Author: Andrea Costa, Esq., Vice President of Financial Planning
Tax reform continues to be a moving target as we enter into the second half of 2021. Estate planners across the country are attempting to extrapolate likely results from analysis of the 99.5 Percent Act introduced by Senator Sanders, the Sensible Taxation and Equity Promotion (STEP) Act put forth by Senator Van Hollen and others, in addition to the Biden Administration’s Green Book.
(A recording of HORAN’s discussion with Army Robinson regarding the release of the Biden Administration’s Green Book can be found HERE)
One interesting theme is the concept of “deemed realization.” Ordinarily, a “realized” gain occurs when an asset is sold for a higher price than the owner’s basis. Basis is typically the purchase price of an asset subject to certain accounting adjustments. However, upon the sale of an asset, the constantly fluctuating fair market value becomes fixed and liquidated at a particular point in time. Income tax would apply at capital gain rates to the value of the purchase price less the owner’s basis in the asset at the time of the sale. This structure has a certain fairness to it because until a capital asset is sold, the owner may not have cash holdings to pay the associated income tax on a capital gain. Moreover, the fair market value of a capital asset rises and falls over time.
The 99.9 Percent Act does not address the concept of deemed realization. The Biden Administration’s Green Book did not address estate and gift tax matters in detail but did indicate that gain would be recognized not only at the sale of an asset but also on transfers by gift or at death.
Under the STEP Act, property owned by a non-grantor trust would be treated as sold for its fair market value every 21 years after establishment of the trust.
This concept of deemed realization is a significant departure from current income taxation that has potential to significantly affect family businesses, family farms and other owners of illiquid assets that may fluctuate in value over time.
If deemed realization becomes law, estate planners might consider building additional flexibility into trusts by including a power of substitution (or “swap power”) in the terms of such a trust. Including a power to substitute assets allows the grantor of a trust (or someone without a beneficial interest in the income or assets of the trust) to transfer personally owned assets into a trust in exchange for trust assets of equivalent value. As a reminder, IRS guidance indicates that a substitution power will not generally trigger estate tax inclusion under IRC § 2042. (See Revenue Ruling 2011-28 and Rev. Rul. 2008-22). This power to substitute assets is commonly used to trigger income tax inclusion to create an intentionally defective grantor trust.
It has long been the case that a wealthy taxpayer facing a serious health diagnosis will exercise the power of substitution to pull low basis assets back into the estate to take advantage of the step-up in basis at death. Could this strategy also be used to reduce the impact of deemed realization every 21 years? For example, in the case of married clients with a significant age gap, a grantor’s younger spouse may be able to exercise such a power to substitute assets to reduce the tax burden of a long-term trust established for the grantor’s children. It may be wise to adequately disclose such an exercise on a timely filed gift tax return at a zero value to start the statute of limitation on challenges from the IRS.
These techniques, alongside all high-net-worth estate planning, should be implemented in consultation with an experienced estate planning attorney. These techniques are complex and may ultimately be challenged by the IRS.
The content of this blog is offered by HORAN Wealth Management, an SEC registered investment advisor. Ms. Costa is an employee of HORAN and a recognized expert in Estate planning but does not manage investment advisory solutions. This information is not intended as legal advice or as a substitute for the particularized advice of your own counsel and should not be relied upon as such, as the advice appropriate for you will be dependent upon the particular facts and circumstances of your situation. The transmission or receipt of this information does not create an attorney-client relationship. We provide links to other sites that we believe may be useful or informative. These links to third-party sites or information are not intended as and should not be interpreted by you as constituting or implying our endorsement, sponsorship, or recommendation of the third-party information, products, or services found there. Neither the information nor any opinion expressed constitutes a solicitation to use our services or to purchase or sale of any security. Any reference to past performance is not to be implied or construed as a guarantee of future results. Market conditions can vary widely over time and there is always the potential of losing money when investing in securities. HORAN and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only and is not intended to provide and should not be relied on for tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.