Take-Away: The recent Proposed Regulations identify situations where the use of a donor’s large applicable exemption amount may create estate tax problems in the future at the time of the donor’s death.

Background:  After the 2017 Tax Act and its Final Regulations, we all assumed that gifts that were made while the applicable exemption amount was higher than the applicable exemption amount on the donor-decedent’s death would enable the donor’s estate to use the higher exemption amount that was in existence at the time of each of his/her lifetime gifts, rather than the lower applicable exemption amount that would apply after January 1, 2026 as to all categories of transfers. That assumption was only partially correct. Two examples show the difference under the new Proposed Regulations.

Final Regulations – Example 1: Ted has a $12,060,000 federal estate tax applicable exemption amount. Ted makes a $8.0 million gift of cash to his children. That gift reduces Ted’s applicable exemption amount to $4,060,000. The applicable exemption amount increases due to inflation adjustments to $13.0 million in 2025, but is then subsequently it is reduced to $6,500,000 on January 1, 2026 automatically. Ted dies in January 2026.  Will Ted’s estate have to pay an estate tax on $1.5 million? In general, the answer is ‘no’, based upon the initial understanding of the anti-claw-back Regulations, where the higher applicable exemption amount will be available for purposes of computing Ted’s federal estate tax liability.

Proposed Regulations – Example 2: The same facts as in Example 1, except that rather than gift $8.0 million in cash to his children, Ted gifts to his children a promissory note of $8.0 million that is payable by Ted. Ted files a federal gift tax return, Form 709, in which he reports the gift of the $8.0 million promissory note.  The assets held in Ted’s estate will be used to pay the promissory note held by his children. Under the recent Proposed Regulations, Ted’s estate will be unable to benefit from the higher exclusion amount that was available at the time of Ted’s gift of the $8.0 million promissory note. Instead, Ted’s estate will only have available of the applicable exclusion amount that exists on his death, $6.5 million, thus resulting in a federal estate tax imposed on the $1.5 million ‘excess’ held in Ted’s estate.

Special Rule – The Higher Exemption Amount: In 2019 the Regulations created a ‘Special Rule’ that allows an estate to calculate its estate tax credit using the higher of either the exclusion amount that is applicable as of the date of the donor’s gift, or the applicable exemption amount that is available on the donor’s death. The 2019 Regulations also adopted the use it or lose it rule by making gifts exceeding the historical exemption amount in order to take advantage of the temporary increased exclusion amount.

Example 3 – Special Rule: Donna makes a gift of $5.0 million today when the applicable exemption amount is $12.06 million. Assume the applicable exemption amount is reduced to $7.06 million starting in 2026. Donna dies after January 1, 2026. Donna would only have $2.0 million of  exclusion remaining. However, since Donna made a gift of $5.0 million when $12.06 million was the applicable exclusion amount, thus using all of the higher exclusion amount, then there would be no ‘clawback’ of the exemption previously used.  Donna died after 1/1/2026 when the previously higher exemption amount  is reduced to  $7,060,000.

Special Rule Exception: There is an exception to the Special Rule which applies to gifts that are includible in the gross estate under IRC 2035, 2036, 2037 or 2042. In addition, unsatisfied enforceable promises and gifts that are subject to the special valuation rules of IRC 2701 and IRC 2702, and the relinquishment or elimination of an interest in any one of these categories. In these situations the special rule (using the higher applicable exemption amount) will not apply.

Proposed Regulations: The Final Regulations that implement the 2017 Tax Act gave power to the IRS to adopt additional Regulations that would prevent abuse in situations where a lifetime gift was made but the donor retained the beneficial use of or control over the transferred property as of the donor’s death after the applicable exemption amount reduction occurs starting in 2026. That is why we now are looking at Proposed Regulations that further complicate an already complicated area of the law. Under the Proposed Regulations, in some situations, the amount that is includible in the donor’s gross estate would only be given the benefit of the applicable exemption amount that is available on the date of the donor-decedent’s death. The Proposed Regulations thus identify exceptions to the Special Rule, and they also provide (as only the IRS can do) ‘exceptions to the exception’ in narrow situations.

  • Example 4 – Gift of Promissory Note: Don has a net worth of $12 million and gives a $11 million note to his children and files a Form 709 gift tax return reporting use of $11 million of Don’s $12.06 million applicable exemption amount. This note is to be satisfied with assets from Don’s taxable gross estate. Assume the applicable exemption amount falls to $6.5 million on January 1, 2026, and Don dies shortly thereafter. While Don may at that time have a net worth of $1.0 million, he has still $12 million of assets and he has not made any payment on the $11 million promissory note. Therefore the $11 million note is includible in Don’s taxable gross estate. The limitation to the Special Rule applies and Don’s estate can only receive the benefit of the lower exclusion amount that is applicable on the date of Don’s death, which is $6.5 million, and therefore Don’s estate would pay federal estate tax on $5.5 million of assets [$12 million – $6.5 million = $5.5 million.] Note that this limitation on the Special Rule would also apply if Don, or a third party empowered to act on Don’s behalf, paid the promissory note within 18 months of Don’s death. In sum, the use of a promissory note or an enforceable promise to pay will not be effective in using the temporarily higher exclusion amount. The higher exclusion amount may be used only if payment actually occurs on Don’s promissory note, and such payment must occur at least 18 months prior to Don’s death.

Example 5 – GRAT: Donna creates a GRAT under IRC 2702. Donna funds the GRAT with $2.0 million of assets that pays to her 21.34% of the initial value of the GRAT’s asset, or $426,800 each year, for 5 years. Donna will not be considered to have made a gift to establish the GRAT (a zeroed out GRAT)  and any assets held under the GRAT after the 5th year and satisfaction of the GRAT’s annuity payments would not be subject to any federal estate tax. If Donna dies before the end of the GRAT’s annuity payment period, some or all of the GRAT’s assets will be included in Donna’s taxable estate due to her retained annuity interest. The Proposed Regulations confirm that the lower applicable exclusion amount as of the date of Donna’s death would apply and not the higher exclusion amount that was available at the time of Donna’s transfer of assets to the GRAT.

Exception to the Exception: The Proposed Regulations provide that the Special Rule will still apply to allow the applicable exemption amount that was higher when a gift was made, where the assets gifted are includible in the donor’s gross estate to apply in two narrow situations: (i) transfers (gifts) where the value of the taxable portion of the transfer did not exceed 5% of the total transfer; and (ii) transfers (gifts) where the retained interests were relinquished or terminated by the termination of a durational period that is described in the original instrument of transfer by either (a) the death of any person, or (b) the passage of time.

Observation: It is clear that gifts of cash (outright or in trust) can take advantage of the higher applicable exemption amount. More risky are gifts of LLC, FLP interests or stock in a closely held corporation, where the donor’s ownership interest includes the ability to determine when a distribution can be made from the entity, or when the entity can be liquidated, where the entire value of the entity might be brought back into the donor’s gross estate at death under IRC 2036(a)(2). If the value of the entity is included in the donor-decedent’s gross estate under IRC 2036, the exception to the Special Rule would apply and the donor will not have the benefit of the likely higher applicable exclusion amount to the date of the transfer, but only the benefit of the exclusion amount as of the date of the donor-decedent’s death. If a gift of an interest in an entity is contemplated at this time, it would be wise to blunt the application of IRC 2036 by creating a special class of voting interests in the entity to control when a distribution, liquidation, or amendment to the governing documents can be made and transferring that interest more than three years prior to the donor’s death to an irrevocable trust outside of the donor’s estate with an independent trustee named for the trust.

Conclusion: The estate tax rules are already complicated, especially with an ever- shifting applicable exclusion amount. The Proposed Regulations present new ‘traps’ where the Special Rule will not apply and effectively clawback lifetime gifts that were thought to be transfer tax-free, thus exposing them to a federal estate tax.