© 2019 by Jonathan G. Blattmachr & Martin M. Shenkman. All Rights Reserved.
With the estate, gift and GST exemption at nearly $11.5 million and scheduled to grow until 2026 when they will be cut in half, few advisers are focusing on wealth transfer tax planning for their clients. And even fewer clients at wealth levels that are not significantly in excess of the current exemptions, e.g. couples perhaps under $25 million, are considering planning options. That may all prove a costly mistake. But nothing seems ever to stay static. And if the political winds turn sharply Democratic, there is a real likelihood that tax changes of extraordinary measure may occur. The good news for some is that the deduction for state and local taxes may be fully restored. There may be bad news for others, such as those holding stock in corporations that may have their income tax rates increased dramatically.
In any case, there are proposals (many of which have been made before) that would drastically affect estate tax planning. Many of the components of the proposals include restrictions on estate tax planning similar to those contained in President Obama’s Greenbook. The climate has also changed. There is an increasing chorus of complaints to the effect that the “wealthy are not paying their share of taxes.” This sentiment may have been compounded by the recent scandal of wealthy and famous people paying bribes to secure college acceptances for their children. Overall, this environment should cause worry for those of wealth and motivate them to act while they can. And because most estate tax planning typically takes years to produce significant positive results, it seems appropriate for practitioners to consider that impact of the proposals on their clients, advise them of potential changes and, at least in many cases, encourage them to act now. There are also significant benefits to beginning planning earlier, rather than waiting for more certainty that the law might in fact change. Every practitioner remembers the rushed transactions at the end of 2012 when it was believed that the exemption might decline from $5 million inflation adjusted to $1 million in 2013. Many of the plans were implemented with inadequate thought and planning, too short of a duration between asset transfers and trust funding and more. These problems were not the result of practitioners and clients both not knowing the risks, but rather were the inevitable result of the compressed time frame during which planning had to be completed. No one should want a repeat of that scenario.
One set of proposals is set forth in Senate Bill S. 309 introduced by Bernie Sanders. S.309 — 116th Congress (2019-2020), dubbed "For the 99.8 Percent Act" (“Proposal”). The title alone reinforces the anti-wealthy sentiment that seems to be growing. Here are some highlights of the bill and a brief discussion as to what the changes mean for certain clients and, perhaps, what they should do.
Drastic Reduction in Exemptions. A significant one and, perhaps, one likely to be adopted would be the reduction in the estate tax exemption to $3.5 million, the level that existed in 2009. So immediately about $8 million of exemption would be lost (forever). Moreover, the gift tax exemption would be reduced to $1 million. Many property owners have already used that much exemption so further gift tax free transfers could not be made except under alternatives such as the gift tax annual exclusion which also would be limited. The $1 million gift exemption might suggest that practitioners would have to deploy GRATs, FLPs/LLCs with discounts, note sales and other techniques to shift wealth from much more moderate estates. But the Act restricts or eliminates many of those techniques as well. The result will be a much costlier, and difficult to plan for, transfer tax system.
So even though some intend to wait until 2024 or 2025 to make further gift tax free transfers under the lifetime exemption, waiting may be very costly for their loved ones. And that brings up an important point: The owner of wealth need not worry about estate, gift or GST tax on his or her own wealth; rather, his or her children (or other loved ones) need to worry. So, motivating the wealthy to engage in significant wealth transfer tax planning can be challenging. But the changes contained in the Proposal would be so significant, that some individuals of means may be prompted to act. Let’s look at some of the additional changes in the Proposal, what they mean, and how they might be avoided by early action.
Much Tougher to Pass on a Family Business or Farm. The tax law contains a few provisions to reduce the effective estate tax burden on certain closely held businesses transmitted at death to family members. One is section 6166 which permits the estate tax on such a business, in some cases, to be paid over a term of about 15 years with a very low interest charge. Another is to allow certain real estate used in a farm or other closely held business to be valued at less than its fair market value, meaning lower taxes. However, the reduction in exemptions and the substantially increased rates (graduated up to 77%) may more than offset the benefits of these special provisions for family enterprises. Another adverse change would be to curb, or eliminate, discounts in valuation which are in jeopardy now on account of the Powell case decided two years ago. To avoid these changes, property owners need to continue transfers in the near future especially under the current huge ($11 million plus) gift tax exemption. Practitioners should consider that a possible broad application of the Powell case (“in conjunction with”) might result in the entirety of a family entity or other asset being included in the decedent’s estate if the decedent held any interests in the entity or asset on death. Thus, one possible focus of planning, for even more moderate wealth clients, might be to shift the remaining equity interests out of their estates now. Since donee trust structures can be created that may permit the client/transferor to benefit from the assets transferred, the scales of transfer versus not might tip in favor of transfer.
Forget GRATs. One of the most widely used estate planning arrangements has been grantor retained annuity trusts (“GRATs”) under which the property owner retains an entitlement to an annuity stream almost equal to the value of the property, whether a family business, stocks, real estate or essentially anything else. Because the taxable gift of the remainder in a GRAT can be made to be zero (or more conservatively close to zero), a GRAT is essentially a “heads I win” for the taxpayer to the extent the growth and income in the trust exceeds the IRS’s section 7520 rate in effect when the GRAT is created or a “tails the IRS loses” if the rate does not exceed that rate because no (or extremely minimal) gift tax is due. However, the Proposal would make GRATs quite unattractive in most situations as the taxable gift of the remainder would have to be at least 25% of the value of the assets contributed to the trust. Unless the return in the trust is extremely high, less will pass to the remainder beneficiaries than the amount of the gift made when the GRAT was created. Hence, anyone contemplating a GRAT should probably act soon. Further, the Proposal sets a minimum 10-year term for GRATs so that the common application of two year rolling GRATs (where the annuity payment amounts are re-GRAT’d to new GRATs) would be proscribed. If clients have or create new GRATs closer in time to any change in law, consideration might be given to using longer term GRATs, e.g. the so-called “99-year GRAT,” since re-gifting annuity payments into new GRATs may be prevented. Practitioners might even consider, for clients that have little remaining exemption, very long term GRATs so that even if the GRAT fails a rise in interest rates (doesn’t that have to happen at some point?) and appreciation of the property might still shift value out of their estate. Taxpayers with no remaining exemption facing a possible enactment of changes similar to the Proposal after the 2020 election may not have many other options.
Forget Super Long Term GST Exempt Trusts. The bill essentially would “outlaw” GST exempt trusts scheduled to last more than 50 years. Trusts are a critical component of good estate planning, but the permanent GST tax avoidance possibilities afforded by trusts may be coming to an end. Although not certain, there seems to be a chance that previously created trusts will be exempted from the 50 year time benefit limit. It may be possible to avoid the limitation not just by creating long terms GST exempt trusts now for descendants but creating a so-called QTIP trust for one’s spouse and, by making the so-called “reverse” QTIP election, allocating GST exemption when the trust is created. While it cannot be certain that trusts existing at the date of enactment will be grandfathered, it may well be worth the effort for clients to create long term trusts now or transfer as much wealth as appropriate to existing long term trusts, to endeavor to avoid this type of restriction. The difference over several generations of the impact of a 50-year cap on GST tax avoidance versus inclusion can be incredible. Practitioners can model the impact and show clients the astounding results. This is valuable not only for the uber-wealthy but for any clients that will not spend down their wealth and who could exceed whatever lower exemption is enacted.
Crummey Trusts and Large Use of Annual Exclusions: Gone. Huge amounts over time can be transferred under the annual exclusion of $15,000 per recipient. One of the largest uses of these exclusion has been for life insurance trusts, often called Crummey Trusts. The limit the Proposal would impose will curb such uses of the annual exclusion. And it seems worthwhile to remember that life insurance is a very favored asset: essentially given a step up in basis even if not in the estate of the insured--because the proceeds paid at death are excluded from gross income under section 101; it's simple to avoid estate tax inclusion of the proceeds by having someone other than the insured own the policy (and hold all incidents of ownership); and, at least to the extent of available annual exclusions, avoid gift tax as premiums are paid. The first two attributes of life insurance would seem to be maintained under the Proposal. While curbing the use of the annual exclusion might seem gift tax troublesome for life insurance, using a split dollar arrangement (see, e.g., Reg. 1.7872-15) can avoid most gift tax problems in getting the proceeds out of the gross estate of the insured. Practitioners should consider suggesting that clients maximize the use of annual demand powers while they can, and also use exemption or leveraging techniques now, to shift value into even traditional ILITs in case the elimination of Crummey powers shuts off the transfer tax free shift of cash into ILITs to pay premiums. For example, while GRATs remain, clients relying on large Crummey powers to make gifts to ILITs which are used to fund insurance premiums, might create GRATs now that pour into those ILITs. That might serve as a transfer tax free means of shifting value into those ILITs before law changes cut off options.
The Biggest Threat Is to Grantor Trusts. Sometimes it's appropriate to remember that the reason grantor trusts (the income of which is attributed to the grantor) are called “defective” is because, when the grantor trust rules came into effect, it almost always was adverse for a trust to be a grantor trust. But over time, grantor trusts have become the best friend of many if not most estate planners. Such trusts permit appreciated assets to be distributed from a GRAT in satisfaction of annuity payments without income recognition. They also permit the trust to grow free of income tax because the grantor pays the income tax on trust income, perhaps the most powerful factor in financial planning. In addition, because the IRS holds that the assets in a grantor trust are treated as still owned by the grantor for income tax purposes (even if they will not be in his or her estate for estate tax purposes), a grantor may buy and sell assets with the trust without income tax recognition with the trust paying for the assets with a low interest note without the interest being subject to income tax. The Proposal would be a game changer. It would provide that all assets in a grantor trust are included in the grantor’s gross estate reduced only by the amount of taxable gifts made to the trust. Hence, growth (occurring just by chance, or because assets sold grow faster than the lower interest note or accumulations of income are tax free to the trust because the income is taxed to the grantor) would not permanently shift wealth out of the grantor’s estate. If grantor trust status ends during lifetime, the grantor would be deemed to have made a gift equal to the value of the trust at that time reduced only by the taxable gifts made to the trust.
What Planners Should Consider Doing. There is no certainty the Proposal will pass. In fact, it seems unlikely with a Republican controlled Senate and a Trump White House to have any likelihood of passing. But unlike undoing some of the income tax changes (e.g., the change in the corporate tax rate), changes to the wealth transfer tax regime likely will not adversely affect the economy or the price of stocks. In fact, the Proposal is designed to raise sufficient taxes to pay for items such as universal health care, which most Americans favor. And if the cost of that only falls on the highly wealthy individuals (and their families), the resistance of the few who would be adversely affected may not be enough to prevent the Sanders changes from being enacted. Taxing the wealthiest .2% in the current environment might prove very popular and it is clear that most voters would have no concern about these changes.
It seems planners should encourage their high net worth clients to act soon. The biggest point of resistance will be the desire not to give up their wealth or their control over that wealth. But self-settled trusts or a new idea discussed in the February 2019 issue of Estate Planning entitled “SPATs: A Flexible Alternative to DAPTs” may allow the property owner to continue to benefit from the property and protect the property from creditor claims. There are many variations on DAPTs, and many variations of spousal lifetime access trusts for married couples, all of which may provide clients a measure of control and benefit from assets transferred. Overall, that is a way to benefit not only members of the client’s family but the family as well.
Remember the rush to use the temporary enhanced exemption in 2012? Well, there may be an even greater rush occurring soon if a blue wave in Washington occurs in 2020.
Jonathan G. Blattmachr, Esq., Editor-in-Chief & Co-Author of Wealth Transfer Planning™
A retired Partner in, and former leader of the Trusts, Estates, and Exempt Organizations section of, the New York law firm Milbank Tweed Hadley & McCloy, LLP—Mr. Blattmachr is recognized as one of the most creative trusts and estates lawyers in the country and is listed in The Best Lawyers in America.
He has written and lectured extensively on estate and trust taxation and charitable giving. Mr. Blattmachr is also widely respected for his dedication to always sharing his expertise and ideas with other lawyers, as well as mentoring less seasoned lawyers. These contributions are recognized in his receiving the Hartman Axley Lifetime Service Award.
Mr. Blattmachr graduated from Columbia University School of Law cum laude, where he was recognized as a Harlan Fiske Stone Scholar, and received his A.B. degree from Bucknell University, majoring in mathematics. He has served as a lecturer-in-law for the Columbia University School of Law and is an Adjunct Professor of Law at New York University Law School for its Masters in Tax Program (LLM). He is a former chairperson of the Trusts & Estates Law Section of the New York State Bar Association and of several committees of the American Bar Association. Mr. Blattmachr is a Fellow and a former Regent of the American College of Trust and Estate Counsel and past chair of its Estate and Gift Tax Committee. He is author or co-author of eight books and more than 500 articles on estate planning and tax topics.
His professional activities, include having served as an Advisor on The American Law Institute, Restatement of the Law, Trusts 3rd; and as a Fellow of The New York Bar Foundation and a member of the American Bar Foundation.
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD, Shenkman Law
Martin M. Shenkman is an attorney in private practice in Ft. Lee, NJ, and New York City. His practice focuses on estate and tax planning, planning for closely held business, and estate administration. Mr. Shenkman is an author of more than 800 articles and over 40 books, including his most recent book on powers of attorney, co-authored with Jonathan Blattmachr. He is an editorial board member of Trusts & Estates Magazine and the Matrimonial Strategist, and the recipient of many awards including the prestigious Accredited Estate Planners (Distinguished) award from NAEPC and Financial Planning Magazine’s 2012 Pro-Bono Financial Planner of the Year for his efforts on behalf of those living with chronic illness and disability.