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George F. Bearup, J.D. Senior Legal Trust Advisor

27-Mar-20

Final 2017 Tax Act Exemption Regulations: Two Out of Three Ain’t Bad

Take-Away: The Final IRS Regulations with regard to the 2017 Tax Act’s temporary increase in the federal gift, estate and GST tax exemptions were published in late November, 2019. Those Final Regulations provide helpful answers to two concerns that were raised by the temporary increase in an individual’s applicable exemption amount. However, the Final Regulations  provided one negative answer to a third planning concern that the 2017 Tax Act raised. Summarized:

  • No Clawback: There will be no clawback of lifetime gifts made using the temporarily enlarged federal gift tax exemption, so that estate taxes will not be indirectly increased when the value of the decedent’s lifetime gifts are added back to the donor-decedent’s taxable estate (good);
  • DSUEA Not Lost: If a spouse dies prior to 2026 leaving a large unused applicable exemption amount (DUSEA) that is ported and available to be used by his/her surviving spouse, that large DSUEA will not be lost when the basic exemption amount (BEA) drops back to its 2017 levels (good) in 2026; and
  • ‘Loss’ of Inflation Adjusted BEA: If a large lifetime gift is made prior to 2026 by the donor, it is possible that no post-2025 gifts will be covered by the donor’s inflation- adjusted post-2025 basic exclusion amount (BEA) until that inflation-adjusted BEA exceeds the value of the donor’s earlier lifetime gift ()

Disclosure: What follows is not easy-reading.

Final Regulations: The effective date of the Final Regulations with regard to the impact of the temporary increase in the federal gift and estate tax exemption, what the Regulations refer to as the Basic Exclusion Amount (or BEA), is November 26, 2019.

Background: The 2017 Tax Act made many changes with regard to the federal gift, estate, and GST taxes and available transfer tax exclusions, i.e. the BEA.  A brief summary of the key changes include the following:

Temporary Basic Exclusion Amount (BEA): The basic exclusion amount (BEA) was temporarily increased from the 2017 level of $5.4 million per person to the current $11.58 million per person through December 31, 2025. Beginning in 2026, the BEA is reduced to 50% of its otherwise applicable level, i.e. a drop in the size of that exemption back to its 2017 level (but that amount is then adjusted for inflation for the interim years before 2026.) The BEA was increased by $5.0 million to $10 million, as adjusted for inflation, but only for 10 years. The BEA amount reverts to $5.0 million, as adjusted for inflation, on January 1, 2026.

Concern #1: This automatic reduction in the federal transfer tax credit (or basic exclusion amount) created a concern with regard to how future federal estate taxes would be calculated with the donor’s death that occurs after 2025, when the value of the donor’s lifetime gifts, sheltered by the donor’s temporarily larger federal gift tax exemption (or credit), were added back to the donor-decedent’s taxable estate to calculate the donor-decedent’s federal estate tax liability. Would the add-back of the value of lifetime gifts (which were gift tax-free by virtue of the larger temporary gift tax exemption that sheltered the gift) to the donor-decedent’s estate cause an estate tax on those prior ‘tax-free’ gifts?

Concern #2: Another concern posed by the scheduled drop in federal transfer tax applicable exemption amount on January 1, 2026 was the impact of that drop on the available exemption due to a deceased spouse’s unused exemption amount (DSUEA) that was otherwise available (via portability) to a surviving spouse who lives beyond January 1, 2026. Was the ‘larger’ DSUEA that resulted from a spouse’s death prior to 2026 when the temporarily larger federal gift and estate tax exemption existed immediately lost when the BEA dropped back to its 2017 level (adjusted for inflation?)

Chained CPI Adjustments: Another change, which was made permanent under the 2017 Tax Act, was how the applicable BEA is annually adjusted for inflation. Prior to 2018, the federal applicable exclusion amount, or BEA,  was annually adjusted for inflation using the traditional Consumer Price Index (CPI.) [Reg. 20.2010-1.] That annual inflation adjustment is applied to the entire applicable exemption amount available to an individual, e.g. the CPI adjustment factor would be applied to the current $11.58 million exemption amount. The 2017 Tax Act tweaked this annual inflation adjustment going forward by applying what is called the Chained-CPI. This alternative measure of inflation is approximately 0.25 % lower than the traditional CPI adjustment. Therefore, the annual increases in the BEA will be less using the Chained-CPI. More importantly, along with this transition to the Chained-CPI was a special rule that limits the actual use of the post-2026 inflation adjustments until the individual’s adjusted BEA exceeds the value of his/her lifetime gifts.

Concern #3: The concern raised by permanently shifting to the Chained-CPI adjustment is the impact of the special rule that deals with the adjustment to the post-2025 basic BEA if large gifts were made prior to 2026 using the temporarily larger BEA to shelter those gifts from taxation. Will the inflation adjusted post-2025 BEA be curtailed by large pre-2026 taxable gifts by the donor?

Final Regulation’s Answers: As noted in the Take-Away, there are positive responses to the first two concerns, and a surprisingly one bad response to the third concern.

Concern #1- Lifetime Gifts Consume the Temporary Larger Gift Tax Exemption Last: This has been covered previously in prior missives. When the value of the donor-decedent’s lifetime gifts are ‘added back’ to the donor-decedent’s estate to calculate federal estate taxes after 2025, the temporary BEA that was available to the donor-decedent at the time of the lifetime gift will be used to calculate the donor-decedent’s federal estate tax liability, even though at the time of the donor’s death, a much smaller BEA will actually be available. This also reinforces the use-it-or-lose-it approach to lifetime gifts before 2026.

Example: Don is single and has not used any of his current $11.58 million federal gift tax exemption. In 2020 Don makes a $3.0 million gift that is reported by him on a federal gift tax return, Form 709. That gift reduces Don’s available BEA to $8.58 million ($11.58 million less $3.0 million = $8.58 million.) If the BEA does not increase and it remains the same on December 31, 2025, i.e. $11.58  million, and Don makes no further taxable gifts, on January 1, 2026 Don’s available BEA will be reduced to $3.18 million, plus whatever inflation adjustment that is made on January 1, 2026 to the then-prevailing BEA of $5.4 million. Don’s 2020 gift of $3.0 million used his original, or permanent, BEA that existed in 2017; Don did not use any of his temporary BEA that was available to him between 2018 and 2025. This results in a use-it-or-lose-it proposition for Don’s temporarily increased BEA.

Concern #2- DSUEA is Not Lost: If a spouse dies between 2018 and 2025 leaving an unused applicable exemption amount (DSUEA) that can be ported to the surviving spouse, and the survivor dies sometime after 2025 when his/her own BEA has dropped back to 2017 levels (adjusted over the interim years by the Chained-CPI) the survivor’s estate will not lose the much larger DSUEA that became available to the surviving spouse prior to 2026. The arrival of the lower BEA on January 1. 2026 will not cause the surviving spouse to lose the DSUEA just because the survivor lived long enough to be in the post-2025 lower BEA period.

Concern #3- Special Rule Causes Loss of Access to Post-2025 BEA Increases: The last concern that the Final Regulations unfortunately re-affirmed was the impact of the Chained-CPI on the post-2025 BEA adjustments, when prior gifts had used the donor’s available transfer tax exemption. Remember, the donor’s permanent BEA is used first to shelter lifetime gifts, and only after the donor’s permanent BEA is fully consumed to shelter lifetime gifts will the donor then begin to use his/her temporary BEA available only through 2025. Those Chained-CPI increases will not be available to the donor until the post-2025 adjusted BEA amount exceeds the amounts gifted by the donor prior to December 31, 2025. The last example below demonstrates how the inflation adjustment, as  applied, will not enable the donor, post-2025, to have available inflation adjusted exemption to shelter future gifts or estate taxes.

Examples: Some examples culled from the Final Regulations follow. I have added names and titles simply to (hopefully) make the examples a bit easier to follow. [Remember the Proverb, don’t kill the messenger!]

Example #1- Use-it-or-lose-it Principle: Don, a single man, made cumulative post-1976 gifts of $9.0 million. All these lifetime gifts were sheltered from gift taxes by Don’s cumulative total of $11.4 million BEAs on the dates of these lifetime gifts. [This example ignores the increase in the BEA from $11.4 million in 2019 to the $11.58 million in 2020.] Don dies in 2026. At the time of Don’s death the BEA has dropped to $6.8 million. Don’s estate is not eligible for any restored exclusion amount. [IRS Notice 2017-15.] Because the total amounts allowable as a credit in computing the gift tax payable on Don’s post-1976 gifts (based on the $9.0 million basic exclusion amount used to determine those credits) exceeds the credit based on the $6.8 million BEA that is allowable on Don’s death, the credit used for purposes of computing Don’s estate tax is based on the basic exclusion amount of $9.0 million, the amount that was used to determine the credits allowable in computing the gift tax payable on Don’s post-1976 gifts. Restated, the first credits used by Don to shelter his lifetime gifts was Don’s permanent BEA ($5.4 million in 2017) and the remaining $3.6 million of the BEA used was Don’s 2017 Tax Act’s temporarily increased The temporarily increased BEA is used only after Don’s permanent DEA is used- hence, Don better use it before he loses it in 2026.

Example #2- Smaller Lifetime Gifts: Same facts as in Example #1, except that Don made post-1976 taxable gifts of $4.0 million (not $9.0 million.) Because the total of the amounts allowable to be used as a credit in computing the gift taxes payable on Don’s post-1976 gifts is less than the credit based on the $6.8 million BEA allowable on Don’s post-2025 death, the credit to be applied for the purpose of computing Don’s federal estate tax liability is based on the $6.8 million BEA as of the date of Don’s death, less his use of the $4.0 million that sheltered Don’s lifetime gifts. Consequently, Don’s estate will have a tax credit of $2.8 million to shelter federal estate taxes. Don’s estate will not be able to use any of his temporarily increased BEA available, since it could only be used between 2018 and 2025, after which that temporary BEA disappeared.

Example #3- Using the DSUEA: Don and Wendy are married. Wendy dies in 2019. At the time of her death, Wendy had available to her a $11.4 million BEA. Wendy had made no taxable gifts and she had no taxable estate. Wendy’s estate personal representative elected portability, so her full $11.4 million exemption was ported to Don, i.e. Don’s DSUEA. [Reg. 20.2010-2.] Don, as a widower, made no taxable gifts, nor did Don remarry prior to his death in 2026. The post-2025 BEA on Don’s death has dropped to $6.8 million. Because the total of the amounts allowable as a credit in computing the gift tax payable on Don’s post-1976 gifts attributable to the BEA ($0.00) is less than the credit based on the BEA allowable on Don’s death, the credit to be applied for purposes of computing Don’s estate’s tax liability is based on Don’s $18.2 applicable exclusion amount [$6.8 million is Don’s personal BEA available to him or his estate in 2026 on the date of his death plus the full $11.4 million DSUEA that Don inherited on Wendy’s death in 2019.]

Example #4- DSUEA: Don is married. Don’s wife, Wendy, dies on December 31, 2025. Prior to her death, Wendy had made only one taxable gift of $3.0 million in 2019. Assume that the Chained-CPI adjusted BEA on December 31, 2025 is $11.4 million. Because Wendy did not consume her full BEA prior to her death, Don’s DUSEA under the portability rules will be $8.4 million [Wendy’s $11.4 million exemption less Wendy’s $3.0 million lifetime gift = $8.4 million DSUEA available to Don.] Don’s DUSEA amount of $8.4 million will not be reduced come January 1, 2026 when Don’s permanent BEA of $6.8 million (having been adjusted upward for ‘chained’ inflation during the intervening years) returns. If Don makes no future gifts prior to his death, Don’s estate’s BEA will be the sum of: (i) Don’s own $6.8 million, i.e. his post-2025 BEA adjusted for cost-of-living; and (ii) the $8.4 million of Wendy’s unused BEA, i.e. the DSUEA, or $18.2 million.

Example #5- GST Exemption: Same facts as in Example #4. The $8.4 million part of Don’s available BEA at his death cannot be used to fund trusts or other similar arrangements where Don’s child, Charlie, could receive lifetime benefits and then have the trust’s assets pass to Don’s grandchildren or more remote descendants without incurring the generation skipping transfer (GST) tax. That is because Wendy’s GST exemption, unlike her federal gift and estate tax exemption, is not portable to her surviving spouse. Don could, however, have transferred $5.7 million to a trust on January 1, 2026 that would be both federal estate and GST tax exempt: Don would use his own GST exemption of $5.7 million; in addition, Don would use $5.7 million of the $8.4 DSUEA amount that Don inherited on Wendy’s death to shelter the transfer from gift or future estate taxes. After the $5.7 million is transferred to the trust for Charlie and his children, Don would have a remaining $2.7 million DSUEA which will not be increased by future annual inflation, along with the annual Chained-CPI inflation adjustments that will occur to Don’s personal $6.8 million exemption after January 1. 2026.

Example #6, Partial Credit, or Don’t Kill the Messenger!: Don and Wendy are married. Wendy dies in 2019 with an unused BEA of $11.4 million, which is ported by Wendy’s personal representative to Don. In 2021 Don makes a taxable gift of $14.0 million. Don dies in 2026. In 2021 the BEA had been adjusted upward, due to the Chain-CPI, to $12.0 million. Don is considered to have applied the DSUEA amount to the 2021 $14.0 million gift before Don is considered to have used any of his own personal BEA to shelter the balance of the 2021 $14 million gift. The amount allowable as a credit in computing Don’s gift tax payable on Don’s post-1976 gifts for that year ($5,545,800) is the tax on $14.0 million, consisting of $11.4 million in DSUEA and $2.6 million of Don’s personal Don’s used BEA is 18.6% of the $14.0 million exclusion amount allocated to the 2021 gift, with the result that $1,031,519 (0.186 X $5,545,800) of the amount allocable as a credit for that year in computing the gift tax payable is based solely on Don’s own BEA. The amount allowable as a credit based solely on the BEA for purposes of computing Don’s estate tax ($2,665,800) is the tax on the $6.8 million BEA on Don’s death in 2026. Because the portion of the credit allocable in computing the gift tax payable on Don’s post-1976 gifts based solely on Don’s BEA ($1,031,519) is less than the credit based solely on the BEA ($2,665,800) allowable on Don’s death, the credit to be applied for purposes of computing Don’s estate tax is based on Don’s $18.2 million applicable exclusion amount, consisting of the $6.8 million BEA on Don’s death plus the $11.4 million DSUEA that Don was able to use due to the portability election in 2021.

Example #7- Special Rule: Don is single. Don has no DSUEA available to him. If Don had gifted $8.7 million in 2019 and he made no further gifts, Don will have used up his entire BEA, assume $5.7 million (adjusted upward by cost-of-living) BEA with his 2019 gift. Don’s BEA amount will still increase based on the Chained-CPI adjustment calculated in relation to the fully adjusted $5.7 million BEA. It will come as a surprise to Don, however, that he will not realize any benefit of those Chain-CPI adjustments, post-2025, until the increasing BEA amount, post-2025, as adjusted for inflation, exceeds the $8.7 million that Don gifted back in 2019.  As noted earlier, the Final Regulations provide a special rule with respect to the post-2025 inflation adjustments. That special rule provides no additional benefit to Don, either as a donor, or a decedent, until the post-2025 BEA, as adjusted for inflation, exceeds the amount of the BEA that was previously allowable and used to shelter Don’s gifts from gift taxes. While it is true that subsequent inflation adjustments are available to Don’s BEA in later years, the BEA on January 1, 2026 is reset to a lower amount. That reset (lower) amount will be subject to annual inflation adjustments; but the exemption that shelters gifts during Don’s life will not available until that Chained-CPI adjusted BEA amount exceeds the value of Don’s 2019 gift. If the amount of the BEA that is allowable during Don’s life exceeds Don’s post-2025 death BEA, there will be no temporary BEA available to Don’s estate, even though the BEA at Don’s death includes post-2025 inflation adjustments. While this special rule does not eliminate the benefit of post-2025 inflation adjustments to Don’s BEA, neither does it change the fact that the credit based on the BEA that Don used to shelter his 2019 lifetime gift can only be applied once. To this extent, this special rule penalizes Don for using part of his temporarily larger BEA before 2026 when he makes taxable gifts.

Conclusion: The good news from the Final Regulations is that there is no worry about a clawback of ‘tax-free’ gifts into the donor-decedent’s taxable estate. In addition, if a surviving spouse possesses some DSUEA due to the death of their spouse, that DSUEA will not be lost or unavailable if the surviving  spouse lives beyond 2025. The only bad news is that while the post-2025 BEA will continue to be adjusted upwards due to Chained-CPI inflation, a donor may not enjoy the benefit of those increasing exemptions until the amount of the post-2026 BEA, as inflation-adjusted, exceeds the value of the donor’s pre-2026 gifts.