On November 26, 2019, the Treasury Department and the IRS issued final regulations under Section 2010 which provided taxpayers with some much needed assurance that they would not be punished for utilizing their gift and estate tax exclusion (“Exclusion”) during their lifetime if Exclusion amounts were lower when they died (“Anti-Clawback Regulations”).[1] See Josh Sage’s article discussing the proposed Anti-Clawback Regulations and how gift and estate taxes are calculated. [2] On April 27, 2022, the IRS published proposed regulations (“Proposed Regulations”) which would deny the favorable treatment provided in the Anti-Clawback Regulations for certain lifetime gifts which the IRS deems undeserving of such treatment.[3] The Proposed Regulations are largely based upon comments and suggestions that the New York State Bar Association Tax Section made to the proposed Anti-Clawback Regulations.[4] The Proposed Regulations mainly affect completed inter vivos gifts over which the grantor retains a significant benefit. While the IRS indicated that these type transactions might be a potential issue in the preamble to the Anti-Clawback Regulations, the Proposed Regulations likely come as a bit of a shock to most taxpayers given the lack of follow up on the IRS’s part for over two years.
Exemption Basics
As Josh discussed in his article, the computations related to federal gift and estate taxes are pretty complex. A full discussion of the steps for calculating the federal gift and estate taxes is beyond the scope of this article, however Josh’s article provides a good foundation. In the United States, federal gift and estate taxes are linked because they utilize the same Exemption and basic rate (although the estate tax is actually a higher effective rate due to it being tax inclusive, meaning that estate tax is paid on the dollars used to pay the tax). At the most basic level, each taxpayer can gift an amount equal to his or her Exclusion, either during life or at death, without having to pay any federal gift or estate tax. Generally, amounts the taxpayer gifts beyond the Exclusion amount are subject to the federal gift tax if given during life or the federal estate tax if given at death. The Exclusion amount is adjusted each year for inflation and is always subject to legislative changes. The Tax Cuts and Jobs Act of 2017 doubled the base Exclusion amount from $5 million to $10 million (without considering inflation adjustments), such that the 2022 Exclusion amount is $12.06 million after adjusting for inflation.[5] However, the increased Exclusion amount is currently scheduled to sunset to $5 million (subject to adjustment for inflation) on January 1, 2026.[6]
This leads to the question of how do taxpayers know which Exclusion amount to use? For example, if a taxpayer gifts $10 million in 2022, but dies in 2026 when Exclusions are (approximate round number here) $6.5 million, will the taxpayer’s estate have to pay taxes on the difference of $3.5 million? Prior to the Anti-Clawback Regulations, taxpayers had little authority to guide them. The Anti-Clawback Regulations made it clear that as long as the gifts were free of the federal gift tax when made, the taxpayer’s estate would not be taxed on such gifts at his death if the Exclusion in effect at his death was insufficient to cover the gift. As Charles J. Allen discussed in his article on the benefits of lifetime gifting, the legislature could always change this treatment.[7] This has led to a “use it or lose it” mentality for many taxpayers while Exclusion amounts are high, because there is no guarantee what the Exclusion amount will be in the future.
Proposed Regulations Details
The Proposed Regulations provide an exemption from the favorable treatment provided in the Anti-Clawback Regulations under Section 20.2010-1(c) for certain completed gifts that are included in the donor’s taxable estate or treated as includible in the gross estate for purposes of Section 2001(b). These gifts are sometimes referred to as “artificial gifts” because while they result in a taxable gift that may use up a donor’s exclusion amount, the donor still retains sufficient interest or control to cause it to be included in the donor’s gross estate. For example, a taxpayer could make a gift of a house and surrounding acreage to his or her child and retain a life estate (the right to continue to live on and enjoy the property during the grantor’s life) in the property. Due to the parent’s retained interest in the property, the property would be included in the parent’s gross estate pursuant to §2036(a)(1).
By making gifts that use the increased Exclusion before it decreases in 2026, taxpayers can effectively increase the amount of Exclusion available to them upon death. Artificial gifts are particularly appealing to taxpayers whose asset levels are high enough that they are concerned about gift and estate taxes (thus they wish to use the increased Exclusion while it is still available), but who may not be comfortable enough that they won’t want or need the ability to continue to benefit from such assets during their lifetime.
The IRS sees artificial gifts as essentially testamentary bequests and therefore intends that taxpayers be limited to the Exclusion amount in effect at their death with respect to such. Such transfers will include, without limitation, the following transfers:[8]
- Transfers includible in the gross estate pursuant to Section 2035, 2036, 2037, 2038, or 2042, regardless of whether all or any part of the transfer was deductible pursuant to Section 2522 or 2523;
- Transfers made by an enforceable promise to the extent they remain unsatisfied as of the date of death;
- Transfers described in Regs. Section 25.2701-5(a)(4) (Section 2701 interest) or Section 25.2702-6(a)(1) (indirect holding of interests under Section 2701); and
- Transfers that would have been described in the prior three bullets but for the transfer, relinquishment, or elimination of an interest, power, or property, effectuated within 18 months of the date of the decedent’s death by the decedent alone, by the decedent in conjunction with any other person, or by any other person.
The language clearly indicates that this is not an exhaustive list. As such, taxpayers should consider the implication of the Proposed Regulations when evaluating potential legislative changes. Importantly, the final bullet point is designed to prevent certain deathbed planning strategies, specifically those involving a third party that has the power to eliminate a donor’s retained interest. These types of plans are called deathbed strategies because the third party often releases the grantor’s retained interest within weeks or even days of the grantor’s death, thereby allowing the grantor to retain some beneficial enjoyment or power over the property right up until his or her death. These strategies generally avoid estate tax inclusion because Section 2035 is relatively narrow and only pulls property back into the taxable estate if the donor himself or herself is the one to relinquish certain rights and powers within the three-year period of his or her death. As opposed to Section 2035, these regulations would apply to relinquishment of the grantor’s rights by third parties.
The Proposed Regulations specifically state that certain transfers will continue to be eligible for favorable treatment under the Anti-Clawback Regulations, even if they would otherwise be captured by the above list. This list of favored transfers includes only those which either (1) qualify for the de minimis exception (the value included in the grantor’s estate was less than or equal to 5% of the total value of the transfer), or (2) such transfers, relinquishments, or eliminations within 18 months of the grantor’s death that occur upon the expiration of a durational period described in the original instrument by either the mere passage of time or the death of any person.
Thus, where grantors specify that certain transfers, relinquishments, or eliminations will happen after some specified period of time or upon some individual’s death, they won’t be punished by the 18-month rule just because that specified time period ended, or the individual died within 18 months of the grantor’s death. Consider the following example as an illustration.
On December 1, 2022, when the Exclusion is $12.06 million, A gives $12 million to his friend B, in trust, for B’s life.[9] A retains the power in the trust agreement to appoint the trust property among B’s two children.[10] The trust agreement specifies that A’s other friend C has the right to eliminate A’s retained power of appointment. A makes no other gifts during his lifetime. A dies on December 1, 2030, when the Exclusion is $6 million.
Generally, as long as C exercises his right to eliminate A’s power of appointment before December 1, 2030, no part of the trust property will be included in A’s taxable estate under Section 2035. Under the Proposed Regulations, if C exercises his power to eliminate A’s power of appointment within 18 months of December 1, 2030, A’s estate is effectively going to be limited to a $6 million Exclusion amount.
Assume instead that the trust agreement provides that A must relinquish the power of appointment upon the passing of seven years after the creation of the trust. Thus, in accordance with the trust agreement, A relinquishes his power of appointment on December 1, 2029. Even though A relinquished a power which would otherwise cause property to be included in his taxable state under Section 2036 within 18 months of his death, because the relinquishment occurred upon the passage of a specific period of time that was specified in the trust agreement, no part of the $12 million gift should be subject to claw-back under the Proposed Regulations.
Effective Date and Conclusion
The Proposed Regulations are set to be applicable to estates of taxpayers dying on or after April 27, 2022, even though Exclusion amounts aren’t scheduled to decrease until 2026. Thus, those taxpayers who pass away before 2026 shouldn’t be affected, assuming no other legislative changes. By making the Proposed Regulations effective now though, the IRS is setting in place a regime to consistently treat all estates similarly. Importantly, there is no exception for transfers based on when they occurred. That is to say, if taxpayers have entered into one or more of the described transfers, regardless of when the transfers occurred, such transfers will be subject to a claw-back if the Exclusion amount is lower on the taxpayer’s date of death.
The Proposed Regulations are just that, proposed. Many taxpayers may prefer to wait for final regulations before they begin to worry. However, prudent taxpayers should at least be aware of what the IRS is planning and might begin reviewing their lifetime gifts to ensure they will not be subject to the Proposed Regulations. Taxpayers who haven’t engaged in significant lifetime gifting should consider tax planning strategies that don’t involve artificial gifts, such as Spousal Lifetime Access Trusts[11] to accomplish their desired goals of retaining at least an indirect benefit in assets while also utilizing the current Exclusion amounts.
[1] REG-118913-21; 87 F.R. 24918-24923, April 27, 2022.
[2] Josh Sage, “IRS Addresses Estate and Gift Tax Exemption Claw-back” (December 2, 2019), https://esapllc.com/clawbackpropreg/.
[3] https://public-inspection.federalregister.gov/2022-08865.pdf.
[4] REG-118913-21; 87 F.R. 24918-24923, April 27, 2022, and New York State Bar Association Tax Section, “Report on the Proposed Section 2010 Regulations” (February 20, 2019), https://nysba.org/NYSBA/Sections/Tax/Tax%20Section%20Reports/Tax%20Section%20Reports%202019/1410%20Report.pdf.
[5] See exemption amounts on the IRS Estate Tax webpage at https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.
[6] Section 2010(c)(3)(C).
[7] Charles Allen, ” The Pros and Cons of Lifetime Gifting” (November 29, 2021), https://esapllc.com/lifetime-gifting-2021/#_ftnref11.
[8] Proposed Reg. Section 20.2010-1(c)(3)(i).
[9] Assume that the transfer is a completed gift for federal gift and estate tax purposes.
[10] This power would cause at least a portion of the trust property to be included in A’s taxable estate under Section 2036.
[11] See my recent articles discussing SLATs, Devin Mills, “Spousal Lifetime Access Trusts Basics” (March 1, 2022), https://www.esapllc.com/slat-planning-2022/ and “Advanced SLAT Issues” (March 30, 2022), https://esapllc.com/advanced-slat-issues-2022/.
