In the wake of the 2016 Presidential election and the unexpected
November Surprise election of Donald J. Trump, who has indicated an
intention to repeal the 'death tax,' the estate planning
community is trying to digest exactly what a repeal of the estate
tax would look like, its implications on the practice and, of
course, planning opportunities that may arise as a consequence.
While one may initially be tempted to conclude that a repeal would
have a chilling effect on planning, given the President Elect's
proposal to replace the estate tax with a mark-to-market capital
gains tax at death for estates exceeding $10 million, a substantial
tax bite at death could still occur, albeit at a lower rate (the
President Elect has proposed retaining the current 20% capital
gains rate). However, in the case of very large estates, a 20%
mark-to-market tax at death could still present significant
liquidity challenges. This newsletter explores various applications
of traditional estate planning 'freeze' transactions that
will likely still play an important role in an estate tax free
environment, with a new focus on freezing value and/or basis for
income tax purposes rather than estate tax purposes.
Admittedly, many of us in the estate planning community were caught
a little (a lot) off guard on election night (as was much of the
country), when Donald J. Trump clinched the necessary electoral
votes to win the keys to the White House. While the President
Elect's website has for months described his plan to repeal the
'death tax' and replace it with a mark-to-market capital
gains tax at death for estates above $10 million, not a lot of
attention was paid to this possibility by the estate planning
community at large. Indeed, just five days before the election,
Steve Akers, John Porter and one of the authors gave a 'Current
Events' presentation at the American Law Institute in Dallas,
and it did not occur to them to discuss (more than in a quick
passing comment) the possibility of the repeal of the estate tax
under a Trump administration. At the time, it simply wasn't
something that people were at all focused on. A lot can happen in
the course of a week, or more appropriately, in one
day.
So here we are, trying to make sense of a whole new dynamic, with a
Republican controlled House, Senate and White House, all of whom
have expressed support for an outright repeal of the estate tax.
[i] A repeal of the estate tax could have far reaching
implications, not only for estate planning attorneys, but also for
private bankers, financial planners, valuation professionals,
accountants and life insurance professionals. The exact contours of
these implications are yet unknown, and much of this will depend
upon if, how and when any changes to the transfer tax laws occur.
Presumably, there are many more pressing issues on the President
Elect's 'to do' list, including the stated repeal of
Obamacare (although he appears to have softened on this stance
post-election), building infrastructure, addressing immigration
issues and fortifying our military in the ongoing defense against
terrorism. Without a doubt, these initiatives will prove expensive
and the new administration will have to find a mechanism to pay for
them or incur tremendous additional national debt. So, while it is
easy in this period of uncertainty to get tunnel vision about when
the repeal of the estate tax may happen, practitioners should keep
in mind that, as with all things in Washington, it may take some
time.
In the meantime, what follows are some preliminary (and admittedly
speculative) thoughts on implications of a possible repeal on the
estate planning practice. Change often means opportunity and this
could certainty be the case with an estate tax repeal. President
Elect Trump's proposal would be to repeal the 'death
tax' and to replace it with a mark-to-market capital gains tax
at death for estates over $10 million; his plan is silent as to
whether gift tax and GST tax repeal would also be on the table and
whether and to what extent conforming changes may be made to the
income tax law. The House Blueprint calls for a repeal of the
estate tax and the GST tax, but makes no mention of repeal of the
gift tax.
The Trump Proposal: Repeal of Estate Tax (the 'Death Tax') with Deemed Capital Gains at Death for Estates over $10 million
Trump's plan would essentially adopt a Canadian-style
approach, replacing the 'death tax' with a mark-to-market
event at death triggering capital gains. This tax would be imposed
at a rate of 20%, with a repeal of the 3.8% net investment income
tax. While the new mark-to-market tax would technically constitute
a capital gains tax at death, rather than an estate tax,
practically, it would represent a reduction in the estate tax rate
to 20% (on a fully appreciated asset) and a near doubling of the
current exemption amount. In other words, under the Trump plan,
there would still be a 'death tax' insofar as a tax would
be triggered by one's death, it just wouldn't be called
that. As Mr. Trump has demonstrated over the past months, branding
can be a powerful tool in shaping public opinion.
From a planning perspective, while a 20% hit on gains may be more
palatable to clients than the current 40% estate tax on value, and
while the $10 million exemption represents a significant increase
to the current $5.45 million estate tax exemption, in the case of
the client with a net worth of $50 to $100 million, or say $1
billion, a 20% mark-to-market event at death would still result in
a significant 'death tax' and could cause a liquidity
crisis. Thus, many of the traditional estate 'freeze'
planning techniques implemented by estate planners to perhaps
discount the current value of assets and shift future growth to
more tax efficient 'buckets' (for instance,
multigenerational dynasty trusts or preferred partnerships) will
very likely remain relevant to the mark-to-market regime under the
Trump proposal. Moreover, having such vehicles in place in advance
of a possible repeal of the estate tax could pay dividends down the
road by providing a platform for future planning and possibly
opening doors to creative structures in a post-repeal world.
The Trump Proposal: Opportunities under the Proposed Regime
As a basic demonstration of this point, planning to shift the
future appreciation of an asset that parent owns to his or her
children will still be important so as to contain the value of the
asset in parent's estate, thereby reducing the parent's
exposure to the mark-to-market capital gains tax at death. This
type of planning may very well involve similar 'freeze'
techniques to those currently used by estate planners. If the
mark-to-market tax would also apply in the case of a gift, as is
the case under the Canadian system, techniques such as sales to
grantor trusts would likely still be utilized to accomplish a fair
market exchange and shift of possible future growth without
triggering a current gift or income tax.
Valuation. Under the Trump proposal, the concept of
valuation discounts will still be very relevant to the extent that
there exists some form of the $10 million exemption from the
mark-to-market tax under the Trump proposal. If, for example,
parent dies owning a 50% interest in an LLC that owns a $25 million
property, will that LLC interest be worth $12.5 million
undiscounted, and therefore subject to capital gains tax on the
$2.5 excess, or will the 50% interest be worth less than $10
million after the application of traditional valuation discounts,
and therefore not subject to the mark-to-market tax? Query also
whether a final version of the Treasury Department's Proposed
Regulations under Section 2704 (or a new similar provision) would
be applicable or relevant under such a regime. Indeed, because this
tax would be an income tax, it might be that the mark-to-market
death tax could incorporate additional limitations on valuation
discounts without some of the Constitutional concerns implicated by
a wealth transfer tax.
Grantor Trusts. The Trump proposal is silent as to whether
the repeal of the 'death tax' will be accompanied by
conforming changes to federal income tax law. As such, it is
unknown whether the mark-to-market tax will also presumably capture
assets held by grantor trusts but that are no longer actually owned
by the grantor. One could imagine the IRS closely examining trust
instruments and administrative records at death to determine
whether trust assets should be subject to the mark-to-market tax.
Therefore, perhaps an increasingly important component of
pre-mortem planning will involve reviewing trust records and taking
protective steps to 'toggle off' grantor trust status
before death, being sensitive to and planning to avoid the various
gain recognition provisions that can apply upon termination of
grantor trust status. Trust reporting and disclosure will also
likely be an important strategic matter for estate planners to
consider in a post-repeal world.
Whittle Down Value, Build Up Basis. Perhaps the new
mark-to-market system will present opportunities that are more
advantageous than those available under current law. For instance,
if the mark-to-market tax will apply based upon the excess of the
fair market value of a decedent's asset at death over his or
her tax basis in the asset (in contrast to the estate tax, which is
imposed solely upon the fair market value of the asset at death),
such would incentivize planning strategies to both build-up basis
and reduce fair market value. For instance, if parent holds a piece
of real property with a very low basis due to years of depreciation
and contributes it to an LLC in exchange for non-voting interests,
and child or another family member contributes cash or high basis
property to the LLC in exchange for voting interests, after a
period of 7 years, the child's LLC interest could be redeemed
in full or partial liquidation through an in kind distribution of
the low-basis property. Perhaps the asset remaining in the LLC
would be an insurance policy on parent's life. Section 101
would presumably override the mark-to-market tax on the life
insurance proceeds. Moreover, at parent's death, to the extent
that he or she only owns a non-voting LLC interest, that interest
would likely be entitled to a discount based upon traditional
valuation principles, and therefore the mark-to-market tax should
be based upon that discounted value. Note, however, that having the
LLC own both life insurance and non-life insurance assets could
potentially trigger the application of the split dollar insurance
regulations under either Treas. Reg. §§ 1.61-22 or
1.7872-15.
Enhancing Outside Basis in Partnership Interests. Consider
a family limited partnership that may hold depreciated real estate
or low basis securities. As discussed above, the mark-to-market tax
will presumably be imposed on the difference between a
decedent's outside basis in his or her partnership interest and
that interest's fair market value. As a component of pre-mortem
planning, estate planners in a post-repeal world may wish to
consider using creative debt allocations to increase the outside
basis of senior-generation family members.[ii] In the alternative,
perhaps the senior-generation family member could issue a personal
guaranty of partnership-level debt, thereby increasing his or her
outside basis in the partnership interest and reducing the mark to
market tax.[iii] In effect, this type of planning would simply
invert the current estate planning paradigm, in which planners
currently attempt to place low basis assets in the hands of
senior-generation family members.
Using Multiple Grantor Trusts. Although likely not
feasible under the current gift tax regime, after a repeal of both
the estate and gift tax, perhaps parent and child could each fund a
grantor trust. Parent's trust could be funded with low basis
property and child's trust with high basis property. After a
period of time, perhaps the two trusts could be merged to reduce
administrative costs, and the grantors could each retain a swap
power over the resulting trust. Under the current Treasury
Regulations, the trustee of the resulting trust may allocate tax
items between the two grantors in any manner that is
'reasonable in light of all of the circumstances.' [iv]
These allocations presumably do not need to have substantial
economic effect, as is the case with partnership allocations,
although there is little authority as regards 'reasonable'
allocations in this context. Moreover, after some period of time,
perhaps parent could exercise his or her swap power to reacquire
the high basis property contributed by the child and substitute
additional low basis property, thereby potentially shifting low
basis assets out of parent's estate and limiting the potential
hit of the mark-to-market death tax.
Dynasty Trusts to Avoid Mark-to-Market Tax for Future
Generations. Multigenerational dynasty trusts are currently
effective vehicles to preserve assets by applying one's GST
exemption to shield trust property from transfer tax for multiple
generations. Under a mark-to-market regime, the same type of
approach may likely apply for multigenerational mark-to-market
efficiency planning. For instance, if parent passes an asset to
child at death (after paying the mark-to-market capital gains tax),
child will ultimately have his or her own mark-to-market event at
death in the future to the extent of any appreciation that occurs
during the child's lifetime. If, instead, the parent passes
that asset at death, or perhaps during lifetime via a gift and/or
sale transaction, to a trust of which the child is merely a
beneficiary, presumably the deemed capital gains tax would not
apply at the death of the child or at the deaths of more remote
descendants. In this regard, a client who has funded a dynasty
trust prior to the estate tax repeal using his or her lifetime
credit would have a powerful platform to engage in post-repeal
estate freeze transactions.
The Fate of Section 1014. Assuming the estate tax repeal
does not carry with it a repeal or restriction on the basis step-up
provisions of Section 1014, the current estate planning paradigm
for clients with a net worth below the applicable exclusion amount
would remain in place. For such clients, and even for more wealthy
clients, a comprehensive pre-mortem evaluation of assets would be
undertaken to ensure the client can receive a basis step-up on the
full $10 million mark-to-market exclusion amount. If necessary,
swap powers could be exercised or grantor trust status could be
triggered in whole or in part to ensure the client dies owning low
basis property eligible for a basis step-up. In this regard, the
$10 million exclusion would represent a doubling of the current
income tax benefit provided to high net worth individuals by
Section 1014, essentially allowing them to remove $10 million of
appreciation from the federal tax system at each generational level
(even before taking into account to the President Elect's
proposed exclusion for 'small businesses and family
farms').
If there is no step-up in basis under Section 1014 for the first
$10 million of asset value, simply no deemed sale (so basis is
carried over from the decedent), valuation discounts may be
irrelevant. Indeed, if the estate is below $10 million and Section
1014 remains in place, valuation discounts could be damaging.
Managing the potential application of such discounts could become
an important component of pre-mortem planning. In any case, the new
system would presumably have to provide detailed rules to address
which assets in an estate in excess of $10 million escape the
mark-to-market death tax and which do not.
The Trump Proposal: Considerations If Gift Tax Is Not Repealed
The current proposal from the President Elect is silent as to
whether or not the federal gift tax will be repealed.
Traditionally, the thought behind not repealing the gift tax along
with the repeal of the estate tax was to provide a 'back
stop' to prevent income tax shifting. For instance, if in a no
gift tax environment, parent decides to gift $5 million to his or
her child so that the income generated will be taxed in child's
lower tax bracket, no gift tax would be caused by the transfer and
an implied understanding could allow the parent to take back the
asset when they feel like it with no gift tax to the child.
Additionally, if there is no estate tax, then the 'bad
facts' implications that would currently be an estate tax
concern under Section 2036 would be a non-factor.[v] The retention
of some form of the gift tax would also protect the proposed
mark-to-market capital gains tax, as deathbed gifting could
otherwise circumvent the tax entirely.
If the gift tax is not included in a proposed repeal of the estate
tax, then much of the planning implemented will still require
navigating the gift tax minefield to ensure no unexpected gift is
triggered under traditional gift tax principles, as well as under
the Chapter 14 special valuation rules. For instance, if parent
wanted to sell interests in an LLC that he/she expects to
appreciate in the future (and ultimately be subject to the 20%
mark-to-market tax at death), a valuation of the fair market value
of those interests would still need to be determined. If the gift
tax remains in place and the appraised value of the interests is
determined to be lower than the finally determined gift tax value,
then there would still be the same type of part sale/part gift
issues that planners contend with today. Thus, the same approaches
to managing the gift and/or sale of hard to value assets (such as
interests in a closely held entity), such as defined value, formula
and price adjustment clauses would still remain an integral part of
the estate planning practice.
In addition to traditional gift tax valuation issues, if the gift
tax were to remain in place, presumably the special valuation rules
under Chapter 14 would still exist and the unique gift tax pitfalls
thereunder would still need to be carefully navigated to avoid
triggering deemed gifts. For instance, the deemed gifts that can
occur under Section 2701 when dealing with traditional transfers,
capital contributions or changes in the capital structure of a
family controlled entity would still present challenges when
structuring preferred partnerships, profits interests or carried
interest transfer transactions. Similarly, the deemed gift
provisions under Section 2702 would still presumably apply with
respect to the creation of trusts with retained interests, joint
purchases and sales of remainder interests. Lapses of interests
under Section 2702 and Applicable Restrictions under Section 2704
could also still remain relevant if the gift tax is not repealed.
Lastly, the Proposed Treasury Regulations under Sections 2704 and
2701 (if finalized) could remain relevant under a continued gift
tax regime.
The Trump Proposal: Considerations If Gift Tax Is Repealed
If the proposed repeal of the estate tax ultimately includes the
repeal of the gift tax, the planning implications and opportunities
presented are different, but are certainly present. If the gift tax
becomes history, then such would provide an opportunity for
creative planning that would enable clients to, in a sense,
reshuffle the deck with respect to trusts and other entities in a
manner they would prefer but perhaps cannot do under current law.
Without the constraints of traditional gift tax rules and the
special valuation rules under Chapter 14, great flexibility in
planning will be afforded. This is even more the case if a gift tax
repeal and the House Blueprint, which calls for the repeal of the
estate and GST taxes without the imposition of a mark-to-market
capital gains tax at death, were to become law. Under such a
regime, clients would have maximum flexibility to modify existing
family planning and governance structures to fulfill tax and
non-tax objectives.
For instance, bargain sales of interests or perhaps outright gifts
could be made by parent to reduce their estates below the $10
million mark-to-market threshold. Perhaps this could be achieved by
way of a transfer into a trust with parent retaining the right to
access to that trust, either as a beneficiary or through withdrawal
rights. Without a gift tax and the rules of Sections 2701 or 2702,
such could be a way to simply remove the asset from the
parent's hands for mark-to-market purposes, while at the same
time enabling the parent to have access to the asset. Further, in
an estate tax free world, the retention of such 'strings'
would be irrelevant and would enable parents to engage in planning
that would provide a 'have your cake and eat it too'
arrangement that is simply not possible under the regime that
exists today. This would allow clients to arrange their family
structures in a way that retains the significant non-tax advantages
afforded by current estate planning techniques (organized
governance, creditor protection, business succession, etc.), while
optimizing current income tax efficiency and providing generous
access and administrative control to family members.
Without the gift tax, various family entities and arrangements
could be structured freely as the family would wish to on an
'on the merits' or 'rough justice' kind of
approach, without having to tip toe through the current Section
2701 minefield that provides significant challenges. For instance,
a manager of a private equity fund could simply make a gift of his
or her general partner interest (with the carried interest) to his
or her child gift tax-free and without the current 'vertical
slice' requirement (or application other non-vertical
approaches). Or perhaps a real estate developer could simply give a
child a profits interest in a new deal without gift tax issues
under Section 2701 or traditional theories. In this manner,
substantial future appreciation could be transferred to such child
or better yet to a trust for child's benefit, and perhaps
parent's benefit too (since there would be no longer be any
'retained strings' estate tax implications under Section
2036).
Another lingering uncertainty is what will come of the GST tax.
While the Trump proposal is silent as to the GST tax, the House
Blueprint explicitly calls for its repeal. A repeal of the GST tax
could present opportunities to reduce administrative complexity and
make other helpful modifications to family trust structures.
Consider, for example, a disposition at death that directs GST
exempt and GST non-exempt property to separate trusts that are
otherwise identical. A repeal of the GST tax would perhaps allow
the merger or other consolidation of the two trusts, thereby
reducing administrative costs and complexity and streamlining
family planning structures. Additional modifications may also be
possible after the repeal of the GST tax, including extending the
perpetuities period of an existing trust or modifying a
grandfathered trust that may otherwise lose such status under the
current GST tax regime.
Of course, a repeal is only as 'permanent' as the attitudes
and preferences of the next Congress. If a repeal of the estate and
gift tax does occur, practitioners should keep in mind that the
eventual reinstatement of some form of a transfer tax is not beyond
the realm of possibility. Granted, it would likely take more
political capital to enact a new 'death tax,' rather than
merely standing in opposition to the repeal of a current estate
tax. However, if a transfer tax system might be reinstated in the
future, perhaps in the case of the Democrats winning control of the
House and/or Senate in 2018 or a Democratic candidate winning the
White House in 2020, then a repeal of the estate, gift and/or GST
taxes under a Trump administration could provide a unique
opportunity for families to restructure entities, trusts and other
arrangements in the most desired manner, free of the restrictions
of current law. A subsequent reinstatement of the transfer tax
system would enable families to plan in advance to get the various
pieces of family structures in place well in advance of any new
transfer tax system.
Moreover, recall that there was no proposed repeal of the gift tax
under President George W. Bush's 2001 Tax Act, which included a
repeal (albeit delayed) of the estate tax. The gift tax protects
the integrity of the income tax system in large measure, such as by
preventing loss property owned by one family member from being
'married up' with gain property owned by another.
While the landscape for estate planning may be changing under a
Trump administration, with change comes opportunity, and freeze
planning will continue to be an important arrow in the
planner's quiver.
First published by Leimberg Information Services, Inc's
Estate Planning Newsletter #2480 (November 16, 2016).
[i] For an excellent discussion of the planning implications
of the 2016 election, see Jim Magner's webex, The 2016 Election
Results Are In: How Will this Impact Us in 2017 and Beyond? (Nov
11, 2016).
[ii] Section 722 and Treas. Reg. § 1.752-1(b).
[iii] See generally Treas. Reg. § 1.752-2(b).
[iv] Treas. Reg. § 1.671-3(a)(2).
[v] For a recent example of 'bad facts' under Section 2036,
see Estate of Beyer v. Comm'r, T.C. Memo 2016-183.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.