Clawback Seems to be Coming Back

Take-Away: Lifetime transfers that are includible in the transferor’s taxable estate at death will not be protected from the fear of double taxation, such as GRATs and QPRTs.  

Background: We have dealt with this topic before (sadly). The 2017 Tax Act increased a transferor’s basic exclusion amount (BEA) that is sheltered from federal transfer taxes. That BEA is adjusted annual for cost-of-living. Today, an individual’s BEA has increased to $12.06 million. However, the BEA is also schedule to drop back to roughly 50% of today’s BEA starting in 2026. The increase in the BEA has promoted a lot of giving over the past few years, but the looming reduction in the BEA creates valid concerns about making large gifts at this time.

“Clawback;” The clawback concern is that the federal estate tax is based upon an ‘adjusted net estate’ which adds back the decedent’s lifetime gifts to the decedent’s estate value, but then applies a credit for the federal gift tax BEA that was used to shelter the lifetime taxable gift. The problem is when large taxable gifts were made by the donor when the BEA was large, like $12.06 million, yet when the donor dies after 2025 his/her estate’s BEA has been reduced by 50%, say to $6.0 million. Gifts that were ‘free’ from federal gift tax due to the large BEA available to the donor at that time, might still cause a federal estate tax to be incurred when the value of the lifetime gift is ‘added back’ to the donor-decedent’s adjusted taxable estate.

• Example: Bud has a taxable estate of $15 million. Bud makes a gift of $11 million to a trust established for his children and grandchildren this year. No gift tax is paid by Bud because his $12.06 million BEA is larger than the value of Bud’s $11 million transfer to the trust. Bud dies in 2026 when the BEA has been reduced to $6.0 million. At Bud’s death his assets are worth $6.0 million. Bud’s lifetime gift of $11 million is added back to his taxable estate, meaning Bud’s adjusted net estate is valued at $17 million. But the BEA in 2025 is $6.0 million. A special rule exists in the Tax Code that permits Bud’s estate to ‘add back’ the BEA that was in place at the time Bud funded the trust with his assets. Hence, the BEA of $12 million will be available to Bud’s estate for purposes of calculating his estate tax liability, not the $6.0 million BEA that otherwise applies in 2026.

Special Anti-Clawback Rule: The Final Regulations with regard to ‘clawback’ created a special rule that is applicable in cases where the credit against the federal estate tax that is attributable to the basic exclusion amount (BEA) is less at the date of the decedent’s death than the sum of the credits attributable to the BEA allowable in computing gift tax payable with regard to the decedent’s lifetime gifts. [IRC 2001(b)(2); Regulation 20.2010-1(c).] In such cases, the portion of the credit against the net tentative estate tax that is attributable to the BEA is based on the sum of the credits attributable to the BEA allowable in computing gift taxes payable with regard to the donor-decedent’s gifts. This rule is intended to ensure that the donor-decedent’s estate is not taxed on completed gifts that, as a result of the increased BEA, were ‘free’ of gift tax when made. In short, this special rule prevents lifetime gifts from being taxed twice. It is commonly called the anti-clawback rule.

Limits to the Special Rule: The Preamble to the Final Regulations however noted that ‘further consideration would be given to the issue of whether gifts that are not ‘true inter vivos transfers, but rather includible in the donor’s gross estate, should be excepted from the special rule.’ The IRS has now published its most recent proposed Regulation that effectively narrows the anti-clawback special rule,  possibly creating a big surprise for some donors.

New Proposed Regulation: The IRS notes that the current special rule does not distinguish between: (i) completed gifts that are treated as adjusted taxable gifts for estate tax calculation purposes and that, by definition, are not included in the donor’s gross estate, and (ii) completed gifts that are treated as testamentary transfers for estate tax purposes and are included in the donor’s gross estate (called an includible gift.) The upshot of this new Proposed Regulation is that includible gifts will be denied the benefit of the anti-clawback special rule.

• Purpose of Special Rule: The claimed purpose of the special rule is to ensure that a bona fide inter vivos transfer of property is consistently treated as a transfer of property by gift for both gift and estate tax purposes. Unlike lifetime gifts which are valued at the time of the gift, and the same with regard to the gift tax exclusion amount used to shelter that gift from tax, property that is includible in the donor’s gross estate is subject to estate tax based on the values, estate tax rates, and subject to the exclusion amounts that are applicable at the date of death.

Example: Bud transfers $10 million in assets to an irrevocable trust for the benefit of his children and grandchildren. While Bud is not the trustee of the trust, in practice the trustee follow’s Bud’s directions with regard to the discretionary distributions from the trust. In addition, while Bud transferred a cottage to the trust, Bud continues to use and enjoy the cottage without paying the trust fair rental value. On Bud’s death, the trust assets have a value of $13 million. Because Bud by implied agreement controlled the disposition of the trust’s income, and in addition, he continued to use the cottage owned by the trust, the full value of the trust’s assets, $13 million, will be includible in Bud’s taxable estate at the time of his death under IRC 2036 (a lifetime transfer with a retained interest.)

• Perceived Abuses: The apparent concern of the IRS is that if includible transfers are subject to the special rule, they can be made in a manner that is designed to intentionally make the increased BEA available against the donor-decedent’s estate tax despite the fact that the donor retained the beneficial use of or the control of the transferred property.
• IRS Examples: The IRS provides examples of includible transfers that would not be protected by the anti-clawback special rule.
• “Examples of such transfers include gifts subject to other powers or interests as described in sections 2035 through 2038 and 2042 of the Code, gifts made by an enforceable promise as described in Rev. Rul. 84-25 and gifts subject to the special valuation rules of sections 2701 and 2702…. For example, a donor may attempt to make the increased BEA available against the estate tax under the special rule by the removal shortly before the donor’s death of the donor’s beneficial use of or the control of the transferred property. Examples of these types of transfers include the elimination by a third-party, shortly before the donor’s death, of interests or powers that otherwise would have resulted in the inclusion of the transferred interest of property in the donor’s gross estate; the payment before death of a gift by an enforceable promise as described in Rev. Rul. 84-25; and the transfer shortly before death of a section 2701 interest within the meaning of Regulation 25.2701-5(a)(4) and section 2702 interest within the meaning of Regulation 25.2702- 6(a)(1).”

What’s It All Mean? The original special rule, practically speaking, assured individuals that they could make large lifetime gifts prior to 2026 without any worry that when they died, after 2025, that their gift-tax-free  lifetime gifts would not ‘come back’ to create any estate tax liability. With this Proposed Regulation, that now means that some lifetime transfers will not benefit from the anti-clawback rule. Examples of common estate planning strategies devices transfers with retained life estates, grantor retained annuity trusts (GRATs) or qualified personal residence trusts (QPRTs) will not be protected by the special rule More exotic planning strategies like grantor retained income properties (GRIPs) and contracts-to-make-a-gift will also not find relief from the clawback ‘double’ taxation.

Conclusion: For the past 4 years not much worry was given to the clawback ‘problem’ after the IRS’s Final Regulations. Now we need to start worrying about it again if individuals are contemplating GRATs and QPRTs where the asset is includible in the transferor’s taxable estate at its date-of-death value.