As in years past, the president’s budget for 2014 targets estate tax planning for high-net-worth individuals. Certain estate planning techniques, like grantor and dynasty trusts, are still on the chopping block and could become unavailable in the near future.
Despite the “permanent” estate tax legislation passed earlier this year, the president wants to return to the higher estate tax rates and lower exemptions that applied in 2009. Under the president’s proposal, as of 2018, the top estate, gift and GST tax rates would return to 45% (up from 40%), the estate and GST tax exemptions would revert to $3.5 million, and the gift tax exemption to $1 million (all down from $5.25 million). None of the exemptions would be inflation-indexed, meaning more families would be subject to estate tax over the years simply due to inflation. The president, however, would keep “exemption portability” between spouses, so a surviving spouse could still benefit from a predeceased spouse’s unused gift or estate tax exemption.
- Potential Impact: The loss of exemption reunification, combined with a smaller gift tax exemption, would make lifetime gift planning far more complicated for wealthy families and closely-held business owners who want to transfer ownership to their family members during life. Direct gifts, which are relatively simple to implement, would be effectively capped at $1 million. Clients would then need to use more complex strategies (like zeroed-out GRATs and installment sales to grantor trusts) to transfer additional wealth at minimal gift tax cost. Unfortunately, this type of complexity can deter many clients from lifetime planning.
Unlike last year’s proposal to subject all grantor trusts to transfer tax, this year’s budget would only tax property transferred to trusts through sales or similar transactions that are “disregarded” for income tax purposes under the grantor trust rules (e.g., sales to grantor trusts). Limited exceptions would apply, such as for trusts deemed grantor trusts solely because a trustee can use trust income to pay premiums on life insurance covering the grantor or his/her spouse (a typical provision found in many irrevocable life insurance trusts).
- Potential Impact: Even in its more restricted form, passage of this proposal would adversely affect planning with grantor trusts. Most installment sales to grantor trusts would become ineffective for estate planning because both the property sold to the trust, plus any later appreciation, would incur estate tax. The exclusion for trusts that only contain a premium paying power affords some comfort, but many advisors like to include other powers that can trigger grantor trust status (such as the grantor’s non-fiduciary power to substitutes trust assets with other assets of an equivalent value). This proposal eliminates that flexibility.
Many states allow the creation of perpetual, or “dynasty” trusts. If created as GST-exempt trusts, these dynasty trusts can perpetually shelter trust assets from estate and GST taxes, generation after generation. The Obama administration, however, wants to terminate a trust’s GST-exempt status on its 90th anniversary and subject the trust assets or subsequent distributions to GST tax.
- Potential Impact: Passage of this proposal would limit the long-term tax leverage afforded by GST exempt trusts and a family’s ability to preserve wealth over time. For example, if a trust is funded with $5.25 million and has net growth of 3% each year for 90 years, the trust would hold over $75 million. If the trust’s GST tax exemption continues, the entire $75 million will be available to the trust beneficiaries. If a 40% GST tax applies, $30 million would be lost in taxes, leaving only $45 million in the trust.
Generally, direct payments to medical care providers or for tuition for another person are gift and GST-tax exempt. HEETs are dynasty trusts that make these “qualified transfers” for the benefit of grandchildren and later generations to avoid GST tax. Meanwhile, the trust assets grow transfer tax-free. To deter the use of HEETs, the Administration would limit the availability of the GST exemption only to qualified transfers made directly by a living donor and not through trusts.
- Potential Impact: This proposal would affect all non-exempt trusts, not just HEETs. A trustee of a non-exempt trust could no longer use qualified transfers to limit GST tax exposure on trust distributions for grandchildren or other “skip” beneficiaries.
The 2014 budget is only the Obama administration’s "wish list" for future tax legislation. With Congress deeply divided over tax reform, it is impossible to predict whether any of these proposals will become law. Still, given the continued fluidity and uncertainty of the current tax situation, now could be the optimum time for planners and clients to take advantage of the targeted techniques.
Attorneys Jonathan M. Forster and Jennifer M. Smith are shareholder and associate, respectively, at Greenberg Traurig LLP.