While we know what the current federal estate tax rules are and that they are supposed to be "permanent" going forward, as the saying goes, "A law is only permanent until Congress decides to change it." So as the struggle in Washington continues to keep incoming revenues up to speed with the exorbitant amount of government spending that is occurring, Congress may very well be forced to close some of the "loopholes" that the wealthy have benefited from in the past in order to decrease the values of their estates for estate tax purposes.
Summary of Current Estate Tax Laws
Before discussing the future of estate taxes, it is important to understand what the current federal estate tax rules provide for and if these rules are likely to be changed in the near future.
Under previous law, the federal estate tax exemption was supposed to drop significantly from $5,120,000 in 2012 to $1,000,000 in 2013, and the estate tax rate was scheduled to jump from 35% to 55%. But Congress and President Obama acted very early in 2013 to pass the American Taxpayer Relief Act (or ATRA for short), which, as mentioned above, has supposedly made the laws governing federal estate taxes, gift taxes and generation-skipping transfer taxes permanent for 2013 and beyond.
Under ATRA, the federal estate tax, gift tax, and generation-skipping transfer tax exemptions were set at $5,000,000 but are to be indexed for inflation beginning in 2011. This means that each exemption sits at $5,250,000 for 2013, will increase to $5,340,000 in 2014, and will continue to be increased according to inflation rates in 2015 and beyond. In addition, ATRA set the top estate tax, gift tax and generation-skipping transfer tax at 40% and made portability of the estate tax and gift tax exemptions between married couples permanent for 2013 and future years.
With these exemptions sitting at such large numbers, it has been estimated by the Tax Policy Center that only 3,800 estates will have to pay estate taxes in 2013. So with such a small number of deceased taxpayers subject to the federal estate tax, it is easy to speculate that Congress could move to reduce the exemptions and increase the top tax rates in order to raise revenue. But in order to raise any significant revenue, Congress would need to set the exemptions at a very low number, such as all the way back to $1,000,000, and set the tax rate very high, such as 55%. Since Congress already had the opportunity to let these exact numbers go into effect on January 1, 2013, but instead they opted to increase the exemption above $5,000,000 and only slightly increase the rate from 35% to 40%, it is unlikely that the exemptions and rate will be changed in the near future, and it is also unlikely that the estate tax will be completely repealed in the near future since the exemptions are considered to be quite generous.
Closing Estate Tax Planning "Loopholes"
So if the estate tax, gift tax, and generation skipping transfer tax exemptions are not likely to be fiddled with any time soon, then what can Congress do in the estate tax area to significantly raise revenues? A look at President Obama's budget proposals over the last several years provides a road map for Congress to act to close many of the estate tax planning "loopholes" that have allowed the ultra wealthy to move appreciating assets outside of their estates, thereby reducing the values of their estates for estate tax purposes, and to create "Dynasty Trusts" that will continue on for many years into the future that will never be taxed again for federal estate tax purposes. Below is a summary of the budget proposals that Congress could implement with regard to raising billions in estate tax, gift tax and generation-skipping transfer tax revenues along with some that will increase income tax revenues.
#1 - Changes to Rules Governing GRATs
A grantor retained annuity trust (or "GRAT" for short) is a type of irrevocable trust which, if properly structured and managed, will pass assets on to the trust beneficiaries free from gift taxes and reduce the value of the grantor's estate. In the typical GRAT arrangement, the grantor transfers specific assets into the name of the GRAT and then retains the right to receive an annual annuity payment for a certain number of years. When the term of the GRAT ends, what is left in the GRAT is distributed to the trust beneficiaries (children or other beneficiaries of the grantor's choice).
So why would someone do this - set up a trust for the benefit of someone else but get all of the assets back in the form of annuity payments? Basically because setting up a GRAT is a gamble since the grantor is really betting on the fact that the assets transferred into the GRAT will appreciate in value above and beyond the minimum interest rate that is required to be paid out in the form of the annuity. Thus, while the grantor will get back some of the assets transferred into the GRAT in the form of annuity payments, the appreciation of the assets in the GRAT above and beyond the required annuity payments will pass to the GRAT beneficiaries outside of the grantor's estate and free of gift taxes.
Another concept that makes the GRAT an attractive way to pass on wealth is while ordinarily the transfer of assets owned by someone into an irrevocable trust for the benefit of someone else would be deemed a gift for federal gift tax purposes, with a GRAT since theoretically all of the assets transferred in could come back to the grantor, the value of the gift to the beneficiaries of the GRAT will be at or close to $0. Thus, it is possible to establish what is referred to as a “zeroed-out GRAT.”
The big drawback of using a GRAT is the fact that if the grantor dies during the term, then all of the assets in the GRAT will be pulled back into the grantor's taxable estate for estate tax purposes. Thus, GRATs usually have short terms, such as two or three years.
So how could Congress tinker with GRATs to make them unattractive? President Obama's budget proposals have attacked GRATs on two fronts: By (1) requiring GRATs to have a minimum term of 10 years, thereby increasing the chance that the grantor will die during the term and causing the GRAT assets to be pulled back into the grantor's taxable estate, and (2) eliminating zeroed-out GRATs by requiring transfers into to GRATs to have some value for gift tax purposes. Both of these changes would severely limit the effectiveness of GRATs as an estate tax reduction technique.
#2 - Eliminate the Benefits of Sales to Intentionally Defective Grantor Trusts
Another technique that is used to move the appreciation of assets outside of a person's taxable estate is the sale to an intentionally defective grantor trust (or "IDGT" for short). With this technique, the irrevocable trust is made "intentionally defective" by requiring the grantor to pay the income taxes generated by the trust assets for income tax purposes, but at the same time the assets in the irrevocable trust will not be included in the grantor's taxable estate for estate tax purposes. In addition, because the IDGT is a grantor trust for income tax purposes, transactions between the grantor and the trust, such as an installment sale to the trust in exchange for a promissory note using today's low interest rates, can occur without capital gains and taxable interest payments.
So how could Congress tinker with sales to IDGTs to make them unattractive? President Obama's budget proposals have attacked this technique on two fronts: By (1) requiring gift tax to be paid upon any distributions from the IDGT, and (2) including the assets remaining in the IDGT at the grantor's death in the grantor's taxable estate. Both of these changes would eliminate the estate tax reduction benefits of sales to IDGTs.
#3 - Eliminate the Benefits of Health and Education Exclusion Trusts
A Health and Education Exclusion Trust, or "HEET" for short, is a special type of irrevocable trust which is designed to allow the grantor of the trust to provide for payments for certain educational and medical expenses of grandchildren and great grandchildren, free from gift taxes and generation-skipping transfer taxes, or GST taxes for short.
A HEET couples the concept of "gifts that aren't really gifts" with "GST transfers that aren't really GST transfers" as authorized in the Internal Revenue Code and state laws that allow for "Dynasty Trusts" to give the grantor the ability to provide for certain educational and medical expenses of the family for many generations to come.
So how could Congress tinker with HEETs to make them unattractive? President Obama's budget proposals have attacked HEETs by making distributions from them subject to GST taxes. In addition, in the 2014 budget proposal, this would become effective on the date the bill is introduced and apply to new HEETs as well as any distributions made after the effective date from pre-existing HEETs. Both of these changes would eliminate the estate tax, gift tax and GST tax benefits of HEETs.
#4 - Limit Dynasty Trusts to 90 Years
A Dynasty Trust is an irrevocable generation-skipping trust that avoids estate taxes and GST taxes as each generation dies and the assets remaining in the trust are passed down within the trust to the next generation. Some states allow Dynasty Trusts to continue for an unlimited number of years, while other states, such as Florida, allow them to continue for a great number of years (360 years in Florida).
So how could Congress tinker with Dynasty Trusts to make them unattractive? President Obama's budget proposals have attacked Dynasty Trusts by requiring them to terminate within 90 years. While this may still seem like a long time for a trust to continue estate tax, gift tax and GST tax free, the current rules governing GST taxes could cause many existing Dynasty Trusts to lose their GST tax exempt status. While limiting Dynasty Trusts to 90 years would not completely eliminate them as an estate tax planning tool, it would greatly reduce their value over future generations.
#5 - Limit the Amount Accumulated in a Tax-Preferred Retirement Account
Limiting the amount that an individual can accumulate in a tax-preferred retirement account is a new proposal in the 2014 budget. According to the summary for this proposal, "Individual Retirement Accounts and other tax-preferred savings vehicles are intended to help middle class families save for retirement. But under current rules, some wealthy individuals are able to accumulate many millions of dollars in these accounts, substantially more than is needed to fund reasonable levels of retirement saving. The Budget would limit an individual's total balance across tax-preferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement, or about $3 million for someone retiring in 2013."
Note that by using the term tax-preferred, the proposal includes both traditional and Roth IRAs, but with such a high limit in the first place, this proposal would only impact ultra high net worth individuals by prohibiting them from making additional contributions once they reach the cap.
#6 - Eliminate "Stretch IRAs"
A "stretch IRA" refers to an individual retirement account that is inherited by a beneficiary who is eligible to take the required minimum distributions from the account over the beneficiary's own life expectancy. This includes any type of individual beneficiary (such as children, grandchildren, nieces, nephews, even friends), but not charitable beneficiaries since they do not have a life expectancy. It also does not apply to surviving spouses, who can simply elect to take an IRA inherited from a deceased spouse and roll it over into their own IRA.
The advantage of stretch IRAs from an estate planning perspective is that if a grandparent leaves the IRA to a grandchild, then the IRA can continue to grow tax-free for the benefit of the grandchild since the grandchild's life expectancy will require the grandchild to withdraw relatively small required minimum distributions over many, many years, leaving the principal and much of the tax-free growth inside the IRA.
So how could Congress tinker with stretch IRAs to make them unattractive? President Obama's budget proposals have attacked stretch IRAs by requiring inherited IRAs to be completely cashed out during the five years following the deceased IRA owner's death. This, in turn, will force the beneficiary to pay income taxes on the withdrawals over five years and do away with the concept of stretch IRAs.
It is important to note that in early 2012, Senator Max Baucus (D - MT) tried to attach stretch IRA killing legislation to a highway bill, but in the end these provisions were stripped from the bill. Therefore, it is quite possible that this proposal will make its way back on the table sooner rather than later.
Where Do We Go From Here?
As mentioned at the very beginning of this article, Congress is in need of more revenue to support the U.S. government's current spending habits. Thus, in the remaining years of the Obama administration, Congress will be looking for "creative" ways to raise revenue. President Obama's budget proposals give Congress a road map to implementing legislation that will only affect a small number of taxpayers but will result in billions of dollars in new revenue. And since it is very likely that some or even all of these proposals will be included in the ongoing debate over comprehensive tax reform, don't be surprised if one or more of the proposals discussed above become law in the next few years. Therefore, it is important to keep current on the Obama administration's revenue-generating proposals and the ongoing discussions about completely overhauling the four-million word Internal Revenue Code in order to avoid being blind-sided by a change that will affect your estate tax planning.