by Vanessa L. Kanaga, Esq., InterActive Legal
Two bills introduced in the Senate could impact estate plans – What is a planner to do?
Ever since the middle of 2020, there have been rumblings in the estate planning profession; murmurs of tax proposals waiting in the wings, the anticipation mounting as the federal elections (eventually) concluded and the White House and Congress shifted to the Democrats. This change in power, combined with the increased spending by the federal government due to the pandemic, led many to expect proposals for changes to the Internal Revenue Code (the "Code"), including those provisions relating to estate planning. At last, the moment we expected has arrived, with two bills introduced in the Senate: the "For the 99.5% Act," introduced by Senators Sanders and Whitehouse on March 25 (the "Sanders' bill"), and the "Sensible Taxation and Equity Promotion Act of 2021," or "STEP" Act, introduced as a proposal by Senators Van Hollen, Booker, Sanders, Whitehouse, and Warren on March 29 (referred to herein as the "Van Hollen bill," although it has not been formally introduced at the time of this writing). Each of these bills proposes changes which, if enacted, would cause a fundamental shift in estate planning, from the foundations up to the more sophisticated spires of wealth preservation strategies. What would these proposals mean for clients, and what should we, as planners, be doing to alert them to the potential changes on the horizon?
Both the Sanders and Van Hollen bills would alter much of what we consider to be the foundations of estate planning, starting with one of the most essential considerations in any estate plan: the basic applicable exclusion amount (often referred to as the "estate tax exemption"). The Sanders bill aims to reduce the estate tax exemption by more than two-thirds, from the current $11.7 million to $3.5 million. Fluctuations in the estate tax exemption are nothing new, but such a large reduction means that many clients who previously never even contemplated a possible estate tax could now be facing an estate tax bill if they were to die while the exemption was at the proposed reduced amount. In addition, the Sanders bill proposes a de-unification of the gift and estate tax exemptions, reducing the exemption for lifetime gifts to $1 million.
In addition, the Sanders bill proposes limitations on the gift tax annual exclusion amount for certain gifts, including gifts of interests in pass-through entities and gifts in trust. Each donor would be limited to a cumulative amount equal to twice the annual exclusion (i.e., $30,000 total under the current rates) for all such gifts, combined, in any given year. This would, of course, cause significant disruption to estate plans that involve a program of annual gifting for family businesses and, perhaps more notably, funding of irrevocable life insurance trusts. Note, however, that there would not be a cumulative limit on annual gifts directly to individuals.
The Van Hollen bill also stands to shake the pillars of estate planning by eliminating the step-up in basis under Code section 1014, replacing it instead with a regime of deemed recognition. This means that beneficiaries receiving property from a decedent would no longer take a basis in the property equal to fair market value at the date of death (or six months later, if alternate valuation is selected), and instead the estate would be required to pay capital gains tax on any appreciated property as if it were sold on the date of death. The same would apply to property transferred in trust (with certain exceptions) either on funding or every 21 years for property held in non-grantor trusts. If enacted, this change would add a new layer of considerations to be taken into account in lifetime gift planning.
Changes Affecting More Advanced/High-Net-Worth Estate Planning Strategies
In addition to the foundational changes referenced above, the Sanders and Van Hollen proposals would affect more sophisticated strategies often deployed to maximize use of the gift, estate, and GST exemptions. These include a proposal to place limitations on grantor retained annuity trusts (GRATs) by requiring a minimum 10-year term (and imposing a maximum term of 10 years past the grantor's life expectancy) and 25% (or $500,000, if greater) remainder value, a proposal to impose limitations on the valuation of certain closely held entities for transfer tax purposes, and a proposal to limit the application of the GST exemption so that trusts lasting longer than 50 years cannot be exempt from GST tax with respect to distributions that are generation-skipping transfers.
The aforementioned changes, if enacted, would make GRATs and "dynasty trusts" much less attractive, and would diminish the value of many techniques involving valuation discounts, such as sales to grantor trusts. However, other proposals in the Sanders bill, if enacted, would significantly diminish the use of grantor trusts as an estate planning technique in any event, by providing for inclusion of grantor trusts in the grantor's estate for estate tax purposes. As a corresponding measure, distributions from grantor trusts would be treated as taxable gifts, as would termination of grantor trust status (though the estate inclusion and taxable gifts would be offset by the amount of the grantor's prior taxable gifts to the trust). The grantor trust has long been a staple of advanced estate planning, because of the income tax-free compounding it permits for trust assets, and because of the grantor's ability to engage in sale transactions with the grantor trust without income tax consequences, under Rev. Rul. 85-13. If the portion of the Sanders bill relating to grantor trusts is enacted, it will limit the circumstances in which "intentionally defective" irrevocable grantor trusts are used in estate planning, if not eliminating their use entirely.
How and When to Notify Clients of These Proposals; Is There Still Time to Plan?
The magnitude and uncertainty of these proposals poses a challenge for estate planners in terms of knowing how to address them. At this stage, it is impossible to know how likely it is that these proposals will be enacted, whether in their current form or with modifications. However, if all of the aforementioned proposals become law, clients with any significant wealth will be affected, and their estate plans will need to be evaluated. Many plans will need to be revised, and planners will need to advise clients on what to do about prior lifetime planning, including existing grantor trusts and irrevocable life insurance trusts that often rely on Crummey powers to fund premium payments.
The Van Hollen proposals eliminating the 1014 step-up in basis, if enacted as written, would be retroactive to January 1, 2021. Fortunately, however, many of the other proposed changes would not be effective until the date of enactment or, in the case of the new reduced estate and gift tax exemption amounts, until January 1, 2022. Accordingly, there is still time for clients to plan for many of these potential changes. For some, it may be a good idea to consider lifetime gifts in order to use the current exemption amount. Others may need to revisit their existing estate planning documents to consider the impact the proposed legislation would have on their plan, and decide whether to make any changes at this time. Note, however, that for those wishing to use their current exemption amount, it is necessary to consider the Van Hollen proposal which, if enacted as written, would trigger gain recognition on the transfer of appreciated property, because it is retroactive to the beginning of the year.
Communicating with clients regarding the elements of these complex proposals and their potential effect on the client's estate plan can be difficult, to say the least. Ideally, attorneys will take proactive steps to alert clients to these proposals and invite them to reach out for further discussion, without providing so much detail as to be overwhelming or possibly lead to misunderstanding. InterActive Legal subscribers will find a sample client letter for use as a starting template in the online subscriber knowledgebase. In many cases, it will also be essential to work with the client's accountant and other advisors to analyze planning alternatives taking into account the client's goals and assets, particularly given the potential effects of the Van Hollen plan to eliminate the step-up in basis and cause periodic deemed recognition for assets held in trust.
Change is often disconcerting, particularly when the timing and scope of the change is unknown, as is the case with these and other potential changes to the Code. However, as attorneys and other professionals, it gives us an opportunity to be of value and service, by alerting clients to potential changes, and ultimately giving them the knowledge and tools they need in order to make an informed decision regarding their estate plan.
Vanessa Kanaga serves as CEO of InterActive Legal. Vanessa received her J.D. from Cornell Law School and holds a B.A. in Philosophy from Wichita State University, as well as an Advanced Professional Certificate from New York University School of Law. She is licensed in New York and Kansas, and currently lives in Arizona. Prior to joining InterActive Legal in 2013, Vanessa practiced in New York, at Milbank LLP and Moses & Singer LLP, and in Kansas, at Hinkle Law Firm, LLC. She has experience in a range of estate planning matters, including high net worth tax planning and asset protection planning. In her role as CEO, Vanessa oversees strategic planning and development of InterActive Legal services and solutions, working with her valued colleagues to continuously provide reliable content and forward-thinking strategies to the estate planning and elder law attorneys who subscribe to InterActive Legal products. Vanessa also serves as the Moderator for the InterActive Legal Roundtable webinar series, fostering collegial discussion among a group of expert panelists on trending topics in estate planning.