Treasury Targets Trusts and Gifts Used by the Wealthy to Mitigate Taxes

While most financial advisors know that the proposed tax increases will prevent affluent investors from using trusts to pass on major wealth to their heirs, something that many, and even estate planners do not know, is that there is a separate threat to investors who use trusts to move assets out of their estate free of taxes. While the threat does not come from Congressional tax writers, instead, it comes via a nearly unnoticed sentence in an obscure Treasury Department document released by the agency early last month. In a little-noticed remark in the agency’s priority plan, the Treasury is looking at whether the IRS could “claw back” taxes on gifts that investors have made under the higher estate and gift tax exemption levels in place since 2018. The recapture would begin once those higher thresholds expire come 2026.

The Treasury item is almost completely unknown in the financial planning and wealth management industry. The decision to target sophisticated moves by the wealthy is the latest blow to tax strategies used by affluent Americans to minimize their tax bills and pass on legacies to heirs. If it becomes the rule, millions of taxpayers could face sudden outsize tax bills.

Squeeze on the Wealthy. The claw back would interact with a provision in the draft tax bill coming from the House of Representatives. That provision would not extend the higher exemptions for estate and gift taxes, instead reversing them by 2026. It would also put an end to backdoor Roth conversions. The emerging bill is now mired in a fresh fight with Republicans over debt limits. The 2017 Republican tax-code overhaul nearly doubled the lifetime exemptions to historic highs. The 2017 law said that come 2026, the limits would revert to their earlier levels, with extra for inflation, unless extended. The current draft tax bill makes clear that extension will not happen.

Clawing back the anti-claw back rule. When the exemptions were doubled nearly four years ago, it spawned a frenzy of estate planning with trusts for rich investors. It also raised a question: What would happen if someone transferred assets to the next generation while the higher exemption is in place, but then died in 2026 or later when the double threshold would no longer be in place?

Treasury appeared to answer that question in November 2019. It said that for people who give assets into trusts for their children during the years of the higher thresholds but die after those levels shrink back, it would not “claw back” from their estate any taxes on amounts transferred above the smaller thresholds. The amounts would be “locked in.”

The Treasury’s priority plan released on Sept. 9 appears to signal that an anti-abuse provision is in the works. One sentence of the plan said that it would examine whether a November 2019 rule saying no claw backs would take place would be revisited. Treasury’s plan is an outline of the top tax issues it plans to focus on over the 12 months beginning in October when the government’s next fiscal year begins.

Targeting ‘have your cake and eat it, too.’ The Treasury plans to target lifetime gifts that would use the donor’s gift tax basic exclusion amount, lifetime exclusion, while at the same time being designed so that the donor retains a beneficial interest in the gifted property. A classic example of this would be a grantor retained income trust, or GRIT. In that type of trust, the grantor transfers assets to the trust, paying taxes on it, but also keeps an income stream from the gifted property. The Internal Revenue Service has flagged trusts that give the appearance that a person is giving up control of their assets and money when they still control how the money and assets are used as potentially abusive.

‘Killing’ Grantor Trusts. The Treasury’s consideration of whether gifts that are includible in the gross estate should be exempted from the anti-claw back rule comes as lawmakers consider other curbs to trusts. The draft House bill would prevent people from using grantor trusts. Specifically, it would treat sales between grantor trusts and their owner as a sale to a third party which means it will be taxable. The measures would only apply to future trusts and future transfers.

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