Proposed IRS Regulations Address "Clawback" for Estate and Gift Tax Exclusion

The IRS recently released proposed regulations that address issues with the new estate and gift tax exclusions that were increased as part of the Tax Cuts and Jobs Act enacted last year. Under the new tax law, the estate and gift tax exclusion amount was temporarily doubled from its previous level, which raises questions about what will happen later if Congress does not act in the meantime to extend the increased exemption amounts or make them permanent.

Prior to the 2018 tax bill, every person had a permanent unified gift and estate tax exclusion amount of $5 million (adjusted for inflation annually). An exclusion amount is basically the amount a person can give during life or at death without ever paying gift or estate tax. When the amount given exceeds the exclusion amount, gift and estate taxes can be incurred.

The Tax Cuts and Jobs Act doubled the gift and estate tax exclusion amounts to $10 million, which would be $11.18 million when adjusted for inflation. This means a married couple could pass over $22 million to their heirs either during life or at death without owing any gift or estate tax! While this increased exclusion amount gives much more clearance for many more Americans, this part of the tax bill is temporary. That means that unless a new tax bill is passed and enacted between now and 2026, the gift and estate tax exclusion amount will revert back to the $5 million level (adjusted for inflation). Keeping in mind that prior gifts count against the exclusion amount, this raises an important question: Do taxpayers making gifts during life at the higher exclusion amounts get penalized if the lower exclusion amounts are in place when the taxpayer dies?

Here is an example of how this might work:

Bob has an estate of $14.18 million. To reduce his Minnesota taxable estate, Bob gifts $11.18 million to his children so that his total estate is now reduced to $3 million (which will equal the Minnesota exclusion amount in 2020). Since the amount given away is below the exclusion amount of $11.18 million, Bob owes no gift tax. Assuming the exclusion amounts do revert back to $5 million in 2026, and Bob dies the next year, would Bob owe tax on the entire $14.18 million or does he get the benefit of making a gift when exclusion amounts were higher?

The new proposed regulations have addressed this clawback issue by stating that there wouldn't be a tax on assets that were gifted when the exclusion covered the gift even if the exclusion amounts reverts to the lower level.

This is good news for Bob - his estate will only be taxed on the $3 million remaining when he dies. Since he used his entire exclusion amount earlier, the entire remaining estate of $3 million is taxed at the 40% rate, but the $11.18 gift he made during his life is not pulled back in and is not taxed. Bob will also not owe any Minnesota estate tax since the Minnesota estate tax exclusion is $3 million starting in 2020 (see post on Minnesota estate tax updates for 2018).

While these proposed regulations are favorable to the taxpayer, they have not been adopted yet. In any event, anyone with a potentially taxable estate should pay attention to these issues and be actively involved in planning their estates in advance.

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