Proposed Build Back Better Act Includes Tax Changes Significantly Impacting Estate Planning

On September 13, 2021, the Chairman of the House Ways and Means Committee released the proposed “Build Back Better Act” (the “Proposed Act”). The House Ways and Means Committee advanced its portion of the Proposed Act on September 15, 2021, which addresses numerous fiscal issues, including many tax increases. This Alert will provide a brief overview of the Proposed Act provisions affecting estate planning for high-income and high-net-worth individuals.

Proposed Legislation

Proposal From House Ways and Means Committee

It must be stressed that the portions of the Proposed Act advanced by the House Ways and Means Committee is near the beginning of the legislative process. At this time, we cannot be certain whether any of the provisions discussed in this Alert will become law.

Increases in Income Taxes

Although this Alert focuses primarily on the proposed changes affecting transfer taxes, we would be remiss if we did not mention some key changes to income taxes.

Under the Proposed Act, the ordinary income tax rate would be increased from 37% to 39.6% for single individuals with taxable income over $400,000 ($450,000 for married couples filing jointly). An additional 3% surtax would be imposed on individuals with modified adjusted gross income in excess of $5 million. In addition, the 3.8% net investment income tax, effectuated as part of the Affordable Care Act, would be expanded to encompass income from a trade or business for single individuals with taxable income over $400,000 ($500,000 for married couples filing jointly). These changes would be implemented after December 31, 2021.

The capital gains tax rate also would be increased from 20% to 25% for single individuals with taxable income over $400,000 ($450,000 for married couples filing jointly). This increase could be effective for all capital gains after September 13, 2021, although there is an exception for gains arising from a transaction that was closed pursuant to a written binding contract in existence as of September 13, 2021.

Reduction in Estate/Gift and GST Tax Exemption Amounts

The Tax Cuts and Jobs Act, which took effect in 2018 and is set to sunset on December 31, 2025, significantly increased the gift/estate tax exemption and generation-skipping transfer (“GST”) tax exemption amounts, which currently are $11.7 million (this amount is $10 million indexed for cost-of-living adjustments after 2010). The Proposed Act reduces the exemption amounts to $5 million indexed for cost-of-living adjustments after 2010 (estimated to be approximately $6 million in 2022). This reduction would be effective after December 31, 2021.

Limitation on Use of Irrevocable Grantor Trusts

One of the most useful estate planning vehicles for high-net-worth individuals is the irrevocable grantor trust. These trusts are structured in such a way that the grantor is treated as the owner for income tax purposes (i.e., they are the deemed owner of the trust assets) but not for transfer tax purposes. As a result, the grantor is able to use assets in his or her taxable estate to pay the income tax liability generated from the trust assets, which indirectly shifts wealth to the trust free of transfer tax.

Under current law, a grantor may sell assets to his or her irrevocable grantor trust without incurring income tax. Because the grantor is treated as both the seller and the purchaser for income tax purposes, there is no gain to report on the sale. The Proposed Act adds section 1062 to the Internal Revenue Code (the “Code”), which treats the sale between an irrevocable grantor trust and its grantor (or deemed owner) in the same manner as a sale between the grantor and a third party. As a result, these sales would no longer be free from income tax.

In addition, under current law, an irrevocable grantor trust is not subject to estate tax at the grantor’s death. The Proposed Act adds section 2901 to the Code, which includes all or the portion of the irrevocable grantor trust deemed owned by the grantor at his or her death in his or her gross estate for estate tax purposes. Further, Code section 2901 treats a distribution from the grantor trust portion to a beneficiary as a gift and the termination of grantor trust status as a gift of the entire grantor trust portion.

Both proposals would be effective as of the date the proposed legislation becomes law (the “Enactment Date”). The new Code sections would be applicable to irrevocable grantor trusts created after the Enactment Date and to the portion of an irrevocable grantor trust which is attributable to a contribution made after the Enactment Date. Irrevocable grantor trusts that were created and funded prior to the Enactment Date will be exempt from the new rules, except to the extent any contributions are made to these trusts after the Enactment Date.

Elimination of Valuation Discounts for Closely-Held Nonbusiness Assets

Another important aspect of estate planning for high-net-worth individuals is the application of valuation discounts to interests in closely-held entities (e.g., family partnerships and limited liability companies). Under current law, an interest in a family partnership or limited liability company that is not publicly traded and in which the owner lacks voting control must be discounted from its underlying value to reflect its lack of marketability and control. These discounts can be substantial and are often disputed by the IRS.

The Proposed Act would amend Code section 2031 by eliminating valuation discounts for nonbusiness assets. Nonbusiness assets are defined as passive assets held for the production of income and not used in the active conduct of a trade or business. A look-through rule would treat the owner as if he or she held a pro-rata portion of the nonbusiness assets outright rather than as part of the closely-held entity. The proposed amendment is far reaching and would increase the value of interests in many closely-held entities for transfer tax purposes. The effective date of the amended Code section would be the Enactment Date.

Changes to Individual Retirement Accounts

Perhaps due to recent articles highlighting multi-million and even multi-billion dollar Roth individual retirement accounts (IRAs), the Proposed Act adds new Code section 409B that prohibits contributions by certain taxpayers to an individual retirement plan when his or her combined account balance in all applicable retirement plans, including traditional IRAs, Roth IRAs and defined contribution plans, exceeds $10 million at the end of the preceding calendar year. This limitation applies to single individuals with taxable income over $400,000 ($450,000 for married couples filing jointly).

In addition, the Proposed Act includes a new mechanism for determining required distributions from large retirement plans held by single individuals with taxable income over $400,000 ($450,000 for married couples filing jointly). The Proposed Act modifies Code section 4974 by adding new required minimum distributions based on threshold amounts regardless of the age of the owner. In any year where an applicable individual’s combined account balance in all applicable retirement plans exceeds $10 million, a minimum distribution of 50% of the excess amount over $10 million must be taken. If the applicable individual’s combined account balance is over $20 million and the applicable individual has one or more Roth accounts, there is a two part additional minimum required distribution. First, 100% of the excess amount over $20 million must be taken from the Roth accounts to the extent of those accounts. Second, 50% of the excess amount over $10 million less the amount taken from the Roth accounts must be taken from the retirement accounts of the individual’s choosing.

The Proposed Act also modifies the rules regarding conversions of traditional IRAs to Roth IRAs. While there are limitations to contributions to Roth IRAs for single individuals with taxable income over $140,000 ($208,000 for married couples filing jointly), there are no such income-based limitations for conversions of traditional IRAs to Roth IRAs. As such, under current law, an individual with taxable income in excess of the threshold amount is permitted to make a contribution to a traditional IRA and subsequently convert the traditional IRA to a Roth IRA. The Proposed Act eliminates Roth IRA conversions for single individuals with taxable income over $400,000 ($450,000 for married couples filing jointly).

The new rules for retirement plans discussed above apply to tax years beginning after December 31, 2021. It should be noted that the effective date for Roth conversions is stated as December 31, 2031.

Increase in Code Section 2032A Special Valuation Reduction

On a more positive note, the Proposed Act bolsters the special valuation reduction provided under Code section 2032A. This reduction allows estates of decedents that own qualified real property used in a farm or other trade or business to value the qualified real property for estate tax purposes based on its actual rather than fair market value. The Proposed Act increases the maximum reduction from $750,000 to $11.7 million. This increase would be effective for estates of decedents dying after December 31, 2021.

Good News (Thus Far)

The Proposed Act did not contain many other proposed tax increases, including:

Retroactive reduction in estate/gift exemption
Increase in the estate/gift tax rate
Deemed capital gains on gifts
Deemed capital gains at death
Elimination of the step-up in basis at death
Limitation on the term of GST exempt trusts
Mark to market tax on long-term trusts

Conclusion

We will continue to monitor the progress of the Proposed Act. Although we cannot be certain whether any of the provisions disclosed in the Proposed Act will become law, we believe it is necessary to highlight that certain provisions discussed in this Alert would be effective as of the Enactment Date. As such, if you wish to take advantage of the current tax laws before any of the proposed changes are enacted, then it is imperative that you contact your attorney at Dean Mead immediately.

If you have questions regarding the proposed Act or would like to discuss the impact of it on your particular estate plan with your attorney at Dean Mead, please contact our toll free number at 877-363-8992.

Orlando

Lauren Y. Detzel
She may be reached at ldetzel@www.deanmead.com or through her assistant, Anna Hernandez, at ahernandez@www.deanmead.com.

Matthew J. Ahearn
He may be reached at mahearn@www.deanmead.com or through his assistant, Maggie Rivera, at mrivera@www.deanmead.com.

David J. Akins
He may be reached at dakins@www.deanmead.com or through his assistant, Maggie Rivera, at mrivera@www.deanmead.com.

Brian M. Malec
He may be reached at bmalec@www.deanmead.com or through his assistant, Anna Hernandez, at ahernandez@www.deanmead.com.

Vincent J. Comito
He may be reached at vcomito@www.deanmead.com or through his assistant, Maggie Rivera, at mrivera@www.deanmead.com.

Ft. Pierce/Stuart

Michael D. Minton
He may be reached at mminton@www.deanmead.com or his assistant, Debra Mercer, at dmercer@www.deanmead.com.

Viera/Melbourne

Robert J. Naberhaus III
He may be reached at RNaberhaus@www.deanmead.com or through his assistant, Linda Mettress, at lmettress@www.deanmead.com.

Vero Beach

Dana M. Apfelbaum
She may be reached at dapfelbaum@www.deanmead.com or through her assistant, Michelle Sheperd, at msheperd@www.deanmead.com.