Preserving Your Legacy
The recently released Green Book has proposed far-reaching changes to the taxation of capital gains and the treatment of property that is gifted or is transferred at death. This includes taxing capital gains at ordinary income rates and treating the receipt of assets because of death as a realization (taxable) event. Also proposed is the reduction of the estate and gift tax exemption amount from $11.7 million to $3.5 million.
These proposed reforms purport to reduce economic disparities among Americans and they would raise needed revenue. This combination of events has caused more people to be aware of what they have, or have not, done for a succession plan. There should be a renewed sense of urgency around evaluating your plan. Every year successful businesspeople review and update their operating plans. That same thing should happen with succession plans.
Current Law
Long-term capital gains and qualified dividends are taxed at graduated rates under the individual income tax, with the highest rate at 23.8% when including the “net investment” income tax, when applicable. Capital gains are taxable only upon sale or other disposition of an appreciated asset, “realization.” Upon a gift the basis is "carried over" from the donor to the donee. There is no realization of capital gain by the donor at the time of the gift, and there is no recognition of capital gain (or loss) by the donee until the donee later disposes of that asset.
Furthermore, when an asset is held by a decedent at death, the basis of the asset for the decedent's heir is adjusted to the fair market value of the asset at the valuation date of the decedent's estate. As a result, any appreciation on assets accruing during the decedent's life avoids federal income tax but is subject to the estate tax if the total estate exceeds the exemption amount currently at $11.7 million.
Green Book Proposals
Change in Tax Rate
Long-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million would be taxed at ordinary income tax rates, currently with 37% generally being the highest rate (40.8% including the net investment income tax, if applicable). This proposal would be effective for gains required to be recognized after "the date of announcement." This date may be as early as in April of this year, the date that Biden first discussed his proposal.
Change in Taxable Triggering Event for Gifts and Estates
Under the proposal, the donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer. A transfer would be defined under the gift and estate tax provisions. The asset would be valued using the methodologies currently used for gift or estate tax purposes. For a donor, the amount of a gain realized would be the excess of the asset's fair market value on the date of the gift over the donor's basis in that asset. For a decedent, the amount of gain would be the excess of the asset's fair market value on the decedent's date of death over the decedent's basis in that asset. That gain would be taxable income to the decedent on "the Federal gift or estate tax return or on a separate capital gains return." Beware, the triggering of these gains could put you income over that $1 million threshold.
The Green book provides other detail on triggering events. A transferred of partial interest would be its proportional share of the fair market value of the entire property. Also, transfers of property into, and distributions in kind from, a trust, partnership, or other non-corporate entity, other than a grantor trust would be recognition events. The deemed owner of a revocable grantor trust would recognize gain on the unrealized appreciation in any asset distributed from the trust to any person other than the deemed owner or the U.S. spouse of the deemed owner. All of the unrealized appreciation on assets of such a revocable grantor trust would be realized at the deemed owner's death or at any other time when the trust becomes irrevocable. There is a new 90-year rule. Gain on unrealized appreciation also would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years. The testing period would begin on January 1, 1940. The first possible recognition event for any taxpayer under this provision would thus be December 31, 2030.
Certain Exclusions
Transfers by a decedent to a U.S. spouse or to charity would carry over the basis of the decedent. Capital gain would not be recognized until the surviving spouse disposes of the asset or dies, and appreciated property transferred to charity would not generate a taxable capital gain. However, a transfer of appreciated assets to a split-interest trust would generate a taxable capital gain, with an exclusion allowed for the charity's share of the gain based on the charity's share of the value transferred as determined for gift or estate tax purposes.
The proposal would exclude from recognition any gain on tangible personal property such as household furnishings and personal effects (excluding collectibles). The $250,000 per-person exclusion under current law for capital gain on a principal residence would apply to all residences and would be portable to the decedent's surviving spouse, making the exclusion effectively $500,000 per couple. The exclusion under current law for capital gain on certain small business stock under Code Sec. 1202 would also apply.
In addition to the above exclusions, the proposal would allow a $1 million per-person exclusion from recognition of other unrealized capital gains on property transferred by gift or held at death. The per-person exclusion would be indexed for inflation after 2022 and would be portable to the decedent's surviving spouse under the same rules that apply to portability for estate and gift tax purposes (making the exclusion effectively $2 million per married couple). The recipient's basis in property received by reason of the decedent's death would be the property's fair market value at the decedent's death. The same basis rule would apply to the donee of gifted property to the extent the unrealized gain on that property at the time of the gift was not shielded from being a recognition event by the donor's $1 million exclusion.
Payment of tax on the appreciation of certain family-owned and operated businesses would not be due until the interest in the business is sold or the business ceases to be family-owned and operated.
The proposal would allow a deferral election with a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death with some exclusions such as for liquid publicly traded financial assets. The IRS would be authorized to require security at any time. That security may be provided from any person, and in any form, deemed acceptable by the IRS.
The IRS would be granted authority to issue any regs necessary to implement the proposal. These would include rules and safe harbors for determining the basis of assets in cases where complete records are unavailable, and reporting requirements for all transfers of appreciated property including value and basis information.
This triggering event portion of the proposal states it would be effective for gains on property transferred by gift, and on property owned at death by decedents dying, after December 31, 2021, and on certain property owned by trusts, partnerships, and other non-corporate entities on January 1, 2022.
Change in Estate and Gift Tax Exemption
As mentioned earlier, one of the primary revenue raisers would be a reduction of the estate and gift tax exemption amount from $11.7 million to $3.5 million. For example, an estate of $5 million which is currently under the $11.7 million limit would be taxable for amounts over $3.5 million or approximately $546 thousand in tax ($5 million, minus $3.5 million, times current estate rate).
Annual gifting is one strategy to consider to help reduce the impact of any decrease in estate exemption. Current limits allow for gifts up to $15,000 per donee per year however when a donor is married, a donor can gift another $15,000 by their spouse to the same donee, as well. While gifting above annual limits will necessitate a gift tax return, no tax will be owed as long as amounts are under the lifetime exemption limit. It is possible to use the full exemption limit ($11.7 million) even if it is latter lowered to $3.5 million. The IRS has confirmed that it will not claw back tax on lifetime gifts if the exemption is subsequently lowered. (IR-2019-189).
With the new focus on raising additional tax revenue from wealthy taxpayers and corporations, planning is more important then ever. Future higher corporate tax rates may mean that the old planning tools of Section 351, contribution of assets to corporations, Section 355, corporate splits, Section 368, tax free reorganizations and Section 1031, like kind exchanges might not be appropriate for future years. Section 1031 has already been modified and is still under attack to limit its benefit and the other sections may soon follow.
Summary
Succession planning should be reviewed, and action should be taking where appropriate to minimize the impact of any laws that are passed. Trusts, partnerships and other non-corporate entities currently used for estate planning are in the administration’s crosshairs for added taxation, see the 90-year rule. Gifting under the current exemption limits might be in order but again these are still proposals so any gifting should make long term economic sense. Your tax advisor should be of help in the review of your succession plans to help preserve your legacy.