Recent legislative proposals and frameworks, including the American Families Plan, the For The 99.5% Act, and the Sensible Taxation and Equity Promotion Act, lay out competing initiatives that could foreshadow tax law changes. These proposals include new spending on green initiatives, paid leave for workers and increased funding for childcare, health care and education. To offset the cost of these initiatives, competing initiatives take different approaches, but all include tax increases on high income and wealthy taxpayers.
It appears increasingly likely that any legislation enacted will include tax increases for those taxpayers. While the specifics will inevitably change as part of the legislative process, taxpayers that could be impacted by the changes are well advised to consider wealth planning to take advantage of provisions that may be available under existing tax law.
Potential tax law changes that could impact high income and wealthy taxpayers planning include:
- Raising the top capital gains tax rate to 39.6% for households with income in excess of $1 million: This would be a substantial increase from the current long-term capital gains tax rate of 20.0%. Founders or families contemplating the sale of their business in the near future should consider the impact of higher capital gains taxes and plan accordingly. With a near doubling of the capital gains tax rate, sellers would have to sell at significantly higher valuations to achieve the same level of after-tax proceeds.
- Recognizing unrealized gains upon death or receiving a gift, and eliminating the basis step up for inherited assets: Under the current law, the death of the taxpayer or gift of an appreciated asset does not trigger gain. The tax basis of inherited assets is reset at the value of the assets at the date of death of the decedent (thus, the “step up in basis”). These provisions have protected heirs from potentially double or triple taxation of assets when passed on in the event of death. The elimination of the basis step-up and addition of the recognition of gain upon the death of the taxpayer appear to be included to ensure a capital gains tax rate increase raises significant revenue. Without it, advocates of this policy change believe that taxpayers would hold onto more assets until death to avoid the higher capital gains rate.
- Reducing the lifetime estate and gift tax exemption: Under the current law, the lifetime estate and gift tax exemption for 2020 was $11.7 million per person. While the current exemption amounts are set to sunset in 2026, these initiatives would accelerate the timing and further reduce the reduction. In 2026, the current exemption amounts will sunset and return to $5 million (adjusted for inflation). The proposed changes may accelerate the timing to this year and reduce the estate exemption amount to as little as $3.5 million and the gift tax exemption to as low as $1 million. The potential changes could result in a reduced exemption amount that significantly increases the number of taxpayers subject to estate or gift tax.
- Eliminating discounts for certain assets held in Limited Liability Companies (LLCs) and Family Limited Partnerships (FLPs): FLPs and LLCs have been a popular estate planning vehicle to allow centralized management, liability protection, and ownership limitation of key family assets. In addition to serving these and other practical purposes, these entities are sometimes valued at a discount to the value of the underlying assets which is beneficial for estate and gift tax purposes.
- Retroactive application: Included among the competing initiatives is language stating that proposed tax increases would be effective from the “date of announcement.” While this language currently seems ambiguous, it is possible that at least some of the legislative changes could be effective from a date that precedes the date of enactment.
With these potential changes, the current climate is ideal for wealth transfer planning. There is no single best method for wealth transfers. There are a variety of techniques that can be deployed to fulfill many different types of goals. There are strategies that allow high net worth individuals to reduce their tax exposure while preserving funds necessary to continue to maintain their current lifestyle. The less concerned an individual is about retaining access or control to assets, the more opportunities become available.
Currently available wealth transfer techniques
There is no substitute for a thorough analysis, but the following are some techniques that could be successful in minimizing exposure if employed before the effective date of legislative changes:
- Grantor-retained annuity trust (GRAT): A GRAT pays an annuity for a limited term, with the assets passing to heirs afterward. The value of the gift is calculated using IRS interest rates to determine how much is expected to be left at the end of the term. Under the current law, the annuity term and payments can be structured as a “Zeroed-Out GRAT” which results in no gift tax consequences. If the assets appreciate faster than the interest rates, the remainder is passed on to heirs without estate or gift tax consequences.
- Intentionally defective grantor trust (IDGT): An IDGT is similar to a GRAT. Assets are often sold to the IDGT in exchange for a note at IRS-prescribed rates. If the assets appreciate faster than the interest rates, the remainder is passed on to heirs without estate or gift tax consequences.
- Charitable lead trust (CLT): A CLT is similar to a GRAT except that the income is paid to a charity, and any remaining assets passed on to heirs. The value of the remainder interest is calculated using IRS interest rates to determine how much is expected to be left at the end of the term. If the assets appreciate faster than the interest rates, the remainder is on passed to heirs without estate or gift tax consequences.
- Charitable remainder trust (CRT): A CRT is the opposite of a CLT in that it pays income to beneficiaries, with the remainder interest going to charity. The assets are removed from the estate and a taxpayer may be able to deduct contributions from income tax.
There are other options that can help individuals accomplish common goals. These options include providing for future generations, providing for a spouse while protecting assets for their children, transferring a personal residence at reduced tax value, leveraging annual gift tax exclusions and using trust structures to exclude insurance proceeds from a decedent’s estate.
Valuation is a key consideration in the wealth transfer planning process. Many business owners misvalue their entities in the process, which can have severe financial consequences including disputes with taxing authorities.
Valuation requirements for wealth transfer planning may include:
- Business valuations
- C to S corporation conversions
- Buy-sell agreement consulting
- Employee stock ownership plan advisory and consulting
- Family limited partnership and limited liability company discount studies
- Restricted stock and blockage discount opinions
- Assessments of strategic alternatives
- Qualified appraisals for charitable contributions
A key component in many wealth transfer plans is the involvement of a qualified appraiser. An objective, well-prepared, supportable valuation performed in good faith by an independent third-party appraiser often becomes the cornerstone of these planning initiatives. A thorough appraisal can help reduce the likelihood of IRS challenges and preserve wealth or assets for future generations.