Editor’s Note: This is the second of three parts on the impact of the 2024 Green Book on trust and estate planning. Read Part 1.
On March 9, the Biden administration released its proposed budget calling for an increase of trillions in federal spending along with his proposed offsetting revenue raisers in General Explanations of the Administration’s Fiscal Year 2024 Revenue Proposals (the 2024 Green Book.) Aside from proposing a minimum tax on certain high-net-worth individuals and treating income tax payments required to be made by the grantor under the grantor trust rules as taxable gifts to the trust, as discussed in Part 1 of this article, the 2024 Green Book also proposes new restrictions on grantor retained annuity trusts and charitable lead annuity trusts.
GRATs and CLATs
The 2024 Green Book targets two vehicles commonly used in transfer tax planning—GRATs and CLATs. The proposal on GRATs is the same proposal that appeared in last year’s Green Book and was previously proposed in the Obama administration’s final two Green Books. The proposal would eliminate short-term GRATs and so called “zeroed-out” GRATs, where the value of the retained annuity interest of the grantor is equal to the value of property transferred, resulting in a taxable gift at or near zero. To do this, the proposal requires a GRAT: (1) to have a term of at least 10 years, (2) last no longer than the life expectancy of the grantor plus 10 years and (3) to have a remainder interest (that is, the amount of the taxable gift) to be at least the greater of (a) 25% of the value of the assets contributed or (b) $500,000 (not to exceed the value of the gift).
The proposal on CLATs has not appeared in prior Green Books. A CLAT is a trust in which an annuity is paid to charity for a term of years and at the end of the term, any remaining property in the trust passes to a noncharitable beneficiary. As with a GRAT, only the present value of the remainder interest is subject to gift tax, which means under current law the trust can be structured so the remainder interest is valued at or near zero (a so-called “zeroed-out CLAT”). As a result, appreciation in excess of the present value calculation passes gift or estate tax free with a corresponding 100% charitable deduction. More transfer tax benefits can be achieved by deferring the amounts that need to be paid to charity by starting with a smaller annuity in the first year that increases each year. Unlike a GRAT, a CLAT isn’t limited to a 20% increase each year, which has led to a technique commonly referred to as a “shark fin CLAT,” deriving its name from the shape of the exponential increase in the annuity percentage over the life of the CLAT. The 2024 Green Book would end the use of zeroed-out CLATs by requiring the noncharitable remainder interest to be at least 10% of the value of the property used to fund the trust. Further, annuity payments would need to be a level, fixed amount over the term of the CLAT.
Ending the Perpetually GST Tax Exempt Trust
By effectively using a taxpayer’s generation-skipping transfer (GST) exemption to transfer assets to a trust that can exist in perpetuity (or at least several centuries), it’s possible to shield assets from the imposition of transfer taxes indefinitely. Various proposals from Democrats over the years have called for these GST-exempt dynastic trusts to become nonexempt after a period of years. The 2024 Green Book carries over a proposal the Biden administration introduced whereby GST tax exemption would only apply to exempt from GST tax: (1) distributions to beneficiaries who are no more than two generations below the transferor or those who are assigned to a younger generation but were alive when the trust was created and (2) a trust on the death of the last in a generation (that is, a taxable termination) for as long as one of the aforementioned beneficiaries is living. The proposed change would apply to both pre-enactment and post-enactment trusts. Pre-enactment trusts will be treated as having been created on the enactment date in identifying which beneficiaries are alive, and the transferor will be deemed to be in the generation immediately above the oldest generation alive at the time of enactment.
This year’s proposal adds two additional proposals to limit techniques to mitigate or defer the imposition of a GST tax liability. The first targets sales between trusts. If a GST tax exempt trust makes a purchase of property that’s subject to the GST tax, the proposal would require a redetermination of the purchasing trust’s inclusion ratio. The value of the purchased assets would be added to the denominator of the fraction with only the amount of that property that was exempt from GST taxes before the purchase would be added to the denominator. This proposal would apply to all post-enactment transactions.
The second targets the inclusion of charitable beneficiaries as a mechanism to avoid GST taxes. The perceived abuse, as described in the 2024 Green Book, is that charities are being included by taxpayers as beneficiaries of non-GST exempt trusts solely or primarily because they aren’t skip persons for GST tax purposes, thereby avoiding a taxable termination event on the death of the last non-skip person to die. The 2024 Green Book states this is being done “even though that organization may be unlikely to ever receive a distribution.” The proposal would ignore any charitable interest for GST tax purposes for all taxable years after enactment, thereby causing taxable terminations to occur for trusts that were relying on the charitable interests as the only non-skip beneficiary of a trust. Notably, the Treasury regulations already contain an anti-abuse provision that disregards any interest if used primarily to postpone or avoid the GST tax, so this proposal is more likely to impact trusts when the charity has a substantive interest.
The use of loans for estate-planning purposes, especially when interest rates are low, can be a very useful estate-planning technique. The 2024 Green Book targets loans to beneficiaries as being used to avoid the income and GST tax consequences of a distribution and suggest they’re often forgiven or otherwise not paid back and it’s difficult for the Internal Revenue Service to track. The perceived loss of federal income tax revenue likely refers to the uncompensated use of trust property by a beneficiary such as with a below-market loan but also with respect to the use of real or tangible property owned by the trust. For GST tax purposes, a loan to a beneficiary who’s a skip person from a non-GST tax exempt trust would avoid GST tax on a taxable distribution unless and until the note is forgiven. Further, grantors in need of liquidity may take a loan from the trust, which doesn’t reduce the value of the trust and the loan may be taken as a deduction on the grantor’s estate tax return to the extent it hasn’t been repaid.
The 2024 Green Book proposes to treat loans to and use of trust property by a trust beneficiary as a distribution for income tax purposes, resulting in distributable net income carrying out to the borrowing beneficiary. This is a similar result to IRC Section 643(i), which applies to certain loans to, and the uncompensated use of trust property by, a U.S. person from a foreign trust. Further, it will also be treated as a distribution for GST tax purposes, meaning that if the beneficiary is a skip person and a loan is taken from a nonexempt trust, GST taxes would be imposed (though a refund would be available if the loan was repaid). The proposal will give regulatory authority to the Treasury Department to identify transfers that would be excluded, such a short-term loans and the use of real or tangible property by a beneficiary for a minimal number of days.
To discourage the grantor of a grantor trust from taking a loan, the 2024 Green Book proposes a special rule for GST tax purposes. If the grantor or the grantor’s spouse takes a loan from a grantor trust, on repayment, the amount repaid will be treated as an additional contribution to the trust. As a result, it would use the borrower’s GST tax exemption to the extent the borrower still has any exemption. In the absence of remaining exemption, transfers to a trust that would constitute an indirect skip would increase the trust’s exclusion ratio or a direct skips would trigger GST taxes. Notably, this could create a planning opportunity for a non-GST exempt if the grantor’s spouse has GST exemption remaining.
Capping Annual Exclusion Gifts
While President Biden hasn’t proposed lowering the estate tax exemption while in office, the 2024 Green Book introduces a proposal to limit how much a taxpayer can transfer using the annual exclusion under IRC Section 2503(b). Under current law, each year a taxpayer may exclude from taxable gifts the first $17,000 in transfers of a present interest in property per donee. Since the creation of the gift tax in 1932, there’s been an amount that can be excluded per donee. The legislative intent behind the annual exclusion was “to obviate the necessity of keeping an account of and reporting numerous small gifts, and … to fix the amount sufficiently large to cover in most cases wedding and Christmas gifts and occasional gifts of relatively small amounts.” Despite the intent of the statutory language, it’s been used as a wealth transfer vehicle to transfer substantial amounts free of gift tax. This includes funding irrevocable life insurance trusts (ILITs) with the use of Crummey powers as well as making transfers of partial interests in closely held entities when the donee has minimal rights to the enjoyment of the property effectively giving the donor a level of retained control.
The 2024 Green Book brings back a proposal advanced during the Obama administration to curb the use of annual exclusions as a transfer tax savings tool. Under this proposal, the requirement that a donee receive a present interest in property for it to qualify for the annual exclusion is eliminated. Instead, a new category of transfers would be created for any transfer to a trust (except IRC Section 2646(c)(2) trusts) and transfers of an interest in a passthrough entity, a partial interest in property and “other transfers of property that, without regard to withdrawal, put, or other such rights in the donee, cannot immediately be liquidated by the donee.” There would be a $50,000 limit on transfers to this new category that could qualify for the annual exclusion. In effect, the annual exclusion per donee limit will continue to apply, but the government will no longer need to scrutinize whether the donee’s rights in a trust or entity are sufficient to constitute a present interest in property, and the amount that can be transferred to, or consisting of such planning vehicles has been curbed.
To illustrate an example of how this proposal would impact an ILIT trust: take the case of an ILIT that gives the grantor’s 10 descendants a Crummey power to withdraw up to the annual exclusion amount. Under current law, if the grantor transfers $170,000 to the trust in 2023, all funds are excluded from taxable gifts under IRC Section 2503(b) ($17,000 multiplied by 10 donees). Under the proposal, next year if $170,000 was transferred to the trust, only $50,000 would be excluded, and there would be a taxable gift of $120,000. This could cause substantial issues for existing ILITs that rely on annual exclusion transfers for large policy premiums. The donor would still be able to make outright gifts to any one or more of the 10 donees of the difference, which using this example would be $12,000 per donee.