The proposed tax provisions released by the House Ways and Means Committee on September 13, include several substantial changes that would affect personal income tax and business tax planning. In addition to the reduction in the estate and gift tax exemption, and elimination of valuation discounts for interests in passive entities (as discussed in a blog by Ami Longstreet), there are proposed changes that would significantly impact the use of grantor trusts. Notably, missing from the proposed legislation, which is a relief to many, is a provision that would do away with the general rule that property acquired from a decedent receives a step-up basis.
Ultimately, although it is unknown if the provisions discussed below will be enacted by Congress, or to what extent, clients need to consider acting now, given that some of the proposals will take effect on the date of enactment, while others would take effect January 1, 2022.
Proposed Changes Applicable to Grantor Trusts
Under current law, a grantor trust is one in which the trust property is treated as being owned by the grantor (the creator of the trust) for income tax purposes, meaning the grantor pays all income tax on behalf of the trust, but the trust property falls outside of the grantor’s estate for estate tax purposes and therefore is not subject to federal estate tax upon the grantor’s death. Essentially, this means that the grantor is allowed to retain some control over the trust’s assets while diminishing their estate by the amount of the tax payment of the trust’s income tax liability, and enjoys the benefit of removing the appreciating assets held by the trust from their estate.
To curtail this strategy, the proposed tax legislation would add two new sections to the Internal Revenue Code (Section 2901 and Section 1062), both substantially limiting the effectiveness and benefit of the use of grantor trusts. Generally, the proposed provisions would alter tax treatment of grantor trusts by automatically including them in the grantor’s estate for estate tax purposes. Specifically, under the current proposed legislation, if the grantor is the deemed owner of any portion of the trust, then:
- the assets of that grantor trust will be part of the grantor’s gross estate.
- any distribution from a grantor trust (to someone other than the grantor, the grantor’s spouse, or to discharge a debt of the grantor) will be treated as a taxable gift from the grantor to the person receiving the distribution.
- all trust assets will be treated as a taxable gift when the trust ceases to be a grantor trust during the grantor’s life (i.e., upon “turning-off” grantor trust status).
- any sale between the grantor and the grantor trust would be treated as if it were a taxable sale to a third party.
Again, these provisions would only apply to grantor trusts created on or after the date of enactment and to any portion of the trust that was created prior to the enactment date which is attributable to a contribution made on or after the enactment date. These provisions, or any subsequent revisions, impact any grantor trust that is defective for estate tax purposes, meaning they will affect not only Intentionally Defective Grantor Trusts (IDGT), but also Irrevocable Life Insurance Trusts (ILIT), Grantor Retained Annuity Trusts (GRAT), Spousal Lifetime Access Trusts (SLATs), and Qualified Personal Residence Trusts (QPRT). For instance, under the proposed legislation, ILITs, a common grantor trust where trust income is used to pay insurance premiums, would likely no longer be permitted to pay such premiums without causing all or a portion of the existing ILIT to be included in the taxpayer’s estate.
What to do now?
Considering the proposed changes, clients need to significantly reexamine their estate planning strategies to ensure they will comply with the proposed rules and determine what to do prior to the date of any rule changes. Notably, clients can still create and fully fund a grantor trust before the enactment date and avoid the assets of the trust from being included in the grantor’s estate, to the extent the assets are not included under any of the provisions discussed above. Additionally, clients should also now consider engaging in any sales or exchanges with an existing grantor trust, using any remaining estate and gift tax, and given the possibility that grantor trust status should be terminated, developing a new estate planning strategy, one that is both tax effective and meets their needs.
To be clear, this is the only proposed legislation, however, clients are encouraged to consult with estate planning and tax advisors to determine the effect this proposed legislation would have on them and whether any action should be taken to ensure their estate planning strategy will continue to meet their needs.