What Changes Might Congress Make to the Estate Tax, and How Can Investing in Opportunity Zones Help?

Several bills that have been introduced in the Senate would have a serious impact on the estate tax and assets that are passed to heirs. These potential changes may become a reality if the American Jobs Plan and American Families Plan, recently introduced by President Biden, are signed into law later this year.  

“These legislative changes will completely change the landscape of estate and gift tax planning as we know it now. The proposed legislation requires the immediate attention of moderately wealthy individuals and their advisors, including their lawyers, accountants, life insurance agents and financial planners,” says Tom Sigmund, an estate planning attorney with Kegler Brown Hill & Ritter. “Further, the non-tax impact of these changes on a client’s estate plan needs to be understood. Often, the estate tax exemption amount drives the amount of property that passes to a non-spouse, especially in second marriages. Our clients’ families may be in for a rude awakening if the estate tax exemption is reduced to the very low levels proposed and more assets than desired pass to a surviving spouse of a blended family.”

Current Estate Law: $11.7 Million Exemption

Under current law, the estate and gift tax lifetime exemption amount is $11.7 million per person ($23.4 million for married couples). The exemptions are unified, meaning any amount of the gift tax exemption used by a person will reduce that person’s estate exemption. Amounts transferred by gift and/or death in excess of the exemption (not including annual gift tax exclusion gifts of $15,000 per person) are subject to 40% tax. 

After 2025: $6 Million Exemption

The current exemption levels are automatically set to expire after 2025, returning to the pre-Tax Cuts and Jobs Acts amount. The TCJA doubled the exemption amount for tax years 2018 through 2025. Once the exemption reverts back, indexed for inflation, we anticipate this being around $6.2 million in 2026 – unless the tax law changes sooner.

For the 99.5% Act

The For the 99.5% Act, introduced by Sens. Bernie Sanders (I-VT) and Sheldon Whitehouse (D-RI) in March, proposes to reduce the estate tax exemption amount to $3.5 million per person ($7 million for married couples). The gift tax exemption would be reduced to $1 million per person.

Under the For the 99.5% Act, estate and gift taxes would no longer be unified as they currently are, limiting the amount that can be gifted during a person’s lifetime. There would be an estate and gift tax increase on amounts above $3.5 million and $1 million, respectively. The tax rate would increase from a flat 40% tax to a progressive tax system:

• 39% on values from $750,000 to $3.5 million
• 45% on values from $3.5 million to $10 million
• 50% on values from $10 million to $50 million
• 55% on values from $50 million to $1 billion
• 65% on values in excess of $1 billion

The effective date of the above changes is Jan. 1, 2022. Changes to trusts, however, may come sooner. For purposes of the gift tax annual exclusion, this estate tax legislation would restrict the following transfers, or asset types, to two times that amount per donor per year – meaning that gifts of this nature in any one calendar year in excess of $30,000 will eat into the donor’s $1 million gift tax exemption:

• Gifts in trust
• Gifts of pass-through entities
• Gifts of property with restrictions on sale or liquidation.

Outright gifts of cash and assets not listed above would still qualify for the unlimited $15,000 per donee annual exclusion.

Currently, irrevocable grantor trusts are designed such that the assets transferred to them, whether by gift or sale, are excluded from the grantor’s taxable estate at death. Any assets that remain in the trust at the end of its term go to beneficiaries with no gift tax, while any assets that are held in trust after the grantor’s death are not subject to transfer taxes at the death of the trust beneficiaries. The For the 99.5% Act would change this so assets in the trust are included in the grantor’s estate at death. Any distributions to beneficiaries would be considered a taxable gift.

Grantor Retained Annuity Trusts (GRATs)

GRATs are a common way of transferring assets that are expected to appreciate rapidly or that produce a high income, and provide an income (annuity stream) for the grantor for a fixed period of time. A popular way to structure GRATs is to set the annuity payment in such a way that the annuity stream during the GRAT term equals the value of the property used to fund the GRAT. This is considered a “zeroed-out GRAT” for gift tax purposes. Appreciation on the assets remaining in the trust at the end of term pass to the beneficiaries of the trust free of the estate and gift tax.

The For the 99.5% Act would require GRATs to have a 10-year minimum term, and the gift made at inception could not be “zeroed out.” The effective date of proposed changes to trusts would be the date the bill is signed into law. Should Congress take action this year, there is a limited window for individuals to make tax-free gifts to trusts.

Sensible Taxation and Equity Promotion (STEP) Act

The STEP Act – introduced by Sens. Chris Van Hollen (D-MD), Cory Booker (D-NJ), Elizabeth Warren (D-MA), Bernie Sanders (I-VT) and Sheldon Whitehouse (D-RI) – proposes, among other changes, to eliminate the step-up in basis that heirs receive at the asset owner’s death and to eliminate valuation discounts for assets transferred to family.

Currently, the decedent’s unrealized gain is not passed on to heirs, and often not taxable to the decedent’s estate because of the estate and gift tax exemption, creating what many consider a tax loophole. When a person inherits an asset, they receive a “step-up” in cost basis to the market value of the asset on the date of the owner’s death. When the heir sells the asset, capital gains taxes are applied to the stepped-up value.

By eliminating the step-up in basis, the decedent’s unrealized capital gain would be taxable to heirs. However, the first $1 million in unrealized capital gains would be excluded from taxation, and any tax owed on illiquid assets could be paid in installments over 15 years.

The STEP Act would also cause unrealized gains to be taxed if property is gifted in trust or otherwise. Unlike the For the 99.5% Act, the effective date for this Act is Jan. 1, 2021.

Will the Bills Pass?

Both bills will be tough to get through the Senate with the filibuster, which requires 60 Senators to move a bill to a final vote. Neither is currently scheduled to go to a vote, but there is a strong possibility that the bills, or similar measures, would be included in the next reconciliation cycle, which only needs 51 votes in the Senate.  

Typically, lawmakers can pass one reconciliation bill per budget resolution, which they did for fiscal year 2021 to enact the American Rescue Plan. In early April, the Senate parliamentarian ruled that special budgetary rules can be used to avoid a filibuster – and the president can use the fiscal 2021 budget resolution for his new spending plans. Tax increases included in the plans include components of Biden’s tax plan, which are also echoed in the bills above.

Would the Changes Be Retroactive?

The For the 99.5% Act, as currently written, does not contain retroactive language, and most provisions go into effect Jan. 1, 2022. The STEP Act, however, would tax unrealized capital gains for deaths occurring or for transfers made on or after Jan. 1, 2021.

Whether or not retroactive language will be included in a second budget resolution remains to be seen.

Estate Minimization Techniques to Consider Now

Gift now while the lifetime exemption is $11.7 million, using high basis assets if possible. Should the limits change next year, there will be no going back if the gifting limits go down to $1 million.

Donors should consider making taxable gifts to take advantage of the current 40% tax exclusive rates. Consider accelerating the payment of estate taxes in the estates of recent decedents to take advantage of minority interest discounts and the 40% estate tax rate. This can be done by, for example, not making Q-tip elections or having a surviving spouse exercise disclaimers.

Assets transferred to irrevocable trusts prior to the date of enactment of the bill would be grandfathered and still benefit from the current lifetime exemption.

Qualified Opportunity Funds

In addition to proposed estate tax changes, long-term capital gains tax rates are expected to almost double if the American Families Plan passes.

To mitigate the impact, realized capital gains could be invested into a Qualified Opportunity Fund (QOF), where they will grow tax-free, and the original realized capital gain will receive a step-up in basis. The tax on the capital gain would be deferred until Dec. 31, 2026. 

Unlike with other assets, beneficiaries of a QOF investment “step into the shoes” of the decedent. Rather than get a step-up in basis at decedent’s death, the recipient takes the decedent’s holding period in the qualified Opportunity Zone fund investment, and will pay the tax on the originally deferred gain in 2027, or upon sale of the QOF investment if prior to Dec. 31, 2026.

QOFs Held in Irrevocable Grantor Trusts

At death, any holdings a person has in a QOF are included in their estate for estate tax purposes. Transferring assets to a grantor trust is not considered a taxable event, and a person who expects their estate to be above the lifetime exemption amount can transfer their interest in a QOF to an irrevocable grantor trust.

Currently, the benefits of holding a QOF in an irrevocable grantor trust include removing the asset value, and any appreciation, from the grantor’s estate. Taxes due on the deferred gain can be paid by the grantor in 2027, and the QOF holding can remain in the trust and grow, unlike typical assets in a grantor trust. If the investment in the QOF is held for at least 10 years, all growth is excluded from capital gains tax. Beneficiaries of the grantor trust won’t owe capital gains taxes, and the grantor is able to exclude it from their estate at death – giving the grantor and beneficiary the best of both worlds.  

How Should This Be Utilized Prior to Any Estate Tax Changes? 

Gifting of a QOF investment to an irrevocable grantor trust, before any estate tax changes, would fall under the current (high) exemption level. If done after, not only would the exemption level be significantly lower, the assets of the trust would be included in the grantor’s estate at death. Any distributions to beneficiaries would be considered a taxable gift. The “best of both worlds” goes away.

If you’re interested in learning about how you can invest your capital gains in a QOF, read our white paper or get in touch with our team at Nest Opportunity Fund today.