Estate Planning Could Be Affected by Administration’s Budget Proposals

April 12, 2013

On Wednesday, April 10, the Obama Administration proposed ambitious spending and revenue changes, as it released its proposed budget for fiscal year 2014 (October 1, 2013-September 30, 2014). As in past years, a number of proposed tax changes affecting estate planning are described in the Treasury Department’s “General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals” (popularly called “the Greenbook”), including a return to the 45 percent transfer tax rate and $3.5 million exemption of 2009. Even though the congressional reception and ultimate outcome are in doubt and nothing will happen soon in any event, the proposals should be kept in mind when considering estate planning actions and may affect the shape and timing of those actions in some cases.

Grantor Trust Proposal Clarified and Narrowed, but Still Tough

Background: Use of Grantor Trusts

A “grantor trust” is treated as “owned” by the grantor (creator) of the trust during the grantor’s lifetime or some shorter period. As a result, after the grantor makes a gift to an irrevocable grantor trust, with the grantor’s descendants, for example, as beneficiaries, the income tax on that trust’s income must be paid by the grantor, even though the income belongs to the trust and its beneficiaries. That permits the grantor to make income tax payments that benefit the trust and its beneficiaries without treating those payments as additional gifts.

Grantor trust treatment also permits transactions between the trust and the grantor without income tax, including sales without capital gain and payment of interest without creating taxable income. That feature has supported the popular and effective estate planning technique of an installment sale to a grantor trust, in which assets are sold to the trust for a promissory note with lenient terms (especially at today’s low interest rates), often with a small “down payment.” The future appreciation in the value of those assets in excess of the modest interest rate escapes gift and estate tax. The trust can also last for multiple generations and be made exempt from the generation-skipping transfer (GST) tax by allocation of the grantor’s GST exemption. That feature of grantor trusts also permits fine-tuning or updating the assets of the trust by the grantor’s exchange of assets with the trust, again without capital gain or gift treatment.

Administration Proposal: Focus on Installment Sales to Grantor Trusts

In last year’s Greenbook, for the first time, the Administration proposed changes to the estate and gift taxation of grantor trusts treated as owned by the grantor for income tax purposes. As written, those proposals appeared designed to treat all such grantor trusts as fully subject to estate tax when the grantor dies, or to gift tax if grantor trust status ceases during the grantor’s life. Observers, including the lawyers of the McGuireWoods Private Wealth Services Group, did not believe that such a sweeping change was intended, and we waited for clarification in this year’s version of the proposal.

This year’s Greenbook does indeed narrow the proposal, although the precise scope might not be known until statutory language is available, which may not be soon. It will not apply to all grantor trusts. For example, it includes a suggestion that it is not aimed at life insurance trusts (even though last year’s Greenbook contained a suggestion that it was).

With respect to those trusts to which it does apply, the proposal will subject to estate tax (or gift tax) only “the portion of the trust attributable to the property received by the trust” from the grantor in an installment sale or similar transaction. 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. But, of course, the amount of that consideration is typically a fixed amount, while the assets that are sold are usually expected to increase in value.


If enacted as proposed, this change would apply to sales after the date the President signs the law and would effectively eliminate all typical estate tax benefits of such sales and 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 during the grantor’s life or making distributions from the trust would be subject to gift tax. Because that portion of the trust would be subject to estate tax, the grantor would be unable to allocate GST exemption to it.

Planning Points

If legislation along these lines is enacted, we believe that there would still be some estate tax value in installment sales to irrevocable trusts that are not grantor trusts. But those advantages would be significantly reduced, and many donors would prefer the more predictable benefits of a grantor retained annuity trust (GRAT). Some efforts might be made to design workarounds, possibly including expanded use of the technique of turning grantor trust status on or off, but those techniques would likely attract close scrutiny by the Internal Revenue Service.

There is some comfort, however, in the Greenbook proposal that the legislation authorize Treasury to create exceptions from the proposed estate tax treatment. Those exceptions could include helpful “safe harbors” that relax the rules in the case of sales that meet certain standards. But it is most unlikely that we will know those exceptions and standards before the legislation is enacted. And it is hard to tell what the legislative prospects are. Estimated to raise revenue of slightly over a billion dollars over ten years, the proposal will not be irresistible as a weapon against deficits, but its appeal in an every-little-bit-helps environment is impossible to predict.

Meanwhile, then, anyone considering an installment sale to a grantor trust should consider completing it, not as a rush project but without avoidable long delay or inattention, which is usually good advice for any estate planning actions like this. Some of those installment sales might be made to trusts that were created and funded in the surge of gift-giving in 2012 when the future of the gift tax exemption was uncertain.

Minimum Ten-Year Term for GRATs

Background: Use of GRATs

A grantor retained annuity trust is economically similar to an installment sale to a grantor trust, in that it protects from estate tax the appreciation in excess of the interest rate used to calculate the amount of the gift when property is transferred to the GRAT and the grantor retains a stream of annual payments for a stated term. Sometimes GRATs are seen as even preferable to installment sales, because GRATs follow a clear and predictable pattern set forth in tax regulations. One disadvantage of a GRAT is that it will be subject to estate tax, but only if the grantor dies during the stated term. For that reason, many GRATs have had relatively short terms, such as two years.

Administration Proposal

This year’s proposal is identical to the one in last year’s Greenbook and would require a GRAT to have a minimum term of ten years. The proposal affirms the common practice of “zeroing-out” by designing the annuity to produce a very low gift tax value, even though the proposal would prevent the value from being exactly zero.

Planning Points

As with this proposal in the past, it is hard to estimate its prospects, although a similar proposal was approved by the House of Representatives in three rather partisan votes in 2010 under Democratic control, and this proposal is estimated to raise almost $3.9 billion over ten years. As with the proposal regarding installment sales, the lesson is that GRATs under consideration should probably be completed if it is reasonable to do so, again not necessarily in a rush but with reasonable dispatch.

Change in GST Tax Rules for “Health and Education Exclusion Trusts” (HEETs)

Background: Use of HEETs

A health and education exclusion trust (HEET) is a complex and uncertain technique. It builds on the statutory rule that distributions from a trust that is not exempt from GST tax 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. By including charities as permissible beneficiaries with somewhat vague interests, the designers of such trusts hope to avoid a GST tax on the “taxable termination” that would otherwise occur as interests in trusts pass from one generation to another.

Administration Proposal

New this year, the Greenbook proposal would limit the exemption of direct payments of tuition and medical expenses from GST tax to such payments made by individuals, not distributions from trusts. 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.

Planning Points

Because of the lack of authority or consensus for their design, the use of HEETs is likely not as widespread as the use of installment sales or GRATs. But because of the abrupt effective date provision that is proposed, any contemplated HEETs should be completed promptly.

Also, because the proposal appears intended to repeal an exception for all generation-skipping trusts, not just trusts designed as HEETs, it might be thought that the creation and funding of all such trusts should be placed on a rush basis. The lawyers of the McGuireWoods Private Wealth Services Group do not recommend that because we expect that the reach of this proposal will be recognized as overbroad, and, if it is enacted, it will be in a more limited form. Even if it might be enacted as proposed, we believe that the care needed in designing all the features of a long-term trust, not just provisions for tuition or medical expenses, ordinarily should not be compromised.

Other Technical Estate Tax Changes

The Greenbook carries forward other proposals made in past years, including a requirement for consistency between estate tax values and income tax basis, an expiration of GST exemption allocations after 90 years, and an extension of liens when payment of the estate tax on closely held business interests is deferred. It omits a proposal in past Greenbooks for Congress to give Treasury greater regulatory authority to limit valuation discounts for nonmarketable interests in corporations, partnerships, LLCs, and other entities, although many observers believe that Treasury already has that authority under existing legislation, and, indeed, a regulation project on the subject has been under consideration for at least ten years.

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 in January at 40 percent and $5 million indexed since 2011, the current Greenbook renews the call to return to 2009 levels, beginning in 2018. It also calls for the “portability” of the exclusion amount between spouses to be permanently retained. By 2018 there will be a new President and there will have been two more congressional elections, and it is hard to guess why 2018 is used. But it certainly does not appear to call for any immediate estate planning action.

Income Tax Proposals

There are income tax proposals in the Greenbook that could significantly affect individual taxpayers. 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. A 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, currently about $3.4 million at age 62. 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. 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 and ensuring a tax of at least 30 percent of adjusted gross income less a 28 percent credit for charitable contributions.

Unlike the technical estate tax proposals, 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 and taxation.

McGuireWoods Fiduciary Advisory Services

McGuireWoods’ Fiduciary Advisory Services and Private Wealth Services Teams stand ready to advise financial institutions and other clients about planning, tax, and fiduciary matters. McGuireWoods’ Private Wealth Services Group has been ranked by Chambers, the international rating service for attorneys, as one of the top wealth management legal practices in the country for several years.