New Treasury proposal would hammer wealthy investors using clever tax strategies

Wealthy Americans already face new restrictions when transferring assets to heirs, particularly when retirement accounts are involved. Now there’s additional sobering news.

In a little-noticed proposal last month, the Treasury Department said it would “claw back” the tax savings of several wealth planning strategies come 2026. That’s the year when the historically high exemption levels for gift and estate taxes are due to be sliced in half. The proposal reflects the Biden administration’s concern that affluent Americans are racing to use clever strategies during the window to create “artificial” gifts to pass on tax-free wealth to future generations.

The April 26 proposal targets strategies in which a taxpayer gives assets to a beneficiary while maintaining control over, or a substantial interest in, them — what the Internal Revenue Service considers to be a disguised gift that’s taxable. But the proposal also takes aim at a staple of estate planning.

It’s a fresh blow to affluent investors and their advisors who thought their careful plans were laid in stone. Financial Planning first reported last September that Treasury was considering the curbs.

“People need to re-evaluate the transactions they’ve done,” said Martin Shenkman, an estate planning lawyer in Fort Lee, New Jersey. “There will be unpleasant surprises for some, and the challenges are daunting.”

Under scrutiny
One arrangement in the crosshairs is a partnership in which a regular interest is given to an heir while the donor retains a preferred interest. Another scenario concerns a promise by a donor to make gifts to a recipient in the future. Still another example involves a trust to which a grantor transfers assets but also receives income from the gifted property. 

In all three instances, the moves use up some or all of a donor’s exemption, which this year is just over $12 million (twice that for married couples). Those temporarily higher levels, a product of the 2017 tax-code overhaul, will fall by roughly half come 2026. For people using the strategies who die that year, the Treasury proposal would claw back taxes on transferred amounts that exceed the lower exemption levels. The lifetime gift and estate tax rate is 40%.

Such taxpayers “would not be able to lock in the currently high use-it-or-lose exemption amount,” said Justin Miller, a partner and the national director of wealth planning at Evercore Wealth Management, in San Francisco.

Pickles
A common estate planning technique can also get caught — even though the strategy, grantor-retained annuity trusts, don’t technically involve artificial gifts. Under Treasury’s proposal, the IRS would calculate the tax bill of a donor who retains an interest of more than 5% of the value of assets she transfers to a GRAT under the lower exemption. If the donor dies before the trust’s term ends, that means her stake is pulled back into her estate – resulting in a bigger tax bill on assets she thought she’d moved out.

Say a donor put $100 million into a GRAT for the benefit of her children last year. Under IRS rules, the trust pays her a yearly “annuity” that totals slightly more than the value of the contributed property or cash over time. In the eyes of the tax agency, the paybacks reduce the taxable value of the gift, say in this case to $10 million. So the donor has shifted $100 million out of her estate for the benefit of her kids, but used up only $10 million of her current exemption. Meanwhile, the trust appreciates, and its gains go to the children tax free. Under the proposal, because the taxable value of the gift is more than 5% of the transferred amount, the donor hasn’t locked that $10 million of her currently higher exemption. She would thus face a higher tax bill come 2026.

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One big issue, Shenkman said, is that the strategies on the firing line are irrevocable. They’re legal contracts that can’t be unwound. “Look at the pickle I’m in!” he said. “I’ve used up my (current) exemption, but it will be clawed back if I die after 2025. At least give me my exemption back so I can do something else!”

Saved by zero
Clary Redd, an estate planning lawyer and partner at law firm Stinson in St. Louis, said the 5% rule wouldn’t apply to a so-called zeroed-out GRAT, in which annuities equal the original value of what was put into the trust. That’s because under current IRS rules, such a trust doesn’t use up any of a donor’s exemption, even as it moves money out of his estate. Assets in that trust, a staple with the 1 percent, appreciate over time, and whatever’s left over after annuities are paid out goes to heirs tax-free.

The proposal also doesn’t affect nuts-and-bolts planning in which a donor bequeaths property while keeping control or possession of it while alive. For example, if Grandma and Grandpa have an estate worth $20 million and set their son up to inherit $7 million when they die, they can safely use their current exemption of over $24 million if they pass away after 2026. “Go big, or don’t bother,” says PNC of the high exemption levels on its website. “Act before the window of opportunity closes.”

“This is welcome certainty for taxpayers and their advisors who can now look to 'completed gift' techniques,” said Kevin Ghassomian, a tax partner at law firm Venable in Los Angeles and New York.

Advisors, tax lawyers, accountants and others have until July 26 to submit comments on the proposal before Treasury takes further steps or changes toward making it the law.

The 10-year itch
Wealth advisors are already chafing from severe curbs on inherited retirement accounts. Under a law that Congress passed in 2019, heirs to traditional individual retirement accounts (IRAs) and workplace retirement plans, including 401(k)s, 403(b)s for educators and 457(b) deferred compensation plans, can no longer “stretch” required minimum withdrawals out over their lifetimes. Instead, they have to drain the accounts within 10 years.

In May 2021, the IRS said that beneficiaries of the accounts weren’t required to take annual distributions prior to the 10-year deadline. Advisors breathed a sigh of relief, because it gave the tax-deferred accounts more time to appreciate in value. 

But on Feb. 23, Treasury reversed course, issuing another little-noticed proposal to require minimum annual distributions in years one through nine. That rule applies to heirs who aren’t spouses or children under age 18 and who inherit a retirement account (not including Roth plans) starting in 2020. The Wall Street Journal reported on May 7 that beneficiaries (other than spouses and children under age 18) of an account whose owner dies after 2019 would have to make annual taxable withdrawals that drain the account by the 10th anniversary of the donor’s death. For some heirs who assumed they could wait until year 10 to empty out the account, thus allowing it to grow over years one through nine, the proposed rule threatens to hit them with the penalty.

With the latest proposed curbs, “people did a lot of creative planning in good faith to use the exemption before it gets reduced, and now the IRS is saying, 'gee, that planning you did was a little too painless'," Shenkman said. "It’s a little bit unfair.”