The Obama Administration’s Fiscal 2014 budget proposals
are out, along with the Treasury Department’s “Greenbook,” formally known as the “General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals
.” The anticipation seems to have been greater than usual this year, maybe because of the buildup caused by tardiness, maybe because the political climate seems equally likely to foster a Grand Bargain or a Great Blowup, or maybe because of particular items to monitor, like, for us, the clarification of the proposed changes to the estate tax treatment of grantor trusts. Maybe we still aren’t convinced that the estate tax was really made “permanent” in the legislation Congress passed on January 1, and we are anxious to see the evidence that it was just a dream. For whatever reason, everyone seemed ready to dive into the Administration’s budget, and this week we got it. Here is a Capital Letters dissection.
THE GRANTOR TRUST PROPOSAL
Capital Letter Number 31
chronicled the recent IRS guidance history tending to give more and more recognition and dignity to the use of grantor trusts in estate planning. Despite that recent history, the new proposal last year would apparently have subjected all grantor trusts (to the extent funded after the date of enactment) to estate tax when the grantor dies or to gift tax upon termination of grantor trust status or on distributions to any beneficiary during the grantor’s life. The estate planning community quickly agreed that that proposal could not mean what it said and settled into the vigil that ended this week with this provision, as expected, significantly narrowed.
This Year’s Revised Proposal
This year’s Greenbook (pages 145-46
) would apply that gift or estate tax treatment, not to all the assets of any grantor trust, but only to “the portion of the trust attributable to the property received by the trust” in “a sale, exchange, or comparable transaction [with the deemed owner of the trust] that is disregarded for income tax purposes by reason of the person’s treatment as a deemed owner of the trust.” The reference to “the portion of the trust” includes the growth in the value of that property, income earned from that property, and the reinvestment of the proceeds of any sales of that property. The amount subject to gift or estate tax will be reduced by the consideration paid by the trust in the sale, presumably including the face amount of the promissory note in most cases, as well as by any amount treated as a taxable gift by the deemed owner. But, of course, the amount of that consideration and the amount of such gifts are typically frozen amounts, while the assets that are sold are usually expected to increase in value.
This year’s Greenbook refers more to “a deemed owner” and less to “the grantor.” The classic paradigm trust deemed owned by a beneficiary for income tax purposes under section 678(a)
would likely be included in the beneficiary’s gross estate anyway, because the power described in section 678(a)
would essentially be a general power of appointment. Therefore, the changes in this Greenbook from references to “the grantor” to “a deemed owner” may indicate that more sophisticated beneficiary-owned trusts are in view.
A Dramatic Effect
Simply put, if enacted as proposed, this change would eliminate all typical estate tax benefits of installment sales to grantor trusts and thus end the use of such sales in the manner to which we have become accustomed. All future appreciation in the assets that are sold would be subject to estate tax no matter how long the grantor lives and whether or not the note is paid off. Attempts to avoid that by terminating grantor trust status or making distributions from the trust during the grantor’s life would be subject to gift tax. Because that portion of the trust would be subject to estate tax, the ETIP rules of section 2642(f)
would prevent the grantor from allocating GST exemption to it.
Lingering Questions About the Proposal
And yet the proposal leaves us wondering. For example, the current Greenbook contains the following sentence, virtually identical to a sentence in last year’s Greenbook:
The proposal would not change the treatment of any trust that is already includable in the grantor’s gross estate under existing provisions of the Internal Revenue Code, including without limitation the following: grantor retained income trusts; grantor retained annuity trusts; personal residence trusts; and qualified personal residence trusts.
As Capital Letter Number 31
pointed out, for example, the implication is that the treatment of GRATs does not have to be changed because GRATs already are treated consistently with the Greenbook proposal. In fact, while it is assumed that all or most GRATs are grantor trusts (which can facilitate payment of the annuity in kind without capital gain), the value of the assets in a long-term GRAT might not be fully included in the grantor’s gross estate, and the termination of a GRAT’s grantor trust status, which may or may not occur at the end of the GRAT term, is not currently treated as a taxable gift. In any event, the trusts cited in the Greenbook – GRITs, GRATs, PRTs, and QPRTs – ordinarily do not acquire assets from the grantor by purchase, so there is no reason to think that they would be affected by this year’s proposal anyway.
The reference to GRITs, GRATs, PRTs, and QPRT was followed in the 2012 Greenbook by a description of the proposed effective date, accompanied by a reference to “[r]egulatory authority …, including the ability to create transition relief for certain types of automatic, periodic contributions to existing grantor trusts,” fueling the speculation that the proposal was aimed at life insurance trusts, where the periodic payment of premiums, while not exactly “automatic,” is typically done under the terms of a preexisting insurance contract.
In contrast, the reference to GRITs, GRATs, PRTs, and QPRT in this year’s Greenbook is followed by disclaimers that the proposal “would not apply to any trust having the exclusive purpose of paying deferred compensation under a nonqualified deferred compensation plan if the assets of such trust are available to satisfy claims of general creditors of the grantor” (possibly a reference to a “rabbi trust”) or “to any trust that is a grantor trust solely by reason of section 677(a)(3)
” (evidently a reference to life insurance trusts). The passes given to these trusts are no doubt meant to be helpful, and they are helpful, but they only highlight the tension that remains inherent in the proposal. For example, life insurance trusts sometimes can and do acquire assets from the grantor by purchase, including life insurance policies, and those policies are certainly expected to increase in value. The fact that they nevertheless are not covered by the clarified proposal still leaves us wondering what policy lies behind the proposal or what characteristics of estate planning techniques actually offend that policy. And the implication that a life insurance trust that purchases a policy from the grantor is
covered by the proposal if it has some other grantor trust feature, like a substitution power under section 675(4)(C)
, even though the economics might be identical, is just as baffling
An Important Promise
In the last sentence, however, the Greenbook description, like last year’s, proposes regulatory authority, except that this time the stated example is “the ability to create exceptions to this provision.” This may be the most important feature of the proposal, because, without it, while narrower than last year’s proposal, the proposal is still very broad. In particular, the proposal appears to apply to all sales, no matter how leveraged, no matter what the interest rate is on any promissory note, no matter what the other terms of the note are, and no matter whether the note is still outstanding at the seller’s death. A GRAT, for example, has clear regulatory safe harbors for all these features and “works” for estate tax purposes if it falls within those safe harbors. It would be odd if a simple installment sale to a grantor trust, which is a sale and not a gift, is subjected to harsher gift (and estate) tax treatment than the funding of a GRAT, which actually is a gift.
But these are complex issues. And for that reason, it may be best, or even crucial, that they be addressed in regulations. So viewed, the changes to this proposal reflected in this year’s Greenbook, and particularly the implicit promise of workable regulations, should be welcomed. Nevertheless, except in the extraordinary event that Treasury and the IRS release an indication of what will be in such regulations before the legislation is enacted, there might still be a gap between enactment and such a release in which a popular and effective estate planning technique will have been chilled.
Last year the almost unlimited proposal was estimated to raise revenues by $910 million over ten years. This year the narrower proposal is estimated to raise revenues by $1.087 billion over ten years.
THIS YEAR’S SURPRISE: HEETS
A health and education exclusion trust (“HEET”) builds on the rule of section 2611(b)(1)
that distributions from a trust directly for a beneficiary’s school tuition or medical care or insurance are not generation-skipping transfers, no matter what generation the beneficiary is in. Sometimes, by including charities as permissible beneficiaries with interests that are vague enough to avoid being treated as separate shares, the designers of such trusts hope that a non-skip person (the charity) will always have an interest in the trust within the meaning of section 2612(a)(1)(A)
, and thereby the trust will avoid a GST tax on the taxable termination that would otherwise occur as interests in trusts pass from one generation to another.
The Greenbook proposal (page 148
) would limit the exemption of direct payments of tuition and medical expenses from GST tax to payments made by individuals, not distributions from trusts. The Greenbook justifies this proposal by stating that “[t]he intent of section 2611(b)(1)
is to exempt from GST tax only those payments that are not subject to gift tax, that is, payments made by a living donor directly to the provider of medical care for another person or directly to a school for another person’s tuition.” Section 2611(b)(1)
exempts from the definition of a “generation-skipping transfer” “any transfer which, if made inter vivos by an individual, would not be treated as a taxable gift by reason of section 2503(e)
….” Certainly that wording was an odd way for Congress to express an intent to limit the exception only to transfers actually made by living individuals (which already are exempt under section 2642(c)(3)(B
Moreover, in contrast with other proposals, the Greenbook proposes that this change would be effective when the bill proposing it is introduced and would apply both to trusts created after that date and to transfers after that date to pre-existing trusts. Such an effective date, once fairly common, is today rather unusual.
The Greenbook’s extraordinary interpretation of congressional intent, coupled with the urgent effective date, reveal a really intense reaction to HEETs. Whatever the objectives behind this proposal, if those objectives are not achieved by legislation we should not be surprised to see Treasury and the IRS pursue those objectives through administrative guidance and enforcement.
Apart from the taxable termination issue under section 2612(a)(1)(A)
, it is not self-evident that either the congressional intent or policies behind the GST tax are offended by the section 2611(b)(1)
exemption for tuition and medical expense payments from treatment as taxable distributions. Perhaps, as consideration of this issue progresses in Congress or in the Treasury and the IRS, we will see the reach of this proposal relaxed or the compelling justification for that reach clarified.
OTHER TECHNICAL TAX CHANGES
The Greenbook carries forward without change the other proposals for technical legislation made in past years, including a requirement for consistency between estate tax values and income tax basis (pages 140-41
), a ten-year minimum term for GRATs (page 142
), an expiration of GST exemption allocations after 90 years (pages 143-44
), and an extension of liens when payment of the estate tax on closely held business interests is deferred (page 147
). And under the heading “Reform Treatment of Financial and Insurance Industry Institutions and Products,” the Greenbook (page 64
) retains last year’s proposal to “Modify Rules That Apply to Sales of Life Insurance Contracts,” including a narrowing of the exceptions to the transfer-for-value rule that appears
to be aimed at “investors.”
MISSING: VALUATION DISCOUNT RULES
The Administration’s Greenbooks have previously called for Congress to give Treasury greater regulatory authority to create more durable rules for disregarding restrictions under section 2704(b)
in valuing nonmarketable interests in corporations, partnerships, LLCs, and other entities. This year’s Greenbook omits that proposal. Many have thought that section 2704(b)(4)
already gives Treasury that authority, and the Treasury-IRS Priority Guidance Plan has included such a regulations project since 2003. While no one welcomes higher transfer tax values, the replacement of the current ad hoc case-by-case approach to these issues with a more holistic approach in regulations might still be an improvement.
REVISITATION OF ESTATE TAX RATES AND EXEMPTIONS
The Greenbooks for the last four years, all the years of the Obama Administration, have proposed permanently setting the estate, gift, and GST taxes at 2009 levels, in which the top rate was 45 percent and the exemptions (technically “exclusion amounts”) were $3.5 million for the estate and GST taxes and $1 million for the gift tax, not indexed for inflation. Even though the rate and exemption for these taxes were permanently set by the American Taxpayer Relief Act of 2012 (ATRA)
at 40 percent and $5 million indexed since 2011, the current Greenbook renews the call to return to 2009 levels, explicitly including a gift tax exemption of only $1 million. Reminiscent of past observations, this year’s Greenbook (page 138
) states that “ATRA retained a substantial portion of the tax cut provided to the most affluent taxpayers under [the 2010 Tax Act] that we cannot afford to continue. We need an estate tax law that is fair and raises an appropriate amount of revenue.” Even so, there is little indication that Congress is eager to revisit what it just made permanent in January.
But this year the Greenbook (pages 138-39
) calls for the return to 2009 levels to occur in 2018. No reason is given. By 2018 there will be a new President and there will have been two more congressional elections. Perhaps waiting four years is a way to achieve a certain revenue target (it is estimated to raise revenue by $71.693 billion over fiscal years 2019 through 2023) and a desired balance between revenue increases and spending cuts. But otherwise 2018 does not stand out as the natural time to raise the estate tax.
Consistently with past proposals, the Greenbook also calls for the portability of the exemption between spouses to be permanently retained.
INCOME TAX PROPOSALS
There are also significant income tax proposals in the Greenbook. For example, so-called “stretch IRAs” inherited by beneficiaries other than the original owner’s spouse would be limited to a term of five years (pages 163-64
). An especially controversial proposal would limit the total amount that could be accumulated in a tax-free retirement arrangement to an amount calculated with reference to the maximum annual benefit from defined benefit plans, said to be about $3.4 million at age 62 today (pages 165-66
For individuals in the 33, 35, and 39.6 percent income tax brackets, the effect of certain exclusions and deductions would be limited to the effect they would have had in the 28 percent bracket (pages 134-35
). And the “Buffett Rule” would be implemented by a new minimum tax, called a “Fair Share Tax,” phased in for adjusted gross incomes from $1 million to $2 million to ensure a tax of at least 30 percent of adjusted gross income less a 28 percent credit for charitable contributions (pages 136-37
These proposals are likely to move forward, if at all, in the context of a broad and intense debate about tax reform, the distribution of tax burdens, and the appropriate “balance” between spending cuts and revenue increases. There are good reasons to doubt that that could ever happen. The opportunity to pull some elements from the Administration’s proposal and some from the House and Senate budget approaches and forge a deal just seems too good to be true. But it just might be too good to pass up.