Proposed Regulations Address the Estate and Gift Tax Clawback Issue
By Melissa Gonzalez
December 21, 2018
The Treasury Department and IRS recently issued proposed regulations to address the effect of legislative changes to the applicable exclusion amount used in computing federal gift and estate taxes.
The proposed regulations provide that individuals taking advantage of the increased gift and estate tax exclusion amounts in effect from 2018 through 2025 will not be adversely impacted after 2025, when the exclusion amount is scheduled to drop to pre-2018 levels, relieving concerns about a possible “clawback,” upon death.
The basic exclusion amount (BEA) for both gift and estate tax increased from $5 million, indexed for inflation, to $10 million, indexed for inflation. The 2018 exclusion was slated to be $5.6 million ($11.2 million for a married couple). As a result of the Tax Cuts and Jobs Act (TCJA), the inflation-adjusted BEA is now $11.18 million ($22.36 million for a married couple) for tax year 2018 and will gradually increase, based on inflation, through 2025. The exemption amount for 2019 is scheduled to be $11.4 million. The increase in the gift, estate and generation skipping transfer tax exemption sunsets after December 31, 2025, at which point it reverts back to $5 million, indexed for inflation, unless Congress renews the provision.
Two questions raised regarding a potential for inconsistent tax treatment or double taxation of transfers resulting from the temporary nature of the increased BEA have been answered in the proposed regulations. First, in cases in which a taxpayer exhausted his or her BEA and paid gift tax on a pre-2018 gift, and then either makes an additional gift or dies during the increased BEA period, the increased BEA will not be absorbed by the pre-2018 gift on which gift tax was paid, so as to deny the taxpayer the full benefit of the increased BEA during the increased BEA period.
Second, in cases in which a taxpayer made a gift during the increased BEA period that was fully sheltered from gift tax by the increased BEA, but makes a gift or dies after the increased BEA period has ended, the gift that was exempt from gift tax, when made during the increased BEA period, will not have the effect of increasing the gift or estate tax on the later transfer (in effect, subjecting the earlier gift to tax even though it was exempt from gift tax when made).
Example from the Proposed Regulations
Taxpayer makes a gift of $11 million in 2018 when the BEA was $10 million. Taxpayer dies in 2026 when the BEA has been reduced to $5 million, with a taxable estate of $4 million.
If there was a clawback, the estate tax would have been approximately $3.6 million, 40% of $9 million (the sum of the $4 million taxable estate and $5 million of the 2018 gift sheltered from the gift tax by the increased exclusion amount). This, in effect, would impose estate tax on the portion of the 2018 gift that was sheltered from gift tax by the increased BEA allowable at that time.
The above example utilizes the BEA in effect before adjusting for inflation. The proposed regulations have addressed the concern that the $5 million 2018 gift sheltered from the gift tax by the increased BEA will be subject to estate tax by allowing the estate to compute its estate tax credit using the higher of the BEA applicable to gifts made during life or the BEA applicable on the date of death. As a result, the $5 million gift made in 2018 will not also be subject to estate tax when the BEA is reduced to pre-2018 levels.
Although the increased BEA sunsets after December 31, 2025, please keep in mind that Congress can reduce the exemption at any time, especially with the recent change in control of the House of Representatives and with the upcoming 2020 presidential election. Gifting considerations to utilize the additional $5,000,000 (increased for inflation) exclusion should not wait.
Please consult your Mazars USA LLP professional for additional information.