New IRS “Clawback” Regulations Have Limited Applicability to Gift Transactions

The Tax Cut and Jobs Act of 2017 (TCJA) doubled the exemption amount available during lifetime or at death from $5 million to $10 million, inflation adjusted, until January 1, 2026. The 2022 exemption amount is $12.06 million and will decline under current law, subject to further inflation adjustments, to $5 million indexed for inflation, or approximately $6.5 million in 2026. The increased exemption amounts automatically decrease on January 1, 2026 (“sunset”) unless a new law is passed by Congress.

Many of our clients followed our recommendation that they take advantage of the higher exemption amount while it is available. These clients engaged in strategies to lock in what might be, unless a new law is passed, the temporary higher gift, estate, and generation-skipping tax (GST) exemptions. These strategies include gifts to irrevocable trusts for spouses (Spousal lifetime Access Trusts or SLATs) or gifts to irrevocable trusts for their beneficiaries. Some clients even made gifts to irrevocable trusts where they (the donor) is a permitted beneficiary. These self-settled irrevocable trusts must be established in jurisdictions that have laws specifically designed to allow the trustmaker to be a discretionary beneficiary—like Delaware, Alaska, and Nevada.

One of the concerns that we had in recommending such gifts is the possible scenario where the client makes gifts while the higher exemption was in place and then dies after the higher exemption sunsets and the exemption reduces. Most commentators believe that the taxpayer’s exemption used when making the gift will not be clawed back at death, resulting in an unanticipated tax.

An example posed in a Forbes Article was 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 because of inflation adjustments and is subsequently reduced to $6,500,000, does this individual have to pay estate tax on $1,500,000? The answer for most will be “No.”

Fortunately, that concern was alleviated in 2019 when the IRS issued a Regulation (Regs. Sec. 20.2010-1(c)) “that allows an estate to calculate its estate tax credit using the higher of the exclusion applicable as of the date of the gift or the exemption amount applicable upon death.” The Forbes Article remarked that the 2019 Regulations also clarified that the taxpayer would need to “use it or lose it” by making gifts exceeding the historical exemption amount to take advantage of the temporary increased exclusion amount.

All was good in terms of no “clawback” rule until April 26 of this year when the IRS issued proposed regulations (Proposed Treasury Regulations to Section 20.2010-1(c)(3) REG-106706-18), which addressed what the IRS viewed as a problem area 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. These scenarios may not qualify for the special rule of no clawback. In these situations, the amount includible in the gross estate would only receive the benefit of the exemption amount available on the date of death. The limited situations where this would occur involve the 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 enumerated situations that occurs within eighteen (18) months of the date of the donor’s death.

In particular, the IRS wanted to address completed gifts of notes that are not repaid within 18 months of death. The IRS gives an example in the Proposed Regulations, which confirm what many planners thought to be true, 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.

Now for the good news. The Proposed Regulations confirm that in most, but not all, cases, such gifts won’t be subject to tax by reason of a clawback of the exemption. Two noted commentators (Martin M. Shenkman and Jonathan G. Blattmachr) conclude that the proposed regulations shouldn’t prevent taxpayers who made gifts from taking advantage of the current higher exemption amount to spousal lifetime access trusts (SLATs), or self–settled domestic asset protection trusts (DAPTs) that were structured to be completed gift trusts, from securing those exemption amounts (assuming other aspects of the planning are respected). We did not recommend to our clients to make gifts of enforceable promissory notes to lock in the exemptions, so it is unlikely that our clients will be affected by the proposed regulations even if they become final. As mentioned above, SLATs and DAPTs, which we did recommend, are unaffected.