Clawback of Gift Taxes

Take-Away:  There initially was some concern if an individual made a large lifetime gift using her or his available applicable exclusion amount, that could come back and haunt the grantor at the time of death if at that time the applicable exclusion amount was lower, either after 2025, or earlier if Congress reduces the applicable exclusion amount. That should not be concern due to current IRS Regulations.

Background: While we now have an applicable exclusion amount of $11.7 million per person, we know also that that exclusion amount is schedule to drop back to about $5.8 million beginning in 2026. We also know that there are bills pending in Congress to reduce a donor’s lifetime exemption amount to $1.0 million. In the past we have heard President Biden suggest that the gift tax applicable exemption amount be reduced to $3.5 million per person. As a result, there has been a lot written about encouraging individuals to make large lifetime gifts now, using their $11.7 million transfer tax exemption. Which in turn raises the concern of whether they make a large lifetime gift using their available applicable exemption amount, will create a larger estate tax on their death, since lifetime gifts are added-back to the deceased donor’s taxable estate. This concern is often called clawback.

Regulations: Current IRS Regulations prevent clawback of taxable gifts made by a donor in excess of their applicable exclusion amount at the time of the gift. Those Regulations were finalized on November 26, 2019. [84 FR 64995-01, 2019 WL 6309937.]  Neither the Regulations nor the statute use the word clawback. The Regulations do, however, carry out the mandate of the 2017 Tax Act  which provided that Treasury had to prescribe regulations to adjust for “any difference between (i) the basic exclusion amount under IRC 2010(c)(3) applicable at the time of the decedent’s death, and (ii) the basic exclusion amount under that asection applicable with respect to any gifts made by the decedent.” [IRC 2001(g)(2).]

Large Lifetime Gifts: The mantra over the past year is for individuals to use their large lifetime gift tax exclusion now, before the tax law changes. The important point to remember is that any reduction in the applicable exclusion amount will come ‘off-the-top.’

Example: Assume President Biden’s proposal becomes the law after October, 2021, and a donor’s maximum applicable exclusion amount is reduced to $3.5 million. Donor Joe previously made taxable gifts of $1.0 million. Joe is encouraged this summer to make a large $5,000,000 gift. That gift of $5.0 million will capture little of the extra exclusion amount if the estate tax exclusion is reduced to $3.5 million in October. With the gift, Joe will have obtained the benefit of $2.5 million of the previously available exclusion amount ($6.0 million of total taxable gifts, less the $2,500,000 exclusion amount.)

Example: Pete and Gladys have assets of $40 million. They fully used their then-available exclusion amounts back in 2012 when they thought the applicable exemption amount was going to drop back to $1.0 million. Pete and Gladys have made some taxable gifts since 2012, so they each have used $5,750,000 of their applicable exclusion amounts coming into 2021. Pete and Gladys have a total of $11,900,000 applicable exemption amount remaining.  Pete and Gladys are encouraged to make a gift in August 2021 of that amount to a dynasty-type  of trust for the benefit of their children and grandchildren. Assume that later in 2021 the applicable exclusion amount is reduced to $5,800,000 per person. Pete and Gladys will have gained the benefit of using their full 2021 exclusion amounts with their gift to the trust.

SLATs: Because of the ‘off-the-top’ calculation for any reduction in the applicable exclusion amount, many married couples will not be able to afford to fully use their $11.7 million of applicable exclusion amount, especially if by doing so they are giving up all access to the property. This is where a spousal lifetime access trust, or SLAT, comes into the picture. While the label SLAT is frequently used, as a practical matter it is nothing more than a traditional irrevocable lifetime trust created for a spouse and children, or a conventional credit shelter trust. Funding the trust uses the donor-spouse’s applicable exclusion amount and also their GST tax applicable exclusion amount, which means that the trust’s assets, and their appreciation, will escape future federal estate and GST taxation.

–SLAT Drawbacks: The donor spouse may be unwilling to make so large a gift in trust, because of the possibility of a future divorce, or the beneficiary-spouse’s premature death, where non-spouses would then become the trust beneficiaries. In addition, the SLAT would be taxed as a grantor trust to the grantor-spouse [IRC 677] which arguably would continue even after the beneficiary-spouse’s death. There are ways however to protect, to a degree, the donor-spouse from these risks:

(i) the Trust could be set up to enable the donor-spouse to borrow trust assets after the beneficiary-spouse’s death;

(ii) the spouses could enter into a post-marital agreement agreeing that any assets transferred to the SLAT would continue to be classified as martial assets in the event the spouses divorce;

(iii) the trust could be drafted using a ‘floating spouse’ provision so that the person married to the donor is the intended lifetime beneficiary, not using the individual’s name; and

(iv) if the beneficiary spouse dies, she or he could be given a testamentary limited power of appointment, to appoint assets either to their surviving spouse, or in further trust for the benefit of the surviving-grantor-spouse.

Conclusion: We may not see any tax laws coming out of Congress in 2021 due to gridlock. But even if there is no legislative change, 2026 is fast approaching when the large applicable exemption amounts are set to sunset. That is why for wealthy individuals they should seriously consider making large gifts now to consume their available applicable exclusion amounts. If they are reluctant to part with the assets and the income those assets produce, they should seriously consider as well creating a SLAT for their spouse.