Grantor Trusts Under Attack in the Build Back Better Act
The Build Back Better Act is the budget reconciliation bill that Democrats are currently debating amongst themselves and could contain the death knell to irrevocable grantor trust planning. With the recent release of the Pandora Papers, there is now even more publicity around wealthy people using trusts to keep assets secret and minimize taxes, which may only make the Democrats’ argument stronger for changing some of the U.S. trust tax laws. The proposed tax changes include drastic changes to grantor trusts that would change the landscape of traditional estate tax planning and has many individuals and estate planners anxious.
Federal Estate Tax Exemption
The Tax Cuts and Jobs Act (TCJA) doubled the estate/gift tax exemption to $10 million per person ($11.7 million in 2021 with inflation indexing). Under current law, this doubling of the exemption will sunset after December 31, 2025 and revert to its pre TCJA level of $5 million (which would be indexed for inflation). The proposal in the Build Back Better Act would accelerate this sunsetting to after December 31, 2021. Lowering the estate/gift tax exemption would result in more people being subject to estate tax, but a larger issue in the proposed bill is that assets held in an irrevocable grantor trust will be included in the grantor’s estate.
Current Grantor Trust Rules
Under the current grantor trust rules, a transfer to an irrevocable grantor trust generally is a completed gift that shifts assets out of the grantor’s estate. Any items of income, deduction and credit of the trust are taxed to the grantor, and distributions out of the trust to beneficiaries are not subject to gift tax. By using a grantor trust, one may make an irrevocable gift to the trust and remove the gifted asset from the grantor’s taxable estate, however, by having certain powers and provisions in the trust, the trust’s taxable income is taxable to the grantor at personal income tax rates. As the grantor is the income taxpayer of the grantor trust (even though the assets are removed from the grantor’s taxable estate), a grantor can sell assets to his/her grantor trust as a disregarded sale without triggering gain on the sale because the grantor and the grantor trust are the same income taxpayer. Further, the grantor’s payment of income tax on the trust’s taxable income is not considered a gift to the trust. There are many planning strategies that rely on these rules to remove assets from a grantor’s taxable estate, such as note sales to grantor trusts. If the assets held in a grantor trust are included in the grantor’s estate, the use of irrevocable grantor trusts would largely be eliminated going forward.
Before getting to the grantor trust proposals, note that a trust may be a non-grantor trust, in which case it is a separate taxpaying entity subject to trust income tax rates and brackets. Non-grantor trusts are subject to very truncated trust income tax rates that reach the top federal income tax rate at about $13,000 of taxable income. The Build Back Better Act also proposes to raise the top federal income tax rate to 39.6% and impose a new 3% surcharge on non-grantor trusts that have modified adjusted gross income over $100,000. High trust income tax rates are often a driving force to use grantor trusts, but also as a non-grantor trust is a separate taxpayer from the grantor the ability to do note sales that are disregarded for income tax purposes is not available, meaning that a note sale to a non-grantor trust would result in the grantor recognizing gain on the sale.
The Grantor Trust Proposals
The proposal would add new Section 2901 to the tax code which would provide that the value of a person’s gross estate includes assets held in a grantor trust, a distribution from a grantor trust to a trust beneficiary (other than the grantor or the grantor’s spouse) is a taxable gift, and if the trust ceases to be a grantor trust during the grantor’s life this is a taxable gift. Note that this would not apply to any trust that is includible in the gross estate without regard to this proposal, which seems clearly aimed at revocable trusts as they are grantor trusts that are otherwise included in a grantor’s estate, however, perhaps this could have wider applicability.
The proposal would also add new Section 1062 to the tax code which would provide that “any transfer of property between a trust and a person who is the deemed owner of the trust (or portion thereof), such treatment of the person as the owner of the trust shall be disregarded in determining whether the transfer is a sale or exchange for purposes of this chapter.” What this means is that a sale between a grantor and his/her grantor trust would no longer be a disregarded sale.
Effective Date of Grantor Trust Proposals
Sections 2901 and 1062 would apply to trusts created on or after the date of enactment and to any portion of a trust established before the date of enactment which is attributable to a contribution made on or after the date of enactment. Therefore, a grantor trust that was created before the Act is signed into law would be grandfathered and would be excluded from the grantor’s estate. However, if a gift is made to an existing grantor trust after the Act is signed into law, one will need to keep track of the value of those gifts versus the value of trust on the date of the gift to know what portion of the trust is excluded and included in the grantor’s estate. This will be an arduous task for many and where possible it would seem best to not make gifts to an existing grantor trust after the Act is signed into law.
Irrevocable Life Insurance Trusts (ILITs)
Life insurance trusts are often used to keep the death benefit out of the insured’s taxable estate and most ILITs are grantor trusts because Section 677(a)(3) results in grantor trust status if trust “income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, or both, may be applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse.” Trustees are typically allowed to use trust income to pay for life insurance premiums on the grantor-insured’s life. Also, there are often other powers that make an ILIT a grantor trust, such as giving the grantor the power to substitute trust assets by substituting other assets of equal value and enabling the grantor to borrow from the trust without adequate interest or without adequate security.
High net worth people who have some or all of their 2021 $11.7 million gift/estate tax exemption remaining may want to consider funding their ILITs to purchase life insurance out of the estate where no further annual exclusion gifts are needed in order to avoid tainting trust under Section 2901. The money could either be paid into the life insurance policy (although this may create a modified endowment contract which has some different tax attributes), keep the money invested in the trust, or put the money into a premiums-paid-in-advance account that many insurance companies offer (the prepaid premiums result in a discount based on an interest rate offered by the insurance company). Note: A modified endowment contract (MEC) is the term given to a life insurance policy whose funding has exceeded federal tax law limits. In other words, the IRS does not consider this to be a life insurance contract anymore. The change in classification was brought about to combat the use of the “life insurance” designation for the purposes of tax avoidance. The IRS has established specific criteria that if met, results in the policy becoming a MEC.
People who have existing grantor trust ILITs and who will not be able to fund their ILITs with large gifts before the Act is signed into law will want to consider other payment strategies to avoid making a gift to their ILITs after the Act is signed into law because post-enactment gifts will taint the ILIT and result in partial inclusion of the trust assets, including the life insurance policy death benefit.
Private split-dollar may be one way to pay premiums for ILIT owned policies without creating a gift to the trust. There are two split-dollar life insurance methods: loan regime and economic benefit regime. Under a loan regime split-dollar arrangement the grantor (or another family member or closely held company) makes interest-bearing loans to the ILIT to pay the premiums. These are loans, not gifts, so this should not taint the ILIT for Section 2901 purposes. The grantor has no specific interest in the policy’s cash value and the ILIT retains all rights to the policy’s cash value and death benefit subject to its obligation to repay the loan.
Note: 1) Some whole life policies do not have cash values in the first two years of the policy and don’t pay a dividend until the policy’s third year. Talk to your financial representative and refer to your individual whole life policy illustration for more information. And 2) Policy benefits are reduced by any outstanding loan or loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest. Withdrawals above the cost basis may result in taxable ordinary income. If the policy lapses, or is surrendered, any outstanding loans considered gain in the policy may be subject to ordinary income taxes. If the policy is a Modified Endowment Contract (MEC), loans are treated like withdrawals, but as gain first, subject to ordinary income taxes. If the policy owner is under 59 ½, any taxable withdrawal may also be subject to a 10% federal tax penalty.
The interest rate on the aforementioned loans should be at least the Applicable Federal Rate, which is currently very low (as of October 2021 the short-term AFR is 0.18%, the mid-term AFR is 0.91%, and the long-term AFR is 1.74%). The ILIT either paid or accrued the interest, however, if the loan interest is not paid that interest will be an imputed gift to ILIT from the grantor; therefore, to avoid any deemed gift the ILIT should pay the grantor the interest (preferably annually).
Under an economic benefit regime split-dollar arrangement the grantor pays the premiums in exchange for an interest in the policy equal to the greater of its cash value or the total premiums paid. In a typical economic benefit regime arrangement, the ILIT would typically be deemed to receive a gift from the grantor equal to the “economic benefit” of the current value of the life insurance coverage using Table 2001-10 rates or lower term rates of the issuing insurance company. However, avoiding a deemed gift is important with an existing grantor trust so the ILIT should reimburse the grantor for the economic benefit cost to avoid having a deemed gift and tainting the trust under Section 2901.
Alternatively, if an existing grandfathered ILIT owns a life insurance policy that needs future premium payments, the death benefit of a policy whose premiums are funded by a third-party lender (i.e., premium financing) should not be included in the taxable estate of the grantor, assuming the grantor does not pay the loan interest or the principal on behalf of the grantor trust.
While ILITs have historically been structured as grantor trusts, an ILIT could be intentionally drafted to be a non-grantor trust. The trust could not contain any of the provisions that would result in grantor trust status, most importantly for ILITs is Section 677(a)(3)’s provision that results in grantor trust status if trust “income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, or both, may be applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse.” Therefore, the trust may want to explicitly state that only principal may be used to pay premiums, but the IRS may take the view that “income” is not limited to current year income and includes prior year income added to principal, so that needs to be kept in mind. Alternatively, a trust could state that trust income can be used to pay premiums only with adverse party consent. An adverse party is a person who has a substantial beneficial interest in the trust that would be adversely affected by the exercise or non-exercise of a power, such as a child who is a trust beneficiary.
Family Limited Liability Company
There is becoming more interest in Family LLCs as an alternative to ILITs. This usually involves having an LLC where a parent owns a small percentage of the LLC and the balance is owned by family members. The parent can retain managerial control over the LLC until death, keeping a large portion of the value out of the parent’s taxable estate while retaining control of the LLC’s assets. Nothing in Section 2901 attacks LLCs. Transfers to an LLC are generally treated as capital contributions and not as taxable gifts under the partnership tax rules, while transfers to irrevocable trusts are gifts. Generally, contributions of property to a partnership in exchange for partnership interests are tax-free exchanges.
With respect to avoiding estate tax inclusion of a life insurance policy owned by the LLC, the IRS privately ruled in PLR 200747002 that an insured-member did not have an incident of ownership over a life insurance policy owned by an LLC that had an independent manager and the insured-member couldn’t exercise any control over the policy. Therefore, it may be possible to structure an LLC to own life insurance on the members’ lives and avoid estate tax inclusion under Section 2042, since proposed Section 2901 is focused on grantor trusts, not LLCs. If an independent manager is not used to manage the insurance LLC as was done in PLR 200747002, the death benefit could be paid to the LLC, and, as long as the LLC is structured appropriately, the insured should only have a proportional amount of the policy proceeds included in his or her estate equal to his or her ownership interest in the LLC.
With appropriate planning, the insured could sell or gift his/her LLC membership interest before death to help avoid or minimize estate inclusion. High net worth individuals have utilized family limited partnerships with general and limited partnership interests to own life insurance policies, but whether using an LLC or FLP the planning technique would be similar and generally involves the parent-insured retaining a 1% general partnership interest and gifting the 99% limited partnership interests to family members.
The grantor trust proposals would be a seismic shift in the estate planning world. The final tax bill, if one is passed into law, is likely to look different than what is currently proposed. But that should not be a reason for inaction and individuals who may be impacted by these proposals should discuss with their financial professionals any proactive steps they should take now while they still can.
Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice. This material contains the current opinions of the author but not necessarily those of Guardian or its subsidiaries and such opinions are subject to change without notice.
Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation.
2021-128424 Exp 10/22