“Déjà vu All Over Again”[i]
The White House last week released the President’s Budget for the Fiscal Year 2023.[ii] The Budget is ambitious, but its “investments,” we are told, “are more than paid for with tax reforms focused on making sure the rich and the largest corporations pay their fair share.” Sounds familiar, doesn’t it?
Of course, the Administration made this same pitch last year, but to no avail. In the fall of 2021, Senators Manchin and Sinema[iii] eviscerated the President’s tax plan, which constituted an integral part of the much-touted Build Back Better program, thereby denying the Democrats the opportunity to pass their tax and social spending agenda using the Senate’s reconciliation process.[iv]
Four months and one budget later, the Administration has reintroduced many of the same tax provisions that were rejected once before; other proposals reflect differing degrees of variation from their 2022 Budget versions.
It is difficult to see how the odds of passage for these tax provisions have improved since they were last considered. Indeed, circumstances have changed for the worse insofar as the Administration is concerned. For one thing, the President’s approval ratings are poor. In addition, the public is concerned about inflation and how it may be affected by still more government spending, which means their elected representatives are also concerned – after all, this is a mid-term election year.
Since 1934, mid-term elections have not been kind to serving presidents, with their political party losing an average of 30 Senate and House seats in the aggregate.[v] In the already closely divided House, as of the end of March, 22 Democrat incumbents have announced they will not be running for re-election.[vi] As for those lawmakers who would like to remain on the public dole, the upcoming elections (in November) will certainly distract them from their legislative responsibilities; with their primary duty being to get re-elected, these folks will be away from Washington for substantial periods during the summer and fall,[vii] thus reducing the timeframe within which to negotiate, finalize, and enact the 2023 Budget’s proposed tax changes.
Should Anything Be Salvaged?
Still, there are some proposals in the President’s tax plan which, for various reasons, are worthy of consideration; specifically, those that target the estate, gift, and generation skipping transfer taxes (the “estate tax regime”). In fact, these “reforms” may even have a chance of being enacted, provided the President takes a more focused approach.
Before describing these proposals, a brief discussion of the estate tax regime may be in order.
The Estate Tax Regime
The gift tax[viii] is imposed on any transfer of property by gift made by a U.S. citizen or resident,[ix] whether made directly or indirectly,[x] and whether made in trust or otherwise. The tax is imposed on the donor and is based on the fair market value of the property transferred. Deductions are allowed for certain gifts to spouses and to charities.
The estate tax[xi] is imposed on the taxable estate[xii] of any person who was a citizen or resident of the United States at the time of death. The estate tax is imposed on the estate of the decedent and generally is based on the fair market value of the property passing at death. The taxable estate generally equals the worldwide gross estate less certain allowable deductions, including a marital deduction for certain bequests to the surviving spouse of the decedent and a deduction for certain bequests to charities.
The gift and estate taxes are unified such that a single graduated rate schedule and exemption apply to an individual’s cumulative taxable gifts and bequests. The unified estate and gift tax rates begin at 18 percent on the first $10,000 in cumulative taxable transfers and reach 40 percent[xiii] on cumulative taxable transfers over $1 million.[xiv]
A unified credit is available with respect to taxable transfers by gift or at death. This credit effectively exempts a total of $12.06 million[xv] (for 2022) in cumulative taxable transfers from the gift tax or the estate tax. The unified credit has the effect of rendering the marginal rates below 40 percent inapplicable. Unused exemption as of the death of a spouse generally is available for use by the surviving spouse; this feature of the law is sometimes referred to as “exemption portability.”
A separate transfer tax is imposed on certain generation-skipping transfers[xvi] in addition to any estate or gift tax that is imposed on such transfers. This tax generally is imposed on transfers, either directly or through a trust or similar arrangement, to a beneficiary who is more than one generation below that of the transferor. For 2022, the generation-skipping transfer tax is determined using a flat 40-percent rate and an exemption of $12.06 million.[xvii]
The Regime’s Function
The estate tax is often described as an imperfect backstop to the income tax. It seeks to tax the unrealized capital gain in the assets that are included in a decedent’s gross estate; this also provides a partial explanation for the adjustment to basis at the time of a taxpayer’s death.[xviii]
The gift tax acts as a backstop to the estate tax; it is imposed upon the assets that a decedent has removed from their future gross estate by virtue of having gifted the assets to individuals (usually younger than the donor) or to trusts for the benefit of such individuals.
The generation-skipping transfer tax is a backstop to both the estate tax and the gift tax; it seeks to ensure that property that passes from a donor to someone who is at least two generations removed from the donor is subjected to an additional level of transfer tax; basically, the equivalent of either the gift tax or the estate tax for which the intervening generation would have been liable had the property not “skipped” such generation.
From my own perspective, I have always viewed the estate tax regime as a way of preventing the “unreasonable” enrichment and empowerment of individuals who did not earn the wealth being passed onto them. Think of what Thomas Jefferson described as the “artificial aristocracy founded on wealth and birth.”[xix]
At the same time, I have always approached the income tax mindful of Solzhenitsyn’s statement that “Human beings are born with different capacities. If they are free, they are not equal. And if they are equal, they are not free.” Think of what Jefferson described as “natural aristocracy.”[xx] Income tax policy must recognize this basic truth and should not seek to suppress it.
Where Are We Going?
The White House and many lawmakers in Congress have been trying to convince their colleagues that the income tax should be amended to fulfill the role for which the estate tax regime is already in place. I attribute this shift, in part, to the apparent reluctance of past Congresses to address what the IRS and other Administrations[xxi] have long identified as “questionable” transfer tax strategies.
Notwithstanding this history, the President and his Party may be in a position to hone in on “reforming” the estate tax regime. However, he has chosen instead to take what may be described as a “throw it at the wall and see what sticks” approach.
First, as stated above, he is asking that the income tax be enlisted to tax unrealized wealth,[xxii] while borrowing very “liberally” – of course – from the rules developed under the estate tax regime to help implement this proposed wealth tax.
For example, under the President’s plan, the donor or the deceased owner of an appreciated asset would realize a capital gain at the time of the gift or testamentary transfer.[xxiii] The amount of the gain realized would be the excess of the asset’s fair market value on the date of the gift or on the decedent’s date of death over the deemed transferor’s basis in that asset. That gain would be reported as taxable income to the donor or decedent on the federal gift or estate tax return (or perhaps on a separate capital gains return).
A transfer would be defined under the gift and estate tax provisions and would be valued at the value used for gift or estate tax purposes. However, for purposes of the imposition of this capital gains tax, the transfer of a partial interest would be valued at its proportional share of the fair market value of the entire property – no valuation discount; however, this rule would not apply to an interest in a trade or business to the extent its assets are actively used in the conduct of that trade or business.[xxiv]
A transfer of property into an irrevocable trust would be a recognition event, as would a distribution in kind from such a trust to a beneficiary.[xxv] Likewise, a transfer of property to, and by, a partnership would be a recognition event if the transfers have the effect of a gift to the transferee.[xxvi]
Exclusions From Deemed Sale Treatment
Thankfully, not every gift or testamentary transfer would be subject to income tax. Certain very familiar-sounding exclusions would apply. For example, capital gain would not be realized on a transfer to a U.S. spouse or to charity.[xxvii] The transfer of appreciated assets to a split-interest trust[xxviii] would be subject to this capital gains tax, with an exclusion from that tax allowed for the charity’s share of the gain based on the charity’s share of the value transferred as determined for gift or estate tax purposes.
The proposal would allow a $5 million per-donor exclusion from recognition of unrealized capital gains on property transferred by gift during life. In addition, the proposal would allow any remaining portion of the $5 million exclusion that has not been used during life as an exclusion from recognition of unrealized capital gains on property transferred by reason of death. This exclusion would be portable to the decedent’s surviving spouse.
Finally, taxpayers could elect not to recognize unrealized appreciation of certain family-owned and operated businesses until the interest in the business is sold or the business ceases to be family-owned and operated. Furthermore, the proposal would allow a 15-year payment plan for the tax on appreciated assets transferred at death, other than liquid assets and other than family businesses for which the above deferral election is made.
“Fix” the Estate Tax Regime?
Sound familiar? They should. In many respects, these proposals mirror the estate tax regime that has been in place for so many years.
Notwithstanding the similarities, an income or gains tax is a different creature from, say, an estate tax. Assuming this proposal were enacted, query how long it would take to resolve the legal challenges that are certain to follow; query also how long we’d have to wait before the regulatory infrastructure for the new tax was drafted, proposed, vetted, and adopted. Even then, who in the overworked, understaffed IRS will administer the new tax?
Then there are the states. Will they follow suit? Will conformity or decoupling be the order of the day?[xxix]
Which brings us to something else the President has thrown against the proverbial (and now filthy) wall. In addition to the above-described “deemed sale regime,” Mr. Biden is taking aim at many of the vehicles and strategies that are most commonly used by estate planners to facilitate the transfer of wealth by their clients on a tax-efficient basis.
Some of the measures included in the President’s proposal appeared in the ill-fated Build Back Better program; others are versions of Obama-era proposals for reforming the estate tax regime.[xxx] Should they fare better? Do they deserve a closer look?
What’s to Reform?
Among the estate and gift tax planning techniques for which the 2023 Budget has proposed “reforms” are the following: short-term GRATs, sales to grantor trusts, and so-called dynasty trusts. Before describing the Administration’s proposals, a brief review of these estate planning tools may be in order.
Individuals who own assets that are expected to appreciate in value often use two techniques for reducing estate taxes that exploit the gift and income tax features of grantor trusts to remove value from their gross estates. The first technique is the funding of a grantor retained annuity trust (“GRAT”) with assets that are expected to appreciate in value. The second technique is the “sale” of an appreciating asset to a grantor trust by the deemed owner of the trust. In both cases, the greater the post-transaction appreciation, the greater the transfer tax benefit achieved.
In general, a GRAT is an irrevocable trust that is funded by an individual grantor with assets that are expected to appreciate in value, in which the grantor retains an annuity interest for a term of years that the grantor expects to survive. At the end of that term, the assets then remaining in the trust are transferred to (or held in further trust for) the remainder beneficiaries without the imposition of any gift tax.[xxxi]
The value of the grantor’s retained annuity is based in part on the applicable federal rate[xxxii] in effect for the month in which the GRAT is created.[xxxiii] Therefore, to the extent the GRAT’s assets appreciate at a rate that exceeds that statutory interest rate, that appreciation will have been transferred, free of gift tax, to the remainder beneficiary of the GRAT.
However, if the grantor dies during the GRAT term, the trust assets (at least the portion needed to produce the retained annuity) are included in the grantor’s gross estate for estate tax purposes.[xxxiv] To this extent, although the beneficiaries will own the remaining trust assets, the estate tax benefit of creating the GRAT (specifically, the tax-free transfer of the appreciation during the GRAT term in excess of the annuity payments) is not realized.
To mitigate the mortality risk during the annuity term – and thereby to essentially eliminate the risk of inclusion in the grantor’s gross estate – the GRAT term is selected to be a number of years that the grantor is expected to survive.[xxxv]
To mitigate the gift tax cost, and to thereby preserve the grantor’s lifetime exclusion, the GRAT is structured to have an annuity interest significant enough to reduce the gift tax value of the remainder interest to close to zero (the “zeroed-out” GRAT).[xxxvi]
As a result, even if the GRAT is unsuccessful, there has been little to no cost or downside risk for the grantor.
Sale to Grantor Trust
Another method of removing an asset’s future appreciation from one’s gross estate for estate tax purposes, while avoiding transfer and income taxes, is the sale of the asset to a grantor trust of which the seller is the deemed owner for income tax purposes.[xxxvii] In most cases, the seller receives the sales price for the appreciating asset in the form of a note issued by the trust that is to be paid from the future income or appreciation from the asset sold to the trust.
The grantor trust utilized under this method is an irrevocable trust of which the individual grantor is treated as the owner of the trust’s assets for income tax purposes.[xxxviii] Thus, for income tax purposes, a grantor trust is taxed as if the grantor owned the trust assets directly; stated differently, the grantor and the trust are treated as the same person for income tax purposes. This results in transactions between the trust and the grantor (the deemed owner) being ignored for income tax purposes;[xxxix] specifically, no capital gain is recognized when an appreciated asset is sold by the deemed owner to the trust, or vice versa.[xl]
For transfer tax purposes, however, the trust and the deemed owner are separate persons and, thus, the receipt of the note in exchange for the grantor’s asset is treated as the receipt of full and adequate consideration, thereby avoiding a taxable gift, and preserving the grantor’s lifetime exclusion.[xli]
Moreover, under certain circumstances, the trust is not included in the gross estate of the deemed owner for estate tax purposes. In this way, the post-sale appreciation has been removed from the deemed owner’s taxable estate – there has been an estate freeze.
That’s Not All
As if the foregoing benefits weren’t enough, both GRATs and sales to grantor trusts afford the grantor and their beneficiaries an opportunity to avoid future capital gains taxes by permitting the grantor to purchase an appreciated asset from the trust at fair market value without triggering gain recognition.[xlii] The subsequent inclusion of that asset in the grantor’s gross estate would, under current law, result in a basis step-up to the asset’s fair market value at the time of the grantor’s death,[xliii] often at an estate tax cost that has been significantly reduced by the judicious use of the grantor’s lifetime exclusion.
In addition, the deemed owner’s payment of the income tax on the trust’s taxable income and gains each year is considered the owner’s payment of their own tax liability and therefore not a gift.[xliv] This allows the property in the trust to grow free of income tax; the income tax payments also further reduce the grantor’s estate.
But Wait, There’s More
In short, GRATs and grantor trusts allow a grantor and their spouse – a combined exclusion amount of $24.12 million[xlv] in 2022 – to substantially reduce their combined federal income, gift, and estate tax obligations.
But what if the grantor could avoid estate and gift taxes not only for the transfer of property to their children, or even to their grandchildren, but for generations beyond? Basically, for complete strangers.
Sounds nuts? It does to me, yet most folks with enough wealth to warrant estate planning are opting to shelter as much of their wealth for these generations of strangers, for these future members of the “artificial aristocracy founded on wealth and birth,” as Jefferson wrote.
By what alchemy is this goal accomplished? And what about the GST tax described earlier, which seeks to ensure the assets of a wealthy family are, in effect, taxed at every generation? Can this too be avoided?
Yep. The GST tax is imposed on gifts and bequests by an individual grantor to transferees who are two or more generations younger than the transferor. Each individual has a lifetime GST tax exemption ($12.06 million in 2022) that can be allocated to transfers made, whether directly or in trust, by that individual to a grandchild or other “skip person,” or to a trust from which a distribution may be made to such a person.[xlvi] The allocation of GST exemption to a transfer or to a trust excludes from the GST tax not only the amount of assets to which GST exemption is allocated, but also all subsequent appreciation and income on that amount during the existence of the trust.
While the property remains in a trust, no estate tax is imposed at the death of any trust beneficiary because the beneficiary typically has no rights to the trust property that would cause the property to be includable in the deceased beneficiary’s gross estate for federal estate tax purposes.[xlvii] By the same token, a distribution from the trust does not trigger any gift tax.[xlviii] And, as indicated immediately above, the allocation of GST exemption will shield trust distributions from GST tax.
Only upon the termination of the trust, when the trust assets are required to vest in one or more persons, will the trust property re-enter the gift and estate tax base.
“What about the rule against perpetuities?” you may ask, “doesn’t it ensure that trust property will in fact re-enter the estate tax regime?” After all, the purpose of the rule is to prevent interests in property that is held in trust from being tied up for generations after the death of the grantor.[xlix]
More and more states, however, are either limiting the application of their rule against perpetuities (for example, permitting trusts to continue for several hundred years) or doing away with the rule altogether.[l] In those states, as a practical matter, trusts are permitted to continue in perpetuity, so the property in those trusts has been permanently removed from the estate and gift tax base.[li]
The Administration’s Proposals[lii]
The Administration and its allies have done a piss-poor job of delivering their message. For many listeners, their plans come across as opportunistic demagoguery; to others, their ostensible goals smack of class conflict. They’re acting like politicians as opposed to lawmakers. But back to Jefferson: “The government you elect is the government you deserve.”
In the process, the very sound reasons for correcting the misappropriation of the provisions discussed in this post are never articulated.
For example, when the legislators in Congress enacted Chapter 14 of the Code (including the GRAT rules) back in 1990,[liii] I doubt they were thinking how wonderful it would be if some of their constituents could employ zeroed-out GRATs to avoid the federal gift tax and estate tax. Ironically, Chapter 14 was added to the Code to assure more accurate gift tax valuations and to prevent the manipulation of such valuations in the case of transfers of certain interests in closely held corporations and partnerships.
Similarly, the grantor trust rules were added to the Code to prevent certain individuals from shifting their income (which presumably was subject to tax at a high rate) to trusts for their children (who benefited from lower tax brackets) by transferring to the trusts the property from which such income[liv] was realized while at the same time retaining “control” over the trust or the property. These anti-tax-avoidance rules have now assumed a place in every estate planner’s toolbox as a means of avoiding the gift tax.[lv]
The GST tax rules were introduced to prevent folks from circumventing the estate tax regime as wealth passed from generation to generation. An underlying assumption was that the property held in trust for the benefit of multiple generations would eventually find its way into the tax regime thanks to the rule against perpetuities. I doubt Congress could have foreseen the relaxation or elimination of the rule against perpetuities.
Whatever the Administration’s motivation, its 2023 Budget proposes certain changes to the application of these rules that should be considered.
The Budget would require that the remainder interest in a GRAT at the time the interest is created have a minimum value for gift tax purposes equal to the greater of 25 percent of the value of the assets transferred to the GRAT or $500,000 (but not more than the value of the assets transferred). No more zeroed-out GRAT.
In addition, the Budget would prohibit any decrease in the amount of the annuity during the GRAT term and would prohibit the grantor from acquiring in an exchange an asset held in the trust without recognizing gain or loss for income tax purposes.[lvi]
Finally, the Budget would require that a GRAT have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years, thereby reintroducing the mortality and gross estate inclusion risks.
In sum, these provisions would impose some downside risk on the use of GRATs so they are less likely to be used purely for tax avoidance purposes.[lvii]
With respect to grantor trusts, the Budget would treat the transfer of an asset for consideration between a grantor trust and its deemed owner as one that is “regarded” for income tax purposes, which would result in the seller recognizing gain on any appreciation in the transferred asset.
The Budget also would provide that the grantor’s payment of the income tax on the income of a grantor trust is a gift. That gift would occur on December 31 of the year in which the income tax is paid (or, if earlier, immediately before the owner’s death, or on the owner’s renunciation of any reimbursement right for that year) unless the deemed owner is reimbursed by the trust during that same year. The amount of the gift is the unreimbursed amount of the income tax paid.[lviii]
Finally, the Budget would provide that the GST exemption apply only to “direct skips” and “taxable distributions” to beneficiaries no more than two generations below the transferor (Gen 1 and Gen 2), and to younger generation beneficiaries who were alive at the creation of the trust; it would also apply to “taxable terminations” occurring while any person described in Gen 1 or Gen 2 is a beneficiary of the trust.[lix] In addition, solely for purposes of determining the duration of the exemption, a pre-enactment trust would be deemed to have been created on the date of enactment. The result of these proposals is that the benefit of the GST exemption that shields property from the GST tax would not last as long as the trust. Instead, it would shield the trust assets from GST tax only as long as the life of any trust beneficiary who either is no younger than the transferor’s grandchild or is a member of a younger generation but who was alive at the creation of the trust. Specifically, this limit on the duration of the GST exemption would be achieved thereby rendering no part of the trust exempt from GST tax.[lx]
To Be Continued
The changes to the estate tax regime described above are relatively modest and inoffensive, and their eventual enactment could hardly be described as surprising. Indeed, I’m certain that many planners have long been wondering when the “party” would be over; others are probably wondering when more severe changes will become law, including a more graduated rate structure with much higher marginal rates.
Unfortunately, these proposals are being lost in the clamor over the Administration’s very aggressive and unwelcome posture on using the income tax as a quasi-estate tax, and thereby fundamentally changing the rules under which folks and their businesses have long been operating.
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[i] From America’s favorite philosopher, Yogi Berra.
[ii] https://www.whitehouse.gov/omb/briefing-room/2022/03/28/fact-sheet-the-presidents-budget-for-fiscal-year-2023/ . The Federal government operates under an October 1 to September 30 fiscal year; thus, the 2023 fiscal year will begin on October 1, 2022.
[iii] One remains on the public stage, but the other?
[iv] And relying on V.P. Harris’s tie-breaking vote as president of the Senate.
[v] Versus 8 Republicans. https://www.thoughtco.com/historical-midterm-election-results-4087704 .
[vii] The House will actually be on recess for August and October, not to mention the week leading up to the election.
[viii] 26 USC Chap. 12.
[ix] For these purposes, “residence” means domicile.
[x] For example, a parent’s contribution of funds to a corporation owned by their children, or the parent’s guarantee of a corporate debt.
[xi] 26 USC Chap 11.
[xii] In addition to interests in property owned by the decedent at the time of death, the estate tax also is imposed on: (1) life insurance that was either payable to the decedent’s estate or in which the decedent had an incident of ownership at death; (2) property over which the decedent had a general power of appointment at death; (3) annuities purchased by the decedent that were payable to the decedent before death; (4) certain interests in jointly held property; (5) property transferred by the decedent before death in which the decedent retained a life estate or over which the decedent had the power to designate who will possess or enjoy the property; (6) property revocably transferred by the decedent before death; and (7) certain transfers taking effect at the death of the decedent.
[xiii] During the Reagan years, the estate tax rate was reduced from 70% to 55%. There is nothing sacrosanct about today’s 40% rate and the large exemption amount.
[xiv] IRC Sec. 2001, Sec. 2501.
[xv] The basic exclusion amount is indexed for inflation.
[xvi] 26 USC Chap. 13.
[xvii] The exemption amount for the generation-skipping transfer tax is the same as the basic exclusion amount used to calculate the unified credit. Sec. 2631. It is important to realize it is not the same exemption – a donor make exhaust their entire gift/estate tax exemption without utilizing any of their GST exemption.
[xviii] Not only of lawfully earned wealth, but also wealth the accumulation of which was facilitated by the failure to pay the correct amount of income taxes. In a sense, the estate tax may be viewed as a sort of lifestyle audit; an examination of the boat, the several homes, the cars, the jewelry, the art, etc., through which any untaxed income was basically laundered.
What, you’ve never encountered a situation in which it was difficult to reconcile an income tax return to a taxpayer’s possessions and lifestyle?
[xix] Thomas Jefferson’s letter of October 28, 1813 to John Adams. https://press-pubs.uchicago.edu/founders/documents/v1ch15s61.html .
[xx] The “grounds” of which, Jefferson tells us, are “virtue and talent.”
[xxi] At least the Clinton and Obama Administrations.
[xxii] Although not discussed here, the President has proposed the imposition of an annual minimum tax equal to 20 percent of total “income” – which for this purpose would include unrealized capital gains – for all taxpayers with wealth (that is, fair market value of assets over liabilities) of an amount greater than $100 million.
[xxiii] Gain on unrealized appreciation also would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years. This provision would apply to property not subject to a recognition event since December 31, 1939, so that the first recognition event would be deemed to occur on December 31, 2030. Think of it as an anti-dynasty trust measure.
[xxiv] This is the more focused approach that the regulations proposed in 2016 should have taken – one that was targeted at the discounted valuation of interests in investment partnerships holding marketable securities, not those that operated businesses. You may recall that, with Mr. Trump’s election, this regulation project was suspended, then withdrawn.
[xxv] A transfer to a grantor trust that is deemed to be wholly owned and revocable by the donor would not be a recognition event.
[xxvi] For example, a transfer of property by a parent to a partnership with their kids in exchange for which the parent receives a disproportionately low equity interest in the partnership.
[xxvii] The transfer would carry over the basis of the donor or decedent and gain recognition would be deferred until the surviving spouse disposes of the asset or dies, and appreciated property transferred to charity would be exempt from capital gains tax.
[xxviii] For example, a charitable remainder trust.
[xxix] You may recall that, in 2020 and into 2021, New York’s legislature was clamoring for a mark-to-market tax. Nuts.
[xxx] Indeed, much (most?) of this Administration’s tax agenda can trace its origins to the Clinton and/or Obama Administrations.
[xxxi] IRC Sec. 2702; Reg. Sec. 25.2702-3.
[xxxii] Under section 7520 of the Code.
[xxxiii] At the creation of the GRAT, the gift tax rules determine the value of the grantor’s gift of the remainder interest in the GRAT by deducting the then-present value of the grantor’s retained annuity interest from the fair market value of the property funding the GRAT. The present value of the grantor’s retained annuity interest is the value of the expected payments to the grantor during the GRAT term determined using a discount rate or rate of return based in part on the applicable Federal rate in effect for the month in which the GRAT is funded.
[xxxiv] IRC Sec. 2036; Reg. Sec. 20.2036-1(c)(2).
[xxxv] Often only two to three years in the case of an asset that is expected to appreciate quickly.
[xxxvi] I.e., the difference between FMV of the property transferred to the GRAT over the present value of the retained annuity interest – the taxable gift – is minimal.
[xxxvii] Rev. Rul. 85-13.
[xxxviii] If the grantor who creates an irrevocable trust retains certain powers with regard to the trust or its assets, the trust is a grantor trust and the grantor is considered the deemed owner of the trust. IRC Sec. 671 et seq. Of course, the grantor has to be careful that the powers retained will not cause the trust to be included in the grantor’s gross estate.
[xxxix] In addition to causing transactions between the grantor trust and its deemed owner to be disregarded for income tax purposes, this feature also generally results in the income tax liability generated by grantor trust assets to be the obligation of the deemed owner, rather than the obligation of the trust or its beneficiaries. No amount paid by the deemed owner of a grantor trust to satisfy this income tax liability is treated as a gift by the deemed owner to the trust or its beneficiaries for federal gift tax purposes.
[xl] It should be noted that GRATs are generally structured as grantor trusts; thus, the payment of the annuity to the grantor is disregarded for income tax purposes, though the grantor is taxed on the trust’s income and gain.
[xli] Of course, one cannot forget the importance of “seeding” the trust with other property, often through a taxable gift.
[xlii] IRC Sec. 675(4)’s substitution power. The trust then will have the same value as before the repurchase by the grantor but without the future capital gains tax liability for the unrealized gain on the asset.
[xliii] IRC Sec. 1014.
[xliv] Rev. Rul. 2004-64.
[xlv] Which may essentially be leveraged to enable the transfer of much more wealth through valuation discounts.
[xlvi] IRC Sec. 2631.
[xlvii] Mind you, many trusts will authorize the trustee to give a beneficiary a general power of appointment over some part of the trust property when doing so would be beneficial from a transfer tax perspective.
[xlviii] Assuming the trust ceases to be a grantor trust after the death of the grantor and/or their spouse, the trust itself will be a taxpayer, unless it distributes its distributable net income, or DNI, for the taxable year; in that case, the beneficiaries to whom the distributions are made will be taxable thereon.
[xlix] It’s time to remind legislators of the wisdom of this gem of the common law.
[l] Query who lobbied for these changes. Trust companies? Wealthy families?
[lii] The Administration and its allies have done a piss-poor job of delivering their message. Their plans come across as opportunistic demagoguery or, perhaps worse, rather than as
[liii] Omnibus Budget Reconciliation Act of 1990.
[liv] Think assignment of income.
[lv] Unfortunately, the blame here lies with the IRS and its issuance of PLR 9535026 (May 31, 1995). Intellectual acrobatics aside, the application of the close scrutiny test and IRC Sec. 482 principles would go a long way toward correcting the course.
[lvi] Think of the regulatory change to the QPRT rules which sought to accomplish the same anti-step-up consequences in the case of a personal residence held in trust.
[lvii] The GRAT proposals would apply to all trusts created on or after the date of enactment.
[lviii] The portion of the proposal characterizing the grantor’s payment of income taxes as a gift also would apply to all trusts created on or after the date of enactment. The gain recognition portion of the proposal would apply to all transactions between a grantor trust and its deemed owner occurring on or after the date of enactment.
[lix] See IRC Sec. 2612 for the definitions of these terms.
Please note that the generation re-assignment rules would not apply for these purposes. See IRC Sec. 2653.
[lx] The proposal would apply on and after the date of enactment to all trusts subject to the generation-skipping transfer tax, regardless of the trust’s inclusion ratio on the date of enactment.