We’re all aware that lifetime taxable gifts of up to $5.12 million can be made through the end of 2012 without incurring any federal gift tax. But, there’s a debate raging over whether a so-called “clawback” tax could expose to estate tax gifts that were sheltered from gift tax by the $5.12 million applicable exclusion amount. A clawback tax could apply to the estates of those who die after 2012, if the estate and gift tax system reverts to the rules in effect before the Economic Growth and Tax Relief Reconciliation Act of 2001.1
Assuming there’s a potential clawback tax, it may be possible to turn that tax into an advantage by drafting an indemnification agreement that requires the gift recipient to pay the tax. As a result, the taxpayer would subtract the actuarial present value of that tax from the value of the taxable gift. An argument could be made for reducing the taxable gift amount based on the U.S. Court of Appeals for the Fifth Circuit’s holding in Succession of McCord v. Commissioner.2
Leveraging Underlying Gift
A clawback tax valuation adjustment could be used to leverage the amount of the underlying gift well above 2012’s $5.12 million gift tax exclusion amount. For example, Maria, age 80, made her first lifetime taxable gift of $6,380,215 in cash on Oct. 1, 2012. Her estate’s clawback tax, if she dies after 2012, is $1.427 million.
The value of an amount due on death generally constitutes a remainder interest that must be determined under Internal Revenue Code Section 7520’s actuarial methods. The actuarial present value of a remainder interest in $1.427 million is $1,285,647.3 But, because the estate tax isn’t payable until nine months after death and because there’s no clawback tax if death occurs during the last three months of 2012, the actuarial present value of Maria’s clawback tax is $1,260,215.
If Maria’s taxable gift may be reduced by the actuarial value of the clawback tax, the net amount of her taxable gift is $5.12 million. Since this amount is equal to 2012’s gift tax applicable exclusion amount, no gift tax will be due.
If the IRS successfully challenges the valuation reduction for the actuarial present value of the clawback tax, there will be a $441,075 gift tax payable on $1,260,215 at the rate of 35 percent. That tax could be reduced if the donees agree to pay the tax and could be further reduced if the donees agree to pay any gross-up tax4.
Questions to Consider
Before proceeding with adjusting 2011 and 2012 gifts for clawback taxes, practitioners must answer these questions:
1. Is there a realistic possibility that the clawback tax exists?
2. Is the donee responsible for paying the clawback tax, such as under an indemnification agreement?
3. Is there a realistic possibility that there’s a basis in the tax law for reducing the value of gifts for the actuarial present value of the clawback tax?
McCord’s Net Gift
A basis in the tax law for clawback tax valuation adjustments may exist in McCord.
In that case, Charles McCord claimed a gift tax valuation adjustment for a tax assumed by donees under an indemnification agreement signed as a condition of receiving the gift. In McCord, the amount of the adjustment was the actuarial value of the estate tax that must be paid on gift taxes paid by the decedent or the decedent’s estate on gifts made within three years of death. That estate tax is sometimes called a “gross-up” tax, because the donor’s taxable estate is grossed up for the gift tax.5 On the other hand, if Charles were to survive three years after making the gift, that estate tax wouldn’t come due.
The Tax Court disallowed the valuation adjustment for the contingent gross-up tax, finding that it was too speculative. It said that no recognized method existed for establishing such an adjustment with enough certainty, because the amount of the tax depended on factors that could change after the gift was made. These factors included the tax law’s tax rates and exemptions, which are known to have changed from time to time, the size of the taxable estate and even the very existence of the estate tax laws.
The U.S. Court of Appeals for the Fifth Circuit reversed.
The appeals court’s analysis began by finding that the tax law in existence on the date of the gift must be assumed to exist into the future and that it would be improper to speculate what the tax law might be on a later date.
The court then looked to the willing buyer/willing seller standard generally applicable in gift tax matters, asking: What would a hypothetical willing buyer take into account? It found that a willing buyer would consider the transfer tax system in effect on the date of death and would insist on applying those rates. The willing buyer would make a calculation using those rates and then decide whether to insist on a discount for the gross-up tax.
The court noted that a buyer would consider the probability of death within the three years following the date of gift and a discount rate for the time value of money. It then said that the method for making such a calculation involving a mortality component and an interest rate component is prescribed by statute under IRC Section 7520. Use of the Section 7520 approach is mandatory. In this case, the gift tax valuation expert was found to have properly applied Section 7520’s mandates to the transfer tax laws in existence as of the date of the gift.
The court found that a willing buyer would reduce the value of the gift by the actuarial value of the contingent gross-up tax and, thus, held for the taxpayer.
Clawback Net Gifts
Assuming the clawback tax exists at the time when a gift is made, and the donee is responsible for paying the tax liability, two features of clawback make it less speculative than the gross-up tax net gift in McCord.
Unlike the gross-up tax, the amount of the clawback tax isn’t dependent on the size of the donor’s ultimate taxable estate. The amount of the clawback tax depends only on the size of the gift. Thus, the amount of the clawback tax is certain on the date of gift.
Also, unlike the gross-up tax, the clawback tax isn’t dependent on whether the decedent dies within three years of the gift. It will be due at death regardless of how long the donor lives. Thus, the mortality risk to the government only affects when (not if) the tax will be paid.
Because the clawback tax net gift is less speculative than McCord’s gross-up tax net gift, it should be on more solid ground.
Definition in Indemnification Agreement
Practitioners can draft an indemnification agreement to make the gift recipient responsible for paying any clawback tax on the gift. That agreement will need to include a technical definition of “clawback.” “Suggested Clawback Definition,” p. 30, is one that practitioners may want to consider.
The ultimate decision whether to claim such a valuation adjustment is up to the donor. Practitioners who believe there’s a realistic possibility that such an adjustment will be sustained on its merits will have to explain both the opportunity and the risks to the donor.
1. Public Law 107-16 (June 7, 2001).
2. Succession of McCord v. Commissioner, 462 F.3d 614 (5th Cir. 2006), reversing Charles T.
McCord Jr., et ux. v. Comm’r, 120 T.C. 358 (2003) on the question of whether a gift tax valuation adjustment may be claimed for the contingent gross-up tax.
3. The Internal Revenue Code Section 7520 discount rate for October 2012 is 1.2 percent. The standard actuarial factor for a remainder interest of a person aged 80 years is 0.90094.
4. The gross-up tax is the estate tax on gift taxes payable by the decedent or the decedent’s estate with respect to gifts made within three years of death. See Michael S. Arlien and William H. Frazier, “The Net, Net Gift,” Trusts & Estates, August 2008 at p. 25.
5. See IRC Section 2035(b), formerly Section 2035(c). The effect of Section 2035(b)’s provisions was called the “gross up” tax in the court’s opinion because the taxable estate is grossed up by the amount of gift taxes paid or payable.