Proposed Tax Code Changes Will Impact Estate Planning

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As part of the proposed Build Back Better Act, there are significant changes to the Tax Code that will effect common estate planning techniques, including gifts to trusts. This is a quick overview of the changes, which include lowering of the estate, gift, and generation-skipping transfer (also known as “transfer tax”) exemptions.

Lower Gift and Estate Exemptions

The proposals reduce the federal estate and gift tax exemption from the current $11.7 million (inflation-adjusted for 2021) to $5 million (inflation-adjusted) effective January 1, 2022, instead of January 1, 2026. The inflation-adjusted exemption is anticipated to be about $6 million.

The 40% estate and gift tax rate did not change. The estate and gift tax changes are not retroactive. There is no limit on the number of annual exclusion gifts, and generation-skipping or dynasty trusts are not limited to 90 years if governed by state law that permits a longer duration.

There is a period for possible tax planning in advance of the impending changes, because the reduced exemption is not effective until January 1, 2022. We recommend considering using the 2021 exemption to move assets out of your estate by December 31, 2021 (or prior to enactment, if grantor trusts are used).

For example, if you have been considering making gifts using your remaining gift tax exclusion and/or GST exemption amounts but have been worried about the potential for retroactivity, the proposed changes may provide you with sufficient comfort to proceed with the gifts before the end of 2021. All of the other factors that must be considered when gifting are still factors, such as the income tax implications of the loss of the step-up in basis and the loss of control and use of the asset.

Valuation Discounts

Valuation discounts have been challenged by the IRS for many years. When an individual owns a closely held business interest that is not publicly traded and does not have voting control, it is unlikely that a third-party purchaser would purchase the interest for its liquidation value. Rather, a third-party purchaser would want a discount from the liquidation value. For transfers of interests in a closely held entity, the proposed Tax Code change eliminates valuation discounts for lack of control or lack of marketability that are attributable to the nonbusiness assets held by the entity. Nonbusiness assets are passive assets that are held for the production of income and not used in the active conduct of a trade or business. Exceptions are provided for assets used as working capital of a business.

This provision is designed to eliminate the strategy of creating family LLCs or limited partnerships to hold passive assets (i.e., a portfolio of stocks, bonds, or mutual funds), and have the LLC or partnership valued for gift and estate tax purposes at a lesser value due to discounts for lack of marketability and minority interests. This change would be effective for transfers made after the effective date of the legislation, so it would be important to make discounted gifts of entities holding passive assets in the very near future. Discounts will likely not be available for year-end gifts of entities holding passive assets.

Please note this is only proposed legislation and will almost certainly change before it is enacted.