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George F. Bearup, J.D. Senior Legal Trust Advisor

November 18, 2022

Clawback, the ‘Special Rule,’ and ‘Includible’ Regulations

Take-Away: While the concept of the clawback of lifetime gifts made by a donor to calculate the donor’s federal estate tax liability is already complicated, the IRS just made the calculation of that phantom federal estate tax liability even more complicated with its new includible exception Regulations.

Background: The 2017 Tax Act effectively doubled an individual’s applicable exemption amount (or sometimes called the basic exclusion amount) with regard to federal transfer taxes. However, that increase was only temporary, viewed as a bonus exemption, because the federal transfer tax exemption amount is schedule to return to about 50% of the current exemption of $12.06 million beginning in 2026. This ever-shifting temporary, or bonus,  applicable exemption amount in turn creates a new ‘problem,’ which is informally referred to as clawback (although that term is not used in either the Tax Code or the Regulations.)

Clawback: As a gross generalization, the value of the donor’s lifetime gifts are added back to  the donor-decedent’s gross estate at the time of the donor’s death as part of the calculation of the donor-decedent’s taxable estate. Accordingly,  if the donor made a lifetime gift when his/her applicable exemption amount was at $12.06 million (2022’s applicable exemption amount amount) , but the donor then dies in 2026 when his/her applicable exemption amount has dropped by roughly 50% (say, to $6.8 million)  it is possible the value of the donor’s  lifetime gifts might be subjected to federal estate taxes, even though the donor’s lifetime gift did not cause a federal gift tax to be paid at the time it was made due to the donor’s temporarily higher basic exclusion amount. Thus, the way the federal estate taxes are computed, adding the value of lifetime gifts to the donor-decedent’s gross estate amount, would result in clawing back taxes from the donor’s taxable estate that the donor did not think he/she ever had to pay due to the use of their temporarily higher basic exclusion amount when the gift was made.

Example: Bob, an unmarried individual, made a $9.0 million gift (his only lifetime gift, ever) in 2019 when his indexed applicable exclusion amount was $11.4 million. With no change in the tax law, Bob dies in 2026 with a taxable gross estate of $20 million. Assume that the 2026  $5 million basic exclusion amount, as indexed for inflation, has increased to $6.8 million. With a 40% federal transfer tax rate and Bob’s applicable exemption amount used up, the intuitively correct federal estate tax is 40% of $20 million, or $8.0 million. However, without any anti-clawback relief, Bob’s estate tax liability actually turns out to be $8,880,00, thus producing a clawback tax penalty of $880,000. This $880,000 of additional transfer tax can be explained as either as:

  • 40% of the amount by which Bob’s $9 million gift exceeded the $6.8 million date-of-death applicable exemption amount; or
  • the gift tax on Bob’s 2019  gift, but as if Bob’s gift had been made in 2026, not 2019; or
  • the additional federal estate tax on Bob’s hypothetical taxable estate of $29 million [$20 million gross estate  + $9 million previously gifted assets = $29 million], meaning as if Bob’s gift had not been made at all.

In short, all of the benefit of the 2017 Tax Act and its doubling of Bob’s available applicable exemption amount promised to Bob to induce him to make a large taxable gift prior to 2026 would be wiped out by the sunset of Bob’s temporary or bonus applicable exemption amount.

Special Anti-Clawback Rule: Congress was aware of this clawback problem when it passed the 2017 Tax Act, so it created a new IRC 2001(g) in which it directed the IRS to create Regulations with respect to any difference between (A) the applicable exclusion amount [defined in IRC 2010(c)(3)] applicable at the time of the donor’s death, and (B) the applicable exclusion amount under that Tax Code section that was applicable with respect to lifetime gifts made by the donor-decedent. The IRS responded in 2019 with a new Regulation that created a special rule that is referred to as the anti-clawback rule. [Regulation 20.2010-1(c.)]  In effect, this special anti-clawback rule provides that when the value of lifetime gifts are added back to the donor-decedent’s gross estate when calculating the donor-decedent’s federal estate tax liability that is due, it will use the sum of the amounts that are attributable to the basic exclusion amount allowable as a credit in computing the gift tax payable on the donor-decedent’s post-1976 gifts. In effect, the temporary or bonus applicable exemption amount available before 2026 will be used to calculate the donor-decedent’s federal estate tax liability, even when the actual applicable exemption amount is cut by 50% in the year of the donor’s death. This was the relief that most planners were looking for when the 2017 Tax Act first passed and clawback became a concern.

Example: Using the prior example’s facts, because Bob’s $9.0 million basic exclusion amount was used for his 2019 gift (his only post-1976 lifetime gift) is greater than the $6.8 million basic exclusion amount that is otherwise allowable in computing Bob’s 2026 federal estate tax liability, the larger amount of $9.0 million will be used instead of the $6.8 million amount to calculate the transfer tax credit available for Bob’s federal estate tax. Thus, by using the larger applicable exemption amount when Bob made his lifetime gift in 2019, the estate tax due by Bob’s estate in 2026 will be $880,000 smaller, effectively eliminating the clawback penalty.

Anti-Abuse Exception: In April of 2022 the IRS proposed a new Regulation that creates an exception to the special anti-clawback rule in order to address a perceived abuse of the anti-clawback bonus. [REG-118912-21, April 27, 2022.] The perceived abuse is the use of the temporary clawback bonus amount, before it is lost, but without the actual loss of the asset, i.e. on paper the large bonus applicable exemption amount is used, but not in reality.

Example: Bob gives a promissory note to his children in the amount of $9.0 million in 2019. Bob reports the unpaid promissory note as a lifetime gift of $9.0 million. Bob uses his then available termporary applicable exemption amount to shelter his $9.0 million gift from paying any federal gift tax in 2019. Bob still has the use, and enjoyment, of his $9.0 million in assets. When Bob dies in 2026, his estate claims that it can use the $9.0 million bonus applicable exclusion amount to calculate Bob’s federal estate tax liability, even though the applicable exclusion amount in 2026 at the time of Bob’s death is $8.6 million. In short, on paper Bob made a gift in 2019 and he used his temporary/bonus exemption amount,  but in reality Bob kept and used his $9.0 million in assets. This strategy was viewed by the IRS as an abuse of the anti-clawback special rule.

Includible: The 2022 proposed Regulation thus identifies exceptions to the special anti-clawback rule for transfers that are includible in the donor-decedent’s gross estate, or which are treated as if includible in the donor-decedent’s gross estate. [IRC 2001(b).] Four separate types of transfers are identified within the exception, which means that the donor’s date-of-death applicable exclusion amount will be used to calculate the donor’s estate federal estate tax liability, not the temporary bonus applicable exemption amount.

(1) Traditional String Gifts: This includes any lifetime transfers that are includible in the transferor’s gross estate under the string sections of the Tax Code: (i) IRC 2035, gifts completed by a transfer or by a relinquishment or release within 3 years of the transferor’s death; (ii) IRC 2036, transfers with a retained life estate; (iii) IRC 2037, transfers which take effect at death; (iv) IRC 2038, revocable transfers; or (v) IRC 2042, life insurance proceeds.

(2) Gifts by Enforceable Promise: This includes a transfer that is made by an enforceable promise to the extent that the promise remains unsatisfied as of the date of the promisor’s death. Therefore, if the promisor keeps the enjoyment of their property until their promise is satisfied, there is some resemblance to IRC 2036, i.e. a lifetime promise but continued enjoyment of the assets required to later satisfy the promise. In the past, these lifetime promises were excluded from the promisor’s adjusted taxable gifts under Revenue Ruling 84-25.

(3) Some Chapter 14 Transfers: Some transfers under either IRC 2701 or 2702 will be includible in the transferor’s estate- these are the special valuation rules where a retained interest in an asset or entity like a family limited partnership or corporation, or a trust, is otherwise valued at $0.00.

(4) A New 18-Month Rule: Covered under this exception are transfers that would have been picked up by the other three exceptions, but for the transfer, relinquishment or elimination of an interest, power, or property that is effectuated within 18 months of the date of the decedent’s death, either by the decedent alone, by the decedent in conjunction with any other person, or by any other person acting alone. While this exception is similar to the current 3-year estate inclusion rule under IRC 2035,  it is conspicuously extended to affirmative action not taken by the decedent but by any other person. Accordingly, this exception to the anti-clawback rule could apply to events within 18 months of an individual’s death that would not cause inclusion in the decedent’s gross estate under IRC 2035. In effect, the decedent will be considered to have maintained or been in an arrangement on his/her date of death if he/she was in the arrangement at least 18 months before their death.

(5) De Minimus Exception: Of course, then the IRS gives to us an exception-to-the-exception, where the lifetime transfers or retained interests or rights will not be drawn back into the donor-decedent’s taxable estate. In other words, the exception to the anti-clawback rules would not apply, and the anti-clawback rule in the 2019 Regulation will continue to apply, to transfers that are includible in the transferor’s gross estate in which the value of the taxable portion of the transfer, determined as of the date of the transfer, was 5% or less of the total value of the transfer.

Example:  Charlie agreed to lend money under a promissory note or other loan arrangement in 2022, which Charlie reported as an enforceable promise to pay, or a taxable gift. Charlie actually satisfied the loan less than 18 months prior to Charlie’s death in 2026. Charlie’s loan will still be considered to be outstanding, so that the assets that Charlie used to repay the loan, or an amount equal to the loan amount, will still be subject to federal estate tax on Charlie’s death, but without the use of the larger temporary/bonus applicable exemption amount when the gift was made and reported.

Example: On the advice of his estate planning attorney due to the increasing IRC 7520 applicable rate of interest, Charlie decides to create and fund a qualified personal residence trust, or QPRT in 2022. Charlie’s home is worth $7.0 million when the gift is made. Charlie selects a certain term of years as his retained exclusive use term in the QPRT instrument. The value of the gift of the QPRT’s remainder interest to Charlie’s children is $2.7 million, which Charlie reports on a Form 709 federal gift tax return that he files for 2022. However, Charlie dies during his retained exclusive use term under the QPRT, when his applicable exclusion amount has dropped down to $6.8 million in 2026. Accordingly, the value of the QPRT’s corpus is includible in Charlie’s gross estate. [Regulation 20.2036-1(c)(2).] Because the value of the taxable portion of Charlie’s transfer to the QPRT ($2.7 million) was more than 5% of the total value of the transfer determined as of the date of Charlie’s gift to the QPRT ($7 million), the 5% de minimus rule is not met, and the regulatory exception to the anti-clawback special rule applies to Charlie’s gift of the QPRT’s remainder interest. In other words, the credit to be used for purposes of computing Charlie’s federal estate tax liability will be based on the $6.8 million basic exclusion amount in the year  of Charlie’s date of death, 2026, not the $7.0+ million that was available to Charlie in 2022.

Effective Date: The 2022 proposed Regulation only applies prospectively, that is only to estates of donor-decedents who die  on or after April 27, 2022.

Conclusion: We are currently in the ‘comment stage’ to the IRS’ proposed anti-abuse exception to the anti-clawback special rule. Lots of estate planning groups, bar associations, and tax preparers have submitted comments and concerns to the IRS with regard to its proposed Regulation. Overkill is a common thread in those comments.  It would be wise to take a look at some lifetime transfers, e.g. IRC 2701 and 2702,  and gifts that might invite a ‘string’ analysis to determine if they fall within the regulatory exception. If so, now would be a good time to take some steps to start the 18-month period running should it later become binding.