This article describes two possible tax law changes currently being considered by Congress. The likely impact on high-net worth individuals and families cannot be overstated. If either bill is signed into law, then the estate tax burden on your heirs will increase by over $3 million (or over $6.8 million for couples).
Planning to minimize the financial effect of these changes requires a long lead time. In my law practice, for example, I anticipate that I will stop accepting new clients for this type of planning no later than the end of September. Contact my law office without delay to begin the planning process.
Introduction
For the first time since 2011, the Democratic Party obtained control over the Presidency and both houses of Congress in the wake of the 2020 election. For President Biden and many legislators, one top priority appeared to be revamping the tax code, specifically how it impacts high-income individuals.
In March 2021, a number of senators proposed two pieces of legislation that could dramatically impact the tax consequences related to estate planning. These pieces of legislation are known as the Sensible Taxation and Equity Promotion (STEP) Act and the 99.5% Act. Given the rapid pace that legislators are unveiling these substantial changes to the tax code, there is little doubt that revising the way the federal government taxes high earners is a top priority for those currently in power.
For The 99.5% Act
The 99.5% Act was unveiled on Thursday, March 25, 2021. Crafted by Bernie Sanders — the independent senator from Vermont — this legislation has several similarities to the For The 99.8% Act proposed by Senator Sanders in January 2019.
The effect that the For the 99.5% Act would have on the estate planning process would be sweeping. The legislation proposes changes not only to the estate tax rates but also reduces gift tax credits. The legislation also removes exemptions from the gift tax for assets held in certain types of trusts.
Tax Rate Increases
Much of the focus on the For The 99.5% Act concerns the impact the legislation has on the estate and gift tax rates as well as generation-skipping transfers. Currently, these tax rates are fixed at 40% for all qualifying estates.
The Act replaces this set percentage with a progressive taxation scheme:
- Estates worth between $3.5 million and $10 million are taxed at 45%
- Estates worth between $10 million and $50 million have a tax rate of 50%
- Estates worth between $50 million and $1 billion are taxed at 55%
- Estates worth more than $1 billion face a tax rate of 65%
Tax Credits
In addition to increasing the tax rate, the act also reins in many of the tax credits relied on during the estate planning process. These include credits for the estate and gift tax as well as generation-skipping transfers.
Under current law, the exemptions for all three taxes are $11.7 million per individual and $23.7 million per married couple. This amount falls drastically under the proposed Act. According to the legislation, estate tax exemptions are reduced to $3.5 million per individual ($7 million per married couple), and gift tax credits fall to $1 million. While the estate tax exemption would continue to be indexed to inflation, the gift tax exemption would not be.
Reduction Of Trust Options
Many estate plans for wealthy families rely on the use of certain “grantor trusts” to shield their assets from the estate tax. These trusts effectively remove the assets from the estate, avoiding any tax burden based on their value.
Using an irrevocable grantor trust, a trust creator could transfer up to $11.7 million into the trust without paying gift taxes. At their death, the assets within the trust are considered not to be the property of the deceased person. The end result is that this money is transferred without any estate tax liability.
The 99.5% Act changes this option. According to the legislation, these types of trusts would be included in a decedent’s estate at the time of their passing. It is important to note that this change would only affect trusts created or contributions made after the date the law goes into effect. This means that while individuals who have spent years building up these trusts could still take advantage of the tax benefits, ; any trusts created in the future will not.
Valuation Discounts
Another less-discussed estate planning tool that could be off the table involves valuation discounts. Under the current law, there are many ways to discount the value of an asset for estate tax purposes, including illiquidity. Many creative estate planners have crafted discounts that apply to assets that retain their marketability. The act would limit valuation discounts to assets used as part of a trade or business. Any discounts related to non-business assets would be eliminated.
The STEP Act
Only days after the proposal of the For The 99.5% Act, a group of five senators proposed the Sensible Taxation and Equity Promotion (STEP) Act. The sponsors include Senators Bernie Sanders of Vermont, Cory Booker of New Jersey, Elizabeth Warren of Massachusetts, Chris Van Hollen of Maryland, and Sheldon Whitehouse of Rhode Island.
The STEP Act also targets assets transferred upon death, but it does so differently compared to the 99.5% Act. This legislation taxes capital gains that are transferred upon death or through a lifetime gift. Unlike the For The 99.5% Act, which would not take effect until December 31, 2021, the STEP Act would be retroactive to December 31, 2020.
The central aspect of this Act involves changes to something known as a “stepped-up basis.” Under the stepped-up basis rule, the value of assets inherited at death is a “stepped-up” to their current market value. This is an enormous benefit for anyone inheriting stocks, bonds, or even real estate that has greatly appreciated over the years.
Without stepped-up basis, the inheritors of this wealth would face tax liability for the capital gains based on the increase in value. The Act also limits the ability of families to use trusts to avoid these taxes in ways similar to the For The 99.5% Act.
Although the STEP Act would allow capital gains taxes upon death, the legislation does outline some exemptions. There is an initial flat exemption of $1 million available to all estates on appreciated assets. The proposed legislation would initially exempt the first $1 million in asset appreciation from any gain recognition. So a smaller estate valued under this proposed initial amount would potentially exempt the heir’s from any steep costs.
There are additional exemptions beyond the $1 million available to everyone. Specifically, there is a $500,000 exemption for personal residences above and beyond the $1 million exemption. There are additional exemptions for gifts and bequests to charity.
Likewise, assets held in retirement accounts would not fall under this rule change. There are also protections to ensure that individuals are not double taxed, with income taxes paid under the Act being deductible for the purposes of the estate tax.
The Outlook On Passage
Washington has earned a reputation for gridlock in recent years, but that should not leave you with the impression that the passage of the Step Act or the 99.5% Act is impossible or even unlikely. Thanks to a process known as budget reconciliation, it is possible that both pieces of legislation could become law before the end of the year.
Budget reconciliation is an important part of why passage is a possibility. Under current Senate rules, the filibuster largely prevents the passage of major legislation without 60 votes. Given the even split in the Senate, it is unlikely that Democrats would be able to find the 10 additional votes they would need.
With budget reconciliation, they won’t need those additional 10 votes. Budget reconciliation rules allow for the passage of legislation that directly impacts the federal budget with only a majority vote. In other words, this legislation is likely to become law if it is included in the impending infrastructure bill that will likely go through the budget reconciliation process in 2021. There are limited opportunities for the use of budget reconciliation each year. It remains to be seen if either of these pieces of legislation will be included in the process.
The Impact Of This Legislation
Should one or both of these pieces of legislation become law, the impact on the estate planning process could be substantial. This impact could occur sooner than you might think. As written, the 99.5% Act goes into effect on December 31, 2021.
This means the 99.5% Act could radically alter the face of your estate plan in the early part of next year. This is true for anyone with an estate plan that is still living into the new year, as well as for any assets that are not gifted by December 31, 2021.
Given the increased tax rates and the tightening of exceptions on certain trust assets, it could be in your best interest to make these gifts or generation-skipping transfers before the year is out.
Arguably the largest impact on estate planning involves the new limits placed on grantor trusts. Countless Americans have created these trusts as a form of estate planning device. In the near future, this option will no longer be available.
Likewise, the implications of the STEP Act on estate planning are clear. Many estate plans make liberal use of the stepped-up basis rule. With that rule largely gone, it could have a steep impact on large estates. It is worth remembering that the $1 million exemption could greatly reduce the impact for families with smaller estates. Ultimately, now is the time to discuss these potential changes to your estate plan with an experienced attorney.
Summary
If you are concerned about burdening your heirs with an exponentially higher estate tax bill, now is the time to begin planning. It will be a complex process that could require you to spend as much as $30,000 — but consider that the goal is to save as much as $6 million. Several professionals will be involved in the process, including your estate planning attorney, your accountant, your financial planner, and perhaps even outside appraisers. If you wait until November or December to begin the planning process, you will be too late. To begin the consultation process, contact my Palo Alto estate planning law office.
