The phrase, “not letting the tax tail wag the investment dog” emerged in the 1960s to discourage business owners from making business based solely upon tax implications. The term “wag the dog” has historically been used whenever a minor detail controls a significant decision. More recently, the term “wagging the dog” has been used to describe how political leaders let loose a flurry of activity to distract their constituents from broader, more significant issues. Just as a small tail should not control an entire dog, a tax attribute should not drive the larger, more significant estate planning decisions.
Recent events in Washington D.C. demonstrate the importance of not elevating potential tax law changes ahead of the more significant family, financial and legal factors impacting estate planning decisions. While I have advised clients and advisors about these potential tax law changes (see my May, 2021, advisory update), as of this morning it appears that none of the substantive tax law changes being proposed will be enacted once the tax bill is signed into law.
In this month’s update, I summarize the new income tax rates that will be applicable to irrevocable trusts, and summarize four important tax rules that remain unchanged.
• Fiduciary Income Rates
The only tax law change impacting estate planning decisions is the increase in tax rates on “non-grantor” or “complex” irrevocable trusts. Trusts with taxable income in excess of $200,000 will face an additional marginal tax of 5%; trusts with taxable income in excess of $500,000 will face an additional marginal tax of 3%. Here is a brief summary of marginal tax rates for Minnesota-based trusts:
Taxable Income: Federal Tax Rates:* Minnesota Tax Rates:
Less than $2,750 10% 5.35%
$2,751 to $9,850 24% 5.35%
$9,851 to $13,450 35% 5.35%
$13,451 to $200,000 37% 7.05% to 9.85%
$200,000 to $500,000 42% 9.85%
More than $500,000 45% 9.85%
• More of the Same: Rules Left Unchanged
While the legislation is not yet finalized, it appears that four important rules will remain unchanged:
Federal Estate and Gift Tax Exemptions
Taxpayers continue to benefit from an historically high federal “unified” gift and estate tax exemptions. By reason of the automatic inflationary adjustments in place under current law, the unified credit applicable to 2022 will be $12,060,000 per person.^ The tax proposal, if enacted, would have decreased the federal exemption to $6,020,000 per person. It is worth nothing that, in the absence of any legislative action before January 1, 2026, the current rules will “sunset,” and the federal estate tax exemption will be reduced to $5.0 million, adjusted for inflation.
“Step Up” in Cost Basis Rules at Death
Taxpayers continue to benefit from the “step up” in cost basis at death for appreciated assets. As a result, family members who inherit assets by reason of death will not pay any capital gains taxes on the immediate sale of the inherited asset(s). There will be no limit or “phase out” of the benefit of the “step up” in cost basis, as had been proposed.
Family Partnership Planning
Taxpayers continue to benefit from the opportunity to take valuation discounts when transferring noncontrolling and unmarketable family business interests. This planning typically involves a three-part strategy, as follows: (1) the senior generation creates a legal entity, such as an LLC or partnership, with the ownership interests in the entity being subject to legal transfer restrictions; (2) the senior generation transfers assets to the entity; and (3) the senior generation gifts some of the entity ownership to the next generation. By reason of the legal restrictions on the transferability of the interest, the value of the gift to the next generations must be “discounted” to account for the transfer restrictions. While the proposals from President Biden and the House aimed to eliminate these valuation discounts, no such changes are being made to the tax code.
Grantor Trust Rules:
Taxpayers continue to benefit from the use of so-called “intentionally defective grantor trusts.” These types of irrevocable trusts are “intentionally defective” in the sense that while the trust assets are excluded from the taxpayer’s ownership for estate tax purposes, the taxpayers retain ownership of the trust assets for income tax purposes. From a tax perspective, the key tax benefit is to allow the appreciation in the value of the contributed assets pass free of gift or estate taxes. In addition to irrevocable trusts created for children and grandchildren, these types of trusts can be established for one’s spouse as a “Spousal Lifetime Access Trust” or “SLAT.”
I am certain that none of the clients with whom I worked over the last year to implement SLAT planning were letting the “tax tail wag the dog.” With each of these families, there were sound family, financial, or business reasons for implementing the gifting strategy. Now, with an increase in income tax rates on complex irrevocable trusts, and the continued retention of the opportunity to use intentionally defective grantor trusts such as SLATs, the beneficial income tax implication with respect to the SLATs is simply “gravy.”