IRS Clawback Proposed Regulation Causes Confusion In The Playing Field

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The world of estate tax planning can be complicated and confusing.

While planners can navigate the situations that taxpayers face by way of planning strategies, financial projections and illustrations, the IRS’s assault on various planning strategies in court cases, Treasury Regulation pronouncements and Proposed Regulations can result in unpredictability, and make the day-to-day life of estate tax planners interesting, to say the least.

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Many had assumed that gifts made while the exemption was higher than upon the date of death would enable the estate of the donor to use the higher exemption amount that was in existence at the time of each gift, in lieu of the lower exemption amount that would apply after January 1, 2026 (or earlier, if the exemption amount is reduced sooner) as to all categories of transfers, but this will apparently not be the case.

This is where it can get complicated.

For example, Polly Purebred has a $12,060,000 estate tax exemption and may make an $8,000,000 cash gift, reducing her exemption to $4,060,000. If the exemption would be $13,000,000 in 2026 by reason of inflation adjustments and is reduced to $6,500,000, does this individual have to pay estate tax on $1,500,000? The answer for most will be no under Regulations finalized in 2019.

What if instead of making a complete traditional gift, Polly instead gifts a promissory note payable by her to her significant other, Underdog, of the same value, and the assets of her estate will be used to satisfy the note? In this scenario, her estate would not be able to take advantage of the increased exclusion amount available at the time of the transfer, and instead would only have the availability of the exclusion applicable on the date of death resulting in estate tax being imposed on the $1,500,000 excess under the new Proposed Regulations.

While 2026 is still more than three years away, it is possible that the House of Representatives could stay in Democratic hands and the Senate could swing by three or four seats further into Democratic control, in which event, it is conceivable that the exemption would be reduced as early as 2023, although the Biden Tax Plan that was published on March 28, 2022 does not make mention of reduction of the exemption amount.

By way of background, the Tax Cuts and Jobs Act (TCJA) was passed in 2017 and provided that the exemption amount would be temporarily doubled to $10,000,000 plus inflation adjustments, but revert back to $5,000,000 plus inflation adjustments in 2026. Further, the TCJA provided the Treasury Department (which oversees the IRS) with authority to issue regulations to prevent abuse for situations where a gift was made but the taxpayer the beneficial use of or control over the transferred property as of the taxpayer’s date of death after the exemption reduction occurs .

Following the enactment of the TCJA, uncertainty remained regarding situations where the estate tax exemption amount that applied at the time of a decadent’s death would be lower than the exclusion amount that applied when the transfer was made by reason of a reduction in the exemption. To address concerns that an estate tax could apply to gifts otherwise exempt from gift tax by the temporarily increased exemption amount, final regulations released by the IRS in 2019 crafted a “Special Rule” that allows an estate to calculate its estate tax credit using the higher of the exclusion amount applicable as of the date of the gift or the exemption amount applicable upon death.

The 2019 Regulations also clarified that in order to take advantage of the temporary increased exclusion amount, the taxpayer would need “use it or lose it” by making gifts exceeding the historical exemption amount. For example, if a taxpayer made a gift of $5,000,000 today when the exemption amount is $12,060,000, and the exemption amount is reduced to $7,000,000 in 2026, the taxpayer would only have $2,000,000 of exclusion remaining. However, if the taxpayer made a gift of $12,060,000 using all of the increased exclusion amount, then there would be no “clawback” of the exemption previously used if the taxpayer died after 2026 when the exemption amount is reduced to only $7,000,000 because of the “ Special Rule”.

It is noteworthy that Proposed Regulations are not binding upon taxpayers, but are generally binding upon the IRS until they become final, at which time they become binding upon both taxpayers and the IRS. Proposed Regulations are issued to the public, which is given a period of time to make comments. The IRS and Treasury Department then review the comments and issue Final Regulations, which are usually a bit more taxpayer friendly than the Proposed Regulations that they replace, but not always.

Since the establishment of the Special Rule, the question of how to treat gifts that are complete at the time of transfer, but still includible in the gross estate of the decadent upon death has not been determined. The Proposed Regulations issued on Tuesday, April 26 make clear that transfers where the donor continues to have title, possession, or other retained rights in the transferred property during life that will be treated as still owned by the donor upon death, which occur under 2035, 2036, 2037, 2038, and 2042 of the Internal Revenue Code, do not qualify for the Special Rule. In these situations, the amount includible in the gross estate would only be given the benefit of the exemption amount available on the date of death. These are referred to as the exceptions to the Special Rule, and of course to make it even more complicated the Proposed Regulations have two exceptions to the exception to the Special Rule.

The exception to the Special Rule applies to gifts that are includible in the gross estate pursuant to 2035, 2036, 2037, 2038, or 2042 of the Code, unsatisfied enforceable promises, gifts subject to the special valuation rules of 2701 (related to valuation of intra-family transfers of equity interests in an entity where the senior generation retains certain preferred rights) and 2702 (related to GRATs and QPRTs), and the relinquishment or elimination of an interest in any one of the aforementioned situations that occurs within eighteen (18) months of the date of the decadent’s death. If a transfer falls under one of these categories, the Special Rule will not apply. But, as mentioned above, there are exceptions to the exception.

The Proposed Regulations further provide that the Special Rule will still apply to allow the exemption amount that was higher when a gift was made to apply in two types of situations where the assets gifted are includible in the donor’s gross estate:

(1) transfers where the value of the taxable portion of the transfer did not exceed five percent of the total transfer, and

(2) transfers where the retained interests were relinquished or terminated by the termination of a durational period described in the original instrument of transfer by either (a) the death of any person, or (b) the passage of time.

While the rules provided under the Proposed Regulations are fairly well defined and complicated, the specific circumstances where a taxable gift may be considered to have occurred are fairly well defined and contained.

Thankfully, the Proposed Regulation provided a few examples to demonstrate how the Special Rule and various exceptions apply. We have provided some of these examples below:

1. Example One: Note or Other Obligation of Taxpayer Given as a Gift.

Assume that a taxpayer with a net worth of $12,000,000 gives an $11,000,000 note to his or her children and files a gift tax return showing use of $11,000,000 of his or her $12,060,000 estate tax exemption. The promissory note is to be satisfied with assets of the taxpayer’s gross estate.

Assume that the exemption goes up to $13,000,000 through 2025, and then is cut to $6,500,000 on January 1, 2026.

The taxpayer dies on January 1, 2027.

The taxpayer may at that time have a net worth of $1,000,000, but he or she still has $12,000,000 of assets and has not made any payment on the $11,000,000 promissory note, and therefore the $11,000,000 note is includible in the taxpayer’s gross estate.

The limitation to the Special Rule applies and the taxpayer can only receive the benefit of the smaller exclusion amount that is applicable on the date of death, which is $6,500,000, and therefore would pay estate tax on $5,500,000 of assets ($12,000,000 – $6,500,000 = $5,500,000) .

This limitation on the Special Rule would also apply if the taxpayer, or a third party empowered to act on the taxpayer’s behalf, paid the note within 18 months of the taxpayer’s death.

This example confirms what many planners thought to be true, which is that the use of a note, or an enforceable promise to pay, will not be effective in using the temporarily increased exclusion amount, if the regulations are made permanent. In order to use the increased exclusion amount payment must actually occur on the note, and such payment must occur 18 months prior to the taxpayer’s death.

2. Example Two: When the Grantor of Grantor Retained Annuity Trust Dies Before the End of the GRAT Term.

The Internal Revenue Code explicitly permits the use of what is called the Grantor Retained Annuity Trust (“GRAT”), whereby assets or ownership interests in investment or business entities can be placed under a trust that pays the Grantor a certain percentage of the day one value of the trust assets each year for a term of years.

What remains in the trust after the term of years is not subject to federal estate tax.

An example would be that a Grantor would place $2,000,000 of assets into a GRAT that would pay the Grantor 21.34% of the day one value of the trust assets ($426,800) each year for five years.

Under this…

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Credit: www.forbes.com /

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