Take-Away: The potential exists for new rules that will apply to the historically high federal gift and estate tax rules. While the IRS has settled concerns about the possible clawback into a donor’s taxable estate with regard to the donor’s lifetime gifts using the temporarily large federal gift tax exemption, the IRS also promised to look into potential abuses using the large federal gift tax exemption.

Background: We are all aware of the 2017 Tax Act’s doubling of the transfer tax exemption (gift or estate) from $5.0 million to $10.0 million, adjusted for inflation. In 2020 that applicable exemption amount was $11.58 million per individual. In 2022 it will exceed $12 million. The Act also provided that this is a temporary increase in the applicable exemption amount, which is set to return (if not earlier by Congress) beginning on January 1, 2026. Some call it a temporary increase in the exemption, others call it a bonus exemption, but it is only available to be used through the end of 2025. The original concern was that this  ‘shifting’ exemption amount would impact how the donor’s estate tax was calculated.

Anti-Clawback Regulations: The question was that if a donor uses his/her bonus exclusion prior to 2026, and then dies thereafter, what amount would be ‘added back’ to the donor-decedent’s estate tax base, when the applicable exemption amount has dropped back to the $5.0+ million level at the time of death?

Clawback: [The amounts will be kept simple and rounded.] A donor makes a gift of $10.0 million in 2021, but dies in 2026, when the gift tax exemption amount falls back to the 2017 level of $5.0 million amount (adjusted in the interim for inflation to maybe $6.0 million, but which ignored in the following example.) The concern is based on the fact that when a donor-decedent’s estate tax is calculated, the donor-decedent’s lifetime gifts are added back to the donor-decedent’s estate tax base. Then, credits are given for the gift tax actually paid or payable for the exemption amount at the date of the decedent-donor’s death. Obviously it would be undesirable if $10 million of gifts were included in the donor-decedent’s death, but the donor-decedent’s estate only had a $5.0 million of an applicable exclusion amount to use against that $10 million gift. Congress directed Treasury to publish Regulations to address this clawback concern. The result was what are now called the final anti-clawback regulations.

Final Anti-Clawback Regulations: Those Final Regulations provide that if the exemption amount that applies to the donor-decedent’s lifetime gifts exceeds the amount that is available at the time of the donor-decedent’s death, then the donor-decedent’s estate can use the higher exemption amount that applies to the donor-decedent’s lifetime gifts. In other words, the donor-decedent who makes a lifetime gift of $10 million using his/her applicable exemption amount will be able to shield the entire $10 million gift from federal estate taxation even if he/she dies in 2026 or later.

Anti-Abuse Rules: However, in the Preamble to the Anti-Clawback Final Regulations, Treasury reserved what it called anti-abuse rules that would prevent the bonus exemption from being used on certain types of lifetime gifts. This arose from comments that Treasury received with regard to the proposed anti-clawback regulations. Those comments brought to Treasury’s attention that donors would be able to make potentially ‘painless’ taxable gifts that ‘lock in’ the bonus exemption amount, even in cases where the donor retains beneficial access to the gifted asset.

For the extremely wealthy, they can gift $11.7 million in 2021 and not have any anxiety. For those less wealthy, they may not be comfortable making an $11.7 million gift this year unless they have some way to potentially access that gift of property in the future. Those ‘access-in-the-future’ lifetime gifts are what these anticipated anti-abuse rules would target. Unfortunately, no rules have yet to be released by Treasury. However, the comments made to the proposed Regulations that triggered Treasury’s decision to reserve the right to issue future anti-abuse rules may provide some indication of what those rules might look like. The common theme is lifetime gifts that consume the donor’s applicable exclusion amount but which allow the donor continued access to the gifted asset.

  • Life Estate/Retained Interests: The Final Regulations that describe Treasury’s anti-clawback position state that transfers subject to a retained life estate or other retained powers or interests by the donor could potentially be targeted by the anti-abuse rules. These are sometimes called artificial gifts because while they result in a taxable gift that consumes the donor’s applicable exclusion amount, including the bonus exclusion, the value of the gift is still included in the donor’s gross taxable estate because the donor retained an interest or control over the transferred asset.  An example would be the string provisions of the Tax Code, e.g. IRC 2036-2038, 2042, or the 3-year claw back provision of IRC 2035.]
  • Grantor Retained Income Trust: With a grantor retained income trust, or GRIT, a donor retains an income interest in the trust’s assets for a specific period of time. If the remainder beneficiary is someone like the donor’s spouse or child, and the interest retained by the donor is not a qualified interest as defined in Chapter 14’s ‘zero valuation’ rules, the interest that is retained by the donor is valued at $0.00, and the taxable gift amount is equal to the total value of the property that was gifted to the GRIT. At the donor’s death, the value of all of the trust property is included in the donor’s gross taxable estate.
  • Preferred Partnership Interest Gifts: Another example of when the anti-abuse rules might apply is with the gift of an interest in a preferred partnership that does not comply with IRC 2701, sometimes called an intentionally defective preferred partnership. This was covered in the November 2021 Perspectives In essence, the strategy is to trigger a gift tax by gifting non-preferred partnership interests to the donee while the donor retains a preferred partnership interest that is not qualified, thus using the donor’s $11.7 million applicable exemption amount, yet retaining access to the partnership’s preferred interests for the balance of the donor’s lifetime.

Conclusion: While the final anti-clawback Regulations provide some comfort that a donor who uses his or her currently large applicable exemption amount now will not have that large gift come back to haunt their estate if they die after 2025 when the applicable exemption amount drops by perhaps 50%, concerns still linger about Treasury’s plan to publish anti-abuse Regulations to address life estates, retained interests, or some of the more exotic strategies like transfers to a GRIT or gifting interests in a preferred partnership. Hopefully we will get some direction from Treasury soon on what gift strategies work, and which will not work in an era of clawback concerns.