Historically, changes to federal tax law are often adopted from a previous attempt by the controlling political party to modify the rules to align with their agenda. In order to have proper perspective on what the future holds for the estate and income tax, we should look at prior Democrat attempts to raise government revenues. As wealth planning professionals investigate potential changes to the tax policy landscape by year end 2021, the deficit hawks are balking at a potential $1-3T economic stimulus package suggested by President Biden’s American Jobs Plan. Deficit information and the effects of COVID-19 are summarized by PriceWaterhouseCoopers here:
Estimated budget deficit relative to pre-COVID baseline (not including 2020 year-end legislation)
Where is the Revenue Going to Come From?
Without fully embracing modern monetary theory (MMT), the deficit hawks in both political parties (yes, fiscally conservative Democrats exist) must come to terms with the economic situation unfolding across our county, namely stagflation. A wage earner’s purchasing power has accelerated to the downside since the pandemic started. It is clear and apparent wages will not be able to outpace the rate of real inflation unless Jerome Powell’s “transitory” spikes in inflation subside. The banks have a key role in how this all plays out, as does Janet Yellen, the new Treasury Secretary. If easy credit accompanies large infrastructure and transfer payment spending from the government, these “transitory” price blips will be exacerbated in severity and duration.
On April 7, 2021, Janet Yellen and her team at the Treasury Department released The Made in America Tax Plan. A striking perspective on the ills of the current tax system is summarized in the chart below. Basically, corporations pay less than 10% of total federal revenues. In a separate chart (not shown), the percentage of corporate taxes to GDP is estimated at just 2% of GDP.
Labor and Corporate Share of Federal Tax Revenue (1950-2019)
The suggested changes to corporate taxation will remain outside the scope of this article but for investment advisors, these changes will be part of the backdrop of the future investment climate. Unbridled capitalism meets its bride, call it what you wish. It is important to address all these proposed changes in context and understand the corporate taxpayer will be disproportionately targeted in 2021.
Potential Estate Tax Changes – Valuation Discounts
Common estate tax plans include gifting or selling a minority interest in closely held businesses to children and other related parties. Because of restrictions due to lack of marketability and lack of control, these transfers could be transacted with an effective discount of 35 – 45 percent, or even more in some cases. This tool has helped the estate tax planning community leverage the available gift tax exemption and transfer more inherent value to the future generation(s).
Seasoned practitioners will remember, back in 2016 proposed regulations were issued which intended to curtail the allowance of valuation discounts for estate tax purposes with respect to deathbed transfers, and the use of insubstantial non-familial interest holders. These proposed regulations were never finalized. In fact, shortly after President Trump gained office, he signed an executive order which turned away from these proposed regulations under the pretense of “Identifying and Reducing Tax Regulatory Burdens.” In IRS Notice 2017-38, Implementation of Executive Order 13789, and the Second Report to the President therein, the proposed regulations were completely removed.
In my professional opinion, the early sunset of the increased lifetime exemption provided under the TCJA should be taken as a given. The less newsworthy and very important policy debate needs to happen over the revival of these 2016 proposed regulations. I think these regulations will be revived and fast-tracked. Wealthy individuals who had restructuring conversations with their tax planning professionals when these proposed regulations were announced in 2016, need to revisit the validity of their current estate tax diagram under the hypothetical scenario these regulations reappear. Any current estate plan which is assuming an allowable valuation discount under IRC 2704 needs some additional consideration before year end. Control issues, and feeble attempts to avoid the definition of control, need to be addressed in one way or another. In some situations, estate planning for a deathbed check-the-box election needs to be reconsidered. Lastly, in order to protect a discount, LLC or partnership agreement may need revisions to contain more restrictive liquidation provisions than those applicable under federal or state law.
Keeping it in Context
Given the relatively small community subject to estate tax and the limited amount of revenue derived therefrom, the policy concerns driving reform in this area will be less concerned with raising revenue, and more concerned with “fairness” and “closing loopholes.” These talking points are part of the guiding principles of the reform framework published by Janet Yellen and the U.S. Department of the Treasury. For the above reasons, I can’t imagine a realty where the estate tax base is broadened by completely eliminating valuation discounts and further reducing the lifetime exemption to $3.5M per individual. Given a stagflationary environment and the focus on corporate tax reform, a measured approach to estate planning in 2021 will 1.) address the technical issues within the provision for valuation discounts, and 2.) fully utilize the lifetime exemption available under the TCJA before the law changes.