“Tax advisors and wealthy taxpayers have been waiting with bated breath to see whether a new tax bill will be passed and, if it is passed, what language the final bill would contain. While the proposed legislation failed to include any changes regarding estate taxes, including a reduction in the estate/gift tax exemption amount to approximately $6,000,000 like many feared, that is not to say it may not be brought in later. Anything might still happen, and practitioners should caution clients about that uncertainty.”

Brandon Ketron, Martin Shenkman, Alan Gassman and Wesley Dickson provide members with timely commentary that examines what President Biden and the White House said and didn’t say about the estate tax laws last week, and what to do about it. Members who wish to learn more about this topic should consider joining Alan and Brandon in their exclusive LISI Webinar “Picking Up the Pieces and Seizing Upon Opportunities---Essential Knowledge and Strategies for Now and Year End Planning in View of Legislative Changes and Present Law.” Click this link for more information: Alan/Brandon

Brandon L. Ketron, CPA, JD, LL.M. is a partner at the law firm of Gassman, Crotty & Denicolo, P.A., in Clearwater, Florida and practices in the areas of Estate Planning, Tax and Corporate and Business Law. Brandon is a frequent contributor to LISI and presents webinars on various topics for both clients and practitioners. Brandon attended Stetson University College of Law where he graduated cum laude, and received his LL.M. in Taxation from the University of Florida. He received his undergraduate degree at Roanoke College where he graduated cum laude with a degree in Business Administration and a concentration in both Accounting and Finance. Brandon is also a licensed CPA in the states of Florida and Virginia. His email address is brandon@gassmanpa.com.

Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is an attorney in private practice in Fort Lee, New Jersey and New York City who concentrates on estate and closely held business planning, tax planning, and estate administration. He is the author of 42 books and more than 1,200 articles. He is a member of the NAEPC Board of Directors (Emeritus), on the Board of the American Brain Foundation, the American Cancer Society’s National Professional Advisor Network and Weill Cornell Medicine Professional Advisory Council.

Alan S. Gassman, J.D., LL.M., is a partner in the law firm of Gassman, Crotty & Denicolo, P.A., and practices in Clearwater, Florida. He is a frequent contributor to LISI, and has published numerous articles and books in publications such as BNA Tax & Accounting, Estate Planning, Trusts and Estates, and Interactive Legal and is coauthor of Gassman and Markham on Florida and Federal Creditor Protection and several other books. His email address is agassman@gassmanpa.com.

Wesley Dickson is a graduate of Stetson University College of Law in Gulfport, Florida. Prior to beginning law school, he attended Stetson University, attaining a bachelor’s degree in Public Management. Having finished law school and passed the bar, Wesley next plans on getting sworn in and practicing tax or business law in Florida.

Here is their commentary:

EXECUTIVE SUMMARY:

Ben Franklin famously said “. . . in this world, nothing is certain except death and taxes.”^[i] If he were alive today reading the pending tax legislation and the potential changes to the estate tax system, he would likely rephrase himself and proclaim that “nothing is certain about death and taxes” . . .  and he would certainly be correct.

Tax advisors and wealthy taxpayers have been waiting with bated breath to see whether a new tax bill will be passed and, if it is passed, what language the final bill would contain. While the proposed legislation failed to include any changes regarding estate taxes, including a reduction in the estate/gift tax exemption amount to approximately $6,000,000 like many feared, that is not to say it may not be brought in later. Anything might still happen, and practitioners should caution clients about that uncertainty.

At this time, the main focus is a new 5% tax to be applied to individual taxpayer’s Modified Adjusted Gross Income (“MAGI”) in excess of $10,000,000 ($5,000,000 if married but filing separately) and “high income” (really a mere $200,000) earning trusts and estates, and an expansion of the Net Investment Income Tax for individual taxpayer’s with MAGI in excess of $400,000 ($500,000 for joint filers) and trusts and estate undistributed income with no income threshold.

Should the new proposed tax legislation go into effect on January 1, 2022, high earners will also feel a significant impact on their Net Investment Income Tax, specifically those who use S-corporations and partnerships to shield themselves from higher taxes.

Other proposed changes to note include a 100% gain exclusion on the sale of Section 1202 Qualified Small Business Stock would be limited to 50% of the gain for those with and AGI exceeding $400,000 (unless otherwise contracted for prior to September 13, 2021), a requirement that crypto currencies be subject to the constructive and wash sale rules, and 15% minimum tax for large corporations on “reported income” to be calculated based on complex formulas.

The proposed legislation did not include (as was originally expected) a removal of the limitation on deductions for State and Local Income taxes paid (SALT Cap). There was no proposal for an increase in personal income tax or capital gains tax rates, no proposal to compress the current rate brackets, no proposal to deny fair market value income tax basis for estates of individuals who die owning appreciated assets, and more.

FACTS:

Net Investment Income Expansion

Under this new tax legislation the Net Investment Income Tax under I.R.C. § 1411, which is presently 3.8%, would be expanded to include income derived in the ordinary course of business for single filers with more than $400,000 in Modified Adjusted Gross Income (MAGI) and on any undistributed income from separately taxed trusts and estates effective January 1, 2022. The income threshold is increased to $500,000 for those filing jointly. Under current law, the 3.8% tax generally only applies to passive investment income (interest, dividends, gain on the sale of stock, etc.).

MAGI is defined as adjusted gross income reduced by any deduction (not taken into account in determining adjusted gross income) allowed for investment interest (as defined in section 163(d)). Generally this number appears on line 11 of the 2020 Form 1040. 

This 3.8% tax, which was first created under the Affordable Care Act, does not apply to the profits of certain types of entities, most notably S corporations.  Historically, S-Corporations could pay a reasonable salary to its owners (subject to self-employment taxes) and avoid such taxes (as well as the 3.8% Net Investment Income Tax) on remaining S-Corporation income, making S-Corporations a popular choice of entity for high earners to minimize employment taxes. The proposed tax legislation would do away with this exclusion by considering all income derived in the ordinary course of a trade or business as subject to the 3.8% Net Investment Income Tax for high earners.

New 5% Surcharge

Starting January 1st, 2022, assuming that President Biden signs the tax legislation, a new 5% tax will be levied against all individual taxpayers to the extent that the taxpayer’s MAGI is in excess of $10,000,000. This amount is lowered to $5,000,000 if the taxpayer is married and filing separately. Further, this tax also applies to all trust and estate income that exceeds $200,000 per trust or estate.

An additional 3% tax will apply to taxpayers to the extent that their MAGI exceeds $25,000,000, or $12,500,000 if the taxpayer is married but filing separately, and on trust and estate income exceeding $500,000 per trust or estate.

Other Proposed Changes

While the announcement of the above two potential changes caused the most commotion, there are other aspects of the legislation that, if passed, will greatly impact the trust and estate planning landscape.

         1.      Bolstering the IRS. The legislation calls for $79 billion to be allocated to the IRS for purposes of increasing the quality and quantity of services and updating the agency’s technology. Another key goal of this funding is to help close the “tax gap”, which is the disparity between the taxes owed and the taxes actually collected.^[ii] That type of funding could result in a substantial increase of tax audits. Practitioners might consider cautioning clients to expect increased audits and perhaps more comprehensive audits.

         2.      Crypto Containment. Should the bill be passed, all crypto currencies (such as Bitcoin and Ethereum) will be subject to the constructive and wash-sale rules as of the date of enactment. For example, if a taxpayer's crypto currency skyrocketed in value overnight, there would be no opportunity (or an extremely limited one) to lock in an offsetting position without triggering gain. This will likely impact many taxpayers, as a recent estimate by the Joint Committee on Taxation places the total value of crypto currencies in the U.S. at roughly $17 billion.

         3.      Corporate Collections. The bill also included a minimum 15% tax on large corporations, which are those that report more than $1 billion in profit annually for three consecutive years. It is worth noting that the bill does not increase the 21% tax rate that applies to C corporations with net income. A White House report estimates that this new tax would collect $325 billion over the next decade.

         3.      Better Left Unsaid. Some of the best news to come out of the proposal came from what was omitted:

                  A.      There was no increase in personal income tax rates;

                  B.      No increase in capital gains tax rates;

                  C.      No reduction of the estate tax exemption;

                  D.      No elimination of the step-up in basis on death; and

                  E.      No proposals to eliminate the ability to utilize “grantor trusts” or valuation discounts for non active trades or businesses.

COMMENT:

Casting a Wide Net on Net Investment Income Tax

Because various entities would become subject to Net Investment Income Tax, most notably S corporations, advisors may consider delaying filing a client’s Form 2553 S Election until the client is informed of the potential impact. C corporations or partnerships may become the planning tools of choice if S corporations can no longer shelter income from the tax. If clients evaluate the continued use of S corporations, the amounts allocated to salary versus distribution etc., practitioners should be alert for the ripple effects on planning. Buy sell agreements may be affected, especially if they rely on formula calculations based on net income.

This tax will also apply to undistributed income of trusts and estates, without a threshold like the one that applies to individual taxpayers. Most trusts and estates that own interests in profitable entities, such as LLCs or partnerships, will be subject to the tax to the extent that the trust or estate’s income is not distributed out to its beneficiaries.

S corporation income that is received by a complex trust is subject to the 3.8% tax if the trust made an Electing Small Business Trust (“ESBT”) election and will be taxed at the highest bracket on Schedule K-1 (regardless of whether it is distributed to beneficiaries). Many trusts have the ability to exchange S corporation ownership interests with beneficiaries who may be in a lower bracket in exchange for a promissory note from the beneficiaries. This can be done shortly after death so that little to no income tax will be owed as a result in the step up in basis of the stock received on death. A beneficiary can then use his or her $400,000 or $500,000 (if filing jointly) exclusion amount on such income.

Many Trusts Will Be in a State of Shock

 As mentioned above, trusts that are taxed separately will face issues under the new rules because the 5% tax would apply to all trust income exceeding $200,000.  This would make distributions of Distributable Net Income (DNI) to reduce a trust's remaining taxable income even more important.  Fortunately, the 5% surcharge will only apply to the extent that the remaining taxable income in the trust is in excess of $200,000 after taking into account distributions made to the beneficiaries. 

An over-simplified example of this is as follows:

Example: A Trust has net taxable income of $1,000,000, and makes a distribution of $700,000 to a beneficiary.  The beneficiary will pay the taxes on such income and the Trust will receive a distribution deduction to reduce its taxable income, resulting in the $700,000 of income distributed not being subject to the new 5% surcharge (assuming that the beneficiary has MAGI of less than $10,000,000).  The remaining $100,000 of the remaining $300,000 of Trust income would be subject to the 5% surtax; however the trustee of the Trust could distribute an additional $101,000 of income to the beneficiary, so that total income retained by the Trust is less than $200,000 to avoid the surtax.  

Drafters of trust documents should become familiar with the applicable Principal and Income Act of the state where the trust is sitused to confirm whether capital gains are treated as principal or income, as principal is not distributable.  Most states allow trust documents to specify that a fiduciary will have the power to treat capital gains as income that can be distributed to beneficiaries, which would escape the additional 5% tax.

Financial advisers managing trust assets will have to make reviewing distributions and trust tax status an integral part of investment planning. If a reallocation or trading transaction is contemplated that will trigger more than $200,000 of gain and push the trust into the 5% surtax position they should review in advance whether distributions can be made to reduce that costly trust tax burden.

Some irrevocable trusts allow for income to be distributed tax-free to charities. Including charities as permissible beneficiaries in non-grantor trusts may become more common because of these tax changes. This may therefore cause a significant benefit for many charitable organizations, including family controlled foundations, but if the income generated under the trust would be considered to be Unrelated Business Taxable Income that would be taxed if received by a charity, then the deductibility of amounts paid to charity by the trust may be limited pursuant to IRC §681.

To facilitate this, the contribution must be made from the gross income of the trust in order to qualify for an unlimited charitable contribution deduction under IRC §642(c). It is noteworthy that the IRS requires that the governing instrument (e.g. the trust document) specifically permit contributions to charity from income, otherwise no deduction will be permitted. If a trust doesn't have the requisite language, it cannot be amended (e.g., via a merger or decanting) to add that required verbiage as the IRS views the requirement as having to be in the original governing instrument, not a modified later version. If the governing instrument does not contain the “magic language” all is not lost.  It may be possible for a trust to contribute assets to a partnership and to have the partnership make the charitable contribution, resulting in the charitable deduction flowing through from a partnership to the trust via a K-1, which the IRS seems to respect.     

In addition to the above, consider the following possible planning implications:

         1.      Grantor trusts might continue to be disregarded for income tax purposes so that all of their income and deductions go onto the income tax return of the Grantor to avoid the harsh trust income tax surtax applicable to non-grantor trusts.

         2.      Non-grantor trusts that may then face the surtax should make a concerted effort to review their tax status before year end. Trusts should have the wealth adviser/CPA evaluate gains and income, and consider possible distributions (e.g., what is appropriate for the beneficiaries and what does the trust agreement permit). This data should be evaluated and distributions made before year end (or within 65 days after year end) to shift income from the trust that may face maximum income tax rates and a surtax to the beneficiaries who may be in a lower income tax bracket and not subject to the surtax. The savings each year could be substantial (or not).

         3.      When planning and drafting trusts consider including a wider class of beneficiaries so that the trustee has more flexibility to distribute income to multiple beneficiaries that may be able to remain, even with trust distributions, in lower income tax brackets and avoid the new high surtax rates.

         4.      Give trustees discretion to make distributions so that they have more flexibility to minimize combined trust/beneficiary income tax results.

         5.      Consider creating special withdrawal powers so that a beneficiary is deemed to be the owner of certain trust income under IRC §678 and therefore taxed to the beneficiary and not the trust.

         6.      Don’t let the tax tail wag the dog.  Before any distributions are made the trustee should consider whether the beneficiaries face any claims or lawsuits that may result in an ex-spouse or creditor attaching to distributions motivated by income tax changes.

         7.      The beneficiary's personal federal and state income tax rates will have to be considered. The beneficiary may also be in the maximum income tax bracket so a distribution would be of limited utility. Even worse, if the trust has situs in a low or no tax state (e.g. Florida), but the beneficiary resides in a high tax state like California, the increase in state income taxation from a distribution may outweigh the federal income tax benefits.

         8.      Finally, if the trust is to have certain income, e.g., capital gains income, taxed to the current beneficiaries rather than being taxed to the trust, either the trust instrument will have to permit that income to be taxed to the beneficiaries, or the trustee may have to take certain actions to achieve that result. It may be feasible to decant the trust into a new trust with different provisions if that becomes necessary.

While the application of the income tax surtax is perhaps less harsh than the massive grantor trust changes contained in other proposals, the application of income tax surtaxes at such low levels of trust income continue the theme that Congress seems to believe trusts are bad things really wealthy people use to evade taxes. The reality for most trusts is more moderate taxpayers are seeking to protect their family, now they may get caught by unexpected high tax rates.    

Biden 2-Step

Prior to the release of the full text of the legislation, tax professionals assisted families to use what has become known as the “Biden 2-Step.” This method of planning does not require the taxpayer to use any of his or her $11,700,000 exemption, which is beneficial now that the estate tax exemption reduction has been removed from the bill.

Step 1:       Make a relatively small gift to an irrevocable trust, and subsequently sell LLC or other interest to the trust with a long-term low interest promissory note; and

Step 2:       Forgive the note immediately before passage of proposed legislation that would reduce the estate/gift tax exemption amount (or whenever the donor felt ready) to use the temporary increased exemption amount.

Step 2 would not need to occur as the proposed legislation does not propose to reduce the current estate/gift tax exemption amount, so the donor can retain the promissory note and the personal financial stability in a higher degree, having future growth outside of their estate. To read more about the Biden 2-Step and why it might be the right planning tool for clients. See Gassman, Hesch, Shenkman, Estate Planning Newsletter #2813 (August 10, 2020)

Flexibility is Key        

Flexibility is critical to any planning given the uncertainty taxpayers face in the current political climate. If possible, trusts should include options to modify and tailor an irrevocable trust to whatever should eventually occur with tax legislation in Washington, keeping in mind that whatever the outcome of the current tax legislative process is, there may again be significant changes after the 2022 or 2024 elections.  You might consider using somewhat of a "kitchen sink" approach to planning and drafting to include several provisions in the trust documents to permit you to modify or change the trusts or planning in light or the uncertainty, which may include:

         1.      Decanting provision to permit the trustee to decant into a new trust (although some of the proposals may have restricted decanting and those might yet be enacted) supplementing any state law rights to decant.

         2.      The use of disclaimer provisions that might permit a person designated as a primary beneficiary to disclaim all assets transferred to the trust and that if such a disclaimer is executed then the assets would revert back to the donor/settlor.

In the typical application of a disclaimer, it would be treated as if the disclaimant predeceased the donor/settlor and the other trust beneficiaries would step into the shoes of the predeceased beneficiary. So, this would be a somewhat novel application of the disclaimer mechanism, and there is no law confirming that this will with certainty work, but if it does it could provide a mechanism to unwind the entire transaction. Some commentators suggest instead creating an initial trust that has only one beneficiary with the right to disclaim, and later using powers of appointment to shift assets to a new trust.

         3.      A provision permitting the trustee to disclaim; however, this may raise issues that a disclaimer could violate the trustee's fiduciary obligations to all of the beneficiaries and prevent the execution of such a disclaimer.

         4.      A provision for a named person to "turn-off" grantor trust status (i.e., convert the trust from a grantor trust for income tax purposes into a non-grantor or complex trust that pays its own taxes). The purpose of this would be to assure the ability to change the trust's income tax status if that proved advantageous in light of the proposed harsh restrictions on grantor trusts. Even if those restrictions are not enacted this provision should not cause any detriment, and hopefully preserve flexibility for future planning options. The person holding this power should act in a non-fiduciary capacity to avoid fiduciary obligations to beneficiaries that might conflict with this power.

         5.      Use a trust protector that is authorized to change trustees, situs, governing law, administrative provisions, etc.

         6.      Incorporate express language into the transfer documentation permitting the transfers to be rescinded, depending on the assets to be transferred to the trust and feelings concerning those transfers.  Recission of the transaction within the same tax year may obviate any income tax consequences of the transfer, which may be useful if some of the proposed changes are enacted in a manner that could have transfers trigger adverse current income tax consequences. To be clear, these types of changes are not in the current version of the tax proposal but it is unclear what might yet be enacted.

         7.      Give the trustee the power to divide the trusts in the event that becomes useful, e.g., to take different actions to modify different portions of the trust differently.

         8.      As discussed elsewhere name a large class of beneficiaries, including charities and give the trustee flexibility to include capital gains in income and to have broad discretion to distribute income and perhaps principal out of the trust.

Conclusion

For tax advisors, the bill is now shorter than it would have otherwise been, and therefore there are only hundreds (as opposed to thousands) of pages of legislation to become familiar with. It remains to be seen what will be included in a final bill, or if the bill will pass at all. Nevertheless, taxpayers and their clients should be aware of the proposed changes and plan accordingly and quickly, as Biden could theoretically sign the bill tomorrow.^[iii]  

Tax advisors who have had to navigate PPP and EIDL loans, the SECURE Act, the CARES Act, and now the Build Back Better Act, and all the tax law changes that are included therewith may wish that they had picked a different career path.  Since time travel does not yet exist, estate tax planners should be sure to stop and take a deep breath and should keep their eyes open in case estate/gift tax changes are brought back into the negotiation table. 

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Brandon Ketron

Martin Shenkman

Alan Gassman

Wesley Dickson

CITE AS:

LISI Estate Planning Newsletter #2917 (November 3, 2021) at http://www.leimbergservices.com. Copyright 2021 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited - Without Express Permission. This newsletter is designed to provide accurate and authoritative information regarding the subject matter covered. It is provided with the understanding that LISI is not engaged in rendering legal, accounting, or other professional advice or services. If such advice is required, the services of a competent professional should be sought. Statements of fact or opinion are the responsibility of the authors and do not represent an opinion on the part of the officers or staff of LISI.

CITATIONS:

 

^[i] This popular quote was written by Ben Franklin in a letter in 1789. The certainty of death and taxes was not a new idea, however, as Christopher Bullock wrote in his 1716 book The Cobbler of Preston, “Tis impossible to be sure of anything but Death and Taxes.”

^[ii] The White House estimates that $600 billion per year in taxes owed is never collected.

^[iii] “By failing to prepare, you are preparing to fail.” - Ben Franklin