On September 15, 2021, the House Ways and Means Committee (House W&M) passed out their 881-page proposed tax legislation (Proposed House Bill) to fund President Biden’s “Build Back Better” plan. This is an important step in the multi-step process toward the enactment of potentially massive tax legislation. For more background on this topic, we recommend that you go back and read our newsletter on this subject published in June 2021.
This newsletter will review what we learned from the Proposed House Bill, including the good, the bad and the very ugly. Be sure to check out our eight planning tips throughout this newsletter. Of possibly extreme importance is your need to review the section near the end discussing the “very ugly” from the Proposed House Bill, especially if you currently have or plan to create an irrevocable grantor trust, which could be as simple as having an irrevocable trust owning one of your life insurance policies. This is a very big deal!
A. The Good
The good was that the House W&M did not include most of the tax law proposals that would have fundamentally changed how our tax system has historically functioned, including for example:
(1) death being treated as an income taxable event.
(2) a gift being treated as an income taxable event.
(3) elimination of the so-called, “step-up in income tax basis” at death.
(4) contributions to and distributions from (partnership taxed) business entities being treated as income taxable events.
(5) trust assets being treated as if sold (deemed sale) every 90 years, with the clock starting on January 1, 1940.
(6) full social security taxation on compensation above $400,000.
(7) S corporation business profits being treated as compensation subject to employment taxation.
B. The Bad
The bad was that the House W&M included many significant tax law changes:
(1) Estate planning related taxation
a. Gift & estate tax exemption amount (known as the Basic Exclusion Amount or BEA) and, presumably, the GST tax exemption amount. The BEA was increased from $5 million (indexed for inflation) to $10 million (indexed for inflation) in the 2017 Tax Act. Under the terms of the 2017 Tax Act, the BEA was to automatically revert back to the prior $5 million (indexed for inflation) amount as of January 1, 2026. This reversion back to $5 million (indexed for inflation) is now to take place as of January 1, 2022.
[Planning Tip 1: The only voluntary way to effectively use the temporary portion of the BEA is to make a taxable gift before the effective date. Further, and as discussed below, if the gift is to be made to one or more grantor trusts, it needs to be completed before the effective date of such tax legislation.]
b. Grantor Trust Rules. This is the elephant in the room! It may sound technical in nature, but its practical effect is huge. Please see the below discussion on the very ugly.
c. Valuation discounts related to non-business assets. Valuation discounts, including lack of marketability and lack of control, will only be permitted for active trade or business assets, and even if an entity is actively involved in a trade or business, it’s passive assets not used in the active conduct of the trade or business are prohibited from being discounted.
[Planning Tip 2: While interests in operating companies may still qualify to use valuation discounts, passive assets will not. As a result, passive assets that may currently qualify for such valuation discounts should be gifted before the effective of such legislation if valuation discounts are deemed important.]
(2) Individual income taxation.
[Planning Tip 3: You may want to seek immediate and ongoing guidance from your CPA or other tax professionals to assist in income tax planning based on the changes in the Proposed House Bill.]
a. Income tax rates and brackets. The top marginal income tax rates will be going up from 37% to 39.6% for individuals earning above $400,000, for married couples filing jointly earning above $450,000, and for non-grantor trusts accumulating above $12,500. While the increase in the top marginal tax rate was not a surprise, it was a surprise that the highest marginal tax rate kicks in at a much lower income threshold. For example, for 2021, singles do not hit the highest marginal tax rate until $523,681 and married couples filing jointly do not hit the highest marginal rate until $628,301. So, while the increase in the top marginal tax rate is not too big of a deal, the change in the brackets makes it way worse for many. These provisions are to apply for tax years beginning after December 31, 2021.
b. Capital gain and qualified dividend tax rates. The top capital gain and qualified dividend tax rates increase from 20% to 25%. Worse news for some is that this higher top tax rate becomes effective for transactions after September 13, 2021, unless the transaction was entered into on or before September 13, 2021, and it was not materially modified after September 13, 2021. Those subject to this higher tax rate will also likely be subject to the 3.8% NIIT (see below), and possibly for a big earnings year for some, an additional 3% surtax (see below). The good news is that this tax rate could have been as high as the top ordinary income tax rate of 39.6% plus the 3.8% NIIT, as had been previously proposed.
c. 3.8% Net Investment income tax (NIIT). The 3.8% NIIT on passive investment earnings was created to help pay for Obamacare. This extra tax will now be expanded to apply to income earned in the ordinary course of a trade or business (i.e., net income or profits) for single individuals above $400,000 and married couples filing jointly above $500,000 of modified adjusted gross income. This will potentially affect owners of pass-through entities and sole proprietorships, i.e., closely held business owners. These provisions are to apply for tax years beginning after December 31, 2021.
d. New 3% surtax for high income earners. An additional 3% surtax is to apply to modified adjusted gross income above $2.5 million for married individuals filing separately and $5 million for other individuals and married couples. For non-grantor trusts, the 3% surtax applies to accumulated (undistributed) modified adjusted gross income above $100,000. This surcharge would apply for tax years beginning after December 31, 2021.
e. Section 199A 20% deduction on qualified trade or business income for pass-through entities. This 20% deduction is to have a lower income cap of $400,000 for single individuals, $500,000 for married couples filing jointly, and $10,000 of accumulated income for non-grantor trusts. This new cap will apply for tax years beginning after December 31, 2021.
f. Exemption of gain on Qualified Small Business Stock. The exclusion of gain on the sale or exchange of such stock on or after the effective date of September 13, 2021 (subject to an exception for binding contracts in place before the effective date) will be limited to a maximum of 50% for those with adjusted gross income equal to or exceeding $400,000.
g. Syndicated conservation easements. With some limited exceptions, no charitable deduction will be permitted for conservation easements where a pass-through entity was utilized and the taxpayer (contributor) to the entity is to be allocated a charitable contribution equal to more than 2.5 times the (tax basis in the) amount contributed by the taxpayer to the entity. This provision is to apply to contributions made after December 23, 2016, based on IRS Notice 2017-10. This is intended to kill the syndicated conservation easement industry and enable the IRS to have an easier time going after those who participated in this perceived abusive tax shelter.
[Planning Tip 4: If you invested in such a conservation easement entity after December 23, 2016, you should seek professional guidance on how to proceed.]
h. Carried Interests. This issue will never die. The carried interest strategy effectively enables owners/managers of pass-through entities to turn future compensation for future services rendered into long-term capital gains. Instead of killing this strategy, Congress talks a big game and then adds in some small difference in the law. The new proposal is to change the required holding period from three years to five years for the acquired interest to achieve long-term capital gain status.
i. Wash sales rules. The wash sales rules will now apply to commodities, currencies and digital assets. This is Congress starting to equalize the treatment of cryptocurrencies (and other non-traditional investment/financial assets) with the treatment of traditional financial assets. The wash sales rules currently prevent a seller of a security from recognizing a loss on the sale if the same type of security is repurchased within 30 days.
(3) Retirement Plans, IRAs & Roth IRAs. Various provisions are being proposed to help prevent the accumulation of large IRA & Roth IRA accounts.
a. Prohibit after-tax contributions to retirement plans and IRA accounts from being converted to a Roth IRA. This provision is to be effective for distributions, transfers and contributions made in taxable years beginning after December 31, 2021.
[Planning Tip 5: If you or your spouse made after-tax contributions to an employee benefit plan, you should strongly consider taking the necessary steps to fully convert these amounts to a Roth IRA account before the end of 2021. Employee benefit plans will normally treat over withholdings to 401(k) accounts as after-tax contributions.]
b. Roth conversions will once again have an income limit. Roth conversions will be permitted for single individuals with less than $400,000 in income and for married couples filing jointly with less than $450,000 of income. The effective date for this new requirement may be deferred to December 31, 2031, to enable the government to collect more revenue on Roth conversions.
[Planning Tip 6: Considering the various proposed income tax changes, renewed consideration should be given to converting at least part of your IRA accounts to Roth IRA accounts, assuming you have the necessary funds to pay the resulting income taxes with funds outside of any IRA, Roth IRA or other retirement plan account.]
c. Contributions prohibited and enhanced required minimum distributions (RMDs) for extra-large accounts. These provisions include: (i) no further contributions to IRA and Roth IRA accounts when total IRAs, Roth IRAs and defined contribution retirement accounts total over $10 million in assets as of the end of the previous tax year and if meet a certain income threshold; (ii) an individual with IRAs, Roth IRAs and defined contribution retirement accounts with over $10 million in total in these accounts as of the end of the previous tax year must distribute out 50% of the excess to the owner; and (iii) other complex distribution rules apply if the IRA, Roth IRA and defined contribution retirement accounts exceed $20 million in assets.
d. Significant new limits on the types of assets that can be owned by an IRA account.
i. Subject to a two-year transition period (with application to tax years beginning after December 31, 2021) IRAs may lose their tax-exempt status if they own any security that requires the IRA owner to have a certain amount of assets or income, a certain level of education or a certain license or credential.
ii. IRAs may lose their tax-exempt status if they own an interest in any privately held corporation, partnership, trust or estate in which the account owner owns at least 10% of such entity or serves as an office of such entity.
[Planning Tip 7: These IRA investment restrictions could be a very big deal for anyone using a non-traditional IRA custodian that enables you to invest in non-traditional assets.]
(4) Corporate tax rates for income earned after 12/31/2021.
a. Tax rate on the first $400,000 is lowered to 18%, the tax rate between $400,000 to $5 million stays at 21%, but the tax rate on income above $5 million increases to 26.5%. An additional income tax is charged on income above $10 million equal to the lesser of 3% or $287,000.
b. Qualified personal services corporations are to be taxed at a flat 26.5% rate.
C. The Very Ugly!
The Proposed House Bill sets out several technical provisions with the purpose of fundamentally changing how the grantor trust rules work as to irrevocable trusts. These are by far the worst provisions in the Proposed House Bill, not because they raise the most tax revenue, but because they are intended to end modern gift and estate tax planning as we have known it since at least the 1980s. These provisions also require anyone who previously set up an irrevocable grantor trust (including irrevocable trusts set up to simply own life insurance) to consider and complete any steps that may need to be taken before the effective date of such tax legislation to avoid future potential tax issues.
(1) Background on grantor trust status.
If you wish to take steps during your life to reduce your eventual estate tax liability, you may need to do some type of irrevocable gifting. These types of gifts normally require you to give up most or all legal control and access to the gifted assets. As a result, most people are not willing to permanently part with a significant portion of their assets. Estate planners discovered long ago that we could use grantor trusts (trusts treated as the creator/grantor for income tax purposes) to enable incredibly flexible gifting, so that most wealthier individuals would be much more willing to make gifts to such trusts. These types of trusts are structured in myriad ways in order to achieve particular benefits, and have various names, such as irrevocable life insurance trusts (ILITs), family gifting trusts (FGTs), spousal limited access trusts (SLATs), grantor retained annuity trusts (GRATs), grantor charitable lead annuity trusts (grantor CLATs), qualified personal residence trusts (QPRTs), and domestic asset protection trusts (DAPTs). Some trust types are even creatures of federal tax statutes, such as GRATs, grantor CLATs, and QPRTs. If the proposed rules are enacted, these types of trusts will no longer serve their intended purposes, at least when it comes to federal tax law, and they may put taxpayers in a much worse tax position if they chose to gift in trust.
(2) Grantor trust rules change radically.
The proposed rule changes are technical in nature, but suffice it to say, grantor trusts will no longer serve their currently intended purposes, at least when it comes to federal tax laws. Estate planners will eventually come up with other planning options, but they may never be anywhere near as flexible as the use of grantor trusts under current law.
(3) Effective date and grandfathered status.
The effective date of these proposed changes is the date of enactment, and not simply January 1, 2022. This could be a very big deal. The Democrats currently intend to enact this proposed legislation, in its final form, before the end of 2021. At least to some extent, an irrevocable grantor trust in existence before the date of enactment is to be considered grandfathered to the extent it owns assets before the date of enactment. In other words, for anyone who has or wants to create such a trust, it needs to be in existence and fully funded before the date of enactment. While the trust will be able to change its investments, you should expect that no additional contributions to the trust will be permitted without at least partially terminating its grandfathered status. Grandfathered trusts will be able to continue utilizing at least some of the existing grantor trust rules.
(4) Switching assets or sales of assets between the grandfathered grantor trust and its creator/grantor.
While it is not clear, even grandfathered trusts may no longer be able to transact with their grantor in arm’s length transactions without having an income taxable event. Under current law, a creator/grantor can buy/sell, lease from/lease to, and borrow from/loan to their grantor trust without any income tax effect, since it is treated as if the creator/grantor is transacting with themselves for income tax purposes. If a creator/grantor of a grandfathered trust will no longer be able to transact with their grandfathered grantor trust, then switching out assets in the trust may cause an income taxable event. As a result, anyone who intends to have a grandfathered trust after the date of enactment should act now to ensure that they are happy with the assets it currently contains.
(5) Need to sufficiently fund existing grantor trusts to enable it to pay its future life insurance premiums and any other future obligations.
Because it may become much more difficult to get assets into a grandfathered grantor trust so it can pay its future obligations without negative tax consequences, sufficient funds or other assets should be contributed to the trust before the date of enactment to reduce the risk of this causing a future tax problem.
For example, if the grandfathered trust ends up needing funds to pay future life insurance premiums on a life insurance policy owned by the trust, then you may be able to loan the necessary funds to the trust. However, while such a loan may end up causing taxable interest income to you, you may not be able to fully deduct the related interest payments to offset this taxable income. In other words, such a loan may end up creating phantom net taxable income.
[Planning Tip 8: Anyone that has an existing irrevocable grantor trust needs to take steps to sure that you are happy with the character and amount of assets that it owns, considering that you may not be able to change or add to these assets in the future without it causing negative tax consequences. It should be emphasized that if you created an irrevocable trust to own one or more life insurance policies, you need to seek professional guidance on if and to the extent that you may need to add assets to such trust before the effective date of any such new tax legislation.]
If you would like to learn more about how the Proposed House Bill may affect you, please call our offices at (678) 720-0750 or e-mail us at email@example.com to schedule an estate planning consultation.