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Proposed Clawback Regulations Impact Estate Planning

On April 27, 2022, the IRS issued proposed regulations clarifying when the use of the current estate and gift tax basic exclusion may leave an estate subject to a penalty, or “clawback.” Under the proposed regulations, many transfers that are completed gifts, but are potentially includible in the donor’s estate, would be subject to the exclusion amount at the time of the donor’s death rather than at the time the gift was made.

Under the 2017 Tax Cuts and Jobs Act (TCJA), the estate and gift tax basic exclusion was temporarily increased from $5 million (adjusted for inflation) to $10 million (adjusted for inflation) for gifts made and decedents dying before January 1, 2026. Beginning in 2026, the basic exclusion is set to return to pre-TCJA amounts adjusted for inflation. The current 2022 exclusion of $12.06 million is projected to decline to approximately $6.5 million in 2026. This anticipated decline in the current large, but temporary, exclusion has created a flurry of estate planning as taxpayers seek to use the increased exclusion before it is gone.

At the time of the increase in the exclusion many taxpayers and estate planners were concerned if there would be a clawback if the increased exclusion were used for lifetime gifts and the donor’s death occurred after the exclusion was decreased. In 2019, final regulations by the Treasury known as the Special Rule ensured that the higher exclusion amount applied to gifts would not be clawed back from the estate of a decedent subject to a lower exclusion amount.

Left unaddressed by the 2019 final regulations was how or if the Special Rule would apply to gifts that remain includible in a decedent’s estate because the donor retains an interest or control over the assets being transferred. The 2022 proposed regulations address such transfers and provide specific examples.

The following types of transactions would be excluded from the anti-clawback Special Rule:

  • Gifts that are includible in the gross estate under Internal Revenue Code Sections (IRC) 2035, 2036, 2037, 2038 or 2042
  • Enforceable gifts of promissory notes, to the extent they remain unsatisfied as of the date of death
  • Gifts subject to the IRC Section 2701 valuation rules (intra-family transfers of equity interests in an entity where the senior generation retains certain preferred rights)
  • Certain transfers to grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTs)
  • Transfers that would fall under the exceptions listed above, but for the transfer, relinquishment, or elimination of an interest within 18 months of the decedent’s death

Based on the proposed regulations here are some examples of transfers that would be excluded from the Special Rule and would have the exclusion amount at the date of death applied:

Example 1 – Individual (A) makes a gift of an $11 million promissory note in 2022. The note remains unpaid at A’s death in 2026. The assets that are to be used to satisfy the note are part of A’s gross estate. The $11 million note is includible in A’s gross estate and the exception to the Special Rule applies. The exclusion applied for computing A’s estate tax is the $6.5 million amount as of A’s death and the estate would pay taxes on $4.5 million of assets ($11 million - $6.5 million). The result would be the same of A paid the note within 18 months prior this death.

Example 2 – Individual (B) transfers $9 million to a grantor retained annuity trust (GRAT) and retains a qualified annuity interest valued at $8 million. The taxable portion of the transfer valued as of the date of the transfer is $1 million. B dies before the end of the GRAT term and all or some the GRAT’s assets become includable in his estate due to his retained annuity interest. The exclusion amount as of the date of B’s death would apply, not the increased exclusion amount at the date assets were transferred to the GRAT.

The proposed regulations provide an exception for de minimis transfers for which the taxable portion of the transfer isn’t more than 5% of the total transfer. In the above example, if the GRAT were structured to have an $8.55 qualified annuity interest resulting in a taxable transfer of $450,000 because the transfer was 5% or less of the total value the de minimis exception would apply. The de minimis exception would apply to zeroed out GRATs as well.

The proposed regulations are complex and nuanced. Taxpayers and their advisors should review current estate plans to assess the potential results of the proposed regulations and make improvements as needed. The proposed regulations are still in the commenting stage and additional updates may be made. They will not be binding until the date they are published as final.

If you need further guidance or have any questions on this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.

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.