Final Clawback Regulations Released
On November 22, 2019, the IRS issued final regulations under a concept known as “clawback” of estate tax exemption. “Clawback” of estate tax exemption arises due to the manner in which the estate tax is calculated and occurs when an estate tax exemption amount decreases. When the Tax Cut and Jobs Act of 2017 was enacted, the Congress “doubled” the “basic exemption amount” (“BEA”) from estate tax. See I.R.C 2010 (c)(3)(C). Estate taxes are only imposed on the value of property above the BEA and the BEA was “permanently” set at $5,000,000 in 2010. That figure has been indexed for inflation ever since so that, before it was increased by the 2017 tax law, it was about $5,500,000. Estate taxes and gift taxes are unified during the life of a taxpayer so that the BEA first shelters gifts from taxation during life and any remaining exemption shelters transfers at death.
The “doubled” BEA exists until January 1, 2026, at which point, the indexed amount from 2025 would be cut in half, e.g., the “doubled” exemption period ends. With inflation, the amount could be in the range of $6,000,000 to $7,000,000 at that time. Of course, it is always possible that Congress may enact rules which would reduce the amount of the BEA in the future, even before 2026. Currently, there are several bills pending (by notable politicians) that would cut the BEA to $3,500,000.
At the time the estate tax exemption was “doubled,” Congress was aware that the tax calculation contained a fatal flaw related to gifting plans. The estate tax is calculated by combining the amount of assets remaining in a decedent’s estate at death and the cumulative “adjusted taxable gifts” made over the decedent’s lifetime. Adjusted taxable gifts include only gifts in excess of the annual exclusion amount, now $15,000 per donee. I.R.C. Section 2503. Nevertheless, under the existing tax calculation, the “doubled” estate tax exemption is only applicable to a decedent who passes away and files an estate tax return (IRS Form 706) prior to January 1, 2026. However, where a taxpayer chooses to make gifts during the period of the “doubled” exemption (e.g., to “lock in” the amount of the unified estate and gift exemption), but passes away after December 31, 2025, the law was unclear.
Under traditional estate tax calculation structure, gifts made by the decedent during life are added back to the value of remaining assets in the estate at death and then, that sum is reduced by the BEA in the year of death. As such, any benefit to the irrevocable transfer by gift during the “doubled” exemption period would be lost, or “clawed” back for decedents passing away after December 31, 2025. Aware of the dilemma, Congress, as part of the Tax Cut and Jobs Act of 2017, directed the IRS to provide regulations for the calculation problem.
In November 2018, the IRS issued proposed regulations to address this concept, IRS Notice IR-2018-229 November 20, 2018. These regulations are now final and binding on all taxpayers. T.D. 9884; 84 F.R. 64995-65000. Several important takeaways can be discerned from these final regulations as noted below.
First, when an individual makes a gift, the gift will only be protected by these clawback regulations to the extent that the cumulative gift amount exceeds the BEA in the year of the decedent’s death. For purposes of the examples herein, we will refer to the “permanently” set $5,000,000 exemption as the BEA and the excess (doubled) exemption as the “bonus” exemption. Under the regulations, a gifting strategy will only help the taxpayer to the extent that the gifts exceed the BEA. In other words, if an individual gifts $5,000,000 in an era when the bonus exemption is $10,000,000 and passes away after the expiration of the bonus exemption, the amount to be consumed or added back at death would be the $5,000,000 BEA and no portion of the bonus would help reduce the estate tax because the taxpayer’s gifts did not exceed the BEA. By contrast, if an individual gives away $8,000,000 in an era when the bonus exemption was applicable, and the BEA is $5,000,000 at death, that decedent will have protection from an $8,000,000 gift even after expiration of the bonus exemption. The amount to calculate the estate tax at death will be reduced by the $8,000,000 used exemption and not by the $5,000,000 BEA generally available for decedents that year. In other words, the exemption for calculating estate tax is the higher of the gifts made or the BEA in the year of death.
A second key element to the final regulations, which was not apparent from the previously proposed regulations, relates to the “Deceased Spouse’s Unused Exemption” (“DSUE”). Since 2011, a surviving spouse can elect to “port” the exemption amount of a predeceased spouse by filing an estate tax return timely with the Internal Revenue Service. This means that the surviving spouse/surviving parent can, at death, utilize the sum of the deceased spouse’s unused exemption and the surviving spouse’s unused exemption. The final regulations make it clear that when a spouse passes away during the bonus exemption period, that DSUE, if claimed by the survivor, will remain available to the survivor even after the bonus exemption period ends. For example, if a spouse claims to “port” the unused exemption of a spouse who has passed away during the bonus era, the amount ported, $11,580,000 for 2020 decedents assuming the entire exemption is unused, will be available to the survivor notwithstanding any future reductions in the estate tax exemption threshold. With respect to the DSUE during the life of the survivor, the regulations clarify that a surviving spouse making gifts must use the DSUE before utilizing any of his/her remaining exemption whether it is the BEA or any bonus exemption available.
The regulations are important not only for what they do say, but also for what they do not say. Based upon the proposed regulations, there had been speculation that several techniques could lock in an exemption, reserve the benefit of the assets for the surviving lifetime of a donor, but yet preserve the exemption. These techniques would be made through the implication of Section 2701 or 2702 of the Internal Revenue Code which both accelerate the gift tax calculation on gifts made where certain interests are retained by the donor. The provisions of Sections 2701 and 2702 were enacted in 1990 in an effort to prevent an abuse of several planning techniques which had been popular in the 1980s. While the regulations do not deal with this issue, the preamble makes it clear that the IRS will issue guidance attempting to outlaw planning mechanisms designed to use the provisions of the Internal Revenue Code to circumvent the means which they were originally intended.
Finally, there had been a concern about the use of the generation skipping tax (GST) exemption. The GST exemption available under the Internal Revenue Code has been matched to mirror the amount of the estate tax BEA even though it is used on different types of transfers and, therefore, consumed by taxpayers at different rates. Nevertheless, the regulations do not clarify and provide guidance on the GST exemption.
In sum, the final regulations are a welcome relief and are generally “taxpayer friendly.” However, before embarking on any complicated gifting strategies, taxpayers should be warned to consider the impact of the regulations and their effect on any contemplated transfer.