United States: Potential Anti-Abuse Rules May Limit Use Of The Temporarily Increased Gift Tax Exclusion

BACKGROUND

For only the second time in its history, the unified gift and estate tax exemption amount is scheduled, under current law, to decline. The Tax Cuts and Jobs Act (TCJA), although it temporarily doubled the basic exclusion amount (BEA) from $5 million to $10 million, adjusted for inflation, also provided that the increased or ''bonus'' exclusion expires after 2025.¹ As explained below, the temporary increase created a computational question of whether taxable gifts that use up the bonus exclusion before 2026 will effectively still be taxed at death if the donor dies after 2025. The Treasury Department and the IRS have now provided by regulation that the answer, generally speaking, is no: lifetime taxable gifts that are shielded against tax by the gift tax exclusion will successfully lock in any higher exclusion amount available during lifetime, even if the exclusion amount is lower at the time of the donor's death.²

By contrast, to the surprise of some, Treasury and the IRS have also announced that not all gifts will successfully preserve the bonus exclusion amount. In the preamble to final regulations on the effect of using up the bonus exclusion amount (the ''anti-clawback regulations''), Treasury and the IRS announced that they have reserved space for ''anti-abuse'' rules. These contemplated anti-abuse rules are targeted, according to the preamble, at gifts that are pulled back into the donor's gross estate at death and/or that exploit the valuation rules of chapter14 of the I.R.C. in order to artificially increase the value of a donor's gift. As no anti-abuse regulations have yet been proposed, the scope of possible future anti-abuse rules is necessarily unclear. This article addresses what the anti-abuse rules might attempt to do, and how taxpayers and their advisors can plan in the meantime.

MECHANICS OF THE ANTI-CLAWBACK REGULATIONS

In order to understand the mechanics of the anti-clawback regulations, one must first understand the mechanics of estate tax calculations. The need for an anti-clawback rule arises because, in the estate tax computation procedures, lifetime gifts are added back into the estate tax base. In particular, §2001(b)(1)³ provides that tentative estate tax is first computed on the sum of the decedent's taxable estate and the decedent's post-1976 adjusted taxable gifts, i.e., taxable gifts other than those that are already included in the gross estate. In other words, any gift made after 1976 is included in the estate tax base, either because it is included in the gross estate⁴ or, if not included in the gross estate, as an ''adjusted'' taxable gift.

The inclusion of post-1976 taxable gifts in the estate tax base does not mean, however, that those gifts are taxed twice. Rather, the inclusion is essentially a computational device for ensuring that a decedent's cumulative wealth transfers, whether made during lifetime or at death, are taxed at the progressive rates that exist at the decedent's death.⁵ Double taxation is avoided, first, by §2010, which restores at death the entire amount of the decedent's gift and estate tax exclusion. Thus, the inclusion of taxable gifts in the estate tax base has the effect, first, of using up the decedent's estate tax exclusion amount.

Second, if the decedent paid or was liable for gift tax on taxable gifts, double taxation at death is avoided by the equivalent of a credit available to the estate for gift taxes payable on lifetime gifts. In particular, §2001(b)(2) subtracts from the tentative estate tax the gift tax that would have been payable with respect to post-1976 gifts made by the decedent, calculated at the estate tax rates in effect at the time of the decedent's death (hereinafter, the ''gift tax payable''). Thus, despite the inclusion in the estate tax base of gifts on which a decedent may have already paid tax, the gifts are not taxed twice; rather the gift tax payable is subtracted from the estate tax generated by the inclusion of the same gifts.⁶

In the wake of TCJA, the computation procedures created the possibility that taxable gifts that were shielded from gift tax by the temporarily increased exclusion amount under §2010 would effectively still be taxed at death if the donor died after 2025. The reason is that those gifts, as discussed, are added into the estate tax, either because they are included in the gross estate or as adjusted taxable gifts. Section 2001(b)(2), however, only allows the equivalent of a credit for gift taxes payable; there is no credit under §2001(b)(2) for a gift made before 2026 that is protected against tax by the bonus exclusion amount, as no gift tax would actually be owed on that gift. In other words, gifts that use up the bonus exclusion amount would potentially be added to the estate tax base but without an offsetting credit, thereby effectively generating an estate tax on those gifts at the donor's death if the donor dies in a year when the exclusion amount is less than it was at the time of the gifts.

Mindful of the potential for clawback,⁷ Congress enacted §2001(g)(2) as part of TCJA. Section 2001(g)(2) directs Treasury to prescribe regulations necessary or appropriate to carry out §2001 ''with respect to any difference between . . . the basic exclusion amount under section 2010(c)(3) applicable at the time of the decedent's death, and . . . the basic exclusion amount under such section applicable with respect to any gifts made by the decedent.''⁸ Exercising this authority, Treasury and the IRS have issued final anti-clawback regulations in order to ensure that gifts that use up the bonus exclusion amount are not effectively taxed at death. The anti-clawback regulations achieve this result by increasing the exclusion amount of a decedent whose gifts used up an exclusion amount that was higher at the time of the gifts. Technically, as the applicable exclusion amount is equal to the sum of two amounts – the basic exclusion amount or ''BEA'' available to all citizens and residents and any deceased spousal unused exclusion (DSUE) inherited from a predeceased spouse, only the BEA is increased. Thus, if the BEA that applies to the decedent's post-1976 gifts exceeds the BEA available at death (as would be the case if an individual made gifts that used up his bonus exclusion and then died in 2026), the estate tax is computed using the BEA that was used up during lifetime.⁹

LOCKING IN THE BONUS EXCLUSION WITH ARTIFICIAL GIFTS

As discussed, under the anti-clawback regulations, the bonus exclusion is locked in as long as the gifts made by the decedent use up an amount of BEA that exceeds the BEA available at the time of the decedent's death. It is irrelevant, under the final anti-clawback regulations, whether the gifts that used up the bonus exclusion are included in the decedent's gross estate at death, as would be the case with gifts in which the donor continues to enjoy the benefits of the gifted property. Gifts that are pulled back into the donor's gross estate at death 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 parent could make a gift of a remainder interest in property to his or her child and retain the right to the income and enjoyment of the property during the parent's lifetime. 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).

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Footnotes

1. Pub. L. No. 115-97.

2. Estate and Gift Taxes; Difference in the Basic Exclusion Amount, T.D. 9884, 84 Fed. Reg. 64,995, 64,996 (Nov. 26, 2019) (to be codified at 20 C.F.R. pt. 20) (hereinafter, ''Preamble'').

3. All section references herein are to the Internal Revenue Code of 1986, as amended (the ''Code''), or the Treasury regulations promulgated thereunder, unless otherwise indicated.

4. A gift made during lifetime may be included in the gross estate, for example, because the decedent retained sufficient control or beneficial interests to cause gross estate inclusion under one of the estate tax ''string'' provisions of §2036-§2039 or §2042.

5. The unified credit under §2010 is now large enough that the progressive rates rarely have an effect. Instead, except for nonresident noncitizens, the gift and estate taxes are effectively imposed at a flat rate of 40% on wealth transfers that exceed the exclusion amount.

6. Section 2001(g)(1) provides that the gift tax payable is computed using the rates in effect at death. Thus, if the decedent paid gift tax a rate that was higher than the rates in effect at death, the credit is still limited to the lower hypothetical tax that would have been paid at the lower rates in effect at death. See Estate of Frederick R. Smith, 94 T.C. 872 (1990).

7. Joint Comm. on Taxation, General Explanation of Public Law 115-97, JCS-1-18 at 89 (Dec. 20, 2018), available at https:// aboutbtax.com/Qsf.

8. §2001(g).

9. Reg. §20.2010-1(c), §20.2010-1(c)(2)(i) Ex. 1.

Originally published by Bloomberg Tax: Tax Management Estates, Gifts, and Trusts Journal^TM on the 18th of May, 2020

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