To PTE or Not to PTE: Estate Planning and SALT PTE Elections

Once Upon a Time . . .

. . . The IRS issued Notice 2020-75, 2020-49 IRB 1453 to bless the passthrough entity (PTE) elections of many states. These elections allow a PTE to pay state and local income tax and credit the PTE’s tax owner with an offsetting (or nearly offsetting) state and local tax benefit. Soon “to PTE” became du monde¹ across the United States² in high-tax states such as New York and California.

Because of the notice, the PTE election provided an elegant solution to the 2017 Tax Cuts and Jobs Act’s $10,000 SALT deduction ceiling,³ which disproportionately affects individuals in high-tax states. States vary regarding if and how one may elect in and out of a PTE election⁴ and the exact mechanism of the benefit (such as a credit for the amount paid or a deduction or exclusion from income for the owner’s share of the PTE’s income).⁵

Of course, no tax policy is without its unintended consequences. Numerous tax specialists and advisers have noted the complexities that result in compliance requirements, cash flow management, and overall income tax consequences as a result of PTE elections.⁶

However, a tale less told involves the estate planning consequences of PTE elections, with twists such as reducing estate benefits, thrills of fiduciary concerns, and ultimately a clash of income versus estate tax consequences. What follows is one such telling of this tale, with Part I addressing the issues created for PTEs owned by intentionally defective grantor trusts (IDGTs) (and, by analogy, similar arrangements), Part II reviewing economic issues created for family-owned PTEs, and Part III noting possible solutions to some of the issues discussed.

Part I: A Tale Told by an IDGT

IDGTs are trusts that are deemed owned by the donor/grantor for income tax purposes⁷ but not included in the grantor’s estate for estate tax purposes.⁸ IDGTs are a cornerstone of advanced estate planning because they allow the donor/grantor to continue paying income taxes on the assets transferred to the IDGT (and out of the donor’s estate). The payment of income taxes does not reduce the donor’s available gift/estate exemption and allows the IDGT assets to grow without the burden of tax — including SALT — during the period the trust retains grantor status (which is usually the earlier of the grantor’s death or an intentional conversion to non-grantor status). IDGTs also provide significant flexibility because they are disregarded from the donor for income tax purposes, allowing for asset swaps and basis strategizing while the trust retains grantor status.

The benefits of IDGTs are amplified by transferring interests in PTEs (including closely held businesses organized as S corporations or limited liability companies, or family limited partnerships used for investments), which allows for valuation discounts for gift purposes.⁹

Note that although this article discusses the PTE election effect in the context of IDGTs, the same issue could arise in the context of other commonly used grantor trusts, such as grantor retained annuity trusts, as well as partnerships to which section 704(e)’s family partnership rules apply.

All Was Well Until the Choice to PTE Arose . . .

In the absence of a PTE election, the income taxes arising at the level of the PTE that is owned by an IDGT are paid by the grantor of the IDGT because the IDGT is disregarded for income tax purposes and the grantor is the deemed income tax owner of the PTE. As noted earlier, this allows the IDGT to grow year on year in value without the burden of income taxes. If a PTE election is made, however, the PTE IDGT’s assets must be deployed to pay taxes attributable to the PTE, which essentially reduces the value of the IDGT. The offsetting credit, however, does not accrue to the IDGT, but to its grantor because the grantor is the deemed income tax owner of the PTE. This effectively causes the IDGT to bear the SALT through diminishment of its PTE interest.

Therefore, the very “defect” that allowed the IDGT to be a strategy of choice for estate tax planning now undercuts the estate benefit if a PTE election is in place.

It is worth noting that not all types of grantor trusts have the same outcome. For example, the effect is not quite as drastic for spousal lifetime access trusts (SLATs), which are also usually structured as grantor trusts.¹⁰ When a spouse is the sole beneficiary of a SLAT and files jointly with the grantor, SALT credit benefits the spouse as much as the grantor, so the fact that the PTE pays the income tax instead of the grantor isn’t as much of an issue. Of course, if the SLAT is intended to also be a generation-skipping trust, there may be a longer-term estate value transfer impact.

Additional nontax complications can arise if a PTE election is made in this context.

Fiduciary Duty of Trustee Making PTE Election

In many states, including California, a legal owner of the PTE (provided it otherwise qualifies as a “qualified taxpayer”), such as the partner or member, would consent/opt in to have their pro rata share or distributive share of income included in the entity’s net income subject to the elective tax.¹¹ Therefore, when an IDGT is a partner or member of the PTE, the trustee of the IDGT would make the election to opt in to the elective tax.¹² Since the trustee is a fiduciary to the trust beneficiaries, a threshold issue is whether consenting to this election could pose an issue regarding a breach of fiduciary duty because making the PTE election has the effect of decreasing the overall value of trust assets available to the beneficiaries.

As a practical matter, this may be a nonissue when the grantor and beneficiaries enjoy a close relationship and may view the overall family wealth as a whole, or when a spouse in a SLAT who files jointly with the grantor is the beneficiary. That said, in situations in which the spouse is not a beneficiary (so that there is an economic cost to the beneficiaries in making the PTE election), the trustee would be well advised to notify the beneficiaries of the intent to make the election and its effect on trust assets. Beneficiaries should be made aware that having the grantor pay income taxes attributable to the IDGT is not a per se benefit they are entitled to and that the trust would ultimately convert to non-grantor and would have to bear its own tax burden anyway.

Issues With the Grantor as Trustee

When the grantor may be acting as the trustee of the IDGT, the issues noted above related to fiduciary duty are amplified. Further, whenever discretionary powers that affect beneficial enjoyment are involved — possibly a good description of PTE elections with respect to family and trust-held PTEs — it is generally better for independent persons to exercise the powers.¹³ For a grantor to retain this ability — albeit as a trustee — can raise the specter of retained control all too easily and cause estate inclusion issues. If the grantor may (directly or through a “related or controlled” person) take part in the PTE election, that may constitute a power to control beneficial enjoyment of trust assets. In addition to estate re-inclusion issues under IRC sections 2036 and 2038, there may also be a risk that the gift is deemed partly incomplete.

Sales to IDGTs and Cash Flow Management Issues With PTE Election

In many instances, gifts to IDGTs (especially those with PTE interests) are combined with a sale, whereby the grantor sells an additional portion of the PTE in exchange for a promissory note from the IDGT. This technique is especially effective in low-interest environments because the grantor’s estate is “frozen” at the value of the note (and interest) — and all appreciation of the underlying assets in excess of the interest rate at the time of sale accrues to the IDGT. To maintain cash flow, many planners try to equalize the amount of cash generated from the assets sold to the IDGT to pay down the interest and amortize the principal on the note due to the grantor. The payment of note by the IDGT (using cash produced by the PTE) provides the grantor liquidity to pay all income taxes, including SALT attributable to the IDGT. Thus, the payment originating in the PTE does “double duty,” relieving the trust of what it owes to the grantor and paying off the grantor’s SALT from the PTE.

However, with the PTE election, cash is expended by the PTE to pay its share of SALT, and the IDGT must further still repay the note due to the grantor. If the IDGT does not possess other income streams, this could result in repayment in kind to the grantor, which unwinds the estate “freeze” that was carefully planned.

Part II: Unintended Impacts of PTE Election on Family PTEs

Separate and apart from the issues discussed above concerning when an IDGT owns interests in a PTE, the choice of PTE election may cause unintended economic issues in the case of family-owned PTEs.

For example, when multiple family members own interests in a PTE, consideration should be given to whether the PTE election would effectively cause the tax burden to shift from the wealthier family members to the less wealthy family members. This situation is most likely to occur when the less wealthy members are subject to a SALT rate that is than less than the PTE elective tax rate.

Consider the situation in which a grantor directly gifted interests in a family limited partnership to her children (not uncommon in family-owned businesses to motivate children to become involved in the business), or one in which a PTE interest was transferred to a grantor retained annuity trust, which terminated in due course and the interests at the time of termination came to be owned by the children of a grantor. Suppose also that the wealthier family members are subject to a SALT rate higher than the PTE elective rate and the less wealthy members’ SALT rate is lower than the elective rate.

Under the PTE election, the PTE would pay the income tax, which would become a partnership expense. In the absence of a special expense allocation (uncommon in family partnership agreements), the tax burden would be allocated pro rata among the family members; that is, the tax expense that is arising predominantly from the wealthier family members is passed to the less wealthy family members. Further, if the less wealthy members are subject to a SALT rate that is less than the PTE elective rate, the effect is worsened if the credit received by the members is not cash refundable (as is the case in California), which, depending on taxable income while the credits are carried, may lead to credits being lost and an overall negative income tax impact for the entire family.¹⁴

A different complication occurs when PTE elections need not apply to all partners (as permitted in California). Paying taxes for only some of the partners is unfair if the partners whose taxes are not paid by the PTE receive no offsetting benefit. In the case of such partner-specific PTE elections, special allocations of the expense from the payment by the PTE of the SALT tax will also need to be considered; ideally, no family member should receive an allocation of a PTE election expense for which they are not benefitting. Whether such allocations would have substantiality in the context of the overall partnership agreement would need to be addressed. Moreover, in the case of S corporations, such special allocations would be flatly unavailable.

Other complications applicable to non-family PTEs apply too, including how to plan for the effect of multistate businesses and entities; because these issues are not unique to family PTEs, they are not further addressed.

Part III: With Some Restructuring, Harmony May Be Possible

Despite the challenges noted in Part I and Part II, harmony between SALT deductions through PTE elections and estate planning may still be achievable, albeit with some complexity. Noted below are several possible techniques that may help preserve this harmony, but have their own considerations:

• Grantor repays trust for offsetting SALT credit. One apparent approach for a grantor to address the reduction in value of an IDGT’s PTE would be paying the IDGT for the offsetting SALT benefit the grantor received because of the PTE election (as applied to the IDGT’s PTE interest). Unfortunately, this simple solution is also very uncertain. If the payment to the IDGT is effectively gratuitous — not being required for the grantor to obtain the SALT benefit — that transfer is likely a taxable gift to the trust. Further, even if the payment is convincingly made in exchange for the offsetting SALT benefit (as might be established if the IDGT trustee must approve the PTE election), it is still uncertain this would avoid gift treatment — on one view, the legal imposition of tax on the IDGT-owned PTE should not be seen as a transfer of value from the PTE to the grantor at all, and if that’s the case, any payment for such value would be a gift (since there was really nothing to pay for).¹⁵ Any attempt to pay for a SALT benefit should, at the very least, consider whether to include formula language to attempt to minimize the chance of a gift,¹⁶ and alternatives should be considered.

• Special allocation of tax expenses or incorporation of expenses into distribution rules. In the case of a partnership, revising the PTE operating agreement to specially allocate the tax expense to those members that benefit from the PTE election may be the easiest solution. For example, if an IDGT and its grantor are both partners, allocating all of the partnership’s PTE election expense corresponding to the IDGT and grantor’s PTE interests solely to the grantor could be a potential option.

  One might also consider whether the PTE tax payment could be treated as a distribution for some purposes, reducing distributions otherwise owed to the beneficiary of a PTE election, and allowing the economic interests of the different partners to be appropriately addressed. For example, when a PTE is owned partly by an IDGT and partly by the IDGT’s grantor, one solution could be to restructure the PTE to cause the grantor to hold preferred interests, including any PTE credits generated to the grantor as part of the distributions on the preferred return due.

• Convert to a non-grantor trust. Although this option is not always feasible since it can trigger income tax consequences of its own (such as when there is debt in excess of basis in the PTE owned by the grantor trust), it at least solves the fiduciary and some tax concerns. That said, it does so at a cost — eliminating the primary benefit of grantor trusts altogether — although it may be possible to reconvert to grantor status in the future.

Conclusion

Whether taxpayers ultimately decide to solve for the conundrum between income tax and estate tax that may arise with a PTE election, at the very least, the decision “to PTE” should not be automatic where a family PTE or other estate planning vehicles are involved. Instead, the decision should be made with additional deliberation around the overall transfer tax and economic effects for the family group as a whole.