No Clawbacks for Gifts if Estate Tax Exemption Changes

Lifetime gift giving can be an effective estate planning strategy for high net-worth clients. Although the estate tax is imposed on the aggregate of the taxable estate and lifetime taxable gifts, gifting removes the appreciation and cash flow of the property gifted from the amount subject to estate taxation.

Prior to the 2017 enactment of the Tax Cuts and Jobs Act (“TCJA”), the amount that each person could cumulatively pass by lifetime taxable gifts, and at death, without federal gift or estate taxation was $5,000,000, inflation-adjusted from 2010 (as such, the inflation-adjusted “unified” gift and estate tax exemption amount for 2017 was $5,490,000). The TCJA dramatically increased the exemption amount to $10,000,000, inflation-adjusted from 2010 (as such, the inflation-adjusted exemption amount for 2020 is $11,580,000). However, the enhanced exemption amounts under the TCJA are temporary and are scheduled to expire at the end of 2025. Consequently, from and after January 1, 2026, the exemption amounts will return to $5,000,000, inflation-adjusted from 2010. Cumulative amounts gifted and left at death in excess of the exemption amounts are taxed at a 40% rate.

Taxpayers should be motivated to take advantage of these enhanced TCJA exemptions before expiration (the 2019 election results could lead to an extension of the enhanced exemption, or to an earlier reduction if the Democrats prevail). This can be done by making lifetime gifts during this temporary period of enhanced gift tax exemption.

As the estate tax is imposed on the aggregate of lifetime taxable gifts and taxable estate, Congress was concerned that an unwarranted increased estate tax could be imposed if a person makes large gifts during the TJCA temporary period of enhanced gift tax exemption, but dies after the expiration of the enhanced exemption. For example, absent a special rule, if one makes taxable gifts of $11,000,000 before 2026 when the exemption amount fully shelters the taxable gifts, and dies after 2026 with $0 (I know that this is unrealistic, but it will make the point), the amount subject to estate taxation would be $11,000,000; but, the exemption amount would only be $5,000,000, inflation-adjusted from 2010. Presuming that the inflation-adjusted exemption amount at the time of death is $6,800,000, the estate tax would equal $1,680,000. In effect, this imposes an estate tax on the previously untaxed gift, known as a “clawback”.

At the direction of the TCJA, last month the IRS issued Treasury Regulations to avoid the clawback. These new regulations allow estates to compute the federal estate tax using the higher of the exemption amount applied to a decedent’s lifetime gifts or the exemption amount applicable on the date of death.

New Regulations

The new regulations provide examples:

Example 1. Individual A who was never married made cumulative taxable gifts of $9 million, all of which were sheltered from gift tax by the cumulative total of $11.4 million in BEA allowable on the dates of the gifts. The BEA on A’s date of death is $6.8 million. Because the total of the amounts allowable as a credit in computing the gift tax payable on A’s post-1976 gifts (based on the $9 million of basic exclusion amount used to determine those credits) exceeds the credit based on the $6.8 million basic exclusion amount allowable on A’s date of death, the credit for purposes of computing A’s estate tax is based on a BEA of $9 million (which is larger than the $6.8 million BEA for the year of death).

Example 2. Same facts except that lifetime gifts were only $4 million. Because the total of the amounts allowable as a credit in computing the gift tax payable on A’s gifts is less than the credit based on the $6.8 million BEA allowable on A’s date of death, the credit applied for purposes of computing A’s estate tax is based on the $6.8 million BEA as of A’s date of death.

In the first example, it is apparent that the gift giver benefitted from the temporarily enhanced exemption as his estate got to use the higher exemption amount that had been available, and utilized, at the time of the gifts. However, in the second example, the gift giver got no advantage from the higher exemption amount that had been available at the time of his gifts because he didn’t utilize the enhanced portion of the exemption. As such, the otherwise applicable date of death exemption applies. For him (and his estate) it is as if there was never an enhanced exemption.

If gift giving is motivated principally by a desire to take advantage of the temporarily enhanced gift tax exemption provided by the TCJA, the gifts need to be at least in amounts cumulatively more that the anticipated post 2025 date of death estate tax exemption amount. Presumably, gifts of less than $6,500,000, may not be strategically advantageous if motivated by the current enhanced gift tax exemption. In order to benefit from the temporarily enhanced exemption amount, gifting should be at, or near, the full enhanced exemption amount (e.g. currently $11,580,000). It seems to be that the enhanced exemption amount offered by the TCJA offers little planning allure for clients unless they are able to consider gift giving on such a high level.