In general, estate planning is not what people wake up and want to chat about. However, this year there is plenty of news around the changes to tax policy that should be motivating you to start the dialogue and/or get educated on how the changes may impact you and your family. Between the prospect of rising income and capital gains tax rates, a decreasing estate tax exemption, potential changes to grantor trust taxation and the frequently discussed loss of step-up of basis at death, there are plenty of reasons to get reacquainted with your plan and to review the opportunities which may be forfeited if legislation is passed in its current form.
Even if you decide not to partake in additional planning, it is better to make that decision your choice, rather than have it removed as an option down the road without considering it. Some of the proposed changes would challenge systems that have been in place for decades, however, it is important to keep in mind that negotiations will alter many of these proposals over coming months.
While premature to assume any of the proposals will even be passed, any one of the changes outlined below may significantly impact future planning. There has not been a better time to initiate conversations about your estate, generational wealth transfer and the impact of these changes on both. Having the right team around you to support your education, decision and ultimate execution and administration is crucial. Below are several proposed changes that should be driving you to meet with your team, or to put one together:
1. Estate Tax Exemption Reduction
Under current law, the estate tax and GST (Generation Skipping Tax) exemptions sit at $11.7 million, having been increased to that level by the TCJA (“The Tax Cuts and Jobs Act of 2017”). However, the current exemption is set to sunset in 2026, reverting to $5 million (inflation-adjusted), barring any other changes prior. Individuals can also currently gift $15,000 per person ($30,000 per couple) to as many people as they wish under current annual exclusion rules.
Surprisingly, Biden has provided no specific proposals regarding changes to the federal gift and estate tax rules. However, the change to the estate tax levels is still being targeted and was recently addressed in the For The 99.5% Act introduced by Bernie Sanders. This proposal would bring the exemptions to as low as $3,500,000 per person. While more uncertain than before, it is not unreasonable to expect that we see multiple iterations of tax policy changes. As such, wealthy taxpayers should consider using their exemptions in 2021 to take advantage of elevated levels and immediately schedule an advisory review with your advisory team.
2. The Loss of the Step-Up in Basis at Death
Under current law, upon passing, a decedent’s assets (owned in their estate) get a step-up in cost basis to the fair market value at death. This step-up provides for the reduction to any potential capital gains that may arise from a possible future sale by those inheriting it. The step-up rule is extremely beneficial to those holding long-term, highly appreciated assets such as concentrated positions, businesses &/or real estate. Assets held in most irrevocable trusts do not get a step up.
Changes to the current step-up rule were proposed within the American Families Plan. Under this proposal, inherited capital gain assets with an existing gain of $1,000,000 or more ($2,500,000 per couple), would no longer benefit from the step-up. Some exemptions for this rule may exist for family-owned businesses, charitable gifts and/or farms. Regardless of whether you qualify for a potential exemption, it seems certain that the estate tax would still apply.
3. The Impact on Grantor Trust Planning
Under current law, a grantor can transfer assets to a trust and retain certain powers over the administration of the trust. Such controls include things such as the power to exchange trust property with other assets of equal value, causing it to be “defective” for income tax purposes (meaning, any income earned by the trust is taxable to the grantor instead of the trust or its beneficiaries). The tax payments paid on behalf of the trust by the grantor are not treated as a gift, thereby providing tax-free growth of the trust assets and a decrease in the value of the grantor’s estate without impacting the estate tax exemption. Upon the grantor’s death, the trust assets are not typically included in the grantor’s estate.
The proposed changes to grantor trust rules will effectively tax grantor trust assets as if the grantor owned them at the time of their death. Any distribution of appreciated property from a grantor trust to anyone other than the grantor would be deemed to be a sale, and a capital gains tax would be imposed at the time of transfer. This would affect both GRAT (Grantor Retained Annuity Trust) and QPRT (Qualified Personal Residence Trust) planning opportunities.
4. Increase to Capital Gains Tax Rate to Ordinary Income Tax Rates
Under current law, long-term federal capital gains rates are advantaged rates that are lower than ordinary income tax rates.
The proposed changes would tax long-term capital gains and qualified dividends at ordinary tax rates for taxpayers whose adjusted gross income (AGI) exceeds $1 million. For qualifying taxpayers, this modification would tax long-term capital gains and qualified dividends in the same manner as short-term capital gains and ordinary dividends, respectively. The 3.8% net investment income tax would likely continue to apply to investment income, which would then subject applicable taxpayers to a maximum federal income tax rate of 43.4% if passed in its currently proposed form. The immediate consideration that comes to mind is to contemplate the sale of certain assets in 2021 in anticipation of tax changes rather than deferring the gain to 2022 or beyond. However, there are other potential implications, including the negative impact to deferred cap gains on Qualified Opportunity Zone investments or other tax-deferral strategies that may expose a gain to a significantly higher rate in the future. That said, there are multiple planning opportunities that can be considered around to address this concern.
Separately, the proposed changes aim to close the carried interest “loophole” that benefits hedge fund and private equity partners by targeting the taxation of carried interest. Carried interest income would be subject to ordinary income tax rates if approved. Interestingly, if capital gains rates were to increase to ordinary income tax rates, this would be somewhat redundant and unnecessary. The fact that this is being discussed separately from capital gains rates, does make us consider the idea that the current proposal on capital gain rate increases may hint that the Biden administration believes that an increase to 39.6% may be lofty.
Other Proposed Changes Worth Discussing
- Increasing Income Tax Rates – The top tax rate is currently 37%. The proposed changes bring that rate to 39.6%. Regardless of whether that occurs in 2021 or slips to 2022, the current rate is set to revert to 39.6% in 2026. In 2021, for those married filing jointly, the top tax bracket kicks in at $628,301 in taxable income.
- Ending Section 1031 like-kind Exchange Rules – This provision has provided for tremendous wealth transfer opportunities. The proposed changes would remove the ability for real estate investors to defer capital gains tax by exchanging like-kind property, if the gains exceed $500,000.
With so much uncertainty around the proposed changes to tax policy, the only certain thing we can recommend is to meet with your advisory team to make sure you consider the opportunities that exist for you today that may be retracted soon. It helps to be prepared with a good understanding of your balance sheet, cash flows & liquidity needs, and high-level goals around wealth transfer (children, education, philanthropy, etc.). With each family requiring customized advice related to their assets, goals and family situation, a formal plan can sometimes take time to crystalize; if your assets are more complex, the timeline can be extended. Don’t wait until December, or for more formal language from Washington, to begin this important discussion.
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