Recently issued proposed clawback regulations (Proposed Treasury Regulations Section 20.2010-1(c)(3)) (the proposed regs), while not as harsh as feared, may undermine the planning your clients completed over the past few years to address the coming reduction in the estate tax exemption or the feared tax law changes. On the bright side, the proposed regs shouldn’t prevent taxpayers who made gifts to take 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). The proposed regs, however, provide complex rules that will change the anticipated results of several other estate-planning arrangements that had been intended to use the exemption.
Clawback Landscape
Some taxpayers engaged in estate tax motivated transactions to secure the use of the exemption before it’s reduced. These taxpayers may have made transfers, often to irrevocable trusts, to endeavor to secure the higher gift, estate and generation-skipping transfer tax exclusions. The Tax Cut and Jobs Act of 2017 (TCJA) doubled the exemption amount from $5 million to $10 million, inflation adjusted. This increased the basic exemption amount (BEA) available to decedents dying after Dec. 31, 2017 and before Jan. 1, 2026.1 The exemption currently is
$12.06 million and will decline, subject to further inflation adjustments, to $5 million, or approximately $6.5 million with current and anticipated inflation adjustments, in 2026. The broader issue created by the TCJA was whether gifts made using the increased exemption before 2026 would be taxed at death if the taxpayer dies after 2025, and the exemption amount is in fact reduced. The recently issued proposed regs confirm that in most, but not all cases, such gifts won’t be subject to tax by reason of a clawback of the exemption. The proposed regs focus on the exceptions to this rule, that is, what transactions that may have been tax free when made will trigger an estate tax if the taxpayer dies after 2025.
Regulatory Authority
When the TCJA Act increased the estate tax exemption, the Republicans were mindful that if the Democrats succeeded in later reducing the exemption, they could undermine the benefits received by taxpayers based on the higher exemption amounts by providing for a clawback of those amounts back into the estate. To protect against that type of later change, the Republicans included sections in the TCJA (Internal Revenue Code Sections 2001(g)(2) and 2010(c)(6)) that provided broad authority to the Treasury to issue regulations to address changes in the exemption.
IRC Section 2001(g)(2) provides:
Modifications to estate tax payable to reflect different basic exclusion amounts. The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out this section with respect to any difference between—(A) the basic exclusion amount under [Code] section 2010(c)(3) applicable at the time of the decedent’s death, and (B) the basic exclusion amount under such section applicable with respect to any gifts made by the decedent.
The Treasury issued regulations in 2019 to address the anti-clawback mandate. These included a special rule assuring that a taxpayer’s estate can determine its estate tax credit using the estate tax exemption amount available at the date of gift if that amount exceeds the exemption amount available on death. The Treasury issued the current proposed regs under the same authority.
Transfers Subject to Clawback
Many wealthy but not super-wealthy taxpayers struggled with the competing goals of wanting to lock in the high exemption while retaining control over their assets. The uber-wealthy taxpayers didn’t have this issue, as they could use all of their exemption knowing that they had sufficient remaining assets to assure that their lifestyles were protected. In response to this conundrum, the estate-planning community created several strategies so their not super-wealthy clients could take advantage of the exemption while not losing total control over their assets. The so-called “promise to pay” gift is one such example. It involves making an enforceable irrevocable promise to pay that could trigger use of exemption but, because the taxpayer wouldn’t actually transfer any of their wealth, retain use of their assets. Other creative techniques or variations or new applications of existing techniques were developed to accomplish these same divergent goals. The proposed regs target these techniques.
The proposed regs identify several types of transfers that generally will be subject to the lower exemption available at death, not the higher exemption used and secured on the date of the lifetime transfer. These appear to include:
- Gifts that are includible in the taxpayer’s gross estate under IRC Sections 2035, 2036, 2037, 2038 and 2042.
- Unsatisfied enforceable promise gifts.
- Gifts subject to the special IRC Section 2701 valuation rules. These generally related to the valuation of intra-family transfers of entity equity interests when the parent (senior generation) retains certain preferred rights. If the taxpayer dies holding a Section 2701 applicable retained interest, they can’t take advantage of the anti-clawback rule.
- Transfers like a grantor retained income trust (GRIT), in which property is pulled back into the gross estate under, for example, Section 2036.
- Certain transfers to grantor retained annuity trusts (GRATs) and qualified personal residence trusts (QPRTs) under Section 2702 if either technique used the higher exemption amount.
- The relinquishment or elimination of an interest in any one of the above transactions within 18 months of the decedent’s death. For example, say your client created a GRIT with an income interest that lasts for their lifetime. If a third party eliminates your client’s income interest, it isn’t clear that the property would still be included in your client’s estate under Section 2035. Generally, Section 2035(a) would include in your client’s gross estate the value of the interest if the taxpayer relinquished their rights within three years of death. However, Section 2035(a) doesn’t apply if it’s eliminated by something other than a voluntary act by the taxpayer. The proposed regs provide that if your client has a Section 2701 retained interest, and that interest is transferred or eliminated within 18 months of death, your client won’t qualify for the higher exemption amount even if the underlying property isn’t included in their estate.
Promise Gifts
Your client generally won’t be able to use the higher exemption amount at the date a promise gift is made if the exemption amount is lower at the client’s death. Further, if the note used in the promise gift is paid within 18 months of the donor’s death, your client will have to use the lower date-of-death exemption amount. However, if the promise gift note is repaid more than 18 months prior to the donor’s death, the gift will be respected, and the higher exemption amount will be preserved.
Note that the proposed regs imply that a gift by promise may in fact be successful, but for the restrictions in the new proposed regs. Nonetheless, in most jurisdictions (Pennsylvania is one exception), a promise to make a gift isn’t enforceable, and therefore, the promise isn’t a gift when the promise is made. If the client dies prior to 2026, the promise gift may actually now be more secure in light of the proposed regs, at least if done under the law of a jurisdiction where the promise is enforceable when made. If the taxpayer dies after 2025, the note used to effect the promise gift will have had to be repaid in full 18 months prior to death. There may be a partial planning idea if the taxpayer can’t repay the entire note. Perhaps the note can be divided into two notes and one repaid in full to secure at least that portion of exclusion.
Example: The taxpayer made an $11.7 million gift by promise when the exclusion was $11.7 million. Realizing that the note must be repaid in full more than 18 months prior to death, the taxpayer would like to pay off the promise note but it isn’t financially feasible to do so. Instead, the taxpayer divides the note into two notes, one for $9 million and one for $2.7 million. The $9 million note is repaid in full, and the taxpayer survives two years. The exemption on death in 2026 is $6.5 million. The taxpayer will have successfully secured an additional $2.5 million from this plan.
Failed GRAT
The common application of the GRAT technique has been to structure a short-term, typically 2-year GRAT, designed to capture upside market volatility. The annuity paid to the grantor would be set high enough so that the value of the remainder in the GRAT would have a nominal value for gift tax purposes.
The result of this traditional GRAT approach is that a substantial portion of the assets of the GRAT (principal plus the IRC Section 7520 mandated return) would be paid back to the taxpayer as the grantor or settlor of the trust. Investment returns, above the mandated federal interest rate, would inure to the benefit of the grantor’s heirs (or a trust for their benefit either created under the GRAT instrument or otherwise).
GRATs can also be created for longer periods of time. One such technique is the so-called “99–year GRAT.” This technique is really an interest arbitrage. Many taxpayers are under the misconception that if they die during the term of a GRAT, the entire GRAT principal is included in their gross tax estate. That’s not correct. Rather, to determine what portion of a GRAT’s assets are included in the settlor’s estate, divide the required annuity payment by the Section 7520 rate in effect at the date of the grantor’s death.2 If interest rates are higher at the date of death as compared to the date of the gift, then less than the full value of the GRAT corpus may be included in the grantor’s estate if they die during the GRAT term. Some taxpayers who had used all of their exemption in prior planning may have pursued the 99-year GRAT (prior to the rise of interest rates in mid-2022).
Regardless of the term of a GRAT, if the settlor dies during the GRAT term, a portion of the principal of the GRAT may be included in the settlor’s estate based on the calculation explained above. Under the proposed regs, if the exemption amount was higher at the date the GRAT was funded than at the settlor’s death, the lower date-of-death exemption amount will be used. The failed GRAT won’t safeguard any of the higher exemption amount (although, as explained, it may result in value being excluded from the taxpayer’s gross estate).
GRIT
A GRIT can be an artificial or painless gift. The taxpayer can make a gift while reserving a life estate in the assets transferred to the GRIT. The gift conceptually would only be of the value of the remainder interest in the trust. However, if the remainder beneficiaries are specified family members, the interest the taxpayer retains has to meet the requirements of a “qualified interest,” essentially an annuity interest. If the retained interest held by the taxpayer isn’t a qualified interest, then the retained interest will be valued at zero for gift tax purposes.3 The result is that the gift will be valued at the full value of the property transferred to the trust. That would enable the taxpayer potentially to use the higher exemption amount yet retain benefit from the value of the property transferred. On death, the entire value of the property will be included in the taxpayer’s gross estate to be offset by the exemption amount. The proposed regs provide that such a transaction unless unwound more than 18 months before the taxpayer’s death will only benefit from the exemption amount available on the taxpayer’s death if lower than what was used on the gift made during lifetime.
Preferred Partnership Interests
The concepts and treatment of preferred partnership interests are similar to those discussed above in the context of a GRIT. A preferred partnership is a limited partnership or limited liability company (each referred to as a family limited partnership (FLP)) with at least two classes of ownership interests, including a preferred partnership interest and a common partnership interest. The preferred partnership interests may be obtained, for example, by a parent or senior family member, for a capital contribution when the FLP is formed or in exchange for interests in an existing FLP as part of a plan to recapitalize the entity. If the requirements of Section 2701 aren’t adhered to, the ‘‘subtraction method’’ must be used to value the common interest, and the preferred interest would be valued at zero. This results in the full value of the property being attributed to the common partnership interests, and that value is treated as a gift. In a typical planning environment, this result would serve as a penalty artificially increasing the gift value. In recent years, taxpayers feared the exemption would be reduced substantially under the various proposed tax regimes. Intentionally violating the Section 2701 rules to enhance the gift to use the exemption, while retaining substantial control or benefit from the assets transferred, served as another type of artificial transfer to lock in the higher exemption amount.
The proposed regs subject this transaction to clawback so that if the taxpayer dies after 2025, the higher exemption amount doesn’t apply.
QPRTs
Assume that a taxpayer made a gift of $7.06 million in 2022, leaving only $5 million of exemption. Then, in 2023, the taxpayer gifts a valuable residence to a QPRT and, even after the discounting the QPRT mechanism provides, the remainder interest on the making of the gift was $5 million, using up the remainder of the taxpayer’s exemption. Even though that $5 million gift used the taxpayer’s excess exemption amount, this won’t avoid clawback. If the taxpayer dies during the fixed QPRT term, the use of excess exemption will be clawed back, and the taxpayer will only have available the lower exemption amount on death. If, however, the taxpayer survived the fixed term, then the QPRT will be successful and the $5 million of excess exemption used on the initial gift to the QPRT will be respected. Thus, even though the QPRT technique is sanctioned by Treasury Regulations Section 25.2702-5, it may not work to protect the increased exemption amount.
Business Entity Transfers
It’s been common to structure gifts of investment or business assets held in the envelope of an FLP. The entity overlay may be used to avoid a trust owning real estate in another jurisdiction for asset protection planning benefits, to facilitate management or to garner valuation discounts. An issue that may arise with such planning is whether the Internal Revenue Service will successfully challenge the transfer as being included in the taxpayer’s estate as a result of the taxpayer having retained excessive control over the entity transferred in conjunction with others. Specifically, in the case of Estate of Powell v. Commissioner,4 the court held that if the taxpayer has the ability, whether alone or in conjunction with other individuals, to control distributions from the entity or liquidation of the entity, the entirety of the interests may be included in the taxpayer’s estate under IRC Section 2036(a)(2). If a portion of the entity interests that had been transferred is included in the taxpayer’s gross estate, then under the proposed regs, the exemption that may be available to offset that value included in the estate will be the lower exemption available on death, not the higher exemption amount on the date of the initial transfer.
In dictum, the court in Powell commented about the potential for double taxation even though it didn’t apply to that case. The underlying cash and securities transferred to the FLP were included in the estate under Section 2036(a)(2) as a component of the value of the partnership interests. That section addresses transfers with the right to control enjoyment of the property. This inclusion occurred because the decedent had the ability, when acting along with her sons, to dissolve the partnership. The court also found that the assets transferred to the FLP, consisting of cash and securities, could be includible in the decedent’s estate under Section 2035. This section includes in the estate certain gifts made within three years of death. To prevent the double taxation that would have occurred by including both the gifted partnership interests and the underlying assets transferred to the FLP in the estate, the Tax Court held that IRC Section 2043(a), which allows an estate to exclude the consideration received for a transfer under Sections 2036 or 2035, applied to the estate tax return. In a future case, if such a double inclusion should occur, only the lower date-of-death exemption will be available to offset that inclusion.
To avoid estate inclusion based on Powell, consider for example, transferring the remaining entity interests the taxpayer has retained so that no interests will remain in the estate. Some commentators have suggested that a governing document for the entity that has a business judgment rule for distributions and liquidations might deflect this type of challenge. Others have suggested creating a special voting interest that controls distributions, liquidations or the right to change those provisions in the governing document and selling those to another trust over which the taxpayer has no control (for example, the taxpayer wouldn’t be named as the investment director of that purchasing trust). Some commentators have suggested that a Powell-type attack shouldn’t apply to an active business (in contrast to an entity passively holding investment securities). Might they view the risks created by the proposed regs, especially if potentially compounded by a double inclusion challenge as discussed in Powell, sufficient to re-evaluate those transactions to add additional steps to deflect this?
QTIPs
In searching for assets that a taxpayer may have been comfortable parting with, many identified assets in a qualified terminable interest property (QTIP) marital deduction trust. If the donee (surviving) spouse relinquishes any portion of the income interest in the QTIP, then under IRC Section 2519, they’ll be treated as making a gift of the remainder of the trust and, under Section 2702, will be treated as if they made a gift of the entire QTIP trust. That gift would use up any deceased spouse unused exemption that was ported over from the first spouse to die and thereafter would use up any of the surviving spouse’s remaining exemption. Because the surviving spouse could relinquish any portion of the income interest, for example, 1%, but still receive the remaining income interests, for example, 99%, there may be no material economic downside to disclaiming a portion of the income interest. Yet that disclaimer could have used all of the surviving spouse’s remaining higher exemption amount.
It appears that under the proposed regs, if the QTIP assets are included in the disclaiming spouse’s estate, the lower post-2025 exemption amount, not the amount available at the time of the earlier gift under Section 2519, may be used by the estate of the beneficiary (surviving) spouse.
Exceptions to Clawback
Even if the transfer fits into one of the clawback scenarios discussed above, the proposed regs provide for two exceptions that allow the higher exemption amount that existed on the date of the initial transfer to apply:
- The relinquishment or elimination of any interest retained in any one of the above transactions more than 18 months prior to the decedent’s death. But if the taxpayer sells the interest retained (such as an income interest in a trust) involved for full and adequate consideration within the 18-month period prior to their death, it appears that clawback would still apply. This is because the proposed regs capture any transfer, whether by gift or as a full consideration sale.
- De minimis transfers for which the taxable portion of the transfer is not more than 5% of the total transfer. So, for example, a taxpayer can use a small amount of excess temporary exclusion if a GRAT is created that’s been structured to be close to a zero-value gift. But if a GRAT is structured to result in a large current gift so as to use the excess exemption amount, it will be ensnared by this 5% rule. For example, assume a client funded a GRAT with $20 million. The value of that gift based on the retained annuity was reduced to $1.2 million. That would seem to have used $1.2 million of exemption. However, if the taxpayer dies during the GRAT term, only the exemption available on death will be available. In other words, the plan won’t have secured $1.2 million of bonus exemption.
Unwinding the Tainted Plan
If a plan that was completed by a taxpayer may be subjected to clawback, the first and immediate step may be to evaluate if that plan can be unwound. For example, some trusts may include a disclaimer provision to unwind the gifts to the trust. If it can’t be unwound, can an exception in the proposed regs, for example, paying off the gift of a promise more than 18 months before death be used to avoid clawback? If clawback is likely and can’t be avoided, the exemption may have been wasted and no further planning may be feasible. In those instances, clients might consider an insurance plan to address the estate tax that may be incurred. Because there will be no exemption for such planning, annual gifts and split-dollar structures may be a solution.
Notice to Clients
Professional advisors should use newsletters, email blasts, mailings, footers on bills or other means to communicate to their clients who may have engaged in planning that could be affected by the proposed regs that their planning may have been impacted and that a meeting with their advisory team to review the implications of the proposed regs is recommended. But caution clients that the proposed regs don’t have the effect of law (yet) and may change before being finalized. For example, your communication to the client might say something like this:
Clawback: A proposed regulation has been issued that will recapture on death the use of the current gift, estate and generation-skipping transfer tax exemption amount. If enacted as proposed, it’s possible that many common estate-planning transactions that appeared to have safeguarded exemption won’t have done so. This could result in more estate tax even though you anticipated that the planning would have safeguarded the high exemption used. This could affect gifts of an enforceable promise to pay, qualified terminable interest property disclaimers, certain Internal Revenue Code Section 2701 transactions, possibly sale transactions involving the receipt of a note. You should review all planning with your advisory team to see if any further actions might be taken to mitigate this possible result.
Endnotes
1. Pub. L. No. 115-97.
2. See Treasury Regulations Section 20.2036-1(c), especially Example 2.
3. Internal Revenue Code Section 2702(a)(2)(A).
4. Estate of Powell v. Commissioner, 148 T.C. 392 (2017).