Proposed Tax Code Changes Will Impact Estate Planning

As part of the proposed Build Back Better Act, there are significant changes to the Tax Code. These changes will effect common estate planning techniques, including gifts to trusts. This is a quick overview of the changes. It includes lowering of the estate, gift, and generation-skipping transfer  exemptions.

Lower Gift and Estate Exemptions

The proposals reduce the federal estate and gift tax exemption from the current $11.7 million to $5 million 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. Additionally, 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. 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. If grantor trusts are used, then prior to enactment.

Accordingly, it is time to prepare if you have been considering making gifts using your remaining gift tax exclusion and/or GST exemption amounts. You may have been worried about the potential for retroactivity, yet the proposed changes 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. This includes 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. This is 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. This is due to lack of control or 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. Nonbusiness assets are 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 valued for gift and estate tax purposes at a lesser value due to discounts for lack of marketability and minor interests. This includes limited partnerships to hold passive assets (i.e., a portfolio of stocks, bonds, or mutual funds). This change would be effective for transfers made after the effective date of the legislation. So it is 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. It may not be enacted at all.