Tax Proposals Would Create Seismic Changes to Estate and Succession Planning
The Biden Administration recently released their “Green Book” highlighting many of the tax proposals aimed at leveling perceived inequities in the tax treatment of high-income taxpayers. The proposals, which focus on capital gain income and appreciated assets, would turn the estate and succession planning world upside down.
Current Law
Long-term capital gains and qualified dividends are taxed at a maximum rate of 20% (23.8% if the Net Investment Income (NII) tax is applicable). Capital gains are typically taxed upon the actual sale or disposition of an asset.
The federal estate and gift tax exemption applies to the total of an individual’s taxable gifts made during life and assets remaining at death. For 2021, the lifetime exemption is $11.7 million per individual and $23.4 million per married couple. The current exemption is set to expire after 2025 at which time it will revert to approximately $5 million per individual. Also, for 2021, the annual gift tax exclusion is $15,000 per donor, per recipient. You can give anyone —such as a relative, friend or even a stranger—up to $15,000 in assets per year, without exhausting your lifetime gift exclusion.
The federal gift and estate tax exemption amount is currently the highest it has been since the tax was enacted in 1916. This means you can pass more to your heirs today, without paying any federal gift or estate tax. The top estate tax rate is 40%.
Proposed Law
Central to the tax proposal is an increase in long-term capital gains and qualified dividends tax rates for high-income earners. The administration proposal defines high-income earners as taxpayers with gross income in excess of $1 million ($500K for married filing separate). To the extent that the $1 million threshold is exceeded, long-term capital gains would be subject to ordinary income tax rates of 43.4% (i.e., 39.6% + 3.8% NII), as opposed to the current 23.8% (i.e., 20.0% + 3.8% NII).
WM Wisdom:
The Administration has proposed that this tax increase would be retro-actively effective for gains recognized after the date “of announcement,” presumably April 2021. Therefore, taxpayers contemplating tax planning techniques during 2021 need to be cognizant of a potential 82% retro-active mid-year capital gains rate increase.
Under the Biden administration’s tax proposal, death and gifts of appreciated property would be treated as realization events (deemed sale) that require gain to be recognized as if the underlying property was sold. The gain would be subject to a $1 million ($2 million for married couples) lifetime exclusion, which would be indexed for inflation after 2022. The donor (i.e., the individual making the gift) or the deceased owner (making the bequest, devise, or other testamentary transfer) of an appreciated asset would realize a capital gain at the time of the transfer.
Transfers of property to irrevocable trusts, partnerships or other non-corporate entities would be deemed realization events. The Administration’s proposals would also restrict the ability to take valuation discounts when transferring partial interests in property, therefore reducing the impact of gifting in an overall estate planning strategy. Any realization tax imposed at death would become a deductible expense on the decedent’s estate tax return, thus reducing estate income.
The tax proposal would be effective for gains on property transferred by gift, and on property owned at death by decedents passing after December 31, 2021, and on certain property owned by trusts, partnerships, and other non-corporate entities on January 1, 2022. Interestingly, The Biden tax proposal does not modify the estate and gift tax lifetime exemption amounts or the top estate tax rate of 40%. However, the Administration plans to allow the current estate regulations to sunset and revert back to pre-TCJA rules ($5M exemption per individual).
WM Wisdom:
Utilizing trusts and family limited partnerships as a key piece of an estate plan have been excellent techniques in minimizing federal estate taxes. However, the new proposal would immediately tax the contribution of assets into these vehicles at a maximum 43.4% rate on the appreciated value. Transfers to revocable grantor trusts would not immediately be subject to the new realization tax when they are funded. However, the grantor would be subject to tax on any unrealized appreciation when assets are distributed to a person other than the owner; or upon the death of the grantor. Estate planners must keep in mind that valuation discounts would be restricted thus triggering an even greater appreciation subject to the new tax.
Estate planners also need to evaluate minimizing the federal estate tax (40%) without triggering a realization tax (43.4%) when restructuring assets as part of an estate plan. Taxpayers can foreseeably have assets under the current or sunsetting estate tax exemption while still being subject to the new realization tax. With the provisions taking effect January 2022, there is a limited 6-month window to consider gifting and other techniques before the realization tax could derail common planning techniques.
Exclusions and other Considerations
Spousal Transfers
The transfer by a decedent to a U.S. spouse (citizen or resident) would carry over the basis of the decedent, and capital gain would not be recognized until the surviving spouse disposes of the asset or dies, at which point the deemed sale rules described above would apply.
Charitable Transfers
A transfer of appreciated property to charity – for example, a contribution of real property or of S corporation stock to a public charity – would not generate a taxable capital gain.
The taxpayer’s transfer of appreciated assets to a split-interest trust (for example, a charitable remainder trust or a charitable lead trust) would generate a taxable capital gain, based upon the actuarially determined value of the noncharitable interest; in other words, an exclusion would be allowed for the charity’s share of the gain inherent in the asset based on the charity’s share of the value transferred as determined for gift or estate tax purposes.
Family Business Exemptions
The tax on the appreciation of certain family-owned and operated businesses would not be due until the interest in the business is sold or the business ceases to be family-owned and operated.
WM Wisdom:
This exclusion described in the Green Book is extremely vague so better guidance defining businesses that will qualify for this exemption is necessary. Given that the Administration considers high-income earners to be those with income in excess of $400K for ordinary tax purposes, planners should be cautioned that any exemption may be small and not beneficial to those families with estates between $10-30M in value. The clarification of this issue will be the single biggest issue when strategizing succession and exit plans for family business owners.
Section 1202 Stock
The exclusion under current law for capital gain on certain small business stock would continue to apply; meaning that the transfer of qualifying C corporation stock by gift or at death would not be treated as a sale of such stock pursuant to the above rules.
WM Wisdom:
Start-up companies who plan to sell in the near future may wish to organize as a traditional C corporation as a planning technique to minimize exit taxes.
90 Year Rule
The Green Book proposal would impose tax on the unrealized appreciation of assets held within a trust, partnership or other non-corporate entity if there has not been a recognition event with respect to the applicable property within the prior 90 years (beginning on January 1, 1940). Accordingly, these entities would be subject to tax with respect to this property beginning on December 31, 2030.
WM Wisdom:
The Administration is focusing on dynasty type trusts that have escaped capital gains taxes for generations. It is important to note that no realization event will need to occur to trigger the tax. Simply put, if the trust holds property that has escaped appreciation taxes since 1940, it will immediately be subject to tax, presumably at a 43.4% rate. Taxpayers should consider planning techniques now as these provisions are effective in roughly nine years.
Payment Plan
The tax proposal allows a 15-year fixed-rate payment plan for the tax on appreciated assets that are transferred at death, except to the extent the tax is attributable to liquid assets (i.e. public traded securities). The IRS would be authorized to require collateral security from the taxpayer at any time it determines there is a reasonable need for security to continue the deferred payment of the tax.
Impact on the Basis of Transferred Property
Under the proposal, the recipient’s basis in property received by reason of the decedent’s death would be the property’s fair market value at the decedent’s death. The same basis rule would apply to the donee of gifted property to the extent the unrealized gain on that property at the time of the gift was not shielded from being a recognition event by the donor’s $1 million exclusion.
For a donor, the amount of the gain realized would be equal to the excess of the asset’s fair market value on the date of the gift over the donor’s adjusted basis in that asset. For a decedent, the amount of gain would be the excess of the asset’s fair market value on the decedent’s date of death over the decedent’s basis in that asset. The restriction against valuation discounts on transfers of partial interests could play a large role in determining taxable gain. That gain would be subject to tax presumably on the federal gift or estate tax return; or on a separate hypothetical capital gains realization tax return.
WM Wisdom:
Below is an illustration of how the new tax proposal may apply to a deceased married couple.
Under current law, the taxpayers’ heirs would inherit the assets with a cost basis equal to the fair market value at the date of death and there would be ZERO federal estate tax due.
Under the proposal, the unrealized gains in excess of $2.5 million, in this case $1.4 million, are subject to tax upon death. Assuming a 43.4% realization tax rate, the estimated tax would be $607,600. This example does not include any additional amounts for state inheritance taxes (if applicable); nor does it contemplate whether states will also adopt the new realization tax concept.
This illustration exemplifies that the new realization tax will have a significant impact on high-income earners as well as middle-class families who have saved their working lives in order to make life better for the next generation.
Planning Implications and Takeaways
Historically, estate planners focused on techniques to minimize estate and gift taxes to pass wealth onto the next generation. With the creation of the new realization tax, a huge curveball has been thrown into the mix.
Specific planning opportunities will depend on the character of assets; unrealized appreciation of those assets; ownership structure, and the taxpayer’s ultimate goals. Wealth transfer techniques that were once efficient will need to be reevaluated to ensure they are still effective. Estate plans will ultimately need to be revisited. There may be increased importance on life insurance strategies and other techniques to protect wealth for future generations.
It is hard to predict if these proposals will make it through Congress. However, it would be prudent to begin gathering a clear picture of your financial position including your basis in appreciated assets so that you will be prepared to act quickly should the provisions become law. At Wouch Maloney, we are ready to lend a helping hand in evaluating how these seismic changes in the tax proposals may impact your overall estate plan.
Suzanne Feldman, CPA, MT and Sweta Joshi, CPA contributed to this article.
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