Proposed Changes to the Federal Tax Law and Their Potential Impact on Existing Estate Plans

We are writing with regard to proposed Federal tax law changes and the impacts they may have on your existing estate plan – specifically one or more “grantor trusts” you have in place – as well as planning needs that may arise in the future. Although significant uncertainty remains regarding the ultimate form the bill at issue may take, the Estate, Trust, and Tax Group at Moye White wants to work proactively to minimize the detrimental impacts that the House Ways and Means Committee’s proposal may have on our clients. 

We are advising clients that currently have one or more grantor trusts, including any Grantor Retainer Annuity Trusts (GRAT), Intentionally Defective Grantor Trusts (IDGT), and Irrevocable Life Insurance Trusts (ILIT) to schedule an appointment with our attorneys so that we may review these trusts and discuss potential estate plan modifications. Similarly, given that the window for using these estate and tax planning vehicles may be closing, we are advising clients who anticipate a potential grantor trust need in the future to meet with our attorneys now so that we can begin this planning as soon as possible.  

Historically, the law and design of grantor trusts has been well settled. Various types of grantor trusts have been used for years to grow and appreciate assets separate from a taxpayer’s estate for estate tax purposes, while still retaining the benefit of trust income being taxed at the settlor’s, rather than the trust’s, income tax rate. The House proposal, part of the Build America Better Act, adds a new section to the IRS Code (effective as of the date of enactment) which would pull grantor trusts including GRATs, IDGTs, and most ILITs into the settlor’s taxable estate. In so doing, the benefit that grantor trusts can sequester assets from a decedent’s estate for purposes of Federal estate tax calculation would be lost. 

Below is a brief discussion of several common grantor trust types that will be impacted should the House proposal be signed into law in its current form: 

  • Irrevocable Life Insurance Trusts: ILITs may be one of the most impacted types of grantor trusts. For a client with an existing insurance policy that he wants an ILIT to own, the client either gifts the policy to the ILIT, subject to the 3-year within death rule of § 2035, or gifts cash to the ILIT itself which the trustee in turn uses to purchase the policy from the client, thereby avoiding the 3-year within death rule. If the latter option is chosen, the ILIT is a “grantor trust” vis-à-vis the settlor so the sale is ignored for Federal income tax purposes and the “transfer-for-value” rule of § 101(a)(2) is avoided. 
  • Grantor Retained Annuity Trusts: GRATs are commonly used to hold corporate interests including stock that will grow in value into the future, but that have yet to substantially increase in value. Gifting unappreciated corporate interests to a GRAT allows the settlor to retain an annuity-based income stream from the GRAT (taxed at the settlor’s income tax rate) for a specified term of years and at the end of the GRAT term the trust property is distributed to the settlor’s children or other beneficiaries at a lower gift tax value. 
  • Intentionally Defective Grantor Trusts: As an alternative to a GRAT, a trust settlor can sell – rather than gift – corporate interests which have already substantially appreciated in value to an IDGT. The trust settlor retains a promissory note for the trust’s purchase of stock while the IDGT itself receives its share of income from the purchased stock and then makes payments to the settlor on the promissory note, ensuring an income stream to the settlor (and at the settlor’s income tax rate) until the note is paid in full. 

This will all change if the House proposals become law in their current iteration. 

In addition to a reduction in the lifetime estate/gift/GST tax exemption from $11,700,000 to approximately $6,200,000, the new rules will provide that any grantor trust, including those described in brief above, created on or after the proposal’s date of enactment will be included in the settlor’s estate for Federal estate tax purposes. Grantor trusts created before enactment of the House proposal may avoid estate tax inclusion by being subject to current law (e.g., they may be “grandfathered”). However, if a gift is made to a grandfathered grantor trust post-enactment, a portion of that trust will then be included in a settlor’s Federal taxable estate. The current proposal retains the 40% Federal estate tax rate; thus, if a settlor dies with an estate exceeding the Federal estate tax exemption amount (currently $11.7 million; proposed to reduce to approximated $6.2 million), they or their estate may be impacted in multiple ways. Using the grantor trust ILIT as an example:

  1. If that settlor retains a $2,000,000 life insurance policy in her own name or dies within 3 years of gifting it to a grantor trust ILIT, her estate will owe $800,000 in Federal estate tax. 
  2. If the settlor gifts or sells the insurance policy to an ILIT that is a grantor trust post-enactment, that policy will be included in the settlor’s gross estate subject to $800,000 in estate tax. 
  3. If a grantor trust ILIT is established before the proposal’s enactment and is therefore grandfathered, but contains Crummey withdrawal rights to qualify ongoing premium payments for the annual gift tax exclusion from trust income, an ever-increasing portion of the policy will be included in the settlor’s Federal taxable estate. 
  4. Alternatively, a large, up-front, lump-sum cash gift can be made to the ILIT so over time the ILIT trustee has funds with which to satisfy ongoing premium obligations. This lump-sum gift can be sheltered by some of the current lifetime gift tax exemption, provided that such exemption (or a sufficient portion of it) is unused at the time this cash gift is made.

This all represents a significant shift in estate and tax planning and demands the attention of clients with one or more grantor trust in place, as well as those that may have a need to initiate planning involving one or more grantor trust in the future based on estate size and assets included. Once you have had an opportunity to consider the above, please contact our office to set a time to discuss how best to proceed.