The celebration following the federal government's increase in the estate tax exemption to $5.25 million is, perhaps, destined to be short lived. President Obama’s proposed budget plan for 2014 came out on April 10, and proposes substantial changes to the estate and income tax code. These changes would mean real changes in estate planning.
According to the budget plan, the federal estate tax rate will increase from 40 to 45 percent. The individual exemption equivalent will be reduced from $5.25 million to $3.5 million, and it will not adjust upward over time to keep pace with inflation. This means that as time goes on and inflation increases, people will surpass the exemption mark due to appreciation in the value of their estate, and be subject to federal estate taxes. Further, these changes are proposed as "permanent changes" meaning that they will not sunset or lapse in time.
The lifetime gifting exemption equivalent is also affected, since the gift and estate taxes use a unified exemption. The maximum amount that a person can leave his or her family in combined taxable lifetime gifts and inheritance is thus reduced from $5.25 million, which increases with inflation, to a non-adjusting maximum of $3.5 million.
Limiting Grantor Retained Annuity Trusts
More surprising and substantive changes are proposed for sophisticated estate plans. A GRAT (grantor retained annuity trust) is a tax-reducing trust popular for giving assets to family members while retaining an income benefit for some defined period of time. The grantor puts his or her assets into the trust and receives an annuity which pays a fixed amount each year. Gift tax is paid when the GRAT is created and the tax is based upon the present value of the remainder of the trust, meaning that the value of the gift, for gift tax purposes is substantially less than the actual fair market value of the assets. One of the real challenges in such planning is that if the grantor dies before the trust ends, the assets become part of the grantor's taxable estate,and the purpose for the trust, reducing estate taxes, is frustrated.. If the grantor survives the term of the trust, any assets left to the beneficiary — usually the grantor’s children — are tax free. GRATs have typically been short-term trusts to make it more likely that the grantor survives beyond the term of the trust.
The proposed budget will require a minimum trust term of ten (10) years for all GRATS. This defined longer term makes it more likely that the grantor may die during the trust’s existence, and increases the chances that the trust does nothing to reduce the value of the taxable estate. If death of the grantor occurs within the ten year term, the trust is taxed as part of estate, effectively losing nearly half its value to federal estate taxes. The proposed budget, therefore, limits greatly the attractiveness of GRATS as an estate planning option.
Eliminating Intentionally Defective Grantor Trusts
The proposed budget also effectively eliminates intentionally defective grantor trusts (IDGT). An IDGT is used to freeze the value of appreciating assets for tax purposes. This strategy allows the grantor to be the owner of the assets for income tax purposes but it removes the value of the assets from the grantor’s taxable estate. As the value of the trust increases, the transferor receives the income earned by the assets (and pays tax on the income) but the assets grow outside of the transferor’s estate.
Under proposed budget:, there would be no separation in the tax codes for this trust. Estate or gift tax would have to be paid on the trust at the time of the owner’s death. This would make the IDGT obsolete.
Signalling a Change?
Perhaps the most significant change reflected in the proposed budget is that the federal government has, once again, returned to a lack of appreciation for the benefits of certainty and stability in estate and business planning. Among the reasons that many celebrated the recent changes to the estate tax code (recent being changes adopted at the last minute, less than six months ago), is that the inflation adjustment and portability provisions signaled, to some, an appreciation for long-term stability and certainty. It appeared to some that having resolved the estate tax exemption amount, and having adjusted it automatically for inflation over time, the federal government was, in effect, acknowledging the need for stability and certainty, eschewing uncertainty, and detrimental periodic and last minute legislative changes.
Of course, perhaps the proposed budget is really the "same as it ever was."
This article is based in large part on an article by Phoebe Venable, entitled "Obama's Budget Plan would Hit Estate Plans Hard," published May 11, 2013, in the Tennessean, and available online here.
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