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The White House’s 2022 budget request includes tax changes – many of which could influence certain trusts and how gains are taxed. Changes would take effect January 1, 2022, so the time to consider changes is now.

Earlier this summer, the White House released details of its fiscal year 2022 budget request to Congress. Among many other provisions, the budget includes changes that would increase taxes on certain individuals. While Congress is responsible for preparing the final budget, the request reflects the priorities of the Biden administration and will receive due consideration in the legislative branches.

Of particular note is a provision in the proposed budget that would significantly impact charitable giving by effectively reducing the benefits of split-interest gifts for taxpayers.

The Advantages of Split-Interest Trusts

Split-interest trusts are popular due to their dual beneficial interests: They can benefit a qualified charity and a noncharitable beneficiary. A charitable remainder trust (CRT) provides noncharitable beneficiaries with exclusive rights to distributions until their interests terminate; at that time, charitable beneficiaries receive the assets left over in the trust. CRTs have been particularly useful for investors who want to divest out of highly appreciated assets but were concerned about the capital gains tax.

A charitable lead trust (CLT) reverses the timing of when charitable and noncharitable beneficiaries receive distributions.

In a CLT, charitable beneficiaries receive the initial distributions, with the remainder going to non-charitable beneficiaries. CLTs have been particularly useful for assets that generate substantial income each year that isn’t needed and where the donor wants to eventually pass the asset to heirs.

For years, the deferral or avoidance of capital gains tax has been a popular selling point for funding CRTs with appreciated assets.

Proposed Changes

Specifically, this White House proposal would treat transfers of appreciated assets – including donations to a split-interest trust – as “realization events.”

  • Under current law, donors of transfers of appreciated assets are not taxed on the appreciation at the time of the transfer. However, the White House proposal would tax the difference between the asset’s fair market value on the date of the transfer and the asset’s adjusted basis. Any appreciation of the asset over its basis would be treated as a taxable gain.
  • While there is an exclusion allowed for the charity’s share of the gain, the gain allocable to the noncharitable portion would be taxed to the donor at the time of the transfer. For example, if a CRT were funded with an asset in which the donor has a $100,000 capital gain and the CRT earned a charitable deduction equal to 60% of the funding amount, the donor would be taxed on $40,000 of the capital gain.

The deemed-realization proposal would take effect on January 1, 2022. This proposal would eliminate the deferral of income tax benefits of transfers to CRTs. Regarding charitable lead non-grantor trusts, the deemed sale would presumably eliminate the benefit unless the noncharitable interest is zeroed out. If enacted, charitable clients would lose significant tax benefits in funding split-interest gifts.

Under the proposal, donors would have a $1 million lifetime exclusion ($2 million per married couple) available to offset the reportable gain. Donors who exceed this exclusion will face new capital gains tax, whether by gift or at death. Remember that the donor would still not pay tax on the portion of the gain allocated to charity. They could offset the remaining gain with the income tax charitable deduction they would receive upon funding the split-interest trust.

Observations

Interestingly, the four-tier tax system that currently applies to CRTs ensures that the appreciation (capital gain) is eventually taxed as distributions pass to the noncharitable beneficiary over time. So, imposing a tax on the gain at the time of funding does not seem necessary. If this type of tax policy intends to make sure that the appreciation doesn’t escape taxation at all, then it is already being accomplished for gifts to CRTs.

Charitable lead trusts can be structured as grantor or non-grantor lead trusts. For grantor CLTs, the question is whether they will be governed by the timing rules outlined in the proposals for certain other grantor trusts, by the rules set forth for split-interest trusts, or by some combination of the two. For non-grantor lead trusts, the gain allocable to the noncharitable portion of the non-grantor lead trust would be taxable to the donor in the year the trust is created. Most non-grantor lead trusts are lead annuity trusts (CLATs). Many of those are designed to generate an income tax charitable deduction equal to or approaching 100% of the gift principal. In these cases, there would presumably be little or no capital gain for the donor to report when funding the CLAT since the value of the noncharitable portion would be zero or close to it. Once again, there is an argument that imposing a tax on the gain when funding a CLT is not necessary.

Looking Ahead

Some charitable planning organizations oppose the Biden administration’s proposal to tax gifts of appreciated property and treat donations to split-interest trusts as realization events. They believe federal tax law should encourage rather than discourage charitable giving.

Since the proposed effective date is January 1, 2022, there is a window of opportunity for donors to make split-interest gifts in 2021 before any new rules take effect. There is still time for modifications to the proposed rule and time for charitable organizations to influence these proposed changes.

We will keep you apprised of any future developments in this area.

For more information about how this may impact your trust or financial plan, please contact your Key Private Bank Advisor.

Publish Date: August 9, 2021.

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

KeyBank does not provide legal advice.

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