By: Jim Picerno
Director of Analytics, The Milwaukee Company
Dynasty Trusts (“DTs”) have long been prized as a tool for efficiently transferring wealth between generations. But if some proposals now under consideration in Washington become law, the value of this tax-savvy estate-planning tool could take a hit, perhaps to the point of crippling DT’s value for tax planning.
A warning shot arrived in the spring with the release of the White House’s “Green Book” -- formally titled the General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals. The document outlined several possible revisions that, if implemented, would greatly limit a DT’s effectiveness at facilitating wealth transfers.
One such proposal is the introduction of what some analysts say would be the first retroactive increase in capital gains taxes in American history. The revision would require trusts to periodically pay capital gains tax every 90 years on increases in the value of the assets the DT holds. What’s more, the proposal starts the clock ticking on January 1, 1940, which means that the first payment triggered by this change would be due as early as 2030. Even if a trust continuously held property since 1940 – with plans to continue holding indefinitely -- the proposal would treat the asset as if it were sold by the end of the 90-year period.
The Green Book also proposed to make the receipt of a gift or bequest a taxable gift. More specifically, any transfer of property would be treated as a sale of the property and the capital gains will be taxed, with gains over $1 million being taxed at the new 39.6% rate (plus the 3.8% net investment income tax).
On September 13, the House Ways and Means Committee released its own set proposed tax increases. Some commentators see these modifications as “softening” those proposed by the Green Book. The motivation for the changes is partly political. Notably, Democrats in states dominated by Republicans may be reluctant to go too far in eliminating tax benefits in order to preserve their re-election appeal. However, the Ways and Means Committee draft still represents a fundamental shift to the tax regime’s treatment of DTs.
The Committee’s proposal would no longer treat gifts and bequests as a sale, but it does include multiple changes that affect DTs that are structured as grantor trusts. This is a reference to an individual – the “grantor” – who establishes the trust and pays the income tax on behalf of an otherwise irrevocable trust over which they have no ownership.
“If a Dynasty Trust is a ‘grantor trust,’ then its income is taxed on the grantor’s personal income tax returns,” explains Maureen O'Leary-Guth, president and owner of O'Leary-Guth Law Office, S.C. in Thiensville, Wis. who also consults with The Milwaukee Co. on estate planning issues. “Currently, a trust can be a grantor trust for income tax purposes even though its assets are excluded from the grantor’s estate for estate tax purposes.”
If the change prevails, the impact on trusts will be substantial. That’s because the proposal includes adding grantor trusts to the grantor’s taxable estate, making them virtually obsolete as an estate planning tool – and potentially causing major problems for such trusts that are already in existence.
“Under current law, a dynasty trust is either never subject to transfer taxes, or only subject to transfer taxes once, when established,” notes Andrew Willms, founder and CEO of The Milwaukee Co., which provides wealth management services for high-net-worth individuals and families. “A change in the law that would subject the trust assets to once-a-generation taxes could be the death knell for dynasty trusts.” These changes would be a radical shift since many dynasty trusts in years past have been established to avoid estate, gift and generation-skipping transfer taxes by taking advantage of laws in some states that permit DTs to exist in perpetuity.
The Ways and Means Committee proposal also wants to tax a sale from a grantor to a grantor trust -- currently such sales are non-taxable.
As of this article’s writing, nothing has been passed yet to change the current laws. As a result, additional revisions are possible before the final round of proposals are set. In the meantime, estate planners are warily monitoring the ebb and flow of discussions in Washington.
“If the political stars align for President Biden, the tax law proposals could be signed into law by the end of the year,” says Peter Smiley, an attorney who specializes in estate and tax planning for O'Leary-Guth Law Office, S.C. He expects that changes that reduce the appeal of dynasty trusts for estate-planning purposes would grandfather in many prior transactions with existing trusts.
“There’s still a lot of work to be done to finalize the proposals,” Smiley reminds, and so the proposed changes to dynasty trusts aren’t imminent as a matter of law. But the clock is ticking.
“If you’ve been thinking of setting up a trust to efficiently pass wealth on to future generations, acting sooner is better,” he advises.