Retroactive Reduction in the Exemption Amount: Is it Likely? Can it Happen? Ideas to Plan for it in Case it Does

As result of the special runoff in Georgia for their two senate seats, the Democrats will now hold power in the Senate, the House, and the Presidency following President-Elect Joe Biden’s inauguration on January 20th. With the Democrats controlling the Presidency, the House, and the Senate, many have started to wonder what tax changes may be on the table, and if so, will such changes be retroactive to January 1. One item that some taxpayers are concerned about is a reduction in the gift and estate tax exemption amount which currently sits at $11.7 Million. Will the exemption amount be reduced? And if so, does Congress have the power to make such reduction take effect retroactively back to January 1, 2021?

Likelihood of Reduction of Estate Tax Exemption Amount

Before diving into the issues presented by a retroactive tax law change, I would like to briefly share my personal thoughts on the likelihood of a reduction of the estate tax exemption amount in 2021. Keep in mind this is merely my personal thoughts and Congress can change the law on a whim. Currently, the Senate is set to be split 50/50 between Democrats and Republicans with Vice President-Elect Harris having the power to cast the tie breaking vote. Thus, the Democrats control the Senate. However, such control is by the slimmest of margins and it would only take one defector to prevent a bill from passing. Some of the more moderate Democrats who are from more moderate states know they will have to answer to their constituents. As a result, I feel it its unlikely that there is any major progressive tax change that will pass. Many of these Senators will more likely concern themselves with protecting their re-election and representing the will of their constituents rather than towing the party line for anything too progressive.

Since it only takes one defector, it is likely nothing that is viewed as overly progressive or overly substantial will pass muster. So what about the estate tax exemption? Reducing the estate tax exemption from $11.7 Million to $1 Million could certainly be considered a substantial and progressive change. But what about a reduction to $5.85 Million? That does not seem quite as progressive. So what will happen? The answer is, of course, that I have no idea and cannot predict what Congress will do. However, I do view a reduction in the exemption amount to $1 Million or even $3.5 Million to be unlikely given the slim margin with which the Democrats hold power. As to a more moderate reduction, I could see something similar being more likely to happen, but at least in my view, is probably unlikely to happen as well. A moderate reduction in the exemption amount would likely not be a huge revenue raiser and there are other items that Congress could more easily focus on to raise more revenue. With that said, Congress may have other priorities on the table for 2021 as well, including items such as COVID-19 relief, infrastructure, and climate change legislation.

Retroactive Tax Law

Does Congress have the power to make retroactive tax changes? Have they done so before? In short, the answer is yes and yes, but a little more discussion on the issue is warranted. Let’s start with Congress’ power to make retroactive tax law change. The Carlton case can shed some light on this issue.[1] In the Carlton case, the U.S. Supreme Court analyzed the constitutionality of retroactively removing a provision providing for an estate tax deduction for proceeds of stock sold from the estate to an employee stock ownership plan, commonly referred to as an ESOP. Mr. Carlton was the executor of an estate who had taken advantage of the deduction and sued arguing that the retroactive removal of the deduction was a violation of due process. All nine justices of the Supreme Court ultimately concluded that the retroactive removal of the deduction did not violate due process, with Justice Scalia and Justice Thomas writing concurring opinions. In short, the Court noted that there were issues raised with retroactive tax legislation but nevertheless allowed the retroactive removal of the deduction to stand.

So, Congress does have the power to make retroactive changes to the tax law and has done so before, but just how far they may go in doing so is still up for debate. Another instance in which Congress has made tax law effective retroactively was in the introduction of the Generation Skipping Transfer Tax (“GSTT”). The bill enacting the GSTT was introduced on September 25, 1985 and signed into law on October 23, 1986, with the GSTT going into effect on the same date. However, the GSTT was retroactively applied to trusts which were created anytime after September 25, 1985. This created the so called “grandfathered in” trusts which are any trusts that were created and irrevocable on September 25, 1985. Thus, by having the GSTT be applicable to any trusts created after the date the bill was introduced, Congress created retroactive tax law dating back to the date of the bill’s introduction.

Therefore, we know that there is some precedent for retroactive tax law. So, will it happen? Going back to my analysis above regarding the Democrats having control of the Senate by the slimmest of margins, I again think this will come into play with any retroactive tax changes. Not only would each Senator who voted for such retroactive tax law change be risking significant political capital, but the whole Democratic party would be doing so. Given the slim majority with which the Democrats control the House (currently 222 Democrats to 211 Republicans with 2 vacancies) and even slimmer control of the Senate, at least in my opinion, I view any substantial retroactive tax law change to be unlikely, including a reduction of the exemption amount. With that said, as stated above, I do not know what the future holds and Congress may change the law on a whim.

Planning Ideas for a Possible Retroactive Reduction in the Estate Tax Exemption Amount

As stated above, I view a retroactive reduction in the estate tax exemption amount to be unlikely, but it nevertheless would be wise to consider including some flexibility in our planning just in case it does. So, for those who want to use their remaining exemption in 2021, what can we do?

Formula Clauses

The first idea that comes to mind is the use of formula gifting clauses. A defined value clause, such as that which was approved by the Tax Court in Wandry[2], may get us there, but there are also some issues and uncertainty in using such a clause. In a defined value clause, the donor typically gives away property equal to the remaining value of his or her estate tax exemption amount, thus the value of the gift is defined by or as the amount of such remaining exemption amount. These clauses typically reference the exemption amount, or the amount that can pass free of transfer taxes, as of the “date of the gift”. The intent of the formula is to avoid a taxable gift in the event the IRS is successful in challenging the valuation whereby the formula serves to adjust the gift such that the gift is equal to the remaining exemption amount taking into account any IRS valuation challenge that is successful. Keep in mind some common errors in the formula as seen in the Nelson case which has previously been written about here.[3] Such formulas are generally not intended to take into account retroactive tax law changes as this is not normally of concern. So if the gift is made on January 15, 2021, when the exemption amount is $11.7 Million, but then Congress retroactively changes the exemption amount such that is now only $1 Million, how much did the donor give away on January 15, 2021? The likely answer is the donor gave away $11.7M worth of property. With that said, its hard to see a Court holding for the IRS in a case like this, but it nevertheless could happen. But perhaps the formula could include language such as “taking into account any retroactive changes to such exemption amount which take effect on or before 12/31/21”? Would this get the donor there? Maybe, but again the same argument is present that the donor released dominion and control over $11.7 Million on January 15, 2021.

Another option is a defined value clause with a formula allocation. Perhaps the donor could make a gift of $11.7M and use a formula allocation clause that allocates his or her exemption amount to one trust and anything above such exemption amount to separate QTIP Marital Trust that qualifies for the gift tax marital deduction. This would fall in line with cases such as McCord[4] and others where the donor parted with $X dollars and that was never disputed, but the $X was then split among two parties based on a formula. In McCord, the other recipient was a charity but that same analysis should apply if the other recipient is a QTIP Marital Trust. Nevertheless, the same issue is present with how to allocate based on the exemption amount. Is it the exemption amount on the date of the gift, January 15, 2021? Potentially, yes.

Disclaimer Planning

In addition to trying to properly craft a formula to consider a retroactive reduction in the exemption amount, a tall task that, at least in my view, still leaves a good bit of uncertainty on the table, one might structure the gift to be able to take advantage of a qualified disclaimer under IRC Section 2518. Under Section 2518, one may disclaim a transfer as long as certain requirements are met, mainly, that such disclaimer be in writing, be made within 9 months of the transfer, and the person who is disclaiming must not have accepted any of the benefits of the transfer prior to such disclaimer.[5] There are many variations of how this disclaimer planning could be incorporated, but to keep it simple, the donor could make a gift to a trust that provides for the trustee to disclaim the property, and if so, such property would pass outright to the donor’s spouse gift tax free. This would allow the donor to punt on the issue of a retroactive reduction in the exemption amount for at least 9 months.

Lifetime QTIP Trust

Another option is to transfer the property to a trust that meets the requirements of a QTIP Marital Trust under Section 2056(b)(7). A QTIP trust must make a QTIP election for transfers to the trust to qualify for the marital deduction. This election is made on the gift tax return which punts the issue of retroactive reduction in the exemption amount to April 15, 2022, or October 15, 2022 if the due date for the gift tax return is extended. However, for the trust to be structured in such a way that it would be eligible to make a QTIP election, the spouse of the donor must be the sole beneficiary and the trust must distribute out income to such spouse at least annually, among other things. This may not be an ideal trust structure for a donor to use his or her exemption amount. There is a type of trust known as a Clayton QTIP Trust[6] whereby the portion of the property which is not subject to a QTIP election passes to a different trust rather than remaining in the Clayton QTIP Trust. While there is some precedent for a Clayton QTIP Trust in the Estate Tax Regulations[7], the same does not apply in the context of gift tax, and there is a high probability the IRS would challenge such a structure in the gift tax context.

Summary

In summary, the Democrats will control all three branches of the government on January 20, 2021. There is some precedent that gives Congress the authority to make retroactive tax changes, but just how far Congress may go in this context is unknown, and there is likely a limitation somewhere. While Congress does have the power to make retroactive tax law, it is unlikely that they will do so in 2021 for the reasons discussed above, at least as to any substantial tax law changes that might cost them political capital. Nevertheless, there are some options to consider in planning to consider any retroactive reductions in the exemption amount. None of the options outlined in this article are ideal but are things to consider when taxpayers are structuring their affairs in light of the 2021 change of power.

 

[1] U.S. v. Carlton, 512 US 26 (1994).

[2]Wandry, T.C. Memo. 2012-88.

[3] Nelson v. Commissioner, TC Memo 2020-81.

[4] McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), See also Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009), Estate of Petter v. Commissioner, 653 F.3d 1012 (9th Cir. 2011)

[5] IRC. Sec. 2518(b).

[6] Clayton Estate v. Commissioner, (97 T.C. 327 (1991), rev’d, 976 F.2d 1486 (5th Cir. 1992)

[7] Treas. Reg. Sec. 20.2056(b)-7(d)(3).