Examining the Effects of the Build Back Better Act on Estates and Trusts

On September 13, 2021, the House Ways and Means Committee released the legislative text of proposed tax changes to be incorporated into the omnibus reconciliation bill known as the “Build Back Better Act.”  One wonders if the geniuses behind the BBBA intended the acronym to be pronounced as “Bubba,” but one thing is sure—having now read BBBA as “Bubba” you will never not pronounce it that way in your head going forward. So what are the effects of the Build Back Better Act on estates & trusts?

While most of the focus has been the corporate[1] and individual tax changes,[2] the proposed changes to grantor trusts and other long-standing estate planning techniques will be the focus of this article. In Part One of this article, we’ll look to the technical provisions in the House Ways and Means Committee’s proposed tax changes.  In Part Two, we’ll take a more holistic look at what these changes mean in practice for estate planners and those individuals who are sure to be affected by the sweeping changes.  Finally, in Part Three, we’ll discuss what provisions in the Biden tax plan were cast on the cutting room floor and failed to make the final draft of the proposed legislation.

 

Part One: A Detailed Look at the Proposed Changes Affecting Estates and Trusts

 

Increase in Capital Gains Rates for Certain High-Income Individuals (§ 138202)

Section 138202 of the BBBA[3] would increase the top capital gains rate from 20% (under the Tax Cuts and Jobs Act (“TCJA”)) to 25%.[4]  This change would apply to taxable years ending after the date of the introduction of the bill, meaning that the effective date of the change would be September 13, 2021.  The proposed capital gains brackets are adjusted to match the income tax brackets, meaning that the top capital gains tax bracket would be $400,000 for single filers, $425,000 for head of household filers, and $450,000 for joint filers.

A transitional rule provides that the existing rate of 20% will continue to apply to gains and losses for the portion of the taxable year prior to the date of introduction. What about gains and losses arising out of transactions entered into before September 13, 2021?  Terribly good question.  If the transactions were entered into pursuant to a binding contract entered into before the 13^th of September, gains or losses arising out of those transactions will be treated as having occurred prior to September 13, 2021; as such, the 20% rate would continue to apply.

Surcharge on High Income Individuals, Trusts, and Estates (§ 138206)

When a taxpayer’s modified adjusted gross income (MAGI – not to EVER be confused with MAGA) exceeds $5 million (or $2.5 million for a married individual filing separately), § 138206 would impose a tax of 3% (a “surcharge” as it were).[5]  MAGI (also not to be confused with the three men bearing gold, frankincense, and myrrh), in this context, means adjusted gross income, less any deduction allowed for investment interest.[6]

Five million dollars of income is a heck of a lot of income for estates and trusts; as such, this should not have an effect on all but the largest of trusts…right?  Wrong.  That $5 million figure applies only to individuals.  When it comes to estates and trusts, the 3% surcharge would kick in at just $100,000 of income.  $4.9 million is a bit of a swing, and the end result is that the surcharge will affect a number of trusts that accumulate income.  In a tiny sliver of good news, the surcharge would not apply to a charitable trust.

Increase in Limitation of Estate Tax Valuation Reduction for Real Property Used in Farming or Other Trades or Businesses (§ 138208)

Much hay was made—not sorry for the pun—about the effect that President Biden’s tax plan would have on small farmers and small family businesses.  Section 138208 extends an olive branch to those concerned agrarians by increasing the special valuation reduction available for qualified real property used in a family farm or family business.

Generally speaking, farming is not the “highest and best use” of a property, according to the IRS.  How the IRS would get their collective administrative dose of plant-based fiber without farmland is anyone’s guess…but here we are.  This reduction allows decedents who own real property used in a farm or business to value the property for estate tax purposes based on its actual use rather than its “highest and best uses” (read: fair market value). This provision increases the allowable reduction from its current level of $750,000 to $11,700,000.

Valuation Rules for Certain Transfers of Nonbusiness Assets (§ 138210)

Section 138210 would amend IRC § 2031 to provide that when an interest in an entity is transferred,[7] whether at death or through a gift, the value of any transferred “nonbusiness assets” held by the entity will be determined as if the transferor had transferred such assets directly to the transferee.  Perhaps even more importantly, no valuation discount will be allowed for such nonbusiness assets, nor will the nonbusiness assets be taken into account in determining the value of the interest in the entity.[8]  We will dig more deeply into the practical effect of this amendment to IRC § 2031 in Part Two.  Note that these changes will apply only to transfers made after the enactment of the Build Back Better Act.

The term “nonbusiness asset” means a passive asset that is (i) held for the production or collection of income, and (ii) is not used in the active conduct of a trade or business.[9]  These passive assets include cash or cash equivalents, stocks in a corporation or any other equity, profits, or capital interest in an entity, evidences of indebtedness, annuities, real properties, assets other than a patent, trademark or copyright which produces royalty income, commodities, collectibles or personal property.

An asset will not be treated as a nonbusiness asset if it is property described in IRC § 1221(a)(1) or (4) (or is a hedge with respect to such property), or if the asset is real property used in the active conduct of one or more “real property trades or businesses,” so long as the transferor materially participates in the trade or business.[10]

A “real property trade or business” is one that involves development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.[11]  The transferor must perform at least 750 hours of services during the taxable year in the real property trade or business in addition to “materially participating,” which is to say, the transferor must be involved in the operations on a regular, continuous, and substantial basis in that business.[12]

What’s more, any passive asset that is held as part of the “reasonably required working capital needs” of a trade or business will not be treated as a nonbusiness asset.  Look-thru rules apply when a passive asset consists of a 10% interest in another entity.

Gird your loins, because the following major changes are sure to make even the calmest and most collected estate planning attorneys quiver in their collective Cole Haan loafers…

Termination of Temporary Increase in Unified Credit (§ 138207)

Section 138207 of the BBBA would terminate the temporary increase in the unified credit against the estate and gift taxes, reverting the credit to its 2010 (pre-Trump combover) level of $5 million per individual, indexed for inflation.  This whopper would apply to the estates of decedents dying and gifts made after December 31, 2021.

Side Note:  Having read a ton of commentary on the BBBA before writing this article, an exceptionally small number of authors actually took the time to explain what the actual unified credit would be in 2022, apparently being quite unwilling to do the math.  Because the TCJA doubled the unified credit, and the BBBA would reduce it to pre-TCJA levels (i.e., in half), even your fearless author, who is generally timorous when it comes to mental math, especially when it involves fractions, can figure this one out without too much trouble.  Under the TCJA, the unified credit would have risen to $12.04 million in 2022.  As such, and without too much mental and/or arithmetic gymnastics, the proposed 2022 unified credit would be $6.02 million.

Certain Tax Rules Applicable to Grantor Trusts (§ 138209)

Perhaps even a bigger deal than the halving of the unified credit, § 138209 of the BBBA pulls the proverbial Persian rug out from under traditional grantor trust planning.  How so, you may ask.

Well, § 138209 would add a new section to the Internal Revenue Code, IRC § 2901. In turn, IRC § 2901 would effectively pull grantor trusts into a decedent’s taxable estate when the decedent is the deemed owner (grantor) of the trust.[13]  But for this provision, a taxpayer could use grantor trusts to exclude assets from their taxable estate, while still maintaining substantial control over the trust.  If § 138209 and IRC § 2901 become the law of the land, however, any portion of a trust of which the decedent is the deemed owner will be included in the grantor/decedent’s taxable gross estate.

What happens if the grantor trust makes a distribution to one or more beneficiaries during the life of the grantor (other than in discharge of an obligation of the grantor)?  Unless the distribution is made to the grantor or the grantor’s spouse, this distribution will be treated as a gift under chapter 12 of the Code.[14]

What if a grantor trust ceases to be a grantor trust during the grantor’s life?  Stated differently, what happens if, during the life of the taxpayer-owner of the trust, the taxpayer ceases to be the owner of the trust under the grantor trust rules?[15]  Why in that case, all assets in the grantor trust will be treated as a gift from the grantor.[16]

But wait, there’s more… 

The provision would also add a new section to the Code, IRC § 1062, which would treat any sales between grantor trusts and their deemed owner (grantor) as equivalent to sales between the owner and a third party.  This third-party sale treatment does not apply to revocable trusts.[17]  Finally, § 138209 adds grantor trusts and their grantors as “related persons” under the attribution / related party rules of IRC § 267(b).[18]

It’s important to note that the amendments made by § 138209 apply only to future trusts and future transfers.  Specifically, the amendments apply only (1) to trusts created on or after the date of the enactment of the Build Back Better Act, and (2) to any portion of a trust established before the enactment of the Build Back Better Act, which is attributable to a contribution made on or after such date.

 

Part Two: The Practical Effect of the Changes

 

The 3% Surcharge on High Income Estates and Trusts (and, I guess, individuals, too)

What is the practical effect of this surcharge?  Let’s call it what it is: a penalty on the accumulation of taxable income in a trust.  Trusts already are taxed at the highest bracket when its income hits a measly $13,050 (compared to $523,600 for a single taxpayer).

What is Congress’ answer?  C’mon, Bubba, let’s pile on some more taxes, then…kick ‘em when they’re down…  Certain planners have suggested that this additional surcharge might lead trusts to invest in tax‑free bonds or investments in assets that can be offset by depreciation.[19]  As likely, Bubba will precipitate more distributions of income than in the past.

The Expedited Shrinkage of the Unified Credit

As you’ll remember, the Tax Cuts and Jobs Act temporarily doubled the transfer tax exemption from $5 million to $10 million (indexed for inflation), meaning that the exemptions rose to $11.7 million per person in 2021 and would have risen to $12.04 million in 2022.  This increase was scheduled to return to earth in 2026, but § 138207 expedites the process.  If the proposed changes become law, the unified credit would be a pittance in 2022—a mere $6.02 million.

I am being a bit sarcastic for a couple of reasons.  First, if you’ve read any of the other articles on Briefly Taxing, that’s kind of my schtick.  Second, this change is not entirely unforeseen.

Remember, this change was scheduled to occur for those individuals shuffling off their mortal coil after December 31, 2025.  Although we’re arriving at the decrease a bit sooner than planned, there is no retroactivity, no claw-backs, and no reason for estate planners to wake up in cold sweats at 2:30 on a Wednesday morning.

From a planning perspective, individuals wishing to take advantage of the $11.7 million exemption may think about making substantial gifts before the end of the year and, perhaps, allocating GST exemption to existing trusts that are not currently GST exempt.  Though halving the estate and gift tax exemption is significant, my point is that it could have been much, much worse that what the doomsday estate planning prophets were predicting.[20]

Farm Property—Not Required to be Valued at Highest and Best Use

As noted in Part One, § 138208 of the BBBA is simply an olive branch to Bubba and the other family farmers, who were some of the most vocal opponents—or at least the most paraded out by political opponents—of the Biden tax proposals.  The narrative that was spun was that Biden’s tax bill would kill family farms, thereby ripping the heart out of middle America.  Given the rhetoric surrounding the family farm, you would have thought that the entirety of Kansas and Idaho would have imploded under the tax inequity.

Notwithstanding the melodrama that ensued after President Biden unveiled his “Green Book,” the PR push seemed to work, and § 138208 was the brainchild to put a tax salve on the foreseen wounds and indignities that Uncle Bill and the other family farmers of America would have suffered.  There are other items in the BBBA that are aimed at helping family farmers, but this is the only tax provision contained in the proposals.

As alluded to above, for estate tax purposes, real property is required to be valued at its highest and best use.[21]  Generally, farming is not a property’s highest and best use.  As such, when a farmer died owning a family farm which passed to his heirs, the estate tax bill would have been calculated as if the farm were a condominium complex or an industrial site—a much higher valuation amount.

Existing law allows for a modest ($750,000) valuation adjustment; however, the proposed changes to the BBBA would allow a valuation adjustment (i.e., a reduction in value) for farmland of up to $11.7 million from what otherwise would be the value of the land determined at its highest and best use.  Thus, if Uncle Bill died and passed his emu farm down to you, it would not matter that there were sizable uranium reserves on the property…at least up to $11.7 million.

Practical Effect of “Limitation” of Discounts on Transfers of Nonbusiness Assets

The proposal practically eliminates valuation discounts for entities unless the entity’s assets are used in an active trade or business.  Gone are the days (assuming the proposal becomes law) of transferring hard to value assets (such as non-publicly traded stock) and having those assets appraised at a bottom-dollar (but fully defensible) value.  Unless the transferred interest is in an operating business, the transferor is out of luck.  Thus, for family entities funded with marketable securities, it may be the end of the proverbial road from a tax planning perspective.

Income Taxation of Transfers to Grantor Trusts

For 30+ years, grantor trusts have been an estate planner’s Jack-of-all-trades.  Need to transfer wealth into a trust?  Sell assets to the trust in exchange for a promissory note bearing a low (but not artificially low) interest rate, and if the assets appreciate at a rate higher than the low interest rate, you’re golden.  Heck, even the interest payments on the promissory note will be income tax free.

Need to take care of highly appreciated assets without triggering capital gains?  Sell them to a grantor trust, and ipso facto no capital gains are recognized.  Estate planners had a field day with grantor trust-based planning.  The two proposed amendments to the Code (IRC § 2901 and IRC § 1062), however, will likely put an end to the technique.

Enter proposed IRC § 1062 to spoil the grantor trust party… 

The proposed amendment to the Code would require gain recognition on sales of assets to a grantor trust.  Note, however, that there is nothing in the proposal which would affect the interest on loans between a grantor and his or her grantor trust.  So, at least there’s that.  Swapping high basis assets with low basis assets (of equal value) will likewise no longer be free of capital gains consequences.

Once again, it’s important to note that this applies only to irrevocable grantor trusts created on or after the date on which the proposed legislation is enacted.  With respect to “grandfathered” irrevocable grantor trusts, any “contribution” into the trust would subject at least a portion of the trust (attributable to the contribution) to the new rules.  What is meant by “contribution” is anyone’s guess, as it is nowhere defined in the proposed language.

The Sweeping Effect of Proposed IRC § 2901 on Estate Taxation of Grantor Trusts

As with proposed IRC § 1062, the provisions of IRC § 2901 will apply only to irrevocable trusts created on or after the date the Build Back Better Act is enacted or to that portion of a grandfathered trust attributable to contributions made after that date.  This is cold comfort to estate planners because IRC § 2901 not only pulls in grantor trusts into the grantor’s taxable estate at the grantor’s death, but it also provides that any distribution from a grantor trust to someone other than the grantor, the grantor’s spouse, or to discharge a debt of the grantor will be treated as a taxable gift from the grantor to the person receiving the distribution.  What’s more, if the trust ceases to be treated as a grantor trust under the grantor trust rules (IRC § 671 through IRC § 679), the grantor will be treated as having made a gift of all trust assets.

This sounds scary enough, but it’s downright terrifying to estate planners who have used grantor retained annuity trusts and irrevocable lifetime insurance trusts (and intentionally defective insurance trusts) with impunity for years.

With grantor retained annuity trusts (GRATs), a taxpayer would transfer assets to a trust, with the taxpayer being entitled to a series of annuitized payments over the next few (two or more) years, which payments would be approximately equivalent to the value of the contributed property.  Because the amount in equals the amount out, the taxpayer would have made a zero net gift to the trust.[22]  If the assets appreciate over the term of the trust, all the better, because that appreciation can pass tax free (estate and gift tax free, specifically) to the taxpayer’s future generations…so long as the taxpayer doesn’t up and croak during the GRAT’s term.

It is not an exaggeration that GRATs have been more heavily favored by estate planners than their first-born children, and they have certainly been more useful to planners.  If IRC § 2901 becomes law, at the end of the GRAT’s term, if the GRAT were to transfer its assets into a grantor trust, those assets would—you guessed it—no longer be estate tax free.  If the GRAT’s assets pass to a non-grantor trust, or to the taxpayer’s much maligned and oft ungrateful offspring, the taxpayer/transferor will be treated as having made a gift equal to the value of the GRAT’s assets (to said ne’er-do-well offspring).

What’s worse, when the powers of IRC § 2901 and IRC § 1062 are combined, if appreciated assets are transferred into the GRAT to fund the annuity payment to the grantor/taxpayer, this transfer would be treated as a deemed sale, giving rise to a wholly unwanted capital gains event.

With respect to irrevocable lifetime insurance trusts (ILITs), well, they would also go the way of Old Yeller.  The very purpose of ILITs, which are almost always grantor trusts, is to ensure that the death benefit of a life insurance policy will escape estate tax.

How are the premiums paid on the life insurance policy at the center of an ILIT?  Why by making annual gifts to the trust, of course.  See the issue here?

Although it is true that existing ILITs will absolutely be grandfathered.  In practice this is about as valuable as a Sno-Cone to an eskimo, because the payments of future premiums by the insured/grantor will be considered a “contribution” to the trust.  What does this mean?  Under IRC § 1062, this “contribution” would result in a portion of the grandfathered ILIT being subject to the estate tax.

This is troublesome if not downright disheartening.  What’s perhaps even more troublesome, from a practical standpoint, is how to accurately track what portion of the ILIT will be subject to estate tax and which portion remains grandfathered.

For those ILITs unfortunate enough to be created after the enactment of the Build Back Better Act, if the ILIT is a grantor trust—as most are—the grantor is out of luck from an estate tax perspective because the death benefit of any insurance policy owned by the trust will be subject to estate tax.  It is going to take a very creative estate planner to create an insurance trust that is not treated as a grantor trust with respect to the insured…but estate planners have done more with less in the past, so hope springs eternal.

Part Three:  What the Proposal Left Out

 

No Basis Cataclysm

Not an insignificant number of estate planners and even lay persons had varying degrees of cardiac events when they read the discussion of eliminating the carryover basis at death contained in President Biden’s “Green Book.”  The death of a taxpayer would, itself, have been treated as a realization event triggering the recognition of capital gains.  The sky was falling, and there were flocks of Chicken Littles decrying the imminently descending stratosphere.

A collective sigh of relief was issued when planners read through the House Ways and Means Committee’s proposed tax legislation.  The specter of death causing an immediate realization of capital gains on appreciated property is nowhere to be found in the proposals, nor are there any changes to the basis step up rule.  As such, beneficiaries of a decedent’s estate will continue to receive a step up in basis at the decedent’s bucket-kicking last.

Other “Bright Spots” (i.e., Omissions from Biden’s Tax Plan)

Among other bright spots, there are no proposed changes to the generation skipping transfer tax regime or to the treatment of dynasty trusts.  The estate tax rate will stay pat at 40%.  The gift tax exemption remains tied to (unified with) the estate tax exemption, and the gift tax annual exclusion remains unchanged.

Conclusion

The sky may not be falling, but the estate planning landscape under it will certainly change if the proposals become law. The shrinkage of the unified credit is jarring, but not completely unexpected—after all, the TCJA’s doubling of the credit was to sunset in 2026, anyhow.  Sure, planners may need to be a bit more creative with a larger number of clients, but it certainly could have been a lot worse than $6.02 million in 2022.

What will sting the most are the sweeping changes to the taxation of grantor trusts—in both the estate & gift and income tax realms.  Grantor trusts have been effective and nigh universally implemented planning mechanisms since the early 1990s.  Estate planners are faced with the real possibility that their security blankets will be wrested away from them.

Whether the provisions discussed above pass without alteration (or at all) remains to be seen.  Change is always scary, but in the constancy of change, death, and taxes one thing reigns supreme:

Job security.

Click here for a copy of the full BBBA Legislative Text.

---

Footnotes:

[1] Corporate Tax Rate:  Replace the current flat 21% corporate tax rate with a graduated rate, starting at 18% on the first $400,000 of income; 21% on income up to $5 million; and 26.5% on income above $5 million; graduated rate would phase out for corporations making more than $10 million.

[2] Individual Tax Rate:  Increase the top marginal individual income tax rate to 39.6%, which would apply to married individuals filing jointly with taxable income over $450,000; to heads of household with taxable income over $425,000; to unmarried individuals with taxable income over $400,000; to married individuals filing separate returns with taxable income over $225,000; and to estates and trusts with taxable income over $12,500.

[3] You said Bubba.  Admit it.

[4] IRC § 1(h)(1)(D).

[5] Effective as of September 13, 2021.

[6] As defined in IRC § 163(d).

[7] Other than interests that are actively traded, within the meaning provided in IRC § 1092.

[8] § 138210(a) (proposed IRC § 2031(d)(1)(A)-(B)).

[9] Proposed IRC § 2031(d)(2)(A)(i)-(ii).

[10] Material participation is determined under the rules of IRC § 469(h)—except that IRC § 469(h)(3) is to be applied without regard to the limitation to farming activity.

[11] IRC § 469(c)(7)(C).

[12] IRC § 469(c)(7)(B)(ii).

[13] § 138209(a)(1) (proposed IRC § 2109(a)(1)).

[14] § 138209(a)(2).

[15] IRC § 671 through IRC § 679.

[16] § 138209(a)(3).

[17] § 138209(b)(1) (proposed IRC § 1062(a)).

[18] § 138209(b)(2) (“A grantor trust and a person treated as the owner of the trust (or portion thereof) under subpart E of part 1 of subchapter J [of the Code]”).

[19] Andy Katzenstein & David Pratt, LISI Estate Planning Newsletter #2904 (September 15, 2021).

[20] See, e.g., David Finkelstein, a heretofore unassuming estate planner from Spokane, who believed that he was imbued with the divine spirit (Latin: numen) after falling asleep on an open, dogeared copy of the Internal Revenue code and having a vision of Guy Tresillian Helvering, who dubbed Finkelstein the Nostradamus of IDGTs, the Sybil of CRUTs, and the Tiresias of FLPs.  (If you can’t tell that this is a joke, I urge you to read more of Briefly Taxing.)

[21] For a detailed, erudite, and sardonic examination of valuing complex assets for estate tax purposes, take a look at my article published by Bloomberg Tax entitled “Valuing a Complex Legacy: Lessons in Valuation from Estate of Jackson.”

[22] A so-called “zeroed-out GRAT.”

Add to favorites