UPDATE – October 6, 2021: The BBB Bill has not been passed by the House of Representatives as the Democratic caucus has not yet reached a consensus. When and if the House Democrats pass the BBB Bill, it will head to the Senate where it will be further amended. It is unknown when the Bill will make it out of Congress and to the President’s desk, but we might see increased pressure as the October 18 deadline to raise the debt limit approaches.
On September 15, the House Ways and Means Committee approved the tax provisions of the proposed Build Back Better Act, which would fund President Biden’s social and education reforms. As we await further Congressional action, we’ll refer to this as the “BBB Bill.”
Although the BBB Bill has not yet been approved by Congress or the President – with likely modifications to come – potential changes to estate taxes, grantor trust and income taxes warrant careful consideration for high-net-worth and high-income individuals. We summarize below the most pertinent aspects of the BBB Bill.
Transfer Taxes: Exemptions Are Going Down and a Popular Planning Technique Goes Away
Congress initially created the modern estate tax back in 1914. Since then, the amount that individuals can pass to their beneficiaries without incurring tax has climbed in fits and starts. The unified estate and gift tax basic exclusion amount (BEA) – the maximum amount that may be passed from an individual to his/her beneficiaries before the transfer incurs gift or estate tax – was set at $5 million per person in 2011, to be adjusted upward for inflation annually. However, the 2017 Tax Cuts and Jobs Act doubled the BEA for nearly a decade with the legislation including a sunset provision back to the inflation-adjusted 2011 figure in 2026. Absent additional action from Congress, the BEA will continue to rise from the current $11.7 million figure in 2021 until 2026 when the figure would speculatively be approximately $6.5 million to $7 million. The figure is currently set to be $12.04 million in 2022.
However, the BBB Bill accelerates the sunset to the inflation-adjusted BEA. The proposed legislation would be effective from January 1, 2022 onward, lowering each individual’s 2022 BEA from $12.04 million to $6.02 million. As a result, individuals are able and encouraged to structure their estate plans prior to the end of the year to take advantage of the vanishing half of their BEA in the event that the BBB Bill passes and is signed into law.
In addition to the lowered BEA, a popular technique for enhancing the efficiency of gifts is on the chopping block. Under current law, gifts of interests in entities holding nonbusiness assets are eligible for valuation discounts based on the lack of marketability associated with the entity interest and the lack of entity control associated with the gifted interest. The BBB Bill proposes to explicitly disallow valuation discounts for such transfers. Additionally, whereas the reduction of the BEA is scheduled to be effective from January 1, 2022 onward, the disallowance of valuation discounts for gifts of interests in nonbusiness entities is scheduled to occur on the effective date of the BBB Bill. If you are considering such a gift, time is of the essence.
Grantor Trust Rules: All Irrevocable Grantor Trusts Would Be Treated as Separate Taxable Entities as of the Effective Date of the BBB Bill
While the exemption may be in place through the end of the year, that does not mean that individuals will have that long to take advantage of planning opportunities. For decades, individuals have been able to create irrevocable trusts and have them treated as “grantor trusts,” meaning that after the transfer of assets to the irrevocable trust (which uses a corresponding amount of the grantor’s BEA), the trust itself, including all future appreciation of the transferred assets, is excluded from the grantor’s taxable estate. At the same time, the grantor can remain individually liable for income taxes earned by the trust so that the gift to the trust would be undiminished by income taxes while the grantor’s taxable estate would be further reduced via income tax payments. Grantor trusts are commonly used as a technique to reduce or eliminate estate taxes in taxable estates.
The BBB Bill provides that any grantor trust created on or after the date of the enactment of the bill will be included in the grantor’s taxable estate, effectively eliminating their utility for gift tax planning. Under the BBB Bill, existing grantor trusts (and contributions made prior to the enactment date) will be grandfathered under the current rules whereas any amounts contributed to a preexisting grantor trust after the enactment date will be subject to the new rules and includable in the grantor’s taxable estate. Therefore, in order to take advantage of the grantor trust rules (and the increased exemption), it is imperative to have your grantor trust both executed and funded prior to the enactment date of the BBB Bill.
This presents a number of considerations depending upon the type of grantor trust contemplated. For example, individuals creating Grantor Retained Annuity Trusts will not be able to utilize a technique known as “rolling GRATs” (where successive short-term GRATs are used to allow an investment to either succeed or fail quickly, and then begin a new annuity term) because one or more successive GRATs would not be available. Further, given the broad language of the BBB Bill, making required annuity payments to a grantor of a preexisting GRAT could trigger a deemed sale and capital gains taxes. Individuals contemplating establishing a life insurance trust as a grantor trust should consider gifting several or many years worth of insurance premium payments to the trust now since contributions to the trust to pay insurance premiums in future years will not be subject to grantor trust rules. Individuals contemplating the sale of an appreciated asset to a grantor trust should execute both their grantor trust as well as the sale documents before the BBB Bill is enacted. Under the current rules, such a sale is not a taxable event since the grantor and the trust are the same taxpayer, but under the new rules, since the grantor and the trust would be separate taxpayers, such a sale would be a taxable event triggering income tax recognition for the grantor. Often, these types of sale transactions involve substantially appreciated assets and built-in gains, and this strategy will be largely unavailable or ineffective after enactment of the BBB Bill.
The grantor trust types noted here are not an exhaustive list. There are several other types of grantor trusts, and as noted above, this type of planning is highly complex and nuanced. Acting sooner rather than later to be grandfathered into the existing grantor trust rules is imperative to ensure your ability to take advantage of this valuable estate and gift tax planning tool.
Income Taxes: They’re Going Up
The BBB Bill contemplates several changes to individual income tax rates, including increasing the top marginal income tax rate, lowering the thresholds to which the top rate applies, increasing the maximum long-term capital gains rate, imposing an additional surtax to high income, expanding the net investment income tax, limiting contributions to IRAs and increasing required minimum distributions, and limiting back door Roth IRA conversions.
The top marginal individual income tax rate would be increased to the pre-Tax Cuts and Job Act rate of 39.6 percent and would also increase the number of people to which it applies by lowering the income threshold, effective January 1, 2022. The top tax rate would apply to those with taxable income exceeding:
- $450,000 for a jointly-filing married couple
- $400,000 for a single individual
- $250,000 for a separately-filing married couple
- $12,500 for a trust or estate.
An additional 3 percent surtax would apply to non-corporate taxpayers on modified adjusted gross income in excess of $5,000,000. Note that for a separately-filing married couple, that threshold would be $2,500,000, and for trusts and estates, the threshold would be $100,000.
As expected, the BBB Bill would increase the maximum capital gains rate from 20 percent to 25 percent. Although this is significant, this is less than Biden’s original proposal to tie out the capital gains rate bracket with the ordinary income rate bracket. The increased rate would apply to capital gains and dividends recognized after September 13, 2021, though some exceptions would apply for sales subject to a binding contract in effect on or before that date.
Currently, an additional 3.8 percent tax is applied to a taxpayer’s net investment income earned from a business if the taxpayer is passive with respect to that business; if a taxpayer is active, that tax is not applied. The BBB Bill would subject active business income to the 3.8 percent tax if income exceeds:
- $500,000 for a jointly-filing married couple
- $250,000 for a separately-filing married couple
- $400,000 for all other taxpayers
Effective January 1, 2022, the BBB Bill would inhibit high income taxpayers’ ability to defer paying these increased income taxes through contributions to IRAs by prohibiting contributions when the total balance of a contributor’s IRAs and other retirement accounts exceeds $10 million and taxable income exceeds $450,000 for a jointly-filing married couple or $400,000 for a single taxpayer or a separately-filing married couple. Further, these taxpayers would be required to take a required minimum distribution equal to 50 percent of the value that exceeds $10 million, plus 100 percent of any amount exceeding $20 million.
Taxpayers with income that exceeds certain thresholds are barred from contributing to Roth IRAs, but in a technique referred to as “back door Roth IRA conversion,” they can make a contribution to a traditional IRA and then convert it to a Roth IRA. The BBB Bill would bar jointly-filing married couples with income exceeding $450,000 and separately-filing married couples and individuals with income exceeding $400,000 from using this technique.
Although the cumulative effect of these changes would be substantial for some high income individuals, there is a glimmer of good news, as the BBB Bill does not include any provisions to eliminate step up in basis rules upon the death of an individual, nor does it include provisions that would trigger capital gains tax when a gift is made upon the death of a taxpayer.
Please stay tuned as the BBB Bill makes its way through the legislative process and contact a Varnum estate planning attorney with your questions. As described above, you will not want to wait until legislation is passed to take action.