Take-Away: A week or so ago I wrote about the historical basis in the federal courts for retroactive changes in tax laws. There is also support for retroactivity in the Tax Code itself. This should concern many donors with regard to making a large gift now, intending to use the donor’s very high federal gift tax exemption, only to find through future legislation that the federal gift tax exemption that the donor relied upon to make their large gift, disappeared, leaving the donor with a federal gift tax liability to pay.

Background: Previously reported was a history of U.S. Supreme Court cases which approved a retroactive change in some tax laws, whether they be income, gift, or estate tax changes. Only entirely ‘new’ taxes created by Congress, e.g. a wealth tax, cannot be given retroactive effect, if that is Congress’ intent.

Retroactivity Under the Tax Code: There is also a reason in the current Tax Code that a legislative drop in the current federal gift tax exemption could be retroactive to the first of this calendar year should Congress act later this year to change the federal gift tax exemption amount. While President Biden on the campaign trail made many proposals with regard to taxes, the one that seems to  attract the most attention of estate planners and donors right now is the possible drop in the federal gift tax exemption amount from its current high of $11.7 million per person to a much lower amount, such as $3.5 million, or maybe even as low as $1.0 million, per person.

Example: Barbara, a wealthy woman, wants to make a gift in 2021 of $11.7 million to an irrevocable trust she establishes for her children and grandchildren. Barbara has never made any taxable gifts in the past, so she has her full $11.7 million federal gift tax credit available to shelter her gift to the irrevocable trust. Barbara transfers $11.7 million in assets to the trust on June 1, 2021. On September 15, 2021, Congress passes a comprehensive tax law that reduces each taxpayer’s federal gift tax credit from $11.7 million to $3.5 million. Did Barbara just make a taxable gift of $8,200,000 to the trust, triggering a gift tax due of $3,280,000?  Maybe so, if Congress does not expressly make that change in a donor’s gift tax credit amount prospective in its effect.

Applicable Credit Amount: The basic exclusion amount is defined in the federal estate tax provisions of the Tax Code. [IRC 2010(c)(3).] The mechanism through which a gift or estate tax is computed is not based on the exclusion, as a generalization, but rather upon a tax credit, called the applicable credit amount, which is defined separately.

IRC 2505: For federal gift tax purposes, the key provision is IRC 2505(a)(1). It provides: “In the case of a citizen or resident of the United States, there shall be allowed as a credit against the gift tax imposed.. for each calendar year an amount equal to…(1) the applicable credit amount in effect under section 2010(c) which would apply if the donor died as of the end of the calendar year..”

  • Credit at the ‘End of the Calendar Year:’ Thus, the credit against the federal gift tax will not be the amount of credit under the law that is in effect at the time of the gift; rather, it is the credit that would have applied for federal estate tax purposes had the donor died at the end of the calendar year. Consequently, that credit would be based on the basic exclusion amount that is in effect at the end of the calendar year in which the gift is made.
  • Result if Reduction in Credit is Silent as to Retroactivity: If Congress enacts a tax law change on or before December 31, 202 to reduce the donor’s federal gift tax exclusion amount from $11.7 million down to a much lower exclusion amount, e.g. $3.5 million (or even $1.0 million), IRC 2505(a)(1) as written would result in a reduced exclusion amount for a gift made at any time during 2021, even if that change in the applicable credit amount is silent as to its retroactivity.
  • Example: Under the prior example, if Congress does not intentionally make its legislative reduction in the Barbara’s transfer tax exclusion amount prospective, Barbara will be left with a $3.28 million federal gift tax liability to pay. Barbara may have been prepared to reduce the size of her estate with a lifetime gift of $11.7 million, yet Barbara may not have anticipated reducing her estate by the amount of $14.98 million. Barbara may want to make her June 1 gift subject to a net, net gift agreement, to shift that potential gift tax liability onto the irrevocable trust.

Planning Options: As has been previously covered, there are some ways to structure a large gift in 2021 to hedge against a disappearing gift tax exemption amount should Congress decide to change the maximum gift tax credit in 2021.  Those strategies will not be rehashed again, but can be summarized by the following:

      Disclaimers:  A  disclaimer gift or trust, where the donee makes a qualified disclaimer and the disclaimed portion under the qualified disclaimer within 9 months returns the disclaimed portion back to the donor- but the donee calls the shots, not the donor;

QTIP-able SLAT: A QTIP-able trust, where the donor’s decision to make the QTIP marital deduction election can be postponed until April, 2022, when a federal gift tax return [Form 709] is required to be filed- which leave the donor in the ‘wait-and-see’ position of control;

Defined Value Gifts: Make gifts using a defined value clause, where the ‘excess’ above the donor’s available exemption amount at the end of the calendar year, if any, passes to a charity or to a marital deduction trust, thus the gift-over causes no gift tax to be incurred; or

Loans: Make a loan instead of a gift, where the loan can be forgiven if Congress does not legislatively reduce the lender’s available federal gift tax exemption amount.

Conclusion: Even if Congress does not formally make a reduction in a donor’s gift tax exemption amount retroactive to the first of the year, it is possible that IRC 2505(a)(1) will have the same effect if Congress changes the applicable exemption amount sometime during 2021 but says nothing about a prospective effective date. With this much uncertainty, large gifts this year should probably include some of the planning options described above to mitigate the risk of inadvertently incurring a federal gift tax when one was not anticipated.