As we begin 2022, we remain uncertain of the estate and income tax landscape for the year. On November 19, 2021, the US House of Representation passed HR 5376 (also known as the "Build Back Better Proposal") by a slim margin with a vote of 220 to 213. As 2021 drew to a close, Senator Manchin pulled his support seemingly ending the potential passage of the Proposal. Negotiations continue, uncertainty remains. We know that a tax change can be made later in the year, but be retroactive to January 1, 2022. We also know that if legislative gridlock continues the current estate tax exemption falls from $12.6 million per person to $5,000,000, adjusted for inflation or about $6,000,000 at this time.

To determine where to go, we should review what is in the Build Back Better Proposal and perhaps more importantly, what was left out of that proposal.

Build Back Better Proposal - Items Included

  • Tax surcharge on individual (1040) income over $10,000,000 (5%) and $25,000,000 (5%+3%)
  • Tax surcharge on trust (1041) income over $200,000 and $500,000
  • The State and Local Tax (“SALT”) deduction is back in 2021 at $80,000 for MFJ returns for 2021-2030 and reduce it back to $10,000 for 2031 thereafter it would expire - but Senator Sanders has already voiced his displeasure with this benefit to high income taxpayers
  • New contribution limits for IRAs
  • Larger IRAs have new/higher Required Minimum Distributions (“RMD”) rules - Accelerated required minimum distributions for retirement accounts in excess of $10 million
  • 3.8% Net Investment Income Tax (“NIIT”) on business income – NIIT would now be applicable corporation distribution
  • Changes to wind, solar and EV credits
  • New Restrictions on business losses
  • Higher corporate minimum taxes
  • International corporate provisions
  • Surcharge $10 million/$25 million 

Perhaps as important as the provisions included were the items considered but not included:

  • No changes to 199A tax on passthrough entities, it had been limited to $500,000 and only $10,000 for trusts
  • No gain at death or upon gift, the basis step-up continues
  • No change to the LTCG rate it had been proposed to increase to ordinary income tax rates or 25%
  • No change to the estate tax exemption it had been subject to a reduction to $5M inflation adjusted
  • No change to the valuation provisions which had been proposed to eliminate discounts on passive assets
  • No gain the sale to an Intentionally Defective Grantor Trust ("IDGT")
  • No grantor trust inclusion and other harsh changes to grantor trust rules
  • No mark-to-market provisions (also known as the Billionaire's tax)
  • Surtax on high income earners
  • Tax increases on large corporations:
    • 15% domestic minimum tax
    • 15% global minimum tax
    • 1% surcharge on stock buybacks
    • Various other reforms - especially international

Special Income Tax Surcharges May Impact Many Trusts

There is a special or additional tax of 5% on income above $10 million control - sell this year. And if income exceeds $25 million there is an additional 3% surtax. The 5% surtax will apply to trust income at a mere $200,000 of income.

This would change how many common trusts are handled, e.g., the credit shelter or family trust formed on the death of the first spouse. Grantor trusts appear to remain so they will be taxed to the settlor (or other person who is deemed the grantor for income tax purposes). However, non-grantor trusts (also called complex trusts) generally pay their own taxes and will have to be carefully monitored. The trust tax rates are substantially higher than the individual and corporate tax rates.

A non-grantor trust pays tax on all income it earned, but it receives a deduction for the income (distributed net income or “DNI”) distributed to beneficiaries.
It contains a mark-to-market tax on billionaires (and trusts with more than $10M.

  • Charity: We may consider using trusts to make charitable contributions. But if that is done the contribution must be made from gross income of the trust to qualify for an unlimited charitable contribution deduction. Also, the IRS requires that the governing instrument permit contributions. If not, no deduction will be permitted. If a trust doesn’t have the requisite language, it cannot be amended (e.g., via a merger or decanting) to add that required verbiage. The IRS views the requirement as having to be in the original governing instrument, not a modified later version. All is not lost; however, it may be possible for a trust to contribute assets to a partnership that invests and pays charitable contributions. When the charitable deduction flows through from a partnership to the trust that owns an interest in that partnership the IRS seems to respect the deduction. So, going forward, charities will be more commonly named in trusts.
  • Grantor Trusts: Trusts that can be maintained as grantor trusts might be continued in that manner to avoid the harsh trust income tax surtax.
  • Year End Planning: Trusts that are characterized as non-grantor trusts that may then face the surtax should make a concerted effort to review their tax status before year end. Discuss with your tax preparer the 65-day rule to avoid trust income tax rules on income actually distributed out of the trust within the first 65 days of the year. Trusts should have the wealth adviser evaluate gains and income, the CPA for the trust evaluate the tax status of that, and the trustee to consider possible distributions (e.g., what is appropriate for the beneficiaries and what does the trust agreement permit). Then this data should be evaluated, and distributions made before year end to shift income from the trust that may face maximum income tax rates and a surtax to the beneficiaries who may be in a lower graduated income tax bracket and not face the surtax. The savings each year could be substantial (or not).
  • Class Beneficiaries: When planning and drafting trusts, consider including a wider class of beneficiaries so that the trustee has more flexibility to distribute income to multiple beneficiaries that may be able to remain, even with trust distributions, in lower income tax brackets and avoid the new high surtax rates. Give trustees discretion to make distributions so that they have flexibility to better plan trust/beneficiary combined income tax results. Mandatory income distributions remain potentially problematic from a creditor protection perspective, but also may serve to limit income tax planning flexibility.
  • Distributions Not So Simple: Before any distributions are made the trustee will have to consider whether the beneficiaries face any claims or lawsuits that may result in an ex-spouse or creditor attaching the larger distributions that income tax changes might motivate. Also, the beneficiary’s personal income tax will have to be considered. The beneficiary may also be in the maximum income tax bracket so a distribution may have no salutary effects.
  • State Tax: Worse, if the trust has situs in a low or no tax state, e.g., Florida, but the beneficiary resides in a high tax state like California, the increase in state income taxation from a distribution may outweigh the federal income tax benefits. For irrevocable trusts, we often utilize the state of Nevada so, we utilize a Nevada trust company as the administrative trustee while the client continues as the investment trustee.
  • Capital Gains: Finally, if the trust is to have certain income, e.g., capital gains income, taxed to the current beneficiaries rather than being taxed to the trust, either the trust instrument will have to permit that income to be taxed to the beneficiaries or the trustee may have to take certain actions to achieve that result. It may be feasible to decant the trust into a new trust with different provisions if that becomes necessary.
  • Trap: Trust tax provisions have a wide ranging and often unexpected impact. These provisions may become the “traps for the unwary.” Anyone with a small irrevocable trust they created for a grandchild, or on the death of a spouse, etc. could unexpectedly face a much higher income tax rate just from the sale of a security to raise cash for distributions.

The Beneficiary Defective Inheritor’s Trust (“BDT”)

A BDT is a grantor trust disregarded for income tax purposes but effective for estate tax purposes.

A Section 678 Trust is one in which a beneficiary is a deemed to be an owner under the “grantor trust” rules of subpart E (Sections 671 to 679). The BDT is an irrevocable trust that can be used to freeze the value of assets for gifts and for estate tax purposes.

Under Section 678, the beneficiary with a right to withdraw everything from a trust is essentially treated as though she were the trust’s grantor for grantor trust purposes. So, all income, deductions and credits are directly attributed to the beneficiary. This could move income from a trust where the surtax is triggered at $200,000 of income to a beneficiary with less than the $10M income where the 5% surcharge kicks in.

This could help if the initial Build Back Better Proposal is enacted. This could be even more important, perhaps, if the Revised Bill with the 5% and 3% Surtaxes are enacted.

Consider a Qualified Subchapter S Trust (“QSST”)

The income of an S corporation is taxed to the shareholders. The “flavor” of the income generally remains the same so Net Investment Income Tax ("NIIT") is avoided on retirement plan/IRA distributions paid to the corporation.

A QSST is a trust where the beneficiary (who is not the grantor) elects to be taxed under Section 678 on the S corporation income as though she were the shareholder. The trust can have only one beneficiary (a US individual taxpayer) and must be required to pay, or does in fact pay, all of its Financial Accounting Income (“FAI”) to the beneficiary.

There is no requirement for the S corporation to have a business purpose and no risk of an Accumulated Earnings tax.

Trustee can use dividends to pay the beneficiary’s income tax liability, so dividends are protected from creditor claims.

This could help if the House Bill is enacted. This could be even more important, perhaps essential, if the Revised Bill with the 5% and 3% Surtaxes are enacted.

Planning Should Make Sense Regardless of Tax Change

Tax planning should always focus first on addressing your non-tax goals. This is more important now than ever before. This is often overlooked, as many planners tout or market a product with a catchy acronym rather than focusing on long term goals.

To the extent that the assets moved into trust safeguard the exemption that is scheduled to decline by half in 2026, then planning now may be sensible regardless of the outcome of current legislative proposals. In other words, use the $12.06 million now before we lose one-half (1/2) of that on January 1, 2026.

Planning should enhance asset protection (from claims, creditors, etc.) and therefore, may be beneficial in all events regardless of tax law changes.

Planning Opportunities That May Be Appropriate This Year

  • Annual Exclusion Gifts - The annual exclusion rises from $20,000 on January 1, 2022. Don't let this be a missed opportunity.
  • Use the Lifetime Exclusion - The $12.06 million exclusion drops to approximately $6,000,000 on January 1, 2026. Gift to use that now before lost.
  • Spousal (Sibling) Limited Access Trust (“SLAT”) - The SLAT provides an ability to reduce your estate and still have indirect access through your spouse.
  • Non-Grantor Incomplete Gift Trusts ("NING" Trust) - The NING can be used as a completed gift trust to both reduce your taxable estate and avoid California income tax.
  • Bond Funded Life Insurance - For clients with net assets in excess of $10 million, substantial life insurance can be obtained WITHOUT ANY OUT-OF-POCKET COST. All costs are paid through an issuance of investment grant bonds. This insurance builds a substantial cash value over time which can provide substantial tax-free retirement income for you and/or your children.
  • Retirement Rescue - Distributions (other than ROTH IRA's) are subject to both income and estate tax. As a result, 70% of the account value can be lost to taxes. Traditional planning using a Charitable Remainder Trust ("CRT") or similar alternatives are not truly tax efficient. The Retirement Rescue Plan can convert this taxable income to tax free distributions. This planning is particularly effective for taxable estates in excess of $12.06 Million in 2022 with substantial retirement benefits. This planning is also effective for a smaller estate with retirement account balances in excess of $1 million.  
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