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

23-Nov-18

Gift Tax Claw-back: Proposed IRS Regulations

Take-Away: Last week the IRS published proposed Regulations that would eliminate our concerns about claw-back, which is the fear that gifts made before 2026 which were protected by the donor’s large lifetime gift tax exemption amount, would be ‘clawed-back’ into the donor’s taxable estate at death, causing those previous gift-tax-exempt transfers to be taxed at the donor’s death. The proposed Regulations, amending the Regulations IRC 2010(c)(3), will prevent the claw-back from taking place.

Background: In order to understand the claw-back issue, you first need to understand how the federal estate tax is calculated.

  • Unified Gift and Estate Tax System: The Tax Code applies a unified rate schedule to an individual’s cumulative lifetime taxable gifts and the individual’s taxable estate on death to arrive at a net tentative tax. The net tentative tax is then reduced by a credit that is based on an applicable exclusion amount (AEA) which is the sum of the basic exclusion amount within the meaning of the Tax Code, and the deceased spouse’s unused exclusion amount (DUSA).
  • 2017 Tax Act: The provisions of the 2017 Tax Act created a great wealth transfer planning opportunity, but at the same time it also created the possibility of claw-back. An individual’s lifetime and estate transfer tax exemption amount was increased to $11.18 million, and that exemption amount will be adjusted upward by a ‘chained’ (i.e. depressed) cost-of-living escalator, through 2025. That is the planning opportunity- the ability to give away more wealth transfer tax-free. The claw-back issue is that the transfer tax exemption amount is scheduled to fall back to the 2017 level beginning in 2026. In short, a ‘window period’ of several years exists to make large lifetime gifts without paying a gift tax. But on the donor’s later death, those large lifetime gifts could come back to create an estate tax liability for the donor-decedent’s estate.
  • Calculation of the Donor’s Estate Tax Liability: Several steps are involved in this cumulative estate tax analysis, which tersely are summarized below:
  • Step 1: The federal estate tax is imposed on the transfer of the decedent’s estate at death. [IRC 2001(a).] That rate is currently 40%, the same for taxable gifts made by a donor.
  • Step 2: A tentative estate tax is determined on the sum of the decedent’s taxable estate plus the adjusted taxable gifts made by the donor-decedent after 1996. [IRC 2001(b)(1).] In short, lifetime gifts are added back to the value of the donor’s taxable estate as a starting point.
  • Step 3: A hypothetical gift tax payable (reduced, but not below zero by the credit amounts allowable in those years when the gifts were made) is then calculated. The credit amount allowable for each of those taxable gifts for each year during which a gift was made is the tentative tax, but this hypothetical tax is calculated using the gift tax rates in effect at the time of the decedent’s death, not the gift tax rates that prevailed when the gift was actually made by the donor. [IRC 2001(b)(2) and (g).] Thus, a hypothetical gift tax is calculated on all lifetime gifts using the tax rate in effect when the donor dies (40%), not the gift tax rates that were actually used when the gift was made by the donor.
  • Step 4: The hypothetical gift tax payable determined under Step 3 is then subtracted from the tentative tax calculated under Step 2. [IRC 2001(b).]
  • Step 5: A credit equal to the tentative tax on the applicable exemption amount as is in effect on the decedent’s death is then determined. [IRC 2010(a)(c).]
  • Step 6: The credit amount calculated in Step 5 is then subtracted from the net tentative estate tax determined in Step 4. [IRC 2001(a).]

Claw-Back Problem: The problem arises in light of the cumulative nature of the gift and estate tax computations and the different manner in which the credit is applied against these two (gift/estate) taxes. If an individual made a gift during the ‘window period’ (2018 through 2025) that was fully sheltered from the federal gift tax by the temporarily increased basic exclusion amount, and the donor dies after 2025, will the lifetime gift that was exempt from federal gift tax when made during the increased basic exemption amount ‘window period’ have the effect of increasing the gift or estate tax on the later transfer at death when estate taxes are calculated? Restated, will the drop-back to lower exemption amount in 2026 subject the decedent-donor’s earlier lifetime gifts to taxation, even though the gifts were exempt when they were made? How the decedent’s federal estate tax liability is calculated could retroactively eliminate the benefit of the increased basic exclusion amount that was available and used for gifts made during the ‘window period.’

  • Example: Charlie makes a gift of $11 million in 2018, when the basic exemption amount was $10.0 million ( cost-of-living increases that amount to $11.18 million.). Charlie dies in 2026 when the basic exemption amount is $5.0 million. Charlie’s estate at the time of his death is $4.0 million. Applying IRC 2001(b) as it is currently written, Charlie’s estate tax liability would be about $3.6 million, [40% federal estate tax rate imposed on a $9.0 million estate, comprised of Charlie’s estate at death ($4.0 million)  plus the value of Charlie’s lifetime gifts ($5.0 million).] In effect,  IRC 2001(b) imposes an estate tax on the portion of Charlie’s 2018 gift that was originally sheltered from federal gift tax by the increased basic exemption amount that was available in 2018 (but not in 2026.)

Claw-back ‘Fix:’ The proposed Regulation would amend Regulation 20.2010-1 to provide that in the case of decedents who die or who made gifts made after December 31, 2017 and before January 1, 2026, the increased basic exclusion amount will be $10 million. A special rule will be added in cases where the portion of the credit as of the decedent’s date of death that is based on the basic exclusion amount is less than the sum of the credit amounts attributable to the basic exclusion amount allowable in computing gift taxes payable within the meaning of IRC 2001(b)(2). Specifically, in that situation, the portion of the credit against the net tentative estate tax (Step 2) that is attributable to the basic exclusion amount would be based upon the greater of those two credit amounts, thus adjusting the amount of the credit in Step 5 of the estate tax determination required to be applied against the net tentative estate tax.

  • Example: Charlie has made cumulative taxable gifts since 1976 equal to $9 million. All of Charlie’s lifetime gifts were sheltered from federal gift tax due to his basic exemption amount of $10 million ($11.18 adjusted by cost-of-living) on the dates of each of his gifts. Charlie dies in 2026 when the basic exclusion amount has returned to the $5.0 million level. The credit to be applied in computing Charlie’s federal estate tax will be the $9 million basic exclusion amount that was used to compute the gift tax payable, not $5 million.

Conclusion: Plenty of estate planners were worried about the specter of claw-back when presented with the ‘window period’ of larger transfer tax exemptions in light of the way federal estate taxes are calculated using a cumulative estate approach. It is of some relief that we can expect the Regulations that implement IRC 2010 to adapt to that ‘window period’s’ larger basic exemption amount to the way in which federal estate taxes are calculated. Perhaps uttering ‘famous last words’ claw-back is nothing to worry about when discussing with clients their opportunity to dramatically shift wealth gift tax free during this ‘window period.’