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President Obama's Budget Proposals Could Impact Estate Planning

on . Posted in Estate Planning Blog

President Obama’s recently published FY2016 budget includes several tax proposals which, if enacted, would significantly affect the estate planning landscape. Some of these proposals include:M

1. Decrease of Estate, Gift, and GST Tax Exemptions and Increase of Tax Rate

There is currently a federal estate, gift, and GST tax exemption of $5 million per person, indexed for inflation. With indexing, the exemption amount in 2015 is $5.43 million. The current tax rate on gifts and bequests above that amount is 40%. Under the American Taxpayer Relief Act of 2012, these parameters were characterized as permanent. Now, however, the President is proposing to lower the parameters to provide only a $3.5 million exemption for estate and GST taxes and a $1 million exemption for gift taxes, neither of which would be indexed for inflation. In addition, the proposal would increase the maximum tax rate for estate, gift, and GST taxes to 45%.

2. Repeal of Step-Up in Basis Rule for Inherited Capital Assets

Currently, when an individual inherits a capital asset, he or she receives a “stepped-up” basis. This means his or her value in the property is equal to its fair market value on the date of the decedent’s death, rather than the value at which the decedent originally purchased the asset. The step-up in basis rule enables individuals who inherit appreciated capital assets to sell them without the appreciation ever being taxed.

For example, if a decedent dies owning a building he purchased years ago for $500,000 that is now worth $2,000,000, his or her heir will receive a basis in the property of $2,000,000. If the heir then sells the property for close to fair market value, he or she will only realize a gain on the difference between the sale price (roughly $2 million) and the stepped-up basis (also $2 million). Because the heir will recognize little to no gain on the sale, he or she will owe very minimal, if any, tax. In contrast, had the decedent sold the building just prior to death for its fair market value, he or she would have realized a gain of $1,500,000, or the difference between the sale price ($2 million) and the decedent’s basis ($500,000), and would owe tax on that amount.

The President has proposed eliminating the tax-free step-up in basis entirely, by treating death as a tax realization event analogous to a sale. In effect, this proposal would require the estate of a decedent who owned an appreciated asset at death to immediately pay federal capital gains tax on the difference between the asset’s fair market value and the decedent’s original basis. In the illustration above, this means that the decedent’s estate would be required to pay capital gains tax on the $1,500,000 difference between the fair market value and the decedent’s basis.

In an effort to protect the middle class, the proposal contains a few exclusions and exemptions. First, for couples, no tax would be due until the death of the second spouse. In addition, there would be a basic exemption of capital gains of $200,000 per couple ($100,000 per individual) and a $500,000 exemption per couple ($250,000 per individual) for a primary residence. These exemptions would be portable between spouses. Finally, no tax would be owed on gifts or bequests to charity or of small, family-owned businesses. In practice, these exemptions and exclusions are too small in value and too narrow in application to afford any real protection against the proposed tax on inherited capital assets.

3. Increase of Maximum Rate on Long-Term Capital Gains

Exacerbating the effect of the President’s proposed treatment of inherited capital assets is the fact that he has also proposed raising the maximum tax rate on long-term capital gains from 23.8% to 28%. As a result, not only would tax on appreciated capital assets be due immediately upon a decedent’s death, it would be due at a higher rate.

4. Restrictions on Grantor-Retained Annuity Trusts (GRATs)

The President has proposed a variety of modifications to the rules for GRATs that would make the use of a GRAT a significantly less valuable estate planning strategy. A GRAT is an irrevocable trust funded with assets expected to appreciate in value, in which the grantor retains an annuity interest for a term of years (typically 2-5 years). At the end of that term, the assets remaining in the trust, as well as any appreciation on the assets, pass to the grantor’s beneficiaries or to a trust for their benefit, tax free.

The President’s proposal would require a GRAT to have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years. This requirement would introduce some downside risk in the use of a GRAT. In addition, the proposal would require that a GRAT’s remainder interest at the time of creation have a minimum value of the greater of 25% of the value of the assets contributed or $500,000. This requirement would eliminate the use of “zeroed-out” GRATs (whereby the present value of the future annuity payments is equal to the valuation of the assets initially placed in the trust, resulting in no taxable gift and minimal use of donor’s lifetime gifting exemption).

5. Modification of Annual Gift Tax Exclusion

Under current law, the annual federal gift tax exclusion allows each individual to gift up to $14,000 to any number of donees, without being subject to gift tax and without those gifts counting against the person’s $5 million lifetime exemption. To qualify for this exclusion, a gift must be a present interest (meaning the donee must have the immediate right to the use, possession, and enjoyment of the property or income therefrom). The President’s proposal would eliminate the present interest requirement for annual exclusion gifts. Instead, the proposal would subject more gifts to tax by limiting the amount each donor may exclude from gift tax to $50,000 per year. As result of this limitation, when a donor’s total gifts in any single year exceed $50,000, the excess would be taxable, even if the gifts to each individual donee did not exceed $14,000.

It is unlikely that Congress will adopt any of these proposals in their current form. Nevertheless, the President’s proposed tax changes are important because they reflect the starting point for negotiations and suggest the direction in which tax reform could be headed. Please contact any of the attorneys in Pabian & Russell, LLC's Estate Planning practice group if you would like to discuss any of these matters.

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