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IRS proposes new “clawback” regulations

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IRS proposes new “clawback” regulations

There is a computational quirk (that tax lawyers call “clawback”) in the manner in which the federal estate tax is calculated. What is “clawback” of estate tax?  Because the estate tax and the gift tax are accumulated into a single “transfer” tax, a problem occurs when the lifetime exclusion from estate/gift tax (called the Basic Exclusion Amount[1] or “BEA”) at the date of passing is less than the BEA on the date an individual makes a gift.  This concept is called “clawback” and is explained in more detail in our December 16, 2019 post.  “Clawback” has become an issue due to the enactment of the Tax Cuts and Jobs Act of 2017, under which the BEA is temporarily increased through 2025 (the BEA for 2022 decedents is $12,060,000), and in 2026 the BEA will be cut in half. While Regulations were finalized in 2019 to address the majority of clawback related issues created by this pending reduction in the estate tax exclusion, the Internal Revenue Service recently proposed additional regulations[2] designed to address an issue that the Service perceived to be a potential “loophole.”

Initially, this computational quirk occurs in the manner the estate and gift taxes are integrated.  Estate taxes are imposed when the value of the estate exceeds the BEA (indexed for inflation) in the year of death.  Without further congressional action, the BEA is set to be cut in half after 2025.  To the extent that the value of a testator or donor’s estate (to which is added lifetime gifts) exceeds the amount of the BEA in the year of a testator’s death, the estate tax is imposed at a rate of forty (40%) percent.

EXAMPLE: Suppose the BEA is $10,000,000 in year one and the donor (with an estate worth $15,000,000) chooses to make a gift of that amount at that time.  If the individual passed away when the estate tax exclusion had dropped to $5,000,000, the estate tax is calculated by adding gifts made ($10M) to the value of the assets remaining in the estate at death (assume $5M) and then applying the BEA from estate tax based upon the BEA of the year of death ($5M).  Thus, gifts made ($10M) plus assets in estate ($5M) creates a taxable estate of $15M, to be reduced by the BEA in year of death ($5M), resulting in a tax due on 40% of $10M ($15M less $5M). Thus, even though the amount gifted was completely “sheltered” by the BEA in the year of the gift, the subsequent reduction in the BEA “claws back” any of the benefit that would have been achieved from making the lifetime gift when the BEA was $10,000,000, and the statutory calculation imposes an estate tax on the portion of the gift that exceeded the final exclusion ($5,000,000) at the decedent’s passing.

Because Congress, when enacting the Tax Cuts and Jobs Act of 2017, was aware of the problem and inequity that occurs when the BEA at the date of passing is less than the BEA on the date an individual makes a gift, the IRS was directed to issue regulations to address computational this difficulty. The 2019 regulations are helpful to taxpayers and solved this issue by allowing the taxpayer to use the higher of the BEA in year of gift or BEA in the year of passing when calculating the estate tax due, notwithstanding the statute.

However, the 2019 Regulations also allowed a potential “loophole” for taxpayers to take advantage of this solution by “locking in” the BEA in the year of gift, even though the taxpayers have not truly parted with the funds. Taxpayers can accomplish this in a variety of ways, typically through a trust or through an entity treated as a partnership (e.g., a Limited Liability Company) for income tax purposes as a result of two specific sections of the Internal Revenue Code enacted in 1990 designed to attack other “abuses” used in the 1980s (and earlier). Those abuses involved “Grantor Retained Income Trusts” or “Preferred partnership freeze.”  These Tax Code sections, I.R.C. Section 2701 and Section 2702 impose a gift tax on the entire amount gifted to one of these vehicles in the year of gift, unless very specific requirements are satisfied.  For those transactions, the goal was to avoid an initial gift and let future appreciation pass gift tax free to heirs by structuring the gift in a certain manner.[3] Now, however, taxpayers are attempting to use those same Tax Code sections to create taxable gifts in order to take advantage of the BEA.

The recently Proposed Regulations attempt to address this loophole and prevent this type of abuse.  In the Proposed Regulations, the IRS uses as an example a “gift” of a promissory note. Suppose an individual with a $15,000,000 estate wants to make a gift in a year the BEA is $12,000,000, but does not really want to give away anything.  The individual donor makes a promise to repay $12,000,000 by signing a legally binding promissory note, and gifts the promissory note to his/her child so that the child is entitled to the $12,000,000 under the note. The donor files a gift tax return (Form 709) with the IRS reporting that they have made a gift of the $12,000,000 promissory note.  The theory is that the donor would hold the entire $15M in assets and at passing, when the exclusion is reduced to say, $6M repay the $12M promissory note.  The taxable estate would be $3M ($15M total reduced by the $12M debt) and the tax would only be imposed on the $3M because the estate would attempt to take advantage of the 2019 Regulations allowing the use of the $12M BEA in the year of the gift.   The donor would have theoretically “gifted” a large amount but in substance would not have parted with his/her assets.

Ignoring for the moment that the promissory note may not be actually “worth” the $12,000,000 claimed, these Proposed Regulations indicate that, to prevent this type of abuse, the gift would be ignored for gift tax purposes. However, they provide an exception where that promissory note is actually, in fact, paid by the decedent more than 18 months before death.

Similar circumstances can arise under Section 2701 with the aforementioned provisions of the Internal Revenue Code for a partnership interest where a parent gives away $12,000,000 “worth” of partnership units but, in fact, retains substantial control and use over the underlying partnership/LLC. If they failed to meet the technical requirements of the Code, the taxpayer could be treated as making a $12M gift but yet control the entity.

Also, under Section 2702, a trust known as a “Grantor Retained Annuity Trust” (GRAT) can be created where a grantor reserves a specified annuity stream from the trust is sanctioned.  However, suppose, instead the parent intentionally “flunks” the rules for proper creation of a Grantor Retained Annuity Trust and reserves an “Income” interest. Under the Code, there would be an initial gift and arguably, that donor would be treated as having made a taxable gift to preserve that exclusion.  In each of these cases, the IRS feels that the taxpayers are trying to “game” the system and, therefore, the Proposed Regulations will not allow the gift to be treated as an actual taxable “gift” for gift tax.

The operative rules of the Proposed Regulations are fairly simple, they simply deny the taxpayer’s estate the use of the enhanced BEA in the year of gift under one of three circumstances:

  1. If the gifted assets are taxable to the estate under one of the “string” provisions of IRC 2035 through 2042.
  2. The transfer is a promissory note.
  3. The transaction is based on the provisions of IRC 2701 or 2702 noted above.

There are exceptions for transactions that are resolved more than 18 months before death and where the value of the gift was less than 5% of the total initial transfer.  However, to understand the rules, one needs to consider and review the seven examples included in the Proposed Regulations. The examples are useful to illustrate how the IRS proposes to outlaw certain techniques.

  • In example one, for example, the taxpayer gifts a $9M promissory note. The IRS says that the note is “included” in the estate and thus, the gift is ignored, unless repaid more than 18 months before death.
  • Example two changes the facts to a cash gift of $2M followed by a gift of a $9M note. The cash gift is respected but the note is not.
  • Example three addresses the case where an individual has his/her BEA and also has claimed BEA from a predeceased spouse (called Deceased Spouse Unused Exclusion or DSUE). The individual makes a gift of the note. Again, a note gift is ignored.
  • Examples four through seven address situations with Grantor Retained trusts and illustrate how the IRS would not permit these transactions to “lock in” gift tax BEA exemption by using trusts.

In sum, the new Proposed Regulations are worth reviewing for taxpayers (and advisors) who hope to engage in gifting transactions to use their BEA before reduction but want to reserve some interest in the gifted property. For taxpayers that are willing (and able) to completely gift funds, the 2019 regulations will  preserve the tax benefits from the clawback.   Note that the Proposed Regulations are not binding until they are finalized after comments from the public and formally adopted.

[1] See IRC Section 2010(c)(3)(C).

[2] REG-118913-21; 87 F.R. 24918-24923; 2022-20 IRB 1089 (April 27, 2022).

[3] A complete discussion of how these transactions would work in this article is beyond the scope of this newsletter.

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