Treasury Proposal Cracks Down On Investors Using Savvy Tax Strategies

Wealthy investors may face new restrictions when transferring assets to heirs, due to a recent proposal by the Treasury Department. The Department stated that it would “claw back” the tax savings of several wealth planning strategies come 2026 when historically high exemption levels for gift and estate taxes are due to be sliced in half. The proposal reflects the Biden administration’s concern that affluent Americans are racing to use clever strategies during the window to create “artificial” gifts to pass on tax-free wealth to future generations. The proposal targets strategies in which a taxpayer gives assets to a beneficiary while maintaining control over a substantial interest in them. These strategies are what the IRS considers to be a disguised gift that is taxable. It is a fresh blow to affluent investors and their advisors who thought their careful plans were laid in stone. 

Under scrutiny. One arrangement in the crosshairs is a partnership in which a regular interest is given to an heir while the donor retains a preferred interest. Another scenario concerns a promise by a donor to make gifts to a recipient in the future. A third example involves a trust to which a grantor transfers assets but also receives income from the gifted property. In all three instances, the moves use up some or all of a donor’s exemption, which this year is just over $12 million, $24 million for married couples. These higher levels, a product of the 2017 tax-code overhaul, will fall roughly by half come 2026. The Treasury proposal would claw back taxes on transferred amounts that exceed the lower exemption levels for people using the strategies who may die that year. The lifetime gift and estate tax rate is 40%. The goal of this is not to allow wealthy taxpayers to lock in the currently high use-it-or-lose exemption amount.

GRATs. A common estate planning technique, Grantor Retained Annuity Trusts (GRATs), may also get caught even though the strategy does not technically involve artificial gifts. Under the Treasury’s proposal, the IRS would calculate the tax bill of a donor who retains an interest of more than 5% of the value of assets they transfer to a GRAT under the lower exemption. If the donor dies before the trust’s term ends, their stake is pulled back into their estate, resulting in a bigger tax bill on assets they thought they had moved out. For example, suppose a donor put $100 million into a GRAT for the benefit of their children last year, under IRS rules. In that case, the trust pays them a yearly “annuity” that totals slightly more than the value of the contributed property or cash over time. In the eyes of the tax agency, the paybacks reduce the taxable value of the gift, say in this case, to $10 million. So the donor has shifted $100 million out of their estate to benefit their kids but used up only $10 million of her current exemption. Meanwhile, the trust appreciates, and its gains go to the children tax-free. Under the proposal, because the taxable value of the gift is more than 5% of the transferred amount, the donor has not locked that $10 million of their currently higher exemption. Meaning they would thus face a higher tax bill come 2026. One big issue is that the strategies on the firing line are irrevocable. They are legal contracts that cannot be unwound. 

Saved by Zero. However, there seems to be a silver lining to the 5% rule. It will not apply to so-called zeroed-out GRATs, in which annuities equal the original value of what was put into the trust. This is because, under current IRS rules, such a trust does not use up any of a donor’s exemption, even as it moves money out of the estate. Assets in that trust, a staple with the 1 percent, appreciate over time, and the left over after annuities goes to heirs tax-free. The proposal also does not affect nuts-and-bolts planning in which a donor bequeaths property while keeping control or possession of it while alive. For example, suppose Grandma and Grandpa have an estate worth $20 million and set their son up to inherit $7 million when they die. In that case, they can safely use their current exemption of over $24 million if they pass away after 2026.

The 10-year itch. Wealth advisors are already chafing from severe curbs on inherited retirement accounts. Under a law that Congress passed in 2019, heirs to traditional individual retirement accounts (IRAs) and workplace retirement plans, including 401(k)s, 403(b)s for educators and 457(b) deferred compensation plans, can no longer “stretch” required minimum withdrawals out over their lifetimes. Instead, they have to drain the accounts within ten years. In May 2021, the IRS said that beneficiaries of the accounts were not required to take annual distributions before the 10-year deadline. Advisors breathed a sigh of relief because it gave the tax-deferred accounts more time to appreciate. But on Feb. 23, Treasury reversed course, issuing another little-noticed proposal to require minimum annual distributions in years one through nine. That rule applies to heirs who are not spouses or children under age 18 and inherit a retirement account starting in 2020. However, this does not include Roth Plans.

Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.

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