planning there is a wide variety of opinions as to what steps might or should be taken and what might be effective.

Income Tax Basis Considerations

Review assets held in irrevocable trusts. Those assets will not qualify for a basis step up on death. If the trust is a grantor trust, and includes a power to substitute, you may be able to swap assets into the trust in exchange for the appreciated trust assets. Review grantor trusts for the potential benefits of swapping appreciated assets into the settlor’s estate to gain a basis step-up on death.

Planning Idea: There is uncertainty as to whether the exercise of a swap power now may trigger gain under some of the tax proposals being considered in Washington, so caution is in order.

Also note that if there is a change in status of the trust from grantor to non-grantor gain could be triggered if the Van Hollen or a similar proposal is enacted. Finally, Van Hollen and President Biden’s proposals might trigger income tax on appreciation of trust assets every 21 or 90 years, respectively. While it is impossible to predict what might be enacted or when, these proposals may completely change the default planning advice that has existed for decades, to always transfer assets into trust. While trusts may provide valuable asset protection, the use of trusts may be disadvantaged by these deemed realization events as contrasted to owning assets outright.

Bottom Line

While it seems prudent to plan now, every taxpayer will have to make their own decisions of how much risk they are willing to accept, what they anticipate might occur with respect to law changes (or not), and the cost and complexity they are willing to incur in light of such uncertainty.  The tax forest certainly is particularly scary right now, but the best shot at finding the wizard, is to assemble your advisory team: estate planning attorney, CPA, insurance consultant, wealth adviser, and more, and craft a plan that you feel best keeps you safe from the Taxing lions, and taxing tiger and taxing bears.

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