A bulletin for friends and clients of the Seward & Kissel Trusts and Estates Group

We hope everyone who receives this bulletin is safe and healthy.

Summary of Key Points

• The House Ways and Means Committee’s recent tax proposals (the “Bill”) are not currently the law, but the fact that they may be enacted into law in the near future, even as soon as in the next few weeks, suggests that friends and clients should consider undertaking estate planning transactions now that will no longer be available if the Bill passes, such as the creation and funding of grantor trusts, as well as gifts and sales using valuation discounts on certain entity interests. These techniques are described in further detail below. The Bill’s most significant income tax and retirement account provisions will be summarized in a separate bulletin that you will be receiving shortly.
• To avoid the risk of missing opportunities in the rush that will ensue if the Bill continues to gather momentum, friends and clients interested in maximizing their wealth transfer opportunities should contact us without delay so that we can devise a proactive strategy responsive to their specific situation, the currently advantageous wealth transfer environment, and the potential imminent changes to the tax laws. The primary opportunities include:
• •  Prior to the Bill’s enactment date:
    • Creation and funding of grantor trusts.
    • Creation and funding of trusts for the benefit of your spouse.
    • Sale of appreciated assets to a grantor trust.
    • Gifts or sales of interests in any entity holding passive assets in order to receive a discount.
    • Pre-funding of insurance premiums on policies held in insurance trusts.
  • Prior to the end of the year:
    • Using your remaining gift, estate and GST exemption before they are halved.
• The Bill’s passage, however, is not guaranteed, and neither is its timeline for passage; and even if it is enacted into law, the provisions contained in the enacted law may differ significantly from the initial proposals contained in the Bill. We will keep you informed of any important developments.

The Bill

On Monday, September 13th, the House Ways and Means Committee released legislative text (again, the “Bill”) of proposed tax reforms to be incorporated into the $3.5 trillion tax-and-spending reconciliation legislation that is the centerpiece of President Biden’s economic agenda. According to an analysis by Congress’s Joint Committee on Taxation, the Bill’s proposed tax reforms would raise $2.1 trillion over the next ten years, with roughly $1 trillion raised from tax increases on high-income Americans and nearly $1 trillion raised from corporate and international tax reforms.

Democrats aim to pass the reconciliation legislation without Republican support under budget reconciliation rules. To do so, they cannot afford to lose any Democratic votes in the Senate, but can afford to lose three votes in the House. Moderate and progressive wings of the Democratic party appear to be divided over the scale of spending, however. Moderate and conservative Democrats, including two Senate Democrats, Joe Manchin of West Virginia and Kyrsten Sinema of Arizona, have objected to the $3.5 trillion price tag. Manchin proposes spending less than half that amount (and Sinema has not publicly expressed her demands). By contrast, some progressive Democrats in the House say they cannot support a bill with lower spending levels.

Given the tensions within the Democratic party, its razor-thin majorities in both chambers, and the staunch Republican opposition to the Bill, the Bill may need to be modified for it to be enacted into law. Some commentators have suggested that the Bill is a starting point for negotiations, and probably represents the worst-case scenario. Nonetheless, some or all of its provisions may become law.

On Monday, October 4th, Senate Majority Leader Chuck Schumer wrote to Senate Democrats that compromises would need to be made, but that he believed the Bill would be passed by the end of October. Of course, the timing of any changes to the law is very uncertain, and there could be months of negotiations on the horizon as the Bill makes its way through both chambers of Congress. There is not yet even a counterpart to the Bill in the Senate as of the date of this bulletin.

The Bill’s Most Significant Provisions Affecting Estate Planning

The Bill’s most significant income tax and retirement account provisions will be summarized in a separate bulletin that you will be receiving shortly. For estate planning purposes, the Bill’s most significant provisions (the impact of each of which can be mitigated if timely action is taken) are as follows:

Decrease in estate and gift tax exemption. The estate and gift tax exemption would be reduced from its current amount, which is $10 million adjusted for inflation from 2010 (or $11,700,000 in 2021), to $5 million adjusted for inflation from 2010 (which is estimated to be approximately $6,030,000 in 2022). This change would be effective January 1, 2022.

Changes to income and transfer tax rules applicable to grantor trusts. Under current law, taxpayers can create so-called “grantor” trusts, which have the following significant estate planning benefits (among others):

• Although transfers to a grantor trust are subject to gift tax, assets in the trust are not subject to estate tax, and distributions from the trust to beneficiaries are not subject to gift tax. This means that post-transfer appreciation in assets transferred to a grantor trust avoids estate and gift taxation (which provides a benefit over retaining the assets personally, since appreciation in the assets would be subject to estate taxation if the property were retained by the transferor rather than transferred to the grantor trust).
• The transferor may engage in transactions with the trust, such as sales, purchases and exchanges, without giving rise to a taxable event. For example, the transferor may sell appreciated property to the trust, or purchase appreciated property from the trust, without the transferor or the trust having to pay any capital gains or ordinary income tax.

The Bill eliminates these benefits of grantor trusts. The assets of a grantor trust would become subject to estate tax in the transferor’s estate on death, and distributions from the trust to beneficiaries would be subject to gift tax. Additionally, sales and exchanges between transferors and grantor trusts would be taxable events for income tax purposes. Under the current language of the Bill, these changes would be applicable to trusts created, and to portions of trusts funded, after the date of enactment of the Bill (the “Enactment Date”); please note, however, that a Congressional report summarizing the Bill appears to state that the drafters’ intent is for sales and exchanges with even pre-Enactment Date grantor trusts to be subject to gain realization, and that a technical correction to the language of the Bill may be necessary to reflect this intent.

Elimination of valuation discounts for interests in entities containing passive, nonbusiness assets. Under current law, taxpayers may fund an entity (typically, an LLC or limited partnership) with investment assets (such as stocks, bonds, fund interests, etc.) and make gifts of fractional interests in the entity that are subject to substantial valuation discounts for lack of control and lack of marketability. For example, a taxpayer may fund an LLC with $10,000,000 of securities and transfer a 20% interest in the LLC to her child. Given the lack of marketability and lack of control associated with the 20% interest, it may be valued at less than $2,000,000 for gift tax purposes (a 20% lack of marketability and lack of control discount would result in a gift tax value of only $1,600,000 for the gift, shielding $400,000 from gift tax). Similarly, if a transferor dies holding a 20% interest in such an entity, for estate tax purposes, the 20% interest would likely be discounted for lack of control and marketability.

The Bill eliminates this kind of valuation discount planning. To the extent that entities contain passive, nonbusiness assets (i.e., cash or cash equivalents, equity or debt securities, real property (with exceptions for active real estate trades and businesses in which the transferor participates significantly), commodities, royalty property, annuities, collectibles, personal property, and other assets specified in regulations, which are held for the production or collection of income and are not used in the active conduct of a trade or business), no valuation discounts would be allowed with respect to the value of the entity attributable to such nonbusiness assets. This change would be effective for transfers made after (and, presumably, to estates of decedents dying after, although the bill does not specify this) the Enactment Date.

Wealth Transfer Opportunities

Given the proposals contained in the Bill, friends and clients who are interested in maximizing wealth transfer opportunities should consider the following estate planning options.

Creation and Funding of Grantor Trusts

Based on the wording of the Bill, it appears that grantor trusts created and funded prior to the Enactment Date will be “grandfathered,” meaning that the favorable transfer tax and income tax rules applicable to grantor trusts under current law would continue to apply to grandfathered trusts even after passage of the Bill. If you have remaining exemption, you can fund these trusts with gifts prior to the Enactment Date. If you do not have exemption remaining, you can loan cash or sell assets to these trusts. (A sale to a trust via a promissory note can allow you to shift to your descendants future appreciation in asset values in excess of the interest rate on the note, free of gift or estate tax. Applicable interest rates are currently quite low.) In either case, you can take advantage of valuation discounts that would not be available after the Enactment Date. Please note, however, that repayment of a note using appreciated property would trigger realization of capital gains if occurring after the Enactment Date.

Creation and Funding of SLATs

A spousal lifetime access trust, or SLAT, is a special type of grantor trust by which a taxpayer can use his or her exemption while leaving open the possibility for the client’s spouse to continue to benefit from the trust. This type of trust can be ideal for clients who are reluctant to completely relinquish all beneficial interests in property transferred to a trust. Under the Bill, SLATs would need to be created and funded prior to the Enactment Date to remain effective.

Gifts and Sales Using Valuation Discounts on Entity Interests

You may want to consider forming LLCs containing passive, nonbusiness assets and making gifts of fractional interests in these entities at discounted gift tax values. As described above, this technique can be combined with the creation and funding of grantor trusts. Under the Bill, these gifts would need to be completed prior to the Enactment Date.

Pre-Funding Insurance Trusts

Under the Bill as currently drafted, annual “Crummey” contributions to insurance trusts could “taint” the trust, causing a portion of the trust assets to become subject to estate tax. You may therefore want to consider how such premiums could be funded in the future. Options include (1) prepaying several years worth of premiums (which would use up your lifetime exemption from gift and estate tax) prior to the Enactment Date, (2) making loans to the trust, which may not be possible depending on the assets owned in the trust, and (3) entering into split-dollar arrangements.

Other Gifts to Make Use of Remaining Exemption

Estate planners often encourage their clients who have sufficient wealth to make lifetime use of their estate, gift and GST tax exemptions, so that future appreciation in the gifted assets will not be subject to transfer taxes. That advice is all the more salient now, given the possibility of an imminent reduction in exemption amounts. There is slightly less time pressure on this objective, given that the current exemptions would remain in effect until end of 2021 under the Bill (although any gifts that will involve valuation discounts on interests in entities holding passive, non-business assets should be completed prior to the Enactment Date, as noted above).

GRATs and CLATs

If you have already used most or all of your estate and gift tax exemption, or if you are worried that ongoing market volatility could further reduce the value of any gifted assets, a GRAT may be worth considering. GRATs are a kind of trust that allows appreciation in trust assets—to the extent they outperform an IRS-determined interest rate—to be transferred to the beneficiaries of the trust free of gift tax. This IRS-determined interest rate is currently quite low, at just 1.03% for September 2021 and 1.09% for October 2021. When the rate is this low, it is much easier for the assets in a GRAT to outperform that benchmark, and thus for clients to transfer wealth to their descendants free of gift and estate tax. For clients who wish to take advantage of the low-interest rate environment to benefit charitable causes as well as their descendants, a similar estate planning vehicle called a CLAT allows assets, plus interest at the aforementioned IRS-determined rate, to be transferred to charity, while appreciation in the value of those assets in excess of the IRS-determined rate is transferred to the client’s descendants free of gift tax. If the CLAT is structured as a grantor trust, the gift to the CLAT (called, in this case, a “grantor CLAT”) can qualify for the charitable deduction.

GRATs and grantor CLATs are grantor trusts, and therefore under the Bill would not be effective wealth planning strategies after the Enactment Date (although future modifications to or clarifications of the Bill could change this). In addition, based on a Congressional Report summarizing the Bill, it appears that the current intent of the Bill’s drafters is to have payments of GRAT annuities with appreciated assets treated as income taxable events, even if the payments are made from pre-Enactment Date GRATs. Accordingly, clients who would like to undertake GRAT or grantor CLAT planning should create and fund these trusts before it is too late, and they should undertake GRAT planning only if they are willing to bear the possible future income tax on annuity payments, or if the GRAT assets will generate sufficient cash or liquidity to make the annuity payments.

Importance of Planning Now

Many of the wealth planning opportunities summarized above will not be available if and when the Bill is enacted into law, which could occur as soon as in the next few weeks (although the timing of any changes to the law is of course very uncertain, and there could be months of negotiations still to come); all of the opportunities summarized above can represent good tax planning (depending, of course, on one’s individual circumstances), even if the Bill is never enacted into law. For these reasons, we encourage friends and clients to contact us now to review their estate plans in light of the potential tax law changes contained in the Bill.

As previously stated, however, the provisions contained in the Bill are not law, and may never become law; and the provisions of any law resulting from the Bill may differ materially from the provisions summarized herein. We will keep you informed of any significant developments.