The IRS recently released final regulations clarifying that gifts made before 2026 using the higher lifetime exemption amounts available under the Tax Cuts and Jobs Act (TCJA) will not be harmful to estates after 2025. The final regulations also specify that a deceased spouse’s higher unused exemption will be locked in and not reduced as a result of sunset provisions.
Gift and estate taxes apply to transfers of wealth by individuals both during life and after death. In general, each individual is allowed a lifetime exemption to offset these potential taxes. Only gifts and transfers of wealth in excess of this lifetime exemption are subject to tax.
Under prior law, individuals were allowed a lifetime exemption of $5 million indexed for inflation for gifts made and estates of decedents dying before January 1, 2018. The TCJA doubled this lifetime exclusion to $10 million, also indexed for inflation. For 2020, the exclusion is $11.58 million.
Additionally, the 2010 Tax Relief Act introduced the concept of “portability” of the federal estate tax exemption between married couples. In simple terms, portability allows a surviving spouse to use a deceased spouse’s unused exemption (DSUE) in addition to his or her own exemption. The increase in the lifetime exclusion and the introduction of portability results in only the very wealthiest couples, those with assets in excess of $22 million, is subject to federal gift and estate taxes.
However, like many provisions in the TCJA, the increase in the exemption is set to sunset on January 1, 2026. At that time, the exemption will revert to the prior $5 million level as adjusted for inflation, or roughly $6 million. It could even decrease sooner should there be a change in the law before 2026. There are two presidential elections in the meantime, so anything is possible.
The statutory sunset of the higher exemption and reversion to the lower amount raises concerns of whether taxpayers who gift using the higher exemption amount and die after 2025 would be denied the higher exemption amount applied to previous gifts and, in effect, be penalized on their estate return. Also, would surviving spouses with DSUE amounts ported during the increased exemption period have their DSUE reduced after 2025?
To address the concern of a possible “clawback” of the exemption amount, the TCJA granted the IRS authority to prescribe regulations with respect to any difference between the exemption that applies at the time of a decedent’s death and the exemption applied to any gifts made by the decedent during his lifetime. On November 23, 2018, the IRS issued proposed regulations which provided a “special rule”: gifts that were sheltered by the higher exemption amount won’t be taxed in a decedent’s estate and estates are allowed to use the greater of the exemption applicable to gifts made during life, or the exemption applicable on the date of death.
In November 2019, the IRS issued final regulations that adopted the proposed regulations and provided additional clarification and examples. The final regulations clarify that individuals taking advantage of the increased exemption by making gifts during the period 2018 to 2025 will not be harmed when the exemption decreases in 2026.
The final regulations also explain that when computing the estate tax, the increased exemption is applied first against the decedent’s taxable gifts. If any exemption remains at death, it is applied against the decedent’s estate. Therefore, if a decedent makes enough lifetime gifts that the computation of gift tax payable equals or exceeds the date of death exemption, there is no remaining exemption available to reduce the estate tax.
Here are two examples from the final regulations illustrating this concept:
- Example 1 - An unmarried individual A made cumulative lifetime gifts of $9 million all of which were sheltered by an $11.4 million exemption allowable on the dates of the gifts. The exemption on A’s date of death is $6.8 million. Because the total exemption allowable in computing the gift tax payable on A’s gifts exceeds the $6.8 million exemption on his death, the exemption for purposes of computing A’s estate tax exclusion is based on the exemption amount of $9 million.
- Example 2 – Assume the same facts as Example 1 except that A made cumulative taxable gifts of $4 million. Because the total of the exemption allowable in computing the gift tax payable on A’s gifts is less than the exemption of $6.8 million allowable on A’s death, the exemption to be applied for purposes of computing A’s estate tax is based on the $6.8 million exemption amount as of A’s death.
The application of the “special rule” as illustrated above in Example 1 is based on actual gifts. Therefore, this rule does not apply to a decedent who did not make gifts in excess of the date of death exemption.
The final regulations also include examples illustrating how the deceased spousal unused exclusion (DSUE) is calculated. If a spouse dies during the increased exemption period, and the deceased spouse’s executor makes the portability election, the DSUE amount received by the surviving spouse is the lesser of the exemption in effect or the unused portion of the spouse’s exemption amount at the time of the deceased spouse’s death. In other words, if the DSUE amount is elected during the increased exemption period, it will not be reduced when the exemption sunsets.
Estate planning considerations
The doubling of the lifetime exemption amount to over $11 million per individual and the IRS’s assurance that there will be no penalty for making use of this higher temporary exclusion threshold for lifetime gifting has created an incredible planning opportunity for those anticipating taxable estates over $6 million when the exemption decreases after 2025 or sooner. For those individuals, now is the time to consider making transfers of money, property, and other assets.
Our estate planning experts at The Bonadio Group are available to help guide you through the planning process of which assets make the most sense to gift and how best to utilize your exemption. Please contact a member of our team to learn more.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.