The House Ways and Means Committee recently released a draft of the tax changes proposed as part of the budget reconciliation bill to implement President Biden’s social and education spending programs. While there are likely to be modifications, the draft provides the first detailed look at the estate and gift tax provisions being proposed to fund the new programs.
The proposed changes differ dramatically from the Biden administration’s earlier proposal unveiled in April. That earlier proposal — termed the American Families Plan — would have left the estate tax exemption and rate untouched in favor of taxing unrealized gains upon death or gift and eliminating the “step up” in basis that occurs upon passing under current law. However, the current proposal contains no mention of taxation of unrealized gains upon death or changes to the basis rules. Instead, it contains three primary changes affecting estate and gift taxes:
- Estate and gift tax exemption: The proposal reduces the exemption from estate and gift taxes from $10,000,000 to $5,000,000, adjusted for inflation from 2011. This means the current inflation-adjusted exemption of $11,700,000 per person would be reduced to approximately $6,000,000 per person for transfers occurring after December 31, 2021. The reduction of the enhanced exemption was already scheduled to occur on January 1, 2026, so this proposal accelerates that reduction by four years.
- Tax status of grantor trusts: Grantor trusts (those trusts for which the creator of the trust continues to be responsible for the income tax liability of the trust) would be included in the grantor’s taxable estate. In addition, sale transactions between a grantor and a grantor trust would be subject to income tax, whereas those are disregarded transactions under current law.
- Valuation discounts: Valuation discounts that reduce the value of a gift would be disallowed for gifts of entities holding non-business assets.
While the reduction in the estate tax exemption would not be effective until the beginning of next year, the changes to grantor trusts and valuation discounts would be effective as of the date of enactment of the new law. This could mean that the opportunity to implement some popular wealth transfer techniques could expire in a matter of weeks.
Grantor trusts have long been one of the most powerful and tax-efficient wealth transfer vehicles utilized by high-net worth taxpayers. Because the grantor of the trust continues to pay taxes on any income generated by the trust (with the income tax payments reducing the taxable estate), the value of the trust assets is able to grow and compound without being diminished by income taxes. In addition, the grantor can sell assets to the trust — often in exchange for a promissory note with a low interest rate — with the transaction being disregarded for income tax purposes, meaning it’s not subject to capital gains taxes or recognition of interest income.
Many families use family LLCs or limited partnerships to consolidate family investment assets, provide for cohesive and efficient management of those assets, and create an educational tool for younger generations. Currently, gifts of fractional interests of those entities are eligible for valuation discounts, reducing the value attributed to a gift or sale of those interests. Because the owner of a non-controlling interest in such an entity typically doesn‘t have any rights to distributions and is restricted from selling the interests, the fair market value of the fractional interest is less than the pro-rata value of the underlying assets. Under the new proposal, these valuation discounts would no longer be available for entities holding non-business assets such as marketable securities.
Since the enactment of the Tax Cuts and Jobs Act in 2017 — which doubled the exemption from estate and gift taxes through 2025 — many taxpayers have taken a “wait and see” approach before implementing large lifetime gifting transactions. While we don’t know if or when the proposed changes will be enacted, families should consider accelerating any gifting plans to take advantage of the current favorable estate and gift tax laws. In addition, the benefit of some commonly used wealth transfer strategies could be eliminated or substantially reduced, potentially even before year-end. Families who are likely to be subject to the estate tax should contact their advisors to discuss their planning options. As always, if you have questions, give us a call.
