April 2, 2021
Estate and Tax Update - "For the 99.5% Act" and new "Wealth Tax"
For the 99.5% Act
On March 25, Senators Bernie Sanders and Sheldon Whitehouse introduced legislation titled the “For the 99.5 Percent Act”. It is early, but the bill is still worth consideration given the House and the Administration are generally on the same side of the issues.
The components of the bill are mostly ideas that have been floated in prior legislative proposals or in budget Green Books during the Obama Administration years, so in general this looks like familiar territory for Democratic policy makers. Since this is likely a revenue raiser in and of itself, it would not be subject to the 10 year budget window in the Senate that causes sunset expirations of tax law changes.
Here is a first pass and quick list of what is included in the bill.
Lowering of Estate and Gift Exclusion and GST Exemption
The current inflated limitations of $11.7 million for the estate tax exclusion and the GST exemption would be reduced to $3.5 million. The gift tax exclusion would be reduced to $1 million. This would be a return to the laws that were in effect during the 2001 EGTRAA phase-in period when the gift tax exclusion was static. The draft of the legislation does not alter the language of Section 2001(g), part of TCJA in 2017, which directed Treasury to issue regulations to address the issue of “clawback” effects upon the lowering of a pre-existing exclusion amount that has been used in a decedent’s lifetime gifting. It remains to be seen if a Yellen Treasury would revisit the current regulations that prevent clawback of prior taxable gifts.
These changes would be effective for deaths, gifts and GST transfers after December 31, 2021.
Estate and Gift Tax Rates
The estate and gift tax rate on cumulative transfers would be increased from the current 40% to 45% for wealth transfer above $3.5 million, 50% for wealth transfers above $10 million, 55% for wealth transfers above $50 million, and 65% for wealth transfers above $1 billion. This change would also be effective after 2021.
By way of adding new Code Section 2031(e), discounts such as for minority interest holdings and lack of marketability would not be permitted for interests held or transferred in entities controlled or majority-owned by the donor/decedent, transferee, and related family members. This elimination of valuation discounts would be effective for transfers after the date the legislation is enacted.
Look-through Rule for Valuation of Nonbusiness Entities
A further valuation change would be new Code Section 2031(d), implementing a restriction of valuations of entity ownership interests where the entity holds passive and other nonbusiness assets. The entity ownership would be ignored for valuation purposes, and the estate or gift value would be derived from a look through to the proportionate share of the entity’s nonbusiness assets. Further detail is drafted regarding the determination of trade or business vs. other assets, and further look through on tiered entities. This change would be effective for transfers occurring after the date the legislation is enacted.
Severe Restrictions to Qualifying GRATs
Code Section 2702 would be revised so that a GRAT would have to have a minimum annuity period of 10 years. A maximum period is also included, being the life expectancy of the donor plus 10 years (apparently targeting the niche planning of 99-year GRATs). Also, the value of the remainder interest upon contribution to the GRAT would have a minimum of the greater of 25% of the present value of the property, or $500,000, but no more than the total value of the property. This eliminates planning with zeroed-out or near zeroed-out GRATs. It becomes difficult to identify when use of a GRAT would make sense given mortality risk and a forced taxable gift within reduced gift tax exclusion levels. This change would be effective when the legislation is enacted.
Inclusion of Grantor Trust Assets in Estate
New Section 2901 would be added to the Code to cause the assets of irrevocable grantor trusts to be included in the grantor’s taxable estate. If grantor trust status is relinquished during life, the trust assets would be treated as being transferred in a completed taxable gift (offset by the amount of taxable gifts previously made by the grantor to the trust). Also, distributions from the grantor trust during the grantor’s life would be treated as completed gifts.
Grantor trust status would extend to a deemed owner of trust assets pursuant to the grantor trust rules of Sections 671 through 679, when the deemed owner “engages in a sale, exchange, or comparable transaction with the trust that is disregarded” for income tax purposes. This would cause beneficiary defective trusts to be included in the taxable estate of a Section 678 deemed owner.
Any estate or gift taxes imposed as a result under this rule would be a liability of the trust, not the grantor, i.e. no tax-free gift imputed by payment of the tax. The grantor trust changes would be effective for trusts created after the date of enactment, for new gifts to grantor trusts after date of enactment, and for new transactions after the date of enactment.
Elimination of Dynasty Trusts
GST exempt transfers and distributions from trusts cannot extend more than 50 years from the creation of the trust. After 50 years, the inclusion ratio of the property transferred from the trust is 1. The proposal does not effect the length of dynasty trusts under state trust law, but would truncate the length of GST exemption. The inclusion ratio of 1 would take effect upon a GST transfer (taxable distribution, taxable termination or direct skip), so it seems that for GST exempt trusts that accumulate income and principal and do not have a distribution or termination until, for example, 70 years, the GST tax event would be at 70 years, not imposed at the 50 year time limit. These changes would be effective on date of enactment of the legislation. For pre-existing GST exempt trusts, the 50 year period commences on date of enactment.
Elimination of Crummey Power Regime
The "present interest" requirement for annual exclusion gifts would be removed for annual exclusion gifts, meaning there is no need to structure for Crummey powers for gifts to trusts. However, the price for that change is that there would be a limit of $20,000 (plus inflation, so now $30,000) allowed as annual exclusions for total gifts by a donor in each year that are made to trusts, as gifts of passthrough entity interests, and/or made in any other manner that the gifted property cannot be immediately liquidated by the donee. It appears that other than outright gifts of cash, cash equivalents and marketable securities, and perhaps fee interests in tangible property, only a very limited amount of other property gifts, and all gifts to trusts regardless of the presence of withdrawal rights, could be made each year and still qualify for the annual exclusion. This change would be effective for all years beginning after the year the legislation is enacted.
A Couple of Changes for the Better
Code Section 2031(c)(1) contains limitations on the amount of exclusion from the gross estate that is allowed for value of land due to the presence of a conservation easement on the land. The proposed legislation would increase the existing cap of $500,000 to $2 million. There is also a proposed change to the percentage of the encumbered land that can be taken into account in the deduction.
Code Section 2032A contains special valuation rules for real property used in farming or other trade or business in determining the gross estate. The current reduction to property valuation is limited to $750,000, adjusted for inflation. For 2020, the adjusted limit for property value reduction was $1,180,000. The proposed legislation adjusts the $750,000 statutory amount to $3 million, and changes the baseline for the inflation adjustment from the year 1997 to 2021.
What is Not Included
Unlike the loosening of existing restrictions on farm property valuation and ceilings on conservation easements, there is no provision to make an exception to any of the above changes for family-owned businesses, such as the now repealed Code Section 2057 deduction for estate assets consisting of family business ownership.
There is no global elimination of date of death valuation as has been proposed by President Biden during the presidential campaign. Perhaps this might become part of income tax and corporate tax legislation to be proposed by the Administration.
Proposed Legislation for a Wealth Tax
Senator Elizabeth Warren, now a member of the Senate Finance Committee, has introduced legislation to create an annual wealth tax.
The legislation largely tracks the wealth tax she had proposed during her presidential campaign in 2020. It is much more of a niche proposal then the Sanders estate and gift tax legislation summarized above, and might seem farfetched and destined toward the dust bin of congressional proposals. But perhaps the toughest part to achieving law will be holding together 50 Democratic and caucusing senators. Who is to say at this point what cannot happen? In any event, it is fascinating to read through what Senator Warren has cooked up on this one.
The bill, titled the “Ultra-Millionaire Tax Act of 2021”, proposes an annual tax assessment of 2% on a taxpayer’s net wealth that exceeds $50 million. The rate would
increase to 3% for net wealth above $1 billion. However, that higher tax rate would be adjusted to 6% for the billionaire class if at any time there is signed into law universal health care that prohibits private health insurance. For taxpayers who attempt to weasel out of the obligation by relinquishing citizenship (covered expatriates under Section 877A), there would be a 40% tax rate applied to the year of exiting. In the year of death, the wealth tax would be imposed in addition to any estate tax.
The bill appropriates $70 billion to Treasury over ten years for enforcement. That is a good idea since the bill would require the IRS to annually audit not less than 30% of taxpayers required to pay the wealth tax.
Section 6161 would be amended to provide for an extension of up to five years to pay the tax for taxpayers that demonstrate “severe liquidity constraints” or if there would be undue hardship on an “ongoing enterprise”. Section 6662 would be amended to include a substantial wealth tax valuation understatement if the value claimed on a wealth tax return was less than 65% of final determination, with a penalty of 30%, but then a 50% penalty for gross understatements if the net wealth value claimed on the return was 40% of the correct amount.
Individuals and trusts would be subject to the wealth tax. Married persons would be treated as one individual. Trusts that have “substantially the same beneficiaries shall be treated as a single applicable taxpayer”. Imagine the regulation-writing project for that item.
All “property of the taxpayer”, unless specifically excluded, would be included in the calculation of net wealth, and then reduced by debts. Any property includable in the gross estate of the taxpayer under estate tax rules would be included as property of the taxpayer. Assets in grantor trusts would be included as property of the taxpayer (and not in the determination of trust wealth). Property transferred to minor children would be included in the transferor’s wealth calculation. Assets excluded from determining wealth would be tangible personal property up to a cumulative $50,000 and which is not a collectible.
Recognizing the elephant in the room of how to administer the valuation requirements of all property of a taxpayer every year (except $50,000 of tangible personal property), Senator Warren has a plan for that in the bill. Unfortunately, the plan is to tell Treasury to figure it out. To value illiquid assets, regulations may “utilize retrospective and prospective formulaic valuation methods not currently in use” by the IRS, “may require the use of formulaic valuation approaches for designated assets, including formulaic approaches based on proxies for determining presumptive valuations, formulaic approaches based on prospective adjustments from purchase prices or other prior events”, etc., etc. In other words, don’t worry about paying for appraisals, we will tell you what your assets are worth under our tables.
Forgetting about the poor billionaires for the moment and focusing on the garden variety $50 million client, a public reaction to the wealth tax might be that a 2% tax rate is not much to ask. For taxpayers now accustomed to income tax rates topping out near 40%, and estate and gift tax rates of a flat 40% above the basic exclusion, a 2% wealth tax seems low.
Of course, a tax rate on wealth is not equivalent to a tax rate on income and capital gains. If a taxpayer would prefer not to have to liquidate invested capital to pay the annual tax, the tax payment would need to come from income and annual return on investment. The current rate on investment income of high bracket taxpayers is a combined 23.8%. Adding a 2% wealth tax burden on to the same investment assets that are producing, for example, a blended 8% return, implies a combined tax burden equivalent to a 48.8% income tax on that capital.
It is still early for both of these newly proposed legislations, however it is clear that estate and tax planning will be a high priority item this year.