On March 9, 2023, the Biden administration released its proposed budget calling for an increase of trillions in federal spending along with his proposed offsetting revenue raisers in General Explanations of the Administration’s Fiscal Year 2024 Revenue Proposals (2024 Green Book). Department of the Treasury, Green Book (March 2023), https://tinyurl.com/5je37vvz. These tax proposals are his third since taking office and first since Republicans took control of the House of Representatives. Given the divided Congress, the chance of many or even any of these proposals becoming law now appears remote. Tax practitioners need to understand the proposals, however, to address client questions prompted by the headlines on the proposed increased taxes on high-net-worth (HNW) individuals. President Biden’s third set of tax proposals builds on his first two. His first Green Book’s headliner for estate planners was a proposal to make death, lifetime giving, and exceeding maximum holding periods for assets in trust recognition events for income tax purposes. His second Green Book contained far more proposals, with much of the attention given to a new proposal to impose a minimum tax on those worth over $100 million, which the Biden administration nicknamed the misnomer the “Billionaire Minimum Income Tax,” despite the markedly lower threshold. Last year’s proposals also gave new life to proposals from the Obama administration that affected estate planning strategies, such as changes to grantor trusts and ending perpetually GST tax-exempt trusts. The 2024 Green Book continues to build upon the prior proposals and adds further targeted attacks on common estate planning techniques for HNW individuals. The following is a summary of the key provisions affecting trust and estate planning.
“Fair Share” Getting Bigger
This year’s proposed budget from the administration calls for trillions of new government spending and lowering the deficit by trillions, which necessarily translates to substantially more revenue in the form of taxes. The President states in his budget message that “[w]e more than fully pay for these investments in our future by asking the wealthy and big corporations to pay their fair share.” Budget of the U.S. Government Fiscal Year 2024, Office of Management and Budget, The Budget Message of the President, p. 2 (March 2023), https://tinyurl.com/4sk3m58u. To the Biden administration, “fair” ostensibly means substantially higher taxes to a small group of taxpayers.
The one that will gain much attention again is the “billionaire minimum tax,” which is a tax imposed by virtue of wealth but isn’t a wealth tax. Instead, it sets a minimum tax rate on income, gains, and unrealized gains of individuals with more than $100 million (not a billion). The mechanics of this year’s proposal remain essentially the same, including a provision phasing in the tax for those over $100 million but under $200 million, having the tax imposed on unrealized gain be available as a credit when the asset is sold, and allowing for installment payments. The most noticeable change is that this year’s proposal calls for a 25 percent tax rate, up from last year’s 20 percent.
Gratuitous transfers would also become taxable events under the 2024 Green Book. In the Biden administration’s first Green Book, the proposal that garnered the most attention from estate planners was making death, lifetime gifts, and exceeding maximum holding periods for assets in trust recognition events for income tax purposes. The income tax liability would be in addition to the potential transfer taxes. Last year’s proposal, which had made some taxpayer-friendly changes from the original proposal, returns to the 2024 Green Book substantively the same. A per donor-decedent $5 million exclusion on the gain is portable to a surviving spouse. This exclusion will remove many taxpayers from the application of this new double taxation system, but HNW individuals will remain affected.
The 2024 Green Book also brings new proposed taxes targeted at HNW individuals. Changes have been suggested to the net investment income tax (NIT) to mirror changes for Medicare tax. Specifically, the tax rate for the NIT would be raised by 1.2 percent for taxpayers with more than $400,000 of income (going from 3.8 percent to 5 percent), and the Medicare tax would also be increased by 1.2 percent for those with earnings over $400,000. A related proposal is to expand what income is subject to the new investment income tax by closing the loophole that has previously protected income from certain pass-through entities.
Other notable income tax hikes for HNW individuals proposed by the Biden administration in each of its Green Books include increasing the top marginal rate for ordinary income to 39.6 percent for single taxpayers earning more than $400,000 and married taxpayers filing jointly with income above $450,000. There also remains a proposal to tax long-term capital gains and qualified dividends at ordinary income tax rates, which, when taken together with other changes, would result in a tax rate of 44.6 percent for taxpayers with more than $1 million of income.
The grantor trust rules have lent themselves to effective transfer tax planning by allowing transactions between the grantor and the grantor trust to be generally disregarded for income tax purposes and the grantor’s estate to be depleted by obligating the grantor to cover the tax liabilities attributable to the grantor trust’s earnings. Because of the rules’ effectiveness, Democrats have proposed various changes that would disincentivize their use as a transfer tax planning tool.
Under President Biden’s proposal this year, which is the same as the proposal he introduced last year, income tax payments required to be made by the grantor under the grantor trust rules would be treated as taxable gifts to the trust in the future. The value of the gift will be determined as of December 31 of each year, where the gift will be the sum of all income taxes paid, less any reimbursements made to the grantor by the trust. A technical addition to this year’s proposal is a sentence clarifying that the gift cannot be reduced by the marital deduction, charitable deduction, or various gift exclusions under Sections 2503(b) and 2503(e). The proposal explicitly excludes revocable trusts from this regime. In addition, the proposal would treat transfers of an asset for consideration between a grantor and a grantor trust to be regarded for income tax purposes, thereby making sales and payments in satisfaction of an obligation recognition events triggering a capital gain (losses would be disallowed).
GRATs and CLATs
The 2024 Green Book targets two vehicles commonly used in transfer tax planning—grantor retained annuity trusts (GRATs) and charitable lead annuity trusts (CLATs). The proposal on GRATs is the same proposal that appeared in last year’s Green Book and was previously proposed in the Obama administration’s final two Green Books. The proposal would eliminate short-term GRATs and so-called “zeroed-out” GRATs, where the value of the grantor’s retained annuity interest equals the value of the property transferred, resulting in a taxable gift at or near zero. To qualify, the proposal requires a GRAT (1) to have a term of at least ten years, (2) last no longer than the life expectancy of the grantor plus ten years, and (3) to have a remainder interest (that is, the amount of the taxable gift) to be at least the greater of (a) 25 percent of the value of the assets contributed or (b) $500,000 (not to exceed the value of the gift).
The proposal on CLATs is new. A CLAT is a trust in which an annuity is paid to charity for a term of years and, at the end of the term, any remaining property in the trust passes to a non-charitable beneficiary. As with a GRAT, only the present value of the remainder interest is subject to gift tax, which means that under current law, the trust can be structured so the remainder interest is valued at or near zero (a so-called “zeroed-out CLAT”). As a result, appreciation in excess of the present value calculation passes gift or estate tax-free with a corresponding 100 percent charitable deduction. More transfer tax benefits can be achieved by deferring the amounts that need to be paid to charity by starting with a smaller annuity in the first year that increases yearly. Unlike a GRAT, a CLAT is not limited to a 20 percent increase each year, leading to a technique commonly referred to as a “shark fin CLAT,” which derives its name from the shape of the exponential increase in the annuity percentage over the life of the CLAT. The 2024 Green Book would end the use of zeroed-out CLATs by requiring the non-charitable remainder interest to be at least ten percent of the value of the property used to fund the trust. Further, annuity payments would need to be a level, fixed amount over the term of the CLAT.
Ending the Perpetually GST Exempt Trust
By effectively using a taxpayer’s generation-skipping transfer (GST) exemption to transfer assets to a trust that can exist in perpetuity (or at least several centuries), it is possible to shield assets from the imposition of transfer taxes indefinitely. Various proposals from Democrats over the years have called for these GST-exempt dynastic trusts to become non-exempt after a period of years. The 2024 Green Book carries over a proposal the Biden administration introduced under which the GST exemption would apply only to the (i) distributions to beneficiaries who are no more than two generations below the transferor or those who are assigned to a younger generation but were alive when the trust was created and (ii) a trust on the death of the last in a generation (i.e., a taxable termination) for as long as one of the aforementioned beneficiaries is living. The proposed change would apply to both pre-enactment and post-enactment trusts. Pre-enactment trusts would be treated as having been created on the enactment date in identifying which beneficiaries are alive, and the transferor would be deemed to be in the generation immediately above the oldest generation alive at the time of enactment.
This year’s proposal adds two additional proposals to limit techniques to mitigate or defer the imposition of a GST tax liability. The first of these new proposals targets sales between trusts. If a GST-exempt trust purchases property subject to the GST tax, the proposal would require a redetermination of the purchasing trust’s inclusion ratio. The value of the purchased assets would be added to the denominator of the fraction, with only the amount of that property that was exempt from GST taxes before the purchase added to the denominator. This proposal would apply to all post-enactment transactions.
The second proposal targets the inclusion of charitable beneficiaries as a mechanism to avoid GST taxes. The perceived abuse, as described in the 2024 Green Book, is that charities are being included by taxpayers as beneficiaries of non-GST exempt trusts solely or primarily because they aren’t skip persons for GST tax purposes, thereby avoiding a taxable termination event on the death of the last non-skip person to die. The 2024 Green Book states this is being done “even though that organization may be unlikely ever to receive a distribution.” The proposal would ignore any charitable interest for GST tax purposes for all taxable years after enactment, thereby causing taxable terminations for trusts relying on the charitable interests as the only non-skip beneficiary of a trust. Notably, the Treasury Regulations already contain an anti-abuse provision that disregards any interest if used primarily to postpone or avoid the GST tax, so this proposal is more likely to affect trusts in which a charity has a substantive interest. Treasury Regulation § 26.2612-1(e)(2)(ii).
Using loans for estate planning can be advantageous, especially when interest rates are low. The Green Book targets loans to beneficiaries used to avoid the income and GST tax consequences of distribution. It suggests the loans are often forgiven or otherwise not paid back, which is difficult for the IRS to track. The perceived loss of federal income tax revenue likely refers to the uncompensated use of trust property by a beneficiary, such as with a below-market loan, but also to the use of real or tangible property owned by the trust. For GST tax purposes, a loan to a beneficiary who is a skip person from a non-GST-exempt trust would avoid GST tax on a taxable distribution unless and until the note is forgiven. Further, grantors in need of liquidity may take a loan from the trust, which doesn’t reduce the value of the trust, and the loan may be taken as a deduction on the grantor’s estate tax return to the extent it hasn’t been repaid.
The 2024 Green Book proposes to treat loans to and use of trust property by a trust beneficiary as a distribution for income tax purposes, resulting in distributable net income carrying out to the borrowing beneficiary. This proposal is similar to Section 643(i), which applies to certain loans to, and the uncompensated use of trust property by, a US person from a foreign trust. Further, it will also be treated as a distribution for GST tax purposes, meaning that if a beneficiary is a skip person and a loan is taken from a non-exempt trust, GST taxes would be imposed (though a refund would be available if the beneficiary repaid the loan). The proposal will give regulatory authority to the Treasury Department to identify transfers that would be excluded, such as short-term loans and a beneficiary’s use of real or tangible property for a minimal number of days.
The 2024 Green Book proposes a special rule for GST tax purposes to discourage the grantor of a grantor trust from taking a loan. If the grantor or the grantor’s spouse takes a loan from a grantor trust, the amount repaid will be treated as an additional contribution to the trust upon repayment. As a result, it would use the borrower’s GST exemption to the extent the borrower still has any exemption. Without a remaining exemption, transfers to a trust that would constitute an indirect skip would increase the trust’s exclusion ratio or a direct skip would trigger GST taxes. Notably, this could create a planning opportunity for a non-GST exemption if the grantor’s spouse has a GST exemption remaining.
Capping Annual Exclusion Gifts
President Biden hasn’t proposed lowering the estate tax exemption while in office, but the 2024 Green Book proposes limiting how much a taxpayer can transfer using the annual exclusion under Section 2503(b). Under current law, a taxpayer may exclude from taxable gifts the first $17,000 in transfers of a present interest in property per donee each year. Since the creation of the gift tax in 1932, there has been an amount that can be excluded per donee. The legislative intent behind the annual exclusion was “to obviate the necessity of keeping an account of and reporting numerous small gifts, and… to fix the amount sufficiently large to cover in most cases wedding and Christmas gifts and occasional gifts of relatively small amounts.” S. Rep. No. 665, 72d Cong., 1st Sess. (1932). Despite the intent of the statutory language, it has been used as a wealth transfer vehicle to transfer substantial amounts free of gift tax. This includes funding irrevocable life insurance trusts (ILITs) with the use of Crummey powers and making transfers of partial interests in closely-held entities in which the donee has minimal rights to the enjoyment of the property, effectively giving the donor a level of retained control.
The Clinton and Obama administrations each proposed to curb annual exclusions as a transfer tax savings tool. The 2024 Green Book brings back the proposal advanced during the Obama administration. Under this proposal, the requirement that a donee receive a present interest in property to qualify for the annual exclusion is eliminated. Instead, a new category of transfers would be created for any transfer to a trust (except Section 2646(c)(2) trusts) and transfers of an interest in a pass-through entity, a partial interest in property, and “other transfers of property that, without regard to withdrawal, put, or other such rights in the donee, cannot immediately be liquidated by the donee.” There would be a $50,000 limit on transfers to this new category that could qualify for the annual exclusion. In effect, the annual exclusion per donee limit would continue to apply. But the government would no longer need to scrutinize whether the donee’s rights in a trust or entity are sufficient to constitute a present interest in the property, and the amount that can be transferred to, or consisting of, such planning vehicles would be curbed.
To illustrate an example of how this proposal would affect an ILIT trust: take the case of an ILIT that gives the grantor’s ten descendants a Crummey power to withdraw up to the annual exclusion amount. Under current law, if the grantor transfers $170,000 to the trust in 2023, all funds are excluded from taxable gifts under Section 2503(b) ($17,000 multiplied by ten donees). If the 2024 Green Book proposal were to become law next year and $170,000 were transferred to the trust, only $50,000 would be excluded, and there would be a taxable gift of $120,000. This result could cause substantial issues for existing ILITs that rely on annual exclusion transfers for large policy premiums. The donor would still be able to make outright gifts to any one or more of the ten donees of the difference, which, using this example, would be $12,000 per donee.
Valuation Clauses and Discounts
The estate, gift, and GST tax regimes (collectively “transfer taxes”) are taxes computed on the fair market value of the property transferred. Given the importance of property valuation, certain valuation and planning techniques have come under fire by the IRS. The 2024 Green Book contains three proposals related to valuations for transfer tax purposes.
To ensure a desired transfer tax outcome, estate planners have employed what is referred to as a “defined value formula clause,” in which the amount transferred in a gift or bequest is based on a value as finally determined for transfer tax purposes. Formula clauses have long been used and accepted as part of testamentary estate planning. For example, a credit shelter trust is funded with the greatest amount possible without exceeding the decedent’s remaining exemption, with the balance passing to a beneficiary that qualifies for the marital or charitable deduction. Similar approaches have been taken during lifetime gifting, especially concerning hard-to-value assets, where the nature of the property transferred doesn’t define the gift but instead the gift is defined by a set dollar amount’s worth of such property as determined for gift tax purposes, including adjustments on audit. Such clauses have gained acceptance by the courts over the years, most notably in Estate of Wandry v. Comm’r, T.C. Memo 2012-88 (March 26, 2012).
The government has consistently challenged the use of these defined valuation formula clauses on various policy grounds. Audits would be disincentivized because no tax liability would result from adjustments, incentivizing the undervaluation of property by taxpayers (implying there’s no downside risk to the taxpayer), and creating ambiguity in the actual ownership of the property at the time of the transfer given the potential for adjustments. But these policy arguments have been unpersuasive to the courts, with the Ninth Circuit Court of Appeals even inviting the government to amend the Treasury Regulations if it disagreed with judicial acceptance of such clauses. Estate of Petter v. Comm’r, 653 F.3d 1012 (9th Cir. 2011). During the later years of the Obama Administration, the Treasury Department did add a regulatory project to its Priority Guidance Plan on the subject, but the project was dropped after President Trump took office and hasn’t made a return. The 2024 Green Book proposes that, starting next year, “if a gift or bequest uses a defined value formula clause that determines value based on the result of involvement of the IRS, then the value of such gift or bequest will be deemed to be the value as reported on the corresponding gift or estate tax return.” The proposal includes only two exceptions for when a defined value clause will be allowed for transfer tax purposes—first, if the value is to be determined by someone other than the IRS (such as an appraiser) within a reasonably short time after the date of transfer, and second if the clause is being used for estate tax purposes to define a “marital or exemption equivalent bequest.”
The second proposal seeks to disallow valuation discounts for transferring certain closely-held entities. As property valuation is based on a fair market value standard, the value of a transfer in partial or fractional interests in property isn’t necessarily the proportionate value of the underlying property. Instead, it considers factors hypothetical buyers and sellers would consider, such as discounts for lack of control and marketability. The 2024 Green Book proposal provides a synopsis of the government’s concern about a transfer of a partial or fractional interest as it “offers opportunities for tax avoidance when those interests are transferred intrafamily… they are not appropriate when families are acting in concert to maximize their economic benefits… artificially reducing the amount of transfer tax due.” The IRS proposed regulations under Section 2704 in 2016 to address its concern, but the proposed rules were ultimately withdrawn. The 2024 Green Book proposal would amend Section 2704(b) to apply a new valuation rule to any intrafamily transfers in which the family collectively owns 25 percent or more of the transferred property. Under this proposal, discounts would be curbed for minority interests by making the value for transfer tax purposes the pro-rata share of the fair market value for the property collectively owned by the family. Discounts still could be applied to the family’s collective interest, if appropriate, but only to the extent attributable to a trade or business. Passive assets (i.e., assets not actively used in a trade or business), even if held in a trust or business, would be segregated and valued as if held directly by a sole individual.
The final proposal is a carryover from last year’s Green Book addressing the valuation of certain promissory notes. The specific type of transaction of concern that gave rise to the proposal is one in which a taxpayer provides assets to a related party (such as a family member but more often a trust for the benefit of a family member) in exchange for a promissory note that has the minimum interest rate required for the loan not to be treated as a below-market loan under the Tax Code. The promissory note is valued at face value for gift tax purposes, meaning the transfer isn’t treated as a gift. When that promissory note is later gifted or included in a decedent’s gross estate, some taxpayers assume that the fair market value is worth less than the face value, given various factors such as a low interest rate or lack of security. The Biden administration proposal states that if the promissory note was initially treated as having a sufficient interest rate to avoid having any forgone interest treated as income or any part of the transaction treated as a gift, then, for valuation purposes, the interest rate from the loan will be the greater of (1) the stated interest rate in the promissory note or (2) the applicable IRS published rate at the date of valuation. In addition, the loan would be assumed to be short-term to avoid the application of discounts. This attempt to bring consistency of valuation standards related to promissory notes was previously raised for regulatory action in prior versions of the Treasury Department’s Priority Guidance Plan before a statutory change was first proposed in last year’s Green Book.
Increased Reporting for Trusts
Last year’s Green Book introduced a provision requiring many trusts to report additional information on their tax returns. This proposal returns this year, requiring all trusts (domestic and foreign if administered in the United States) with an estimated value over $300,000 at the end of a taxable year or $10,000 of income (in each case, indexed for inflation) to report information about its grantor, trustees, and “general information with regard to the nature and estimated total value of the trust’s assets as the Secretary may prescribe.” Given the broad delegation to the IRS, no one can be certain how burdensome the reporting would be pending regulatory action. Regardless, with such low thresholds of value and income that would trigger the reporting obligation, this will be painful for all trusts and potentially cost-prohibitive for some.
This year’s proposal adds GST tax reporting obligations on the annual fiduciary income tax return. Under the new provisions of this proposal, a return would need to report the GST inclusion ratio at the time of any distribution to a non-skip person. Further, the return must report any trust modification or transaction with another trust during the year. The proposal states that this will provide the IRS “with current information necessary to verify the GST effect of any trust contribution or distribution.” This proposed reporting would likely require greater participation by the attorney in preparing the fiduciary income tax return.
Three other proposals carried forward from last year that estate planners might find interest in and aren’t going to capture any headlines. One proposal would expand the application of the definition of “executor” under IRC Section 2203. Section 2203 applies when there is no fiduciary appointed and acting in the United States, in which case any person in actual or constructive possession of property in the decedent’s gross estate will be treated as the executor for estate tax purposes. The limitation to only estate taxes can be problematic, as it doesn’t allow a party to represent the estate regarding income taxes, gift taxes, and other filing obligations without a court-appointed fiduciary. The provision also can be confusing in practice, as multiple people could be an executor under Section 2203 by virtue of possessing even trivial amounts of the decedent’s property. Like last year, the 2024 Green Book proposes that the definition of “executor” apply for all taxes and would grant the Treasury Department regulatory authority to establish a priority order when multiple parties meet the definition.
The second proposal would extend the special estate tax lien under Section 6324 to continue during any deferral or installment payment period for estate taxes. Under current law, the lien ends after ten years, even if the liability has not been paid.
The third proposal increases the cap on valuation decreases for special-use properties. The fair market value of a property for estate tax purposes is generally determined at the property’s highest and best use. An election can be made under IRC Section 2032A, however, allowing qualified real property or personal property to have its value reduced to reflect its actual use. Under current law, the reduction in value is capped at $1.31 million for decedents dying in 2023. The proposal would increase this cap to $13 million, effective for those dying on or after the election date.
As demonstrated by the number of repeat proposals, the Biden administration had little success enacting any prior proposals. With a Republican-controlled House of Representatives, the administration’s chances of success only decreased when the new Congress took their seats. Nevertheless, keeping track of all the proposals covered here is essential for two reasons. First, with the headlines about taxing HNW to pay for trillions in spending, advisors can be an informed resource for their clients by understanding the details. Second, these proposals could one day become law if political fortunes change, so an understanding of the proposal helps identify current opportunities and potential future risks that could affect your clients. Third, it provides insight into what the Biden administration thinks requires statutory change versus regulatory guidance.