Clawback – Good New; But Think Twice When Splitting Gifts

Take-Away: The worries that some commentators had expressed that clawback of lifetime gifts brought back into a donor’s taxable estate on death could cause estate tax problems after the doubled estate tax exemption falls in 2026 were eliminated by an IRS proposed Regulation. But the order in which the exemption is applied coupled with the drop in a taxpayer’s exemption after 2025, back to its 2017 level, may have an impact on gift-splitting by spouses between now and 2026.

Background: We now have extremely high transfer tax exemption amounts, i.e. $11.4 million for each individual. That increase sunsets at the end of 2025. That high exemption amount is scheduled to drop back to about $5.6 million in 2026. A concern of many advisors was that if large lifetime gifts were made by an individual using their enlarged transfer tax exemption before 2026, the value of those large lifetime gifts would be added back to the donor’s taxable estate on the donor’s death, possibly exposing those tax-free lifetime gifts to federal estate taxation when the estate tax exemption is reduced to a much smaller amount, a concept known as clawback [the value of lifetime gifts are clawed-back into the donor’s estate when calculating the donor’s estate tax liability when the estate tax exemption is lower.]

Clawback Repudiated: Despite the confusion that surrounds just how long we will have to enjoy the high transfer tax exemption amounts, the IRS clarified with certainty that there will be no clawback of the value of the donor’s lifetime gifts for those donors who move ahead now and make large taxable gifts in reliance upon their temporary large transfer tax exemption. The IRS released proposed Regulations last November that provides assurance to those donors who take advantage of the increased gift and estate tax exemption before 2026 that they will not be penalized for having used the higher exemption amount to shelter lifetime gifts from taxation if/when the transfer tax exemption drops back to its pre-2018 level. [Prop Reg. 20.2010-1(c). REG-106706-18, Nov. 23, 2018.]

Implications for Gift-Splitting: Under the same proposed Regulations, an individual may lock-in the enlarged gift tax exemption amount by making taxable gifts that consume that enhanced exemption amount before 2026. The big however is that to preserve the enhanced exemption amount beyond 2025, an individual must first use his/her original gift tax exclusion amount. Restated, the lock-in effect of using up the enhanced gift tax exemption amount does not begin under the proposed Regulations until taxable gifts have first used up the donor’s original gift tax exclusion amount.

• Gift-Splitting: The gift-splitting election by spouses is authorized under the Tax Code. [IRC 2513.] Gift splitting is commonly done when one spouse owns the asset that is the subject of the gift, but their spouse joins in the lifetime gift so that it is reported as a gift of 50% from each spouse (despite how title to the subject of the gift was held.) Gift-splitting is an all or nothing election that is made on a Federal gift tax return Form 709 filed for the calendar year in which the gift is made. There is no ‘cherry-picking’ on the gift tax return with regard to which gifts are split and which ones are not split- as indicated, it is all gifts are split, or no gifts are split.
• Ordering Rule: Due to the proposed Regulation’s ordering rule, it may no longer make sense for spouses to elect to split large gifts over the next several years while the enhanced exemption is available.
• Example #1: Husband, who has never made taxable gifts before, makes a taxable gift in 2019 of $10 million. That gift is equal to the sum of both the Husband’s original exemption amount and his temporary enhanced exemption amount. [I am ignoring the impact of inflation adjustments on these exemption amounts just to keep the example simple, so the original exemption is $5.0 million and the enhanced exemption is $5.0 million.] Thus, under the proposed Regulation, Husband will have successfully locked-in and used his enhanced exemption amount.
• Example #2:  Same facts, but suppose, instead, that Husband and Wife elect to split gifts in 2019 and report that split gift on a Form 709. As a result of their decision to split the gift, each of Husband and Wife will be deemed to have made a gift of $5 million to the donee. These deemed gifts will consume each of Husband and Wife’s original exemption amounts, but not any of either spouse’s enhanced exemption amount. Unless Husband and Wife make additional taxable gifts or they die prior to 2026, the married couple will not benefit from either of their enhanced gift tax exemption amounts.
• Example #3: Husband, who has never made taxable gifts before, makes a taxable gift of $12 million in 2019. The amount of Husband’s gift exceeds his own original exclusion amount, including his temporary enhanced exemption amount. Logic would dictate that Wife should agree to split the $12 million gift with Husband for the year. With a split gift each of Husband and Wife will be deemed to have made a $6.0 million gift. That means that each will have used up his/her original exemption amount, and each will have consumed $1.0 million of their respective enhanced exemption amounts. While logical to split the $12 million gift, that may not be the optimal approach. If Husband and Wife did not elect gift-splitting, Husband will be able to lock-in his entire enhanced exemption amount. With a flat 40% federal transfer tax rate for lifetime gifts or transfers on death, preserving all of Wife’s $5.0 million enhanced exemption could shelter up $2.0 million of transfer taxes. This savings is compared to the $800,000 saved if Husband and Wife split the gift and they lock-in only $2.0 million of their enhanced exemption amounts. Needless to say the drawback to not splitting the gift is that Husband will owe $800,000 in federal gift taxes on the amount that his $12 million gift exceeds his $10 million original and enhanced exemption amounts. While we can rationalize that it is tax efficient for Husband to pay a gift tax because the gift tax paid (if Husband survives 3 years from his gift) is not included in his estate tax base. [IRC 2053(b).] But whose kidding whom, despite claims of ‘tax efficiency’ donors seldom voluntarily incur a gift tax when it can be avoided by gift splitting. It is better that Husband only give $10 million fulling consuming his original exemption amount and his enhanced exemption amount, or alternatively (blissfully ignoring step-transaction risks) gift $10 million to the donee and then gift the remaining $2.0 million to Wife with the hope that she will then gift that $2.0 million to the same donee.

Conclusion: There is no need to worry about clawback, which is the good news coming from the proposed Regulation. However, the ordering rule under that Regulation may put a damper on split gifts by spouses, or force some type of multiple gift steps.  Probably until the Regulation becomes final, gift splitting of substantial gifts between spouses should be put on hold. Due to the way IRC 2001(e) is currently written, the exclusion amount that is consumed by the consenting spouse who agrees to split gifts will not be restored, even if the value of the property is ultimately pulled back into the donor-spouse’s gross estate at death.  In short, there is a lot of confusion when the Regulation’s ordering rule is applied to gift splitting.