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Don’t Misplace Your Trust – Proposed Tax Law Overhaul Targets Grantor Trusts, IRAs, and Other Financial Planning Tools

It’s been clear from the start that the new administration in Washington has its sights set on overhauling the tax code. However, the outline of proposed tax legislation unveiled on September 13 by the House Ways and Means Committee has made those changes all the more likely. Among those affected by the proposals would be high-net-worth and high-income individuals attempting to save for retirement or plan their estates. Here, we give you the rundown on the changes you should be aware of and how they could affect you.

Drop in Unified Credit

One section of the proposal would end the temporary increase in unified credit that began in 2017, significantly lowering the threshold for exemption from gift and estate taxes. Currently, estates up to $11.7 million (for individuals—double for married couples) are exempt from estate and gift taxes. The proposal would cut that amount by over half, dropping the unified credit threshold to $5 million, as it was in 2010. (The Committee outline notes that this amount will be indexed for inflation.) Individuals who could be affected by this change should consider implementing spousal lifetime access trusts (SLATs) to capture the current exemption limits, as we have previously recommended in prior blog articles.

Elimination of Grantor Trust Advantages

Many individuals have found grantor trusts to be a helpful estate planning tool to remove assets from the grantor’s taxable estate without utilizing the lifetime exemption amounts. They also allow for the taxation of trust income at individual income tax rates and not at trust rates. The proposed changes will significantly weaken the benefits of such a planning strategy. If an individual is deemed the owner of a grantor trust, the assets of that trust will be pulled into that individual’s taxable estate at the time of death as though they had not been in a grantor trust at all. Accordingly trust grantors need to be prepared to modify their trusts by year end through a non-judicial settlement agreement (NJSA) or by exercising elections built into the trusts, to capture the existing exemptions.  Please check with us for details.

Valuation Reduction for Real Property in Family Businesses

Finally, some good news! One section of the proposal aims to increase the special valuation reduction for estate taxes on real property (e.g. land, buildings, crops, etc.) that is used in a family farm or family business. The exemption would increase from $750,000 to $11.7 million. For estate tax purposes, such property could be valued based on its actual farm use and not on the traditional basis of fair market value (which may be artificially high). This allows heirs to pay taxes only on the property’s useful value at the time of transfer, which may ensure that the property actually remain in the family and not be lost to heavy taxes.

Removal of Valuation Discounts for Non-Business Assets

This provision of the proposal seeks to clarify that nonbusiness assets, i.e. assets that passively generate income and are not actively used in trade or business (such as idle equipment, loans receivable, and vacant land) should not receive a valuation discount for the purposes of transfer taxes. These assets will be assessed at and taxed at fair market value. Now is the time to utilize valuation discounts for gifting purposes before this strategy expires at year end.

Changes to IRA Contribution Limits and RMDs

Currently, individuals can add to their retirement accounts regardless of the balance of those accounts prior to their contributions. New provisions in the tax proposal will prohibit individuals from making contributions to IRAs (both traditional and Roth) if that individual’s retirement accounts (including IRAs and defined contribution plans such as 401(k)s) exceed a total value of $10 million at the end of the prior taxable year. In addition, high-income individuals will face increased minimum distribution amounts for accounts that have balances greater than $10 million. This required minimum distribution (RMD) only applies to individuals who qualify as “high-income” ($450,000 annually for married couples filing jointly, $425,000 for heads of households, $400,000 for unmarried individuals, and $225,000 for married individuals filing separately). These individuals must withdraw at least 50% of the excess funds in their accounts by year’s end to meet the minimum distribution requirement.

Roth Conversions Elimination

Not only would the proposed changes prohibit high earners from building up their IRAs, but they would eliminate a key retirement saving strategy: the Roth conversion, or, informally, the “backdoor Roth.” Under current law, individuals may convert their pre-tax savings from a traditional IRA or defined contribution plan to an after-tax Roth account, provided they pay the resultant taxes at the time of conversion. This allows individuals to pay taxes on their retirement savings now rather than at the time of withdrawal. The proposal aims to eliminate Roth conversions entirely, meaning that high earners will not have the opportunity to save after-tax dollars for retirement.

Restrictions on IRA Investments

A handful of provisions would impose restrictions on how IRA funds may be invested. First, one section of the proposal would prohibit IRA investments that are contingent on certain conditions of the account holder, such as minimum level of assets/income, minimum education, and investor accreditation. Proposed changes would also prohibit the investment of IRA funds in entities in which the account holder has a substantial interest (50% or greater generally or 10% for non-tradable investments). This would be not only an IRA investment rule, but an IRA requirement—meaning that an account in violation of the standard would no longer qualify as an IRA and therefore would lose the tax benefits of an IRA. Additional sections of the proposal would expand the statute of limitations on IRA non-compliance from 3 to 6 years and would treat IRA owners as disqualified persons in the context of prohibited transaction rules. It’s important that anyone investing IRA funds be aware of these changes and how their investments may be affected.

Most of these changes are slated to go into effect after December 31, 2021, so don’t wait! Contact your McBrayer attorney today to find out how to best preserve your legacy and retirement savings.

This blog was authored by our Estate Planning Team.
Ivan Schell

Ivan Schell is a Member of McBrayer PLLC. His multifaceted legal practice includes estate planning and administration, private foundation and public charity formation and planning, physician practice consultation and healthcare law, employee benefits law, and closely-held corporation planning transitions. He can be reached at ischell@mcbrayerfirm.com or by calling (502) 327-5400, ext. 2351.

Sean MumawSean Mumaw is a McBrayer Member practicing out of both the Louisville and Lexington offices. His practice area focuses on estate planning but also includes tax (estate, gift, income, and inheritance), general business law, business succession planning, real estate, and the like. He can be reached at smumaw@mcbrayerfirm.com or (502) 327-5400, ext. 2304.

Maxine Bizer

McBrayer attorney Maxine Bizer centers her practice on estate planning and administration and probate. She practices in McBrayer's Louisville office. Ms. Bizer can be reached at mbizer@mcbrayerfirm.com or (502) 327-5400, ext. 2354.

Services may be performed by others.

This article does not constitute legal advice.

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