On April 27, 2022, the IRS issued proposed regulations intended to provide additional clarity on the estate and gift tax “anti-clawback” provision adopted by the Service in late 2019. The proposed regulations would exclude certain lifetime gifts that are treated as includible in the donor’s gross estate from the favorable treatment provided by the anti-clawback rules. This change could affect lifetime gift transactions involving grantor-retained annuity trusts (“GRATs”), qualified personal residence trusts (“QPRTs”), family partnerships with preferred equity interests, life insurance policies and promissory notes.
Overview of Anti-Clawback Provision
The anti-clawback rules were implemented as a result of the increase in the estate and gift tax lifetime exemption amount from $5 million to $10 million (adjusted for inflation – the amount currently stands at $12,060,000 for tax year 2022) included as a part of the Tax Cuts and Jobs Act of 2017. Since the increase in the lifetime exemption is only temporary (the exemption is scheduled to be cut in half after 2025), regulations were needed to address whether lifetime gifts utilizing the increased exemption amount would potentially be subject to estate tax at death. Under the anti-clawback provision, the exemption amount used to calculate estate tax on a decedent will be the higher of the applicable exemption on the date of death, or the applicable exemption on gifts made during the decedent’s life. This rule effectively ensures that the donor’s estate will not be taxed on completed gifts on which no gift tax was imposed during their lifetime because they utilized the higher exemption amount.
Example: On January 1, 2022, Paula makes an outright cash gift of $12,000,000. This is her only lifetime gift prior to passing away on January 1, 2026, at which time the lifetime exemption amount for estate tax purposes has been reduced to $6,800,000 (this amount includes hypothetical inflation adjustments). The exemption amount for calculating Paula’s estate tax is $12,000,000, the amount of exemption applicable to gifts made during Paula’s life, since this is greater than the applicable exemption on the date of death.
Excluded Gifts Under Proposed Regulations
The proposed regulations recently issued by the IRS would exclude certain gift transactions which are includible in the gross estate from the calculation of the applicable exemption amount on lifetime gifts when determining estate tax at death. As a result, using the increased lifetime exemption amount on such gifts would not result in any estate tax savings if the donor were to pass away after December 31, 2025. The following types of transactions would be excluded from the purview of the anti-clawback rules:
- Transfers where the donor retains a life estate or other powers or interests as described in IRC Secs. 2035 – 2038 and Sec. 2042, including certain gifts made within three years of death and life insurance policies with reversionary interests;
- Enforceable gifts of promissory notes, if the promissory note has not yet been paid;
- Gifts of interests in family partnerships under Sec. 2701 where the senior generation maintains a preferred equity interest;
- Gifts of interests in trusts, including GRATs and QPRTs, subject to the special valuation rules of Sec. 2702; and
- The relinquishment of an interest involving any of the above transactions within eighteen months of the donor’s death.
Example: Greg makes a completed gift of a promissory note in the amount of $9,000,000 on January 1, 2022. The promissory note is Greg’s only lifetime gift, and it remains unpaid as of the date of Greg’s death on January 1, 2026, at which time the lifetime exemption amount for estate tax purposes has been adjusted to $6,800,000. The note is treated as includible in Greg’s gross estate, and the anti-clawback rules do not apply to the original gift of the note in 2022. As a result, Greg’s estate tax is calculated using the reduced $6,800,000 lifetime exemption amount.
There are two exceptions provided in the proposed regulations for situations where the anti-clawback rules can still apply to gifts that are includible in the gross estate. These exceptions are for transfers where the portion subject to gift tax is less than five percent of the total value of the transfer, and relinquishments of interests that are triggered by either the passage of time or the death of an individual, if provided for in the terms of the original instrument of the transfer.
In light of the new proposed regulations, careful planning to avoid estate tax inclusion of lifetime gifts is more important than ever before. If you have questions about how the proposed regulations may impact your estate tax planning, please contact your Bennett Thrasher tax advisor by emailing email@example.com.