Time is of the Essence for High-Net Worth Estates
Potential Changes in Estate Tax Laws
You may have heard about the most recent House proposal in September, 2021 that addresses changes to the tax law, which will cover the costs of a massive ($3.5 trillion) proposed spending package. There have been various proposals since President Biden was elected that target an increase in various taxes. Until now, none of the prior proposals have successfully passed. This might be a different scenario.
Brief Summary of Recent Estate Tax History
Most of the current popular tax concerns, such as income, estate, gift, and corporate taxes, are governed by the Tax Cuts and Jobs Act (TCJA). The TCJA was effective as of January 1, 2018 and is set to sunset on December 31, 2025. The sunset provision means that the tax laws that were in effect on December 31, 2017 will again govern beginning in 2026.
The current (i.e., 2021) estate tax exemption is a whopping $11,700,000 per person, which can be doubled for married spouses with intentional planning for a total of nearly $24,000,000. The estate tax exemption generally increases each year for inflation. Under the TCJA, the increased exemption will revert back to 2017 exemption of $5,490,000, adjusted for inflation, or approximately $6,000,000, beginning on January 1, 2026.
What is important in the House Proposal for Estate Tax Planning?
I. Capital Gains Taxes Increase
The rate of capital gains will increase to 25%, which is 5% higher than the current 20%. The 25% is closer in line to what it was prior to the TCJA. Capital gains taxes are an important consideration when transferring or selling assets during life. The 5% increase may be substantial for assets that have significant built-in capital gains. Two common scenarios are real estate and small businesses.
For example, if someone purchased real estate 30 years ago with an adjusted cost basis of $150,000, and the property is now worth $2,000,000 (i.e., built-in gains of $1,850,000), the 5% increase in capital gains results in $92,000 more in capital gains tax, for a total capital gains tax of $462,500. This is only FEDERAL capital gains tax. If you live in an area such as New York City, you can add up to 25% to the capital gains tax without taking advantage of other estate planning tools (i.e., Delaware Asset Protection Trusts, 1031 Exchange, Charitable Trusts, etc.).
What to do: Discuss with your attorney or accountant whether certain assets might benefit from being sold this year while the capital gains tax is still at the lower rate.
II. Federal Estate Tax Exemption Reduced Sooner than 2026
As summarized above, the current estate tax exemption is set to expire December 31, 2025 and reduced to 2017 levels of approximately $6,000,000. The Proposal would accelerate the effective date to January 1, 2022.
For estates that are greater than $6,000,000, they will essentially lose an equivalent amount that can be given away estate tax-free during life or at death.
What to do: Discuss with your attorney how to reduce your estate by making gifts or otherwise transferring portions of your estate while the exemption is still $11.7 million.
III. Grantor Trust Rules for Income Tax Purposes will be Eliminated
Trusts which are treated as owned by the Grantor for income tax purposes (i.e., Grantor Trusts) will be deemed as owned by the Grantor for estate tax purposes as well. This means that most common trusts used for estate tax planning purposes will be included in the Grantor’s taxable estate. This includes Grantor Retained Annuity Trusts (GRAT), Irrevocable Life Insurance Trusts (ILIT) or Spousal Lifetime Access Trusts (SLAT), just to name a few.
Explanation of Grantor Trusts
Grantor Trusts are a great tool for estate planning in that it allows the Trust assets to grow without the Trust assets being utilized to pay the Trust’s annual income tax. In addition, as the Grantor pays the Trust’s income tax annually, the Grantor’s estate continues to be reduced. Any assets in the Trust are excludible from the Grantor’s estate as it is considered a completed lifetime gift.
Under the Proposed rules, any Grantor Trusts created after the effective will be included in the Grantor’s estate for estate tax purposes. In addition, existing Grantor Trusts that receive additional contributions will also be included in the Grantor’s estate. The timing is for any trust that is created after the EFFECTIVE DATE, which is the date the proposal is approved (could be in 2021).
What to do: Discuss with your attorney whether you should URGENTLY CREATE AND FUND certain trusts before the EFFECTIVE DATE. Remember, under the current rules, the effective date might be earlier than January 1, 2022. Any delay can create a significant impact in the amount of estate taxes that your estate might have to pay when you die.
IV. Other Proposals that Might Impact Estate Planning
Valuation Discounts May be Eliminated
Many individuals have an interest in a corporation or limited liability company for purposes of liability protection and not for running an operating business. Under the current rules, discounting for these types of assets may be eliminated.
What to do: Make an inventory of your current holdings and determine with your attorney or accountant which ones are operating a business and which are being held for non-operating purposes. Determine if any changes can and must be made.
Back-Door IRA Conversions May be Limited
Current law does not allow individuals to make contributions to a Roth IRA if their income exceeds a certain level. However, these same individuals can get around the limitation rule by first contributing to a non-deductible traditional IRA and then converting to a Roth IRA. The primary benefit of a Roth IRA is that any increase in value over time is not includible in the annuitant’s income taxes when withdrawals are made during retirement. The Proposal would disallow Roth conversions for taxpayers whose taxable income exceeds $450,000 for married taxpayers filing jointly or $400,000 for single taxpayers or married taxpayers filing separately.
What to do: Discuss with your financial advisor your options in converting certain traditional IRA account to Roth IRA accounts and with your accountant the tax impact of the conversion.
Take Action Now
There are many other proposals that impact various areas of the tax law. Some have more chance of being adopted than others. However, it is very likely that a change will affect and limit estate tax planning options.
If you have any questions on the areas of the tax law that impact your estate and asset planning, please do not hesitate to contact me.