New Tax Proposal Weakens Grantor Trusts

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Targeting Grantor Trusts to Help Close Tax Gap

For decades, trusts have been used in estate planning as a way for people to ensure that their assets are distributed according to their wishes after death. Trusts give individuals more flexibility with their assets than a simple Will and can utilize strategies to reduce potential income, gift and estate taxes. The new proposal under the Build Back Better (BBB) plan makes major changes to the way trusts, especially Grantor trusts, can be used in estate planning.  Keep in mind that, as of this writing, the Build Better Back plan has not been approved by Congress or passed into law.  These changes take place if, and only if, the BBB becomes law.

What are the proposed changes to Grantor Trust rules?

The BBB proposal suggests a new code section IRC 2901 that would apply to trusts created after the date of enactment. It includes:

  • A provision to include the value of all assets held in a grantor trust in the grantor’s estate as of the grantor’s date of death.
  • Any sale transactions between a grantor and a grantor trust would be subject to income taxation as if between the grantor and a third party.
  • Distributions from a grantor trust to a beneficiary other than the grantor or the grantor’s spouse will be treated as a taxable gift from the grantor to the distribution recipient.
  • If a grantor chooses to “turn-off” the grantor trust power during his or her lifetime, flipping the trust into a nongrantor trust, the proposed legislation will treat such action as an additional gift of the assets of the trust to the trust beneficiaries, valued as of the date the power is relinquished.

These potential changes would apply only to trusts established on or after the date of enactment of the proposed law, and to any contributions to grandfathered grantor trusts made on or after the date of enactment. While the date of enactment is not yet set, the BBB says that these changes will take effect IMMEDIATELY upon the enactment of the BBB. The proposed changes will reduce or eliminate the benefits of trust-driven estate planning strategies including Grantor Retained Annuity Trusts (GRATs), Intentionally Defective Grantor Trusts (IDGTs) and Spousal Lifetime Access Trusts (SLATs).

Grantor trusts are a highly valued estate planning technique that allows transferring assets out of a grantor’s estate for estate tax purposes, while having the grantor remain the owner for income tax purposes. This has provided the benefit of allowing transactions between a grantor and his/her grantor trust to occur without income tax ramifications.  Often, this removes that asset from the grantor’s taxable estate, and also removes the future growth of that asset from the grantor’s estate.

The proposed changes to the grantor trust rules will impact several popular grantor trust planning strategies including:

 

Spousal Lifetime Access Trusts (SLAT) is a trust set up by a grantor for the benefit of his or her spouse and offspring. It is difficult to structure a SLAT as nongrantor trust given that the grantor’s spouse is the primary beneficiary. If a SLAT is established after date of enactment of the proposed law, it will likely be included in the Grantor’s estate on his or her death.

 

Irrevocable Life Insurance Trusts are most often established to hold life insurance on the grantor’s life in a manner that excludes the death benefit from the grantor’s taxable estate. Many life insurance trusts are structured as grantor trusts. Under the proposed law, this would result in the value of the death benefit being included in the grantor’s estate upon his or her death. Grandfathered insurance trusts would be exempt from this inclusion, but care must be taken going forward regarding the source of funds for future premium payments, especially if funded by the grantor through annual gifts to the trust. If the proposed changes are enacted, these additional contributions to otherwise grandfathered grantor trusts would result in some portion of the insurance trust assets being included in the grantor’s estate.

 

Grantor Retained Annuity Trusts The BBB plan allows the distribution of assets to beneficiaries (or to nongrantor trusts for the benefit of trust beneficiaries) at the end of the GRAT term to result in a gift by the grantor to such beneficiaries calculated on the fair market value of such assets at the time of distribution. The proposed change effectively renders the GRAT worthless as a mechanism for a leveraged transfer of assets—the grantor is no better off than if he or she made a direct transfer of the assets to his or her chosen beneficiary. Additionally, if a GRAT uses appreciated assets to pay the annuity payment owed to the grantor during the trust term, that payment will be viewed as a sale for which income tax is recognized.

 

Qualified Personal Residence Trusts (QPRTs) may be rendered similarly useless under the new legislation for the same reason applicable to GRATs. If the distribution to beneficiaries at the end of the QPRT term is subject to gift tax on the fair market value of the asset at that time, the benefit of the QPRT is eliminated.

 

Why the focus on Grantor Trusts?

Many in Congress believe that there is an overuse of Grantor trusts by wealthy individuals to transfer assets free of estate taxes to their heirs. A recent ProPublica article states that “more than half of the 100 wealthiest Americans have used GRATs or similar trusts as part of their planning strategies. The defining feature of a Grantor Trust is that as it relates to income taxes, the trust and the Grantor (creator of the trust) are viewed as one. The income earned on the trust is sent to the Grantor and is reported on the Grantor’s income tax return. 

This is significant for a few reasons. One potential benefit is that the income tax bracket for trusts is substantially compressed compared to individual rates. Another potential benefit is since the Grantor and the Grantor trust are considered one and the same, transactions between the two are not deemed a taxable event. Lastly, a grantor trust can be created wherein the assets of the trust, and the future appreciation of those assets, are removed from the Grantor’s taxable estate even though income from the trust is still taxable to the Grantor. 

When would this take effect?

The Build Back Better bill provides that any grantor trust created on or after the date of the enactment of the bill will be included in the grantor’s taxable estate, effectively eliminating their utility for gift tax planning. 

Under the BBB plan, existing grantor trusts (and contributions made prior to the enactment date) will be grandfathered under the current rules whereas any amounts contributed to a pre-existing grantor trust after the enactment date will be subject to the new rules and includable in the grantor’s taxable estate. Therefore, to take advantage of the grantor trust rules (and the increased exemption), it is imperative to have your grantor trust both executed and funded prior to the enactment date of the BBB Bill.

What actions should individuals take now?

There is a very limited window of time that individuals can make any changes. Once the Build Back Better plan takes effect these changes will be enacted. It is crucial for individuals to consider the value of their taxable estate as it is today and also what it could be in the future at the time of their death. Now is the time to create and fully fund any Grantor Trusts.  Keep in mind that the estate tax exemption is likely to decrease in the future.

At this time, people with existing Grantor Trusts should engage in any sales or exchanges with their existing trust. It may be advantageous to consider, as Grantor, selling or exchanging high basis assets for low basis assets in an irrevocable grantor trust prior to the BBB date of enactment to avoid a capital gain realization event

Work with your estate planning professional to determine if you should terminate Grantor status. In some cases, it may be beneficial if you wish to continue making contributions to the trust after the BBB date of enactment.

People who have funded GRATs with highly appreciated assets may want to consider swapping those low basis assets with high basis assets to reduce the possibility of gain resulting from the annuity payment.

If someone had been considering an Intentionally Defective Grantor Trust (IDGT), they need to take action now. The trust must be executed and funded prior to the date of enactment. It should be noted that, in order to avoid capital gains on the sale of an appreciated asset, that sale must also take place prior to the enactment.

Individuals with existing Life Insurance trusts may want to explore options for pre-funding all future premium payments to avoid this outcome. Alternatively, clients with existing grantor life insurance trusts may seek to modify such trusts to make them nongrantor trusts, if possible, prior to the enactment date of the proposed law.

As with GRATs and IDGTs, any action on a Spousal Lifetime Access Trust (SLAT) needs to happen immediately. They need to be drafted and funded prior to enactment of the Build Back Better plan. Grantor SLATS could still offer some limited creditor protection. As irrevocable trusts they could help Grantors remove assets from their control.

There is uncertainty about the window of opportunity to review and adjust any existing Grantor Trusts or future ones before the Build Back Better plan takes effect. Individuals should discuss potential options with their estate planning team and set a quick timeline to coordinate any actions. Madonia & Associates is available for new and existing clients to discuss their estate planning needs, call us today at (312) 578-9300.