LUTZ BUSINESS INSIGHTS
build back better act + impact on high net-worth family estate planning
joe hefflinger, director & investment adviser
Last week, the House Ways and Means Committee released its proposal to pay for the $3.5 trillion Build Back Better Act. While the potential legislation contains a wide array of adjustments to the tax code, this post will focus more directly on the proposed changes that could impact your estate planning. For further context on these issues and a general overview of how our estate laws work, see my previous post here: https://www.lutz.us/high-net-worth-families-review-estate-plans-pre-election/).
It’s important to note that if a bill ultimately gets passed, it may look materially different from the provisions I will highlight below. Also, it’s essential to understand that time could be of the essence. While some of the changes wouldn’t go into effect until January 1, 2022, certain crucial planning tools that your estate attorney would likely want to implement before year-end could be rendered ineffective as of the date of the bill’s passage (which could technically happen at any time now). The outcome is uncertain at this point; those with a high net-worth (in this case, I’m referring to couples with a net worth approaching $20 million or greater or individuals approaching $10 million) should be reviewing options with their estate attorney now.
Key Estate Changes Proposed by the House Ways and Means Committee
Decrease in the Estate/GST and Gift Tax Exemption
The current transfer tax exemptions are $11.7 million per person in 2021 ($23.4 million per couple). Under current law, those exemptions are scheduled to “sunset” and decrease to $5 million each adjusted for inflation on January 1, 2026. The recent proposal accelerates this to January 1, 2022, meaning they will roughly be cut in half next year to approximately $6 million per person (or $12 million per couple) adjusted for inflation.
Valuation of “Non-Business Assets”
It’s currently common when transferring an interest in a closely held business for estate purposes to discount the value based on a lack of control and a lack of marketability. This approach will still be available for interests in operating (active) businesses but not for family entities funded with marketable securities (passive assets). This change would apply to transfers made on or after the date the new law is passed.
Income Taxation of Grantor Trusts
Much of the sophisticated planning done by estate attorneys to help clients minimize estate taxes has centered around the use of grantor trusts. These trusts allow you (the grantor) to transfer assets that are removed from your estate while also allowing you to continue to pay the income taxes associated with the trust’s assets on behalf of the trust beneficiaries (without counting as a gift). Because the grantor is still treated as the owner of the trust for income tax purposes (but not for estate tax purposes), transactions between the trust and the grantor are “disregarded.” This means assets can be sold or exchanged with the trust, and the trust can pay interest on low-interest notes owed to the grantor without triggering any income tax consequences.
The recent proposal would cause any gain inherent in an asset sold to a grantor trust to be recognized and thus create taxation (where under current law, there would be none). In addition, it’s common for a grantor to “swap” assets of equal value with other trust assets in a transaction that is typically disregarded for income tax purposes. The recent proposal would seem to create a taxable event in this scenario. These changes would apply to grantor trusts created on or after the date the new act is passed. Existing grantor trusts would be “grandfathered,” but future contributions to existing trusts would not be.
Estate Taxation of Grantor Trusts
Under the proposal, any portion of a grantor trust’s assets that a person is the “deemed owner” will be included as a part of their taxable estate. Any distribution from a grantor trust will be treated as a taxable gift (with limited exceptions). Lastly, if a trust’s grantor status is terminated during the grantor’s lifetime, the assets will be treated as being gifted at that time by the grantor.
These three provisions effectively render most grantor trusts useless for estate planning purposes. This potentially impacts (subject to future clarification) some of the most useful estate planning techniques commonly employed by estate planners, namely intentionally defective grantor trusts (IDGTs), grantor retained annuity trusts (GRATs) and spousal lifetime access trusts (SLATs), each of which is discussed in more detail below. As outlined above, the effective date for these changes to grantor trusts would be the date of bill passage, and grandfather status would be allowed for existing trusts.
Irrevocable Life Insurance Trusts (ILITs)
ILITs are designed to ensure that a life insurance death benefit is not subject to estate tax and are typically structured as grantor trusts. Existing ILITs would be grandfathered, but it would appear that future contributions to ILITs for purposes of paying insurance premiums could cause some of the death benefit to be included in the estate. This would be a major limitation on the usefulness of ILITs going forward if not carved out from the final bill.
Relief for Farmers
One of the positive changes in the proposal is a welcome change for those in the farming community. Current law allows property used in farming to be valued based on “use” (typically a lower value) and not its true market value, but the downward adjustment is limited to $750,000. The proposal would allow a downward adjustment of up to $11.7 million.
Notable Changes Not Included in the Recent Proposal (but still could be)
Increase in the Estate and Gift Tax Rates
The current proposal leaves the estate and gift tax rates at 40%. It had been speculated that a return to the 45-55% range we’ve seen in the past 10-20 years was possible.
Change in the Basis Rules at Death
Under current law, your heirs will typically receive any assets you leave them upon your death with a “stepped-up basis,” meaning they get to hold those assets with a basis equal to their fair market value on the date of your death. At various times, factions in DC have floated the idea of eliminating the basis step-up at death (meaning heirs would take a lower carryover basis instead) or alternatively the realization of capital gains at death (meaning the deceased individual’s estate would owe capital gains tax on appreciated assets at death). This could obviously be a major complication for your heirs if you hold assets with a large amount of appreciation. As of now, these changes are not included in the proposal.
Estate Moves High Net-Worth Families Should be Considering Right Now
Given the potential estate law changes that could be made effective as soon as a bill passes, what estate updates should high net-worth families be evaluating now? Here are a few to consider:
If the estate and gift exemptions are reduced next year, you could miss out on a great opportunity to pass a large amount of wealth free of tax. To lock in the use of the current larger exemption this year, you’d need to be in a position to have at least one spouse transfer upwards of $11.7 million out of their estate. Even if you’re not comfortable gifting that full amount, gifting a lower amount would still be effective in removing that reduced amount and any future appreciation out of your estate. These types of outright gifts are commonly made to irrevocable trusts (often grantor trusts) for the future benefit of your children and/or grandchildren. Treasury Regulations from 2019 indicate that transfers covered under an individual’s exemption in the year of transfer can’t be “clawed back” later at their death if the exemption has subsequently been reduced.
If the thought of transferring that amount of wealth outright this year makes you uneasy, talk to your estate attorney about a spousal limited access trust (SLAT). If structured correctly, SLATs can potentially allow for trust distributions of the transferred assets back to the transferor’s spouse during their lifetime. You wouldn’t go down this route if you expected to need the funds in the future. However, if there is some type of unexpected financial hardship down the road, it can be comforting to know that you have the ability to access the funds again (indirectly through your spouse) if needed. Obviously, the possibility of a future divorce or the premature death of the spouse beneficiary needs to be considered. SLATs are typically grantor trusts and will be impacted under the current proposal.
Estate “Freeze” Techniques
If you aren’t comfortable making a large outright gift, an estate freeze may be a better fit for you. A freeze transaction has the net effect of removing the future appreciation of an asset (above a predefined “hurdle” rate established by the IRS) from your estate. There are several different structures to accomplish this. Some of which involve transferring assets to a trust in exchange for a promissory note equal to the fair market value of the assets sold. The transfer to the trust can be structured as either a sale or a gift (or some of each), depending on whether you want to use up some exemption (and if so, how much).
Two of the more common freeze structures are IDGTs and GRATs (referenced above). Your estate attorney can highlight the key differences between each and examine the appropriate fit for your situation. Both IDGTs and GRATs are typically grantor trusts and can be powerful tools under current law, especially in a low-interest-rate environment where the hurdle rate that the transferred asset has to beat is so low. These tools can also be leveraged even further if you have an asset to transfer whose value can be discounted when transferring for estate purposes (as discussed above).
Keep in mind, however, that the ability to use SLATs, GRATs, IDGTs and some discounts could be rendered ineffective as of the date a new bill is passed (which could come at any time now).
Call Your Estate Attorney Today
So, what does all of this mean to you? If your personal balance sheet is approaching the $20 million range or greater for couples ($10 million for individuals), it means you should at least be reaching out to your estate attorney and other advisors now to discuss what impact these potential changes could have on your personal planning. If you are uncertain about what amount of assets you can transfer and still have enough left over to comfortably live on, we at Lutz Financial can do a cash flow analysis to help you better answer that question. From a timing perspective, keep in mind that high-level estate planning of this nature usually takes some time to complete (and your attorney will likely already be busy due to high demand). Whether you ultimately decide to make any estate updates now or not, it’s essential that you at least talk to your advisors and understand your options. If you have any questions, please feel free to contact us.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.
ABOUT THE AUTHOR
JOE HEFFLINGER, JD, CFP®, CAP® + DIRECTOR & INVESTMENT ADVISER
Joe Hefflinger is an Investment Adviser and Director at Lutz Financial. With 15+ years of relevant experience, he specializes in comprehensive financial planning and investment advisory services for professionals, business owners, and retirees. He lives in Omaha, NE, with his wife Kim, and daughters Lily and Jolie.
AREAS OF FOCUS
- Retirement Cash Flow Planning
- Insurance Planning
- Estate Planning
- Business Owner Exit Planning
- Charitable Planning
- Tax Planning
AFFILIATIONS AND CREDENTIALS
- Financial Planning Association, Member
- Nebraska State Bar Association, Member
- Omaha Estate Planning Council, Member
- CERTIFIED FINANCIAL PLANNER™
- Chartered Advisor in Philanthropy®
- JD, Creighton University School of Law, Omaha, NE
- BS in Economics, Santa Clara University, Santa Clara, CA
- Partnership 4 Kids - Past Board Member
- Omaha Venture Group, Member
- Christ the King Sports Club, Member
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- Long-Term Care Planning 101
- Why High Net-Worth Families Should Review Their Estate Plans Pre-Election
- Portfolio Management for Retirees During a Financial Crisis
- It's Time to Review Your Personal Umbrella Policy
- Will I Outlive My Assets?
- Planning for Health Care Costs in Retirement
- The Opposite of Spoiled: A Book That Helps Parents Talk to Their Kids About Money
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