Take-Away: When dealing with lifetime gifts during this period of the temporary increase in an individual’s basic exclusion amount (BEA) it is important to keep in mind that there exists a priority with regard to what tax exemptions are used to shelter lifetime gifts. That priority is: (i) deceased spouse’s unused exemption amount (DSUEA); (ii) the individual’s own original BEA available back in 2017; and (iii) the temporary or bonus BEA that is available to the individual between now and the end of 2025. How that priority in tax exemptions is used by the donor will impact the amount of the credit that will be available to the deceased-donor’s estate to shelter their estate from federal estate taxes.

Caution: This review falls into the ‘mind-numbing’ category.

Background: The 2017 Tax Act essentially doubled an individual’s original basic exclusion amount, or BEA, from $5 million to $10 million. Both of these amounts are adjusted for inflation. That extra or bonus BEA is called either the temporary, or for this summary, the bonus BEA, because it expires at the end of 2025. The only way to lock-in the bonus BEA is to use it before 2026. For purposes of the examples that follow, it is assumed that we are beyond the period of the bonus BEA and are back into a period when the original BEA has returned to its 2017 level, but which has increased in amount due to interim inflation adjustments, but the bonus BEA has disappeared.

Anti-Clawback: As reported earlier, if an individual makes lifetime gifts that use up the bonus BEA but he/she dies after 2025 when the original BEA returns, the lifetime gift will still be shielded from federal estate tax, even if the BEA at the donor’s death is less than the BEA that was used during the individual’s lifetime, aka the clawback of lifetime gifts used to calculate the donor-decedent’s estate tax liability. The Final Regulations released in late November, 2019 confirmed an anti-clawback rule, which is good news in that large lifetime gifts will not cause an artificially higher value estate on which the donor-decedent’s federal estate tax is assessed.

Priority of Exemptions: The Final Regulations also confirm the priority of exemptions that will be used to shield lifetime gifts from gift taxation. If the individual’s spouse has died and the deceased spouse’s unused exemption amount (DSUEA) has been ported to their surviving spouse with a portability election made on a timely filed federal estate tax return [Form 706], that DSUEA amount must first be used by the survivor to shelter lifetime gifts from federal gift taxation. Next, the survivor’s own original BEA is used to shelter lifetime gifts, after their DSUEA amount has been exhausted. Only after both the ported DSUEA and the original BEA have been used, will the survivor then begin to use their bonus BEA. Consequently, the locked-in effect of using the donor’s bonus BEA does not begin until taxable gifts have first consumed the donor’s available ported DSUEA and the donor’s original BEA. [You will recall that the deceased spouse’s GST exemption is not subject to a portability election.]

Estate Tax Credit Calculation: The Final Regulations provide technical rules for the computation of the credit that is applicable to large lifetime gifts that consume the donor’s original BEA when calculating the deceased-donor’s federal estate tax liability. Under these rules a donor’s estate is allowed a credit for the greater of: (i) the credit available for the year of the donor’s death, based solely on their then available BEA; or (ii) the credit that was used during the donor’s lifetime, also based solely on the BEA (consisting of the donor’s DSUEA and their original BEA). Restated, the credit that is used when calculating federal estate taxes is the larger of (i) the BEA available credit used for the year of the donor’s death (original), or (ii) the BEA based credit that was used during the donor’s lifetime (original and bonus.)

Peculiar Calculation: What is peculiar is that the BEA-based credit for the year of the donor-decedent’s death is computed as if no DSUEA were available to the deceased-donor. This has the effect of artificially reducing the BEA-based credit for the year of the donor’s death, which thus makes it easier to cause the BEA-based credit used during lifetime to exceed the BEA-based credit for the year of the donor’s death.

  • Example #1: Don, the donor, dies in 2028. In 2028 the BEA has dropped to $6.8 million (the ‘old’ $5.4 million credit back in 2017 adjusted for inflation over the last 11 years.) Don had inherited $6.8 million in DSUEA from his late wife Wanda, i.e. a portability election had been timely made after Wanda’s death. Assuming no gifts were made by Don, and the transfer tax rate schedule currently in effect stays the same, the total applicable credit available to Don’s estate would be $5,385,800. The BEA-based credit for the year of Don’s death would be $2,665,800. The reason is that the BEA-based credit is a smaller portion of the total credit, i.e. the first $1.0 million of credit is computed at lower marginal rates set for in the rate table. [IRC 2001(c).]

In contrast to the BEA-based tax credit for the year of Don’s death, the BEA-based credits used for a lifetime gift is computed using a fraction. For each year in which gifts were made by Don, the BEA-based credit used during his lifetime is equal to the total applicable credit used during the year, multiplied by the BEA divided by the total applicable exclusion.

  • Example #2: Don made a $13.6 million taxable gift during his lifetime, which used up $6.8 million of the DSUEA that Don ported after Wanda’s death, and Don’s own $6.8 million BEA in 2028. The BEA-based tax credit used by Don’s gift is equal to $5,385,800 (the total applicable credit for a $13.6 million taxable gift) multiplied by the fraction of $6.8 million divided by $13.6 million, or $2,692,900.

Note that Don’s estate tax credit, $2,692,900, is greater than the estate tax credit in example #1, $2,665,800. Apparently, the BEA-based credit used by Don’s lifetime gift is greater than the credit that would be computed on the $6.8 million BEA available at Don’s death. If the date-of-death BEA is $6.8 million, then the BEA-based tax credit for the year of Don’s death is only $2,665,800. A $13.6 million gift by Don that uses up equal parts of Don’s DSUEA tax credit and his own BEA tax credit, in contrast, generates a BEA-based credit at Don’s death of $2,692,900. Thus, Don’s taxable gift during his lifetime creates an additional $27,100 of estate tax credit at his death, compared to when the identical exclusion amounts are used at Don’s death.

The upshot of this peculiar way in which the estate tax credit available at Don’s death is calculated, even if lifetime gifts do no more than consume Don’s original BEA, and do not even use up any of Don’s bonus BEA, is that the BEA-based credit available to Don’s estate will be greater than if Don had not made any lifetime taxable gifts.

Example #3: In 2020, Don made a $1.0 million taxable gift that used up $1.0 of Wanda’s $6.8 million ported DSUEA that was inherited by Don via a portability election after Wanda’s death. In 2021, Don made a $12.6 million taxable gift that used up the remaining $5.8 million of Don’s inherited DSUEA, plus Don’s own original $6.8 million BEA (the 2028 available BEA amount.) The BEA-based tax credit used by Don’s lifetime gift is $2,720,000. This amount applies at Don’s death rather than the $2,665,800 BEA-based tax credit for the year of Don’s death. Therefore, an additional $64,200 of estate tax credit is artificially generated by Don’s use of $1.0 million DSUEA in 2020 and then ‘staging’ of the two successive annual taxable gifts by Don.

Practical Observations: While these BEA/DSUEA rules are difficult to understand and implement, there are a couple of important points to keep in mind:

  1. Portability: Married couples should consider relying on a timely portability election as opposed to using the deceased spouse’s original BEA to shelter transfers to a credit shelter-type trust.
  2. Use DSUEA: As indicated in Example #3, it makes sense for a surviving spouse who holds an inherited ported DSUEA credit amount to use at least $1.0 million of the ported DSUEA first, or whatever amount is needed to ‘push’ that lifetime taxable gift into the highest tax bracket. Only in later years, should the donor then begin to use his/her own original By ‘staging’ gifts in this manner prior to 2026, and by using the DSUEA first, the donor can artificially generate an additional $135,500 exclusion from federal estate taxes at the donor-decedent’s death, even if he/she never uses any of his/her bonus BEA prior to 2026.
  3. Artificial Values:  The Final Regulations reserved the right to publish additional rules that, intended as anti-abuse rules, will address the impact of taxable gifts that use the donor’s BEA (original and inherited ported DSUEA tax credits) during lifetime, but are ‘pulled back’ into the donor-decedent’s gross estate at death. In particular, these rules will focus on artificially inflated lifetime gifts [under IRC 2701] even if those gifts are not ‘pulled back’ into the donor-decedent’s gross taxable estate under IRC 2036 or 2038. We can expect more rules from the IRS to address artificially increased values of lifetime gifts that are used by donor’s for the sole purpose of ‘locking-in’ the donor’s bonus

Conclusion: These rules are admittedly very complex. The ‘creation’ of large artificial estate tax credits through lifetime gifts that use a ported DSUEA may not have been what Congress intended, but that is the result of these computational rules. Perhaps they will be eliminated in future Regulations, but for the time being, they provide yet another reason to make large lifetime gifts, especially if a DSUEA currently exists, prior to 2026 when the bonus BEA disappear.