Amid record inflation, spiking interest rates, the largest war in continental Europe since World War II, and a sharply divided electorate — the upcoming midterms will set a direction that will reverberate for years. While estate planning considerations may not be top-of-mind for most voters, it’s important for advisors to be aware of the potential changes on the horizon should Democrats retain their majority.

We can’t be certain what the next few months will have in store. But based on recent legislative and policy proposals, we believe it likely that there may be significant changes to grantor trusts on the table, in addition to increased scrutiny from the IRS that will keep estate-holders and businesses on their toes.

Build Back Better May Offer Perspective on Future Changes

While history doesn’t always repeat itself, it often does rhyme. Should the Democratic Party hold onto the House and Senate in the midterm election, it’s likely that their future proposals will look like those proposed, but not implemented in the recent past.

The initial $3.5 trillion iteration of the Build Back Better bill, proposed in late 2021, outlined a slew of changes that would impact estate plans.

Among the proposals in the bill, those with the most significant impact on planners were:

• Lowering the estate and gift tax exemptions back down to $5,000,000 (adjusted for inflation) from $12 million, or $24.1 million for married couples
• Eliminating valuation discounts for transfers of interests in businesses holding “passive” assets (meaning assets not used in the “conduct of trade or business”)
• Changing several rules pertaining to grantor trusts

Of all of the provisions, the proposed changes to the grantor trust provisions would have likely caused the most headache for advisors and their clients.

As you may know, a grantor trust is structured such that the grantor retains control over the assets placed in the trust. A client who places income-producing assets inside of a grantor trust is still liable to pay income tax on the proceeds. However, the assets remain outside of their taxable estate, reducing the estate tax burden.

Existing rules around grantor trusts were written decades ago to combat against wealthy clients taking advantage of lower tax rates by gifting income-producing assets into the trust. The rules were written at a time when marginal tax rates were historically high. Now that tax rates have come down significantly relative to when the original rules were written, planners are still utilizing grantor trusts to take advantage of these very same provisions.

The BBB bill was aimed at eliminating many of those advantages that grantor trusts currently enjoy and would have instead implemented the following:

• Assets that are owned inside of a grantor trust would be includable in the client’s taxable estate, even if the trust were irrevocable
• If a grantor trust was terminated for any reason and became a non-grantor trust, the grantor would be considered to have made a gift based on the value of the trust assets
• Any distributions from the trust during the grantor’s lifetime would be classified as a gift
• Transfers between the grantor and their trust would be subject to income tax, essentially removing the most basic advantage of a grantor trust

The above changes would have dramatically altered the estate planning landscape. While they were eliminated from the final bill, they are worth examining in the context of possible future policy decisions.

The Long-Term Impact of the Inflation Reduction Act

This August, we saw a revised version of the BBB bill, in the form of the Inflation Reduction Act, signed into law, sponsored by senators Chuck Schumer and Joe Manchin. The current bill leaves out the above provisions. However, a handful of new provisions are likely to impact estate planning professionals:

• 15% corporate alternative minimum tax (AMT) on corporations with a three-year average book income in excess of $1,000,000,000
• A new 1% excise tax on corporate stock buybacks and repurchases
• Extension of the cap on deductions allowed for excess business losses
• $80,000,000,000 in funding for the IRS over next 10 years with the goal of generating about $124,000,000,000 in revenue over that time

There are second-order effects to consider: some of the $80 billion in new spending is allocated to hiring 87,000 new IRS agents. Additional capacity at the IRS is likely to increase scrutiny of some plans that may otherwise fly under the radar, such as Section 419 or Section 79 plans. Improved tax policy enforcement may also increase the likelihood of business owners being “caught” taking deductions for items they shouldn’t, such as the premiums paid on a corporate-owned life insurance policy.

The ramifications of the above changes have already begun to impact estate plans already implemented. Looking forward, clients will also have to tread lightly so as to not only avoid any potential impacts from rule changes, but also be extra aware of future legislative changes given increased enforcement and scrutiny by the IRS.

Looking Forward to the Midterms

In order to gain control of both chambers, Republicans need to pick up four seats in the House and just one in the Senate.

Historically speaking, the party in control of the presidency has gained seats in only two elections in the past 100 years. Further, since 2008, voters have ousted the party in power in seven out of eight elections, a trend that hasn’t occurred since the second World War.

Not only does momentum point to a Republican victory in a few weeks, but opinion polls show that Americans tend to vote with their pocketbooks. According to pollster YouGov, 73% of registered voters ranked inflation and prices as “very important” to their midterm voting decisions. And inflation continues to rise: the September CPI print showed that prices increased at 8.2% year-over-year, potentially hurting Democratic hopes.

The pollsters at FiveThirtyEight give both parties approximately a 30% chance of keeping/taking control of both the House and the Senate. But it looks likely that we’ll wind up with a split legislature: there is a 67% probability that the Democrats retain control of the Senate and a 70% probability that the Republicans take control of the House.

Should Republicans win both the House and Senate, estate planners and advisors should be able to rest easy. It’s highly likely that under such a regime, President Biden’s preferred agenda would be stuck in limbo. In this scenario, tax rate increases and/or other major changes that would impact estate planning would seem highly unlikely. A split House and Senate would likely lead to similar gridlock.

The scenario that may keep planning professionals up at night is the one-in-three chance that the Democrats defy history and manage to keep control of both the House and Senate. In this case, any changes may depend on the Democrats’ margin of victory. As we saw with Build Back Better, a small handful of senators who break from the party line can hold up any passage of a bill indefinitely.

Only if Democrats in the House and Senate can achieve a significant majority are we likely to see any of the estate planning provisions from the original BBB bill reemerge in a different legislative package. Among these could be increases to both corporate and personal tax rates, as well as an increase or even elimination of the cap on income tax deductions.