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Congress has proposed a new tax on Billionaire’s (but it actually might apply at $100 million of … [+]
Introduction
Senator Wyden has proposed new taxes to tap the very rich. One goal is to stop a common tax plan (some call it a “game”) the wealthy can play. They buy assets that grow in value. Rather than selling them which would trigger a gain and tax on that gain (which ordinary folks like us face) they borrow against the value of the assets, often at terms us regular folks could not get, and use the cash from the borrowing pay lifestyle costs (think yachts and the like). Since they borrowed and did not sell there should be no gain realized on this plan. Then on death the value of the assets is increased to its then fair value. The proponents suggest that this enables the super-rich to avoid paying current tax on what is tantamount to income, then their heirs inherit with a step up in income tax basis that eliminates the gain that would have otherwise been recognized.
And true to all proposals to increase tax on the wealthy, the jargon used is about “closing tax loopholes.”
Will The Law Pass Constitutional Muster?
There are questions as to whether a wealth tax would be constitutional. While the proposed new law might be argued to be a tax on income the calculations and rules of the new regime generally speaking apply based on a calculation of wealth. The Supreme Court will be hearing a case soon on whether the government can tax unrealized gains. Moore v. U.S. No. 22-800. That might provide some insight into the validity of the proposed law.
What Might This Proposal Portend for Merely Wealthy Folk?
The Senate bill applies generally to those with $1 billion of net worth. But it will apply to trusts with 1/10th of that or only $100 million of assets. The House bill that is similar would apply to anyone with $100 million of assets, so a much lower threshold. H.R. 8558.
The Democrats have been proposing for years significant tax increases on the wealthy. These have included restrictions on, or elimination of, many of the estate and income tax planning techniques that the wealthy have used. None of these changes have been enacted. So why yet another change? Well this proposal only supposedly targets billionaires. Perhaps that thought is that those with rocket ships as toys should pay more tax. Perhaps the thought is that the country is so in need of revenue, especially given the significant increase in the cost of debt service as interest rates have risen, that bipartisan support might be achievable for a tax increase that only costs those who are so wealthy that perhaps voters won’t care. Whatever the plan, if this proposal is enacted (and perhaps it might be if the constitutional issues are resolved permitting it to be), what might this type of plan portend for very wealthy but not super wealthy folks? Perhaps if this is enacted it might be expanded to those with merely $25 million of income or $50 million of assets. If that were to occur, those merely rich folk might be next. Perhaps this is a strategic attempt to get some action on restrictions of what perhaps might be called aggressive tax planning. Perhaps this is the first “shot over the bow” of tax restrictions. So, even if you are nowhere in the league of those to be taxed, get familiar with this proposal. This might just be the coming attraction for the old adage: “Coming soon to a theatre near you.”
When Might This All Be Effective?
The new rules, if enacted will be effective for taxable years beginning after December 31, 2023. Yep, that means for 2024. That will give taxpayers lots of time to plan (not!). If that happens, the law might not be enacted until well into 2024, and taxpayers will not have time to plan for the portion of the year that will have already passed.
What About Estate Tax in the Proposals Tax Scenario?
Step-up is an increase (really an adjustment) in the income tax basis on which gain or loss is calculated when an asset is sold. This is done on death when most assets in someone’s estate are marked to have tax basis equal fair market value. Seems that the proponents of this example seem to be leaving out the estate tax on those assets that get a step-up. While some taxpayers might have taken the position that assets outside their estate in so-called grantor trusts (trusts that are regarded for estate planning purposes but not income tax purposes so that the income of the trust is reported by its creator but the assets are excluded from her estate), the IRS has tried to quash that technique. Revenue Ruling 2023-2. But it is not clear how many have taken advantage of that “technique.” Apart from that, it seems you have to pay the estate tax at 40% to get those capital gains to disappear. But that wrinkle may not fit the intended narrative.
Overview of Some Aspects of the Billionaire’s Tax Proposal
There are several key concepts in the proposal. The very wealthy could lose the ability to step up the income tax basis on certain assets on death. That could cost inheritors a bundle. Taxpayers with more than $100 million in income, or more than $1 billion in assets for 3-years will face mark-to-market rules. These could require that marketable assets like stocks and bonds must be valued each year and the increase in value would be taxed regardless of whether you sold those assets. When a closely held business or other non-tradable, or non-marketable, asset is sold wealthy taxpayers would pay, in addition to the regular income tax on their gain, an imputed interest calculated on the amount of tax that had been deferred before the sale. This calculation assumes that the ultimate gain was realized equally in each year since the purchase of the asset. The imputed interest would be paid on the tax that would have been due in each of those prior years until the year of sale. This tax would endeavor to put those with family business or real estate holdings in a comparable position of the those holding stocks and bonds. This mechanism addressed the difficulty, if not impossibility, of determining the value of such non-tradable assets each year. Other mechanisms, all discussed below, will require the super wealthy to recognize gain on the occurrence of certain transactions or events that heretofore had not caused gain to be recognized.
And of course, knowing that the uber wealthy all have lots of smart tax experts to help them, the proposal has transition and anti-abuse rules. The proposal includes detailed definitions of all the new tax concepts introduced. New rules to determine accounting periods and accounting methods are provided for. And of course, to keep the mystery in it all, the Secretary of the Treasury is given latitude to provide rules in the future to clarify the new law and prevent the wealthy from trying to creatively avoid the impact of the new rules. Lots of special rules are also included.
Overview of Rules Eliminating Deferral on Transactions by Wealth Taxpayers
The proposal includes extensive rules to endeavor to limit or prevent very wealthy taxpayers from deferring the gain that they will now, if the new law is enacted, have to recognize, report and pay tax on. Below is a discussion of the new tax law sections that the proposal would enact to limit deferral for the very wealthy to pay tax. There are lots of new terms that must be defined to understand the proposals. Those have been bolded and will be defined in the discussion.
Section 490 Provides An Overview Of The Elimination Of Tax Deferral For Applicable Taxpayers
If there is a taxable event for a tradable covered asset (e.g. stocks or bonds) of any applicable taxpayer (those with $100 million of income or $1 billion of wealth) during the tax year gain or loss will have to be recognized. That means a potential current income tax cost. If there is an applicable transfer of any nontradable covered asset (e.g. a family business or real estate) by any applicable taxpayer during the tax year the tax on any gain will be increased by an interest surcharge (to make the tax on the transfer of non-marketable assets similar to that on a marketable asset, details are below).
The above rules set the stage to tax the very wealthy as if they sold assets each year, regardless of whether they actually have done so. That approach would prevent them from owning valuable appreciating assets and borrowing against them to get cash for new investments or living expenses, and not having to pay income tax on that. While that is the stated intent, the law would tax the very wealthy even if they lived on their salary and were not using this assumed approach to fund their lifestyle.
Section 491 Addresses the Treatment of Tradable Covered Assets
Tradable covered assets (generally marketable securities like stocks and bonds but special rules might include other positions), which are held by applicable taxpayers (the really wealthy) will have to be “marked to market” (the tax basis, which is generally what you paid, will be adjusted to the actual market value at the end of the year) every year. The taxpayer will have to report taxable income, generally as a capital gain (which is subject to a favorable tax rate as compared to other income), based on the value of the stock at the end of the year in excess of the income tax basis of the stock (generally what was paid adjusted for prior year adjustments under this new rule).
Section 492 Deferral Recapture Amount On Applicable Transfers Of Nontradable Covered Assets
As mentioned above, the rules for taxation of non-marketable (referred to as “nontradable”) covered assets, like a family business or real estate seek to place such assets in a similar tax regime as that applicable to marketable securities that are taxed each year. The mechanism to accomplish that is an interest charge assessed on the tax that would have been due if the non-marketable asset appreciated in equal amounts in each year since acquisition and that hypothetical equal annual gain triggered tax on it in each such year. Interest is then calculated on that hypothetical for each year. The actual rule and calculations include many additional details.
· If some of the gain is allocated to years before the taxpayer was an “applicable taxpayer” (i.e., before the taxpayer had $100M of income or $1 billion of assets) that gain is allocated to the first year the taxpayer met the requirements of being sufficiently wealthy to pay this tax.
· The tax rate that is used in the calculation of the imputed is the highest income tax rate for the year of the applicable transfer.
· The calculation also includes the net investment income tax (“NIIT”).
· Interest is calculated at the short-term applicable federal rate plus one percent.
· The period for which interest is calculated is from the date the tax return would have been due for the year in which the imputed or hypothetical gain was allocated (presumably April 15th in the following year) until the date that the applicable transfer occurred (e.g., the sale of the closely held business).
· There is a cap on the total federal income tax inclusive of the imputed interests. It cannot exceed 49% of the gain. If the capital gains tax would have been 20% the cap could still be nearly 2.5 times that amount. If there is a state income tax on the actual gain then obviously the total tax can exceed 50% of the gain.
· Rules are provided as to how capital losses are treated in the calculation.
· Special rules are provided as to how dividends of C corporations are treated for these purposes to prevent paying large dividends to reduce the value of the entity.
· Special rules are also provided for how the rules apply to certain real estate investment trusts (“REITs”).
Section 493 Special Rules For Application Of Nondeferral Rules To Certain Passthrough Entities
This provision provides rules requires looking through entities in which the taxpayer owns 5%, or if the interest has a value of $50 million or more, to report a pro-rata mark to market gains on marketable securities and a flow through of gains on nontradable interests the entity owns. This is a look through to apparently prevent wealthy taxpayers from avoiding the Billionaire’s tax by having interests held inside entities. The provision, and its implementation, will be complex.
An ”applicable owner” subject to this rule is any taxpayer who owns 5% of a non-tradeable (non-marketable, e.g., a family or privately held) entity or for whom the value of the entity interests is $50 million or more.
An ownership in an entity meeting these requirements is subject to similar treatment as marketable securities (“tradable covered assets”) or a non-marketable private entity (“nontradable covered asset”.) An entity subject to these provisions is called an “applicable entity.” It could be a limited liability company (“LLC”), partnership, limited partnership (“LP”), S corporation, etc. The Secretary of the Treasury can identify other entities that might also be included. That approach, which is common throughout this new tax, suggests the intent to have flexibility so that Regulations and guidance can be issued to prevent work-arounds to avoid the new law. That might portend potentially long and complex regulations over many years or decades.
A taxpayer subject to this rule must notify any applicable entity in which he or she has an ownership interest that meets either of the above criteria. Then that entity must provide the requisite information to the taxpayer so that the taxpayer can comply with the new Billionaire’s tax rules. Also, to prevent taxpayers from using tiers of entities to evade these rules the entity notified by the taxpayer may be required to notify lower tier entities. The taxpayer is then required to report gains on their personal income tax return marketable (tradable) assets that need to be marked to market each year, and gains on non-tradable assets based on the rules described above.
In the first year of this new rule the taxpayer will have to take into account all prior built in gains in the entities assets. Because of the potential cash flow impact of this treatment taxpayers may elect to pay that built in gain over five years. Consider the financial impact of this. If a taxpayer owns 5% of an entity they may have not control over distributions from the entity. If the entity has a huge built in unrealized capital gain on a position, the taxpayer may have to report that gain and have no right to get any distribution from the entity. Presumably those proposing the bill are not concerned about the ability of people in this wealth strata to find a means to finance paying the tax bills triggered by these rules.
To avoid double taxation once gains are reported the Secretary of the Treasury is to issue rules providing a mechanism for taxpayers affected to increase their tax basis in their entity interest to avoid a future tax on gains that were already taxed. Those affected will no doubt be adding lots of CPAs to their family offices.
To perhaps minimize the complexity facing entities the entity affected by these rules may choose to elect to treat all its equity owners as applicable taxpayers as to a gain from a traded asset. That will presumably minimize the reporting complexity for the entity. This will therefore be a new provision/concept to address in the governing documents of these entities (e.g., who can make this election, or must the election not be made unless a super-majority of equity holders approve, etc.).
Some pass through entity governing documents may provide that the entity is required to make a distribution to facilitate its owners paying their income taxes on their respective pro-rata shares of entity income. That is done to avoid a cash flow squeeze on the owners. Those subject to the new tax may not be covered by those provisions as it will depend on the language used whether the entity would have to make a sufficient distribution. These types of provisions should be revisited if the law is enacted to be certain that tax distribution provisions function as desired.
Should the governing documents for entities be revised to provide that if they have to incur administrative costs and professional fees to comply with the new law that the equity holders triggering that work will be responsible to reimburse the entity for those costs? Otherwise, a partnership with ten partners, nine of whom are not subject to the Billionaire’s tax could incur costs because one partner is snagged by the new rules.
Section 494 Treatment Of Gifts, Bequests, And Transfers In Trust
Under current law a gifts, bequests, and certain other transfers of assets (e.g., a sale to a grantor trust) are disregarded and do not generally trigger gain. The proposal will treat these transfers as triggering taxable gain for income tax if the transferor meets the wealth or income requirements to be an applicable taxpayer. This would, if enacted, radically change estate planning for the very wealthy.
There are a number of special rules where wealthy taxpayers do not have to recognize gain. For example, a transfer to a spouse who is a U.S. citizen, or indent to a divorce, will not trigger gain.
Certain exceptions apply to this realization rule, including for transfers to a U.S. spouse, surviving spouse, or a former spouse incident to divorce. In addition transfers to or for the benefit of a charity or other specified trusts are exempt from realization. In the case of a charitable transfer in a split interest trust (such as a charitable remainder trust), special rules apply to determine the non-taxable charitable portion. Transfers to “wholly” revocable grantor trusts will not trigger gain. This is directed at revocable or living trusts used to safeguard assets of the aging and reduce or avoid probate implications. It is not clear what “wholly” revocable means and what might violate this requirement. Perhaps for those approaching the applicable taxpayer threshold their revocable trusts might track this language in a manner of saying that “notwithstanding anything herein to the contrary the trust shall be and remain wholly revocable as defined in [reference to new statute]” to avoid an inadvertent tax.
Some revocable trusts include protective mechanisms to safeguard the settlors creating such trusts. For example, the trust cannot be revoked or modified unless an independent person, e.g. the client’s lawyer or CPA concurs with the proposed change. That might be done to prevent a fraudster from taking advantage of an older client. Query, which such a protective mechanism violate the “wholly” revocable and thereby result in a different tax treatment under the Billionaire’s tax?
Similar to prior proposals to tax the wealthy, transfers by applicable taxpayers (those who meet the $100 million income or $1 billion in asset thresholds) to grantor trusts (trusts which are disregarded for income tax purposes and on which the income is reported on the transferor taxpayer’s income tax return) will be treated as taxable realization events. This would dramatically change tax planning for the superrich.
There are other events listed in the proposed law that would also trigger gain:
· The deemed owner of the trust (usually the settlor creating it but other persons in certain instances may be deemed owners) no longer is treated as the owner of the grantor trust assets for income tax purposes. This could result on the death of the owner or the relinquishment of various powers that serve to characterize the trust as a grantor trust for income tax purposes.
· The distribution of assets from a trust (other than a wholly revocable living trust) to the grantor, the grantor’s spouse, or in satisfaction of the owner’s obligation (e.g., a charitable pledge).
· The property would no longer be included in the grantor’s estate for estate tax purposes.
· The death of the deemed owner of the trust.
In general, for transfers where gain or loss is recognized (including transfers involving a disallowed loss)
If the transfer is done at a loss (i.e., the fair value of the asset is less than the cost basis, typically what was paid for it), that loss will be disallowed. But if in the future the property appreciates and is sold or transferred at a gain, the previously disallowed loss may be permitted. This will significantly complicate recordkeeping but presumably those affected will simply hire more CPAs to manage the recordkeeping.
Section 495 Which Taxpayers are “Applicable Taxpayers” Subject to the New Rules?
Which taxpayers meet the requirements to be an “applicable taxpayer” subject to these new taxes? An applicable taxpayer is an individual who meets either of two tests.
· The first test is an income test. The taxpayer must have applicable adjusted gross income of more than $100 million. The same test applies whether the taxpayer testing files a joint income tax return with a spouse, or files a single non-married return. Trust income of $10 million will trigger the filing. This may affect planning. Example: Let’s say a trust is selling a $40 million asset. If it is paid in 1/3rd increments over three years that would pull the trust into the application of the Billionaire’s tax. In contrast, if the sale is for $40 million one time payment the trust may only pass the Billionaire’s tax threshold requirement in one year and will avoid being characterized as an applicable taxpayer.
· The second test is an asset test. The taxpayer must have a net worth (aggregate applicable value of all covered assets) at year end (generally December 31) greater than $1 billion. The same test applies whether the taxpayer testing files a joint income tax return with a spouse, or files a single non-married return. For trusts this is only $100 million or 1/10th the general amount. For taxpayers who are married but file separate income tax returns it would be at a threshold of $500 million. That same amount would apply for a non-resident alien.
· Either of the tests must be met in each of the three prior tax years. Example: So in year-1 the taxpayer may have income in excess of $100 million, in year-2 and year-3 the taxpayer may have a net worth in excess of $1 billion. The taxpayer would be characterized as an “applicable taxpayer” subject to the new tax regime.
· The next rule is a bit like the Roach Motel. Remember the tagline? “Roaches check in, but they don’t check out!” Once a taxpayer is tagged as an “applicable taxpayer” they will continue to be characterized as subject to the new taxes until both the taxpayer’s income and net worth drop below half the income and net worth thresholds for three years. After that three year period (so it is a three year lookback and three year look forward) the applicable taxpayer might choose to no longer be characterized as subject to the new taxes. No doubt the intent of those proposing the new taxes is to minimize the ability of the very wealthy this law targets to manipulate income or assets to circumvent the tax.
· Wealth married taxpayers who file separate income tax returns face a halving of the thresholds to $50 million of income and $500 million of net worth.
· Non-grantor (co-called complex) trusts will also be characterized as applicable taxpayers if they meet the same tests. The trust’s income is determined before any deduction permitted to the trust for distributions to beneficiaries. So trusts will not be able to avoid the income test by making distributions.
· As discussed above, grantor trusts (those on which the deemed tax owner of the trust is taxed on trust income) are aggregated with the income and assets of that deemed owner (usually but not always the person who created the trust). It is not clear how the calculation will be made when a trust converts its status from grantor to non-grantor. Query what happens to the tax paid by the individual? Will the trust that tax reimbursement clause be able to reimburse the settlor/owner for the new tax paid? The issue might arise that this new law could not have been contemplated when irrevocable trusts were drafted including a tax reimbursement clause. Thus, those provisions may not have contemplated the new Billionaire’s tax and beneficiaries or trustees may object to a reimbursement being made. Example: Here is illustrative tax reimbursement language (courtesy of Interactive Legal software): “For each taxable year thereof, the Trustee (excluding, however, any Interested Trustee) may, but shall not be required to, reimburse the Grantor from assets of any trust hereunder for the Grantor’s income tax (Federal, state, local, or foreign) on the amount (if any) of the gross income of such trust that is reportable directly on the Grantor’s return under Code Sec. 671.” Is the new tax really an “income tax” that can be reimbursed? If the sole test the taxpayer passes to be subject to the new tax regime is based on net worth might trustees be worried about making such a reimbursement? Given that the tax on nontradable assets is capped at 49% (federal, not counting state tax) if a grantor trust sells the interests in a family business, and if the trustee is concerned that the reimbursement provision is not broad enough, how will the taxpayer pay for the tax due?
· Grantor trusts have another consideration. Assets in a grantor trust are treated for purposes of the new tax regime as if they are owned by the grantor. While the grantor is usually the settlor who created the trust that is not always the case. The so-called Beneficiary Defective Irrevocable Trust (“BDIT”) is taxed by virtue of this annual demand or Crummey power to a beneficiary and not to the settlor. So, it would seem in that type of trust plan the beneficiary would have to aggregate trust income and assets for purposes of applying the new tax regime. This could result in some surprising results and not the new tax rules should be considered when planning such trusts.
· If a non-grantor trust with $100 million of assets would be tagged by the new Billionaire’s tax what if that trust were divided? Perhaps there are four children who are the primary beneficiaries of the trust. If the trust is divided into four separate $25 million trusts, and the multiple trust rule that could be argued by the IRS to aggregate the trusts did not apply, the proposed Billionaire’s tax could be avoided.
· Certain charitable trusts are excluded from the new tax rules, but the application of this is uncertain as it was noted earlier that CRTs may face a bifurcated calculation.
· Estates are subject to a harsher rule it seems than any other taxpayer. If the taxpayer was subject to the new tax regime in the year of death, i.e., the taxpayer qualified as an applicable taxpayer, then that person’s estate will be an applicable taxpayer. But the estate will be classified as an applicable taxpayer even if the decedent was not an applicable taxpayer in the year of death, but was one in any of the three years prior to death.
Section 496 Special Rules When Characterization As An Applicable Taxpayer Changes
As discussed above, in the first year a taxpayer is characterized as an applicable taxpayer and subject to the new tax regime, they could face a substantial tax on the unrealized appreciation of assets affected. So, the new rule provides some flexibility by permitting the taxpayer affected to pay the tax due in installments over five years. Consider that if assets of the taxpayer are also held in a grantor trust are included in this calculation, presumably since the taxpayer is making the election it will apply to gain inside the grantor trust that the taxpayer is responsible for. But will it? Should the trustee join in the election? Trustees may also seek to ask deemed owners for whom they might make a tax reimbursement whether or not the five-year election was made. If it was, the trustee may want to parse out tax reimbursements accordingly (assuming that tax reimbursements can even be made. See the discussion above).
Applicable taxpayers are given another election option. They might elect to treat gain from private equity, non-marketable assets (called nontradable assets under the new law) as taxable in their first year of being subject to the new law but only for purposes of recognizing an additional gain. The taxpayer can select any value they want for this purpose. While that might suffice for purposes of the new Billionaire’s tax, taxpayers making this election might choose to confirm their valuation of nontradable assets to values that were reported on bank or other third-party financial statements. The law makes it clear that a formal (and typically costly) appraisal is not required. Why would it be when a taxpayer is voluntarily agreeing to pay tax before they otherwise would have been required to. Perhaps someone might opt to do this if they felt that they were in a lower tax bracket now than in the future, but it would seem that most taxpayers subject to this new Billionaire’s tax regime will likely be in the maximum income tax brackets in all years. The reason perhaps to consider this election is that if gain is recognized annually the imputed interest charge/tax would be avoided.
The above elections, to spread gain over five years or to include nontradable asset values in income before required can only be made the first time that the taxpayer is characterized as an applicable taxpayer. So, if the taxpayer falls below the requisite threshold for being subject to the new law, which based on the discussion above would require three years of continual non-qualification, they will not qualify for either election if after that they again are characterized as an applicable taxpayer.
Another special rule permits a taxpayer who meets the criteria to be an applicable taxpayer in the first year this tax regime is enacted can designated $1 billion of tradable stock as being treated as a non-tradable asset. That will facilitate such an electing taxpayer deferring gain on the unrealized appreciation of the stock so that they can continue to hold it into future years until there is a realization event that would affect a nontradable asset.
Section 497 Rules Governing Covered Assets
What assets are subject to the new tax regime? It seems all assets other than certain retirement plans, certain insurance policies, certain annuity contracts and cash. Excluding cash likely has no relevance as when can cash have a different income tax basis from its fair market value? Also, seeing the word “certain,” as in certain insurance policies, should be an alert that there will be rules determining which of those indicated assets are included or not in the new tax regime. But, as should be no surprise, all of these excluded assets are considered when determining whether a particular taxpayer meets the net worth test to be subjected to the new taxes.
As was discussed above, different tax regimes apply to marketable assets then to private equity and real estate assets. Under the new law the former are referred to as tradable covered assets since they are traded on an exchange and the value readily determined. The latter assets are referred to as nontradable covered asset because they are not traded regularly so a value cannot easily be determined until an actual event occurs. While that is the theory, the law actually applies in a different way.
Tradable covered asset is an investment which is traded on an established securities market, or which is readily tradable on a secondary market or an electronic platform so that its value can readily be determined. Derivatives of such assets are also treated as a tradable covered asset. Assets in the second category of nontradable covered assets are any other assets.
As discussed above a taxpayer to be subject to the new law must have $1 billion in net worth so values must be assigned to the taxpayers assets. Marketable or tradable assets are valued at the values on those markets. That seems pretty straightforward. However, values of nontradable assets are complicated because obtaining an appraisal would be costly, unwieldy and would be raised as a major impediment to compliance by those involved. So here’s what the new law seems to provide. For nontradable assets use the value that is the greater of: (1) original cost basis generally what you paid for it (which for many people and assets will be quite low compared to its real current value, or (2) the adjusted basis of the assets (presumably the tax adjusted basis), or (3) the value determined as of the date of the most recent event establishing value (what might that mean? A partner book capital amount?), or (4) the value included in an applicable financial statement which shall be determined pursuant to rules provided by the Secretary of the Treasury. Might that include financial statements given to third parties?
Finally, the value of covered assets is reduced by outstanding debts and liabilities.
Section 498 More Definitions
Recall that tradable or marketable assets may have to be marked to market each year and tax paid. When might gain be triggered on a nontradable applicable asset? When an applicable transfer occurs. That is a sale, exchange, disposition, or other transfer that results in gain being recognized. Also, as noted above there are certain “events” that under general tax rules are treated as non-recognition events but which for purposes of the new Billionaire’s tax will be recognized. Those were referred to as disregarded nonrecognition event. These might include what would otherwise be a tax free formation of a company under Code Section 351 and also the tax free exchange of qualifying real estate assets for new real estate assets under Code Section 1031 rules. See Section 211. And, other transactions the Secretary of the Treasury identifies to prevent wealthy taxpayers from avoiding these rules.
Section 213 Special Rules Apply for Certain Trusts (“Applicable Trusts”)
Grantor trusts are generally taxed to the owner for income tax purposes and aggregated with the owner for purposes of applying the tests under the proposed new tax regime. Non-grantor or complex trusts pay their own income tax and are subject to special rules some of which have been noted above. If a non-grantor trust transfers trust assets to a beneficiary that will be treated as a realization event triggering gain. Also, loans from a trust to a beneficiary are treated the same as distributions. That means they will carry taxable income out of the trust to the beneficiary if the trust meets the requirements to be subjected to the new tax regime. That treatment will prevent wealthy taxpayers from borrowing money from large trusts to qualify. This is similar to proposals made in recent years but only applies to the very wealthy.
Another concept that had been included in proposals over recent years has reappeared here as applicable only to the very wealthy caught in the net of this new tax proposal. This new rule would destroy the ability to create perpetual trusts and grow wealth outside of the estate tax system by forcing trusts to which it applies to recognize gain on trust assets after some specified time period set to be the later of the following: (1) 90 years after January 1, 1940 (December 31, 2030), 90-years after the trust was established, or the last year such property was subjected to tax.
Special rules were provided for foreign trusts.
Section 222 Private Placement Life Insurance And Annuity Contracts
New rules have been proposed for certain annuities and private placement life insurance (“PPLI”) arrangements. One goal of these rules is to prevent very wealthy taxpayers from merely borrowing from PPLI policies to avoid the tax regime under this new system. The rules appear to permit the deferral of income tax a PPLI policy might provide during the insured’s lifetime but at death that deferred gain plus a 10% penalty or additional tax would be assessed. In some cases that tax on death might eliminate the benefit of using PPLI as a planning tool. The tax saving during lifetime would have to be considered and weighed against the cost on death of these new taxes.
Planning Ideas
Following are some possible planning ideas that those who might be affected by the new law should consider. Everyone should also consider the comment earlier in this article, that if this Billionaire’s tax regime is enacted, that it might be expanded in future years to those with far less income or wealth than the thresholds provided. There is no question that many in politics seek to tax the very wealthy and also that the government is in dire need of funds making tax increases more likely:
1. Consummate large transfers to trusts before the end of 2023.
2. Update entity documentation forms to deal with whether or not the entity can elect to have all equity owners treated as applicable taxpayers, and if so what type of vote or approval, and by whom, that decision can be made.
3. Might it prove possible to avoid some aspects of the new law for large non-grantor trusts to be divided into smaller taxpayers to avoid meeting the income or net worth tests? What aggregation rules might apply to separate trusts? Might the multiple trust rule under Code Section 643(f) have any relevance to the new law?
4. Split trust into separate trust with perhaps one trust having appreciated assets and the other not significantly appreciated assets so that the overall income or wealth level of the affected taxpayer can be maintained below the threshold.
5. Use community property trusts to achieve a full basis step up when either spouse dies thereby perhaps reducing the risk of exceeding the income threshold in future years.
6. Sell trust assets to freeze value in selling trust below $100 million.
7. Make gifts to reduce wealth below $1 billion.
8. Make gifts to charitable remainder trusts (“CRTs”) to reduce the size of your asset base. But note that special rules apply for trusts that benefit both individuals and charity (so-called split-interest trusts) such as a CRT that will determine the non-taxable charitable portion. Thus, even with CRTs some gain may have to be recognized on funding. If that is in fact the result the increase in charitable planning to offset the impact of the new taxes may not provide the cover hoped for. While it would seem plausible to fund a CRT in 2023 before the effective date of the new law to avoid this bifurcation of tax impact there is little time before year end and it is unlikely many people would be moved to make significant transfers on the basis of a merely proposed tax change.
9. Revocable trust provisions might track the new statutory language in a manner of saying that “notwithstanding anything herein to the contrary the trust shall be and remain wholly revocable as defined in [reference to new statute]” to avoid an inadvertent tax on a transfer into such trusts.
10. Broaden tax reimbursement provisions in all irrevocable trusts to contemplate this type of tax.
Conclusion
The new Billionaire’s tax provides for a dramatic change in how wealthy taxpayers will be taxed. Many of the concepts have been previously proposed in prior legislation. Perhaps an objective of this new proposal is not only to raise revenue but to limit the changes to only the very wealthy so that perhaps it might be enacted on the basis of the perspective that many Americans view the super wealthy as not paying their fair share of taxes. Given the divisions in Congress it is impossible to predict what might occur. Also, with the growing need for governmental revenue, e.g. to meet debt service in light of higher interest rates, perhaps there may be bipartisan support sufficient to pass this type of proposal. If this proposal does get enacted it is also possible that it will set the stage to make these types of changes for lower levels of still very wealthy taxpayers in the future. There are a number of planning suggestions those who might be subject to these rules might consider.
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