Take-Away: The IRS just published its Final Regulations that address the clawback concern with regard to lifetime gifts, the value of which are added back into the donor-decedent’s taxable estate. Clawback is an interpretion problem that was created by the 2017 Tax Act and its 2025 sunset provision. A computational problem results due to the discrepancy between the higher federal tax law’s applicable exemption amount that was used to shelter the donor’s lifetime gifts from federal gift taxes and the decedent-donor’s applicable exemption amount when it drops to its 2017 level post-2025. The Final Regulations address that computational discrepancy to eliminate the clawback concern, but they also act reconfirm the use it or lose it approach to the temporarily increased federal gift tax applicable exemption amount prior to 2026.

IR 2019-189 is the source of these anti-clawback Final Regulations.

Background: The 2017 Tax Act essentially doubled the amount of an individual’s federal estate and gift tax applicable exemption amount, from $5.0 million to about $11 million.  The 2017 Tax Act however placed a sunset on the doubled applicable exemption amount on December 31, 2025; after that date the applicable exemption amount drops back to somewhere between $5.5 million and $6.0 million (the amount will be adjusted for inflation, which is why the amount of the applicable exemption beginning in 2026 is uncertain at this time.) That drop in an individual’s estate and gift tax applicable exemption amount [from $11.4 million to $6.0 million (guesstimated) creates an estate tax calculation problem informally called clawback.

  • Calculation of Federal Estate Tax: The calculation of a decedent’s taxable estate requires that the value of all of the decedent’s lifetime gifts be added back to the decedent’s taxable estate, i.e. the value of those lifetime gifts is added back to the value of the assets owned by the decedent at the time of his death, thus increasing the size of the decedent’s taxable estate. Thus, the added back value of lifetime gifts is indirectly used to calculate the decedent’s federal estate tax liability. Note that a credit is applied against the estate tax computation for the decedent-donor’s lifetime applicable exemption amount that was used when the gift was made. The clawback problem arises because the gift tax exemption used to shelter the gift was much higher in the 2018 to 2025 period than the gift (or estate) tax credit that will be used in 2026 at the time of the donor-decedent’s death.
  • Clawback Problem: Restated, a clawback problem is created when large lifetime gifts are made by a donor between 2018 and 2025, and the donor’s death occurs sometime after 2025 when the federal estate and gift tax exemption falls back to its lower amount of $5 to $6 million. Is the computational amount of the lifetime gifts clawed back into the donor-decedent’s taxable estate, i.e. an estate tax is imposed on previously tax-exempt lifetime gifts? What credit is used in the calculation: The 2025 available credit or the higher credit that was available when the lifetime gift was made? The tax law, as currently written, would require the post-2025 smaller credit amount to be used in the taxable estate calculation, which leads to an estate tax on prior gifts that were fully sheltered from federal gift tax by virtue of the much larger federal gift tax exemption when the gift was made.
  • Example: A donor has $11 million in assets in 2019. The donor gifts $7 million in 2019 to his children. The donor’s remaining $4 million in assets does not appreciate in value after the 2019 gift. The donor dies in 2026 with a taxable estate of $4 million, when the federal estate tax exemption is $6 million (assumed, due to inflation of the 2017 amount.) The donor’s taxable estate will be $11 million [the $4 million that the decedent owned at death, plus the $7 million that he gave away in 2019.] The donor will have used up all of his applicable exemption amount of $6 million the way the 2017 Tax Act is written, which means that the donor will have a taxable estate of $11 million with not enough exemption available to calculate the donor-decedent’s estate tax liability.
  • Clawback Solution- Deeming the Prior Exemption Amount: While the math is complicated, if not convoluted (but hey, we’re talking about the IRS and Congress, so I harbor no illusions that it will make much sense anyway), the way the statute is written, and now interpreted in the Final Regulations, the tax credit, or applicable exemption amount, that was available when the gift was made, e.g. $11.4 million is treated, or deemed, as a credit against the decedent’s taxable estate in 2026, even though in the year of death the donor-decedent’s available applicable exemption is the much lower amount, e.g. $6 million. The result is that the tax penalty of the add back of the value of lifetime gifts is mitigated by deeming the larger applicable exemption amount to be available in 2026 when the estate tax is calculated, not the smaller credit that is scheduled to return after 2025.
  • Example: Using the same example above, while the donor will have a taxable estate of $11 in the year of his death in 2026, the credit used against his taxable estate will be $11 million (the amount available in 2019) not the $6 million ( the amount available in 2026 going forward.)

Sunset Interpretation of Applicable Exemption Amount Used: What is important to keep in mind is that the additional estate and gift tax applicable exemption amount created by the 2017 Tax Act is viewed as only temporary. If the temporary exemption is not used, come 2026, the temporary exemption is lost (forever) when the exemption amount drops back from $11.4+ million (temporary) back to $5.5+ million (original, assume it grows due to inflation to $6.0 million.)

  • Key Point: If a large gift is made by an individual prior to 2026, that individual is deemed to have used their original $5.5 million of the applicable exemption amount first, not the temporarily increased applicable exemption amount to shelter that lifetime gift from federal gift taxation.
  • Example: Charlie makes a $7.0 million gift in 2019. Charlie uses part of his $11.4 million applicable exemption amount to shelter that gift from gift taxation. Charlie makes no more lifetime gifts. Charlie dies in 2026. At the time of Charlies’ death, the applicable exemption amount will have increased (due to inflation in the intervening years) to $6.0 million. Charlies’ estate will have no applicable exemption amount available to satisfy any of his estate’s federal estate tax liability because Charlie will be treated/deemed to have used his original exemption amount to cover his 2019 lifetime gift ($5.5 million original + $1.5 million temporary.) By making no more taxable gifts, Charlie will have wasted roughly $4.0 million of his temporary applicable exemption amount.

Use-it-or-lose-it: Many folks erroneously believe that if they make a large taxable gift at this time, they will be using their temporary increased applicable exemption amount first, thus preserving their original applicable exemption amount (existing back in 2017) to shelter any federal estate taxes that will become due at their death. That is not, however, how the 2017 Tax Act and the Final Regulations interpret when and how the temporary applicable exemption amount is to be used. Large taxable gifts today will consume, first, the donor’s original applicable exemption amount. Only if the lifetime gift exceeds $5.5+ million will the donor begin to consume (use) their temporary increased applicable exemption amount.

Conclusion: After the enactment of the 2017 Tax Act, the period between 2018 and 2025 has been informally described as the use-it-or-lose-it period when it comes to making lifetime gifts. Lifetime gifts are treated as using the donor’s original applicable exemption amount first. Only gifts in excess of $5.5+ million will start to utilize the donor’s temporarily increased applicable exemption amount. The Final Regulations change nothing other than to clarify that the disparity between the temporary and original applicable exemption amounts will not be used to punish an estate with higher federal estate taxes if the donor-decedent made a lifetime gift larger than the donor’s original applicable exclusion amount. Consequently,  the Final Regulations underscore the importance of a donor using his/her temporary applicable exemption amount while it lasts.  For wealthy individuals, the emphasis in these years before 2026 needs to be on employing strategies to use their temporary applicable exemption amount, employing such strategies as SLATs, GRATs, and dynasty-type trusts.