A proposal by the Obama Administration regarding grantor trusts has estate planners on edge as they ponder its implications.

A grantor trust is a trust in which an individual, normally the grantor, is treated as the owner for income tax purposes. Under current rules, a grantor trust is taxed as if the grantor or another person owns the trust assets directly, and the deemed owner and the trust are treated as one and the same. For transfer tax purposes, however, the trust and the deemed owner are separate persons, and the trust is generally not included in the deemed owner’s gross estate.

This “lack of coordination” between the income and transfer tax rules makes it possible for estate planners to be a hero to their clients by transferring wealth from the deemed owner without transfer tax consequences. It’s also the reason given for the Administration proposal.

To the extent that the income tax rules treat a grantor of a trust as an owner of the trust, the proposal would (1) include the assets of that trust in the gross estate of the grantor for estate tax purposes, (2) subject to gift taxes any distribution from the trust to one or more beneficiaries during the grantor’s life, and (3) subject to gift tax the remaining trust assets at any time during the grantor’s life if the grantor ceases to be treated as an owner of the trust for income tax purposes.

The consequences? “It’s the end of life as we know it,” said Steven Breitstone, partner and co-head of the Tax and Trusts & Estates practice at Mineola, N.Y.-based Meltzer, Lippe, Goldstein & Breitstone. “It’s very serious. What the proposal does is make anything transferred to a grantor trust formed after the date of enactment includable in the estate of the grantor. Leveraged transfers to nongrantor trusts may be subject to current capital gains taxation. Most large estate planning transactions involve some kind of leveraged transfer to a grantor trust so the assets grow outside of the estate.”

These proposed changes have gained little attention, but will have a significant impact on high net worth clients and their financial planners, according to Breitstone.

“The changes would put an end to much of estate planning as we know it for the wealthier client who owns a business or actively managed real estate, as these types of assets are typically illiquid,” said Breitstone. “The imposition of the toll charge of a capital gains tax could be an insurmountable hurdle. What’s more, these clients may have estates that are too large to plan for with straightforward annual exclusion gifts or even gifts of the current lifetime exemption of $5,120,000.”

Under current law, Breitstone says a common strategy is to leverage the exemptions, generally relying in large part on the ability to transfer assets to a grantor trust without incurring an income tax at the time of transfer. The Administration’s proposals would, in effect, impose an income tax on appreciated assets transferred in these leveraged estate planning transactions.

“It’s the only game in town to transfer large assets out of an estate,” he said. “Estate planning involving a business or real estate always involves a grantor trust. This would shut down the ability to do this type of estate planning. It would involve a tremendous tax increase on business and real estate that will require businesses to liquidate assets to pay the tax. That’s not good for job creation. In fact, it’s the antithesis of job creation.”

During the remainder of the year, Breitstone suggests that clients consider locking in the ability to engage in estate planning transactions involving leveraged transfers to grantor trusts, since in the years ahead, it may become more difficult to plan for a client who holds illiquid interests in a business or real estate.