By Tasha Dickinson & Emily Snider
The Internal Revenue Service has released proposed regulations dealing with the so-called “clawback” issue raised by the increase in the basic exclusion amount for determining the unified credit against the estate, gift, and generation-skipping transfer (GST) tax. With the passage of the Tax Cut and Jobs Act of 2017, starting in 2018, the basic exclusion amount under Code Section 2010 was increased to $10,000,000, adjusted for inflation. This change means that individuals having a gross estate worth less than $11,400,000 will not owe federal estate, gift, or GST tax. However, this increased exemption amount will “sunset” in 2026, meaning that, without further act of Congress, the credit available for estate, gift, and GST tax purposes will revert to prior amounts.
The recent proposed regulations address the problem arising where an individual makes a tax-free gift during the time period while the exclusion amount is over $11 Million and then dies with a taxable estate or makes subsequent gifts after 2025, when the exclusion is less than that. The examples from the Preamble to the Proposed Regulations illustrate the concern that the prior gifts will be “clawed back” into the estate, which are summarized here:
Individual A makes a gift of $11 million in 2018, when the exclusion amount was over $11 million. No gift tax is due in 2018, because the gift is less than the exclusion amount. Individual A dies in 2026 with a taxable estate of $4 million, when the exclusion amount is roughly $5.5 million. Under a literal application of existing law, estate tax of $3,600,000 would be due. This is because the current law would tax the amount of the $11 million gift in excess of the roughly $5.5 Million exclusion amount in effect upon the decedents death, in addition to the amount of the decedent’s taxable estate. A similar problem would arise if Individual A died in 2026 after making the gift in 2018 but leaving no taxable estate: existing law would still impose an estate tax of 40% on the amount of the prior gift that is in excess of $5.5 Million, for a total estate tax bill of around $2 Million dollars.
See IRS Notice of Proposed Rulemaking, 83 FR at 59346 (Examples 1 and 2). To correct this problem, the proposed regulations amend Treasury Regulation § 20.2010-1 to provide a special rule for calculating the basic exclusion amount that will allow the greater of two applicable credit amounts to be applied against the net tentative estate tax. The two applicable credit amounts are (i) the basic exclusion amount in effect on the date of the decedent’s death, or (ii) the total exclusion amount allowable in determining the gift tax payable under the estate tax computation. The effect of the proposed regulations is to eliminate the subsequent imposition of estate tax on gifts made during the time period when the exclusion amount is over $11 Million. Put differently, the “clawback” is not something with which clients need to worry under the Proposed Regulations.
An important point to note is that the proposed regulations limit the increase of the exclusion amount for this purpose only to the extent that the exclusion is actually used during the eight-year period of the temporary increase. For example, if the decedent made taxable gifts of $9 Million while the amount was over $11 Million, the credit to be applied in the estate tax computation is limited to $9 Million. This “use-it-or-lose-it” rule should incentivize making gifts before 2026 to take the full advantage of the temporary increase in the credit.
The proposed regulations were released on November 23, 2018. The comment period ends on February 21, 2019. These regulations will not become effective until on or after the date of a Treasury decision adopting the rules as final regulations in the Federal Register.