Taxation - Income, Estate & Gift
By R. Matthew Pate, JD, LL.M.
Under the Tax Cuts and Jobs Act of 2017 (TCJA), the estate and gift tax lifetime exemption amounts were doubled from approximately $5.5 million to nearly $11.2 million. In 2026, however, unless Congress acts, the exemption will revert to the lower level provided under prior law (with inflation adjustments), essentially reducing the exemption by half.
As a result, many large estate owners are currently contemplating gift arrangements that could take advantage of a potentially temporary estate tax break.
For example, assuming inflation of 2%, an individual with an estate of $12.84 million would face no federal liability on December 31, 2025, but a $2.5 million estate tax the following day, on January 1, 2026. He or she may therefore consider making a large gift to family members or trusts for their benefit prior to expiration of this law.
Because of the manner in which estate taxes are calculated, however, professional advisors may tap the brakes on such gifts due to so-called "clawback" of prior gifts.
What is clawback?
Clawback is the risk of prior gifts being brought into the taxable estate when future estate tax exemptions are lower than when the gift was made. Under the rules governing the computation of federal estate taxes, a taxable estate is increased by prior taxable gifts, then reduced by the then available (at death) estate tax exemption amount (as well as gift taxes previously paid). As a result, an individual who had taken advantage of generous gift tax exemptions faced the prospects of a higher estate tax liability than a similarly sized estate (due to a "clawback" of such gift for estate tax purposes). This was most recently a planning concern in 2012 when the $5 million gift tax exemption was scheduled to sunset at the end of the year and revert to $1 million.
For example, clawback theoretically includes prior taxable gifts initially shielded from gift tax in the taxable estate without a corresponding increase in the available estate tax credit.
What did Congress and the US Treasury Department do under the TCJA?
Clawback was avoided in 2013 when the law was extended and then subsequently modified with the TCJA, but the prospects of a divided Congress for the foreseeable future coupled with generous estate exemptions nonetheless seem to heighten the risk that sunset will occur in 2026.
Understanding this potential, legislators provided some guidance within the text of the legislation itself.
Specifically, Section 2001(g) included a conforming amendment that required Treasury to issue regulations necessary to account for any difference between the exclusion amount applicable at the time of a decedent's death, and the exclusion amount applicable with respect to any gifts made by the decedent.
Treasury's subsequent guidance (issued as proposed and temporary regulations in November 2018) addressed some of the primary concerns, but left several other questions unanswered (note as well that legislation and regulations can always be modified in the future).
NO ESTATE CLAWBACK FOR GIFTS THAT EXCEED NEW EXEMPTION
The regulations provide that a decedent’s available estate tax credit amount is to be increased by any higher amount previously available when a taxable gift was made. For example:
BUT TAXABLE GIFTS APPEAR TO COME FROM BOTTOM OF EXEMPTION PILE
While the regulations do not explicitly address what portion of the exemption is assumed to be used in the event of gifts, it appears that gifts will be assumed to come from "the bottom" of the exemption pile. As a result, it would appear that the increased exemption available under current law is only truly beneficial to the extent gifts exceed the exemption available post-sunset.
For example, assume a $5 million gift is made during a $10 million exemption period, leaving an individual with a $5 million estate exemption currently. If a reversion to a $5 million exemption occurs, such individual will be considered to have used $5 million of the then exemption, per the following:
WHICH MEANS INFLATION ADJUSTMENTS POST SUNSET MAY BE LOST AS WELL
One additional impact of the methodology to account for large gifts post sunset is that such gifts may result in the loss of inflation adjustments as well. For example, assume a gift is made that exceeded the post sunset exemption amount. It appears that the benefit of future inflation adjustments will not be available to such individual until the new exemption exceeds the value of the prior gift.
|Exemption Post Sunset||$6.5M|
No additional estate and gift exemption would become available in this situation until the exemption reaches $10 million under inflation adjustments.
WHAT ABOUT PORTABILITY OF HIGHER EXEMPTION POST SUNSET?
Lastly, a related question concerns whether an exemption available under spousal portability is impacted by sunset. For example, assume a husband dies in 2025, allowing his spouse to port over a $12 million exemption. If his spouse survives into 2026, her own exemption would be reduced under sunset.
What about the portable exemption? While the proposed clawback regulations do not address this question, regulations applicable to portability seem to provide that the higher $12 million amount remains available to the surviving spouse (i.e., whatever exemption was passed under portability remains).
The anti-clawback regulations provide welcome guidance for those contemplating large gifts prior to sunset, as well as those who may have made large gifts and paid gift tax prior to the increase in the exemption in 2017; but it is important to note that the current increased exemptions do not appear to permit preservation of the marginal difference through gifting.
Note as well that the current regulations are only proposed, and it is possible that additional changes are made to the final regulations that modify these conclusions.
R. Matthew Pate, JD, LL.M.,joined The Nautilus Group in 2004 after receiving his masters in law in taxation from Southern Methodist University's Dedman School of Law. Matt is a manager within the Nautilus case development unit, where he applies his extensive experience in estate and business succession planning, tax issues involving closely held businesses, asset protection, and charitable planning arrangements. Matt employs a customized and high touch approach to suit the unique circumstances of the case specifics and the client's objectives. He received his BA from Georgetown University and graduated from the University of Texas School of Law in 2001.
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