Recently issued proposed clawback regulations (Proposed Treasury Regulations Section 20.2010-1(c)(3)), (the proposed regs) may undermine the planning your clients completed over the past few years to address the coming reduction in the estate tax exemption or the then feared tax law changes. While the proposed regs aren’t as harsh as some had feared, they undermine some common planning approaches that have been used in recent years. 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.
Exemption Issue
The Tax Cut and Jobs Act of 2017 (TCJA) doubled the exemption amount from $5 million to $10 million, inflation adjusted until Jan. 1, 2026. The 2022 exemption amount is $12.06 million and will decline, subject to further inflation adjustments, to $5 million, or approximately $6.5 million, with current and guesstimated inflation adjustments, in 2026. To take advantage of the higher exemption amount, some taxpayers engaged in estate tax-motivated transactions to secure the use of the exemption before it expired. These taxpayers may have made transfers, often to irrevocable trusts, to secure the temporary higher gift, estate and generation-skipping tax (GST) exemptions. But it’s not clear under the TCJA what happens if the taxpayer makes gifts while the higher exemption was in place and then dies after the higher exemption sunsets and the exemption is lower. Will the exemption the taxpayer used when the gift was made be clawed back at death, resulting in an unanticipated tax? The proposed regs confirms 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/donor dies after 2025.
Preventing Abuse
The Treasury is concerned about gifts that some have referred to as “artificial” or “painless” in that the taxpayer could retain an interest in or control over the assets involved, lock in the exemption (at least that’s what some practitioners had hoped) and have their tax cake and eat it too.” Such artificial gift transfers include funding a grantor retained interest trust (GRIT) to a family member so that the gift would be deemed made of the entire amount transferred with no reduction for the interest retained because, under Internal Revenue Code Section 2702, the value of the retained remainder would be zero. Similarly, a preferred partnership could be structured that intentionally violated the requirements under IRC Section 2701 so that the equity the donor received in the entity would be valued at zero. The taxpayer could have retained a preferred interest structured so the entire value of the entity would be treated as a gift when certain family members acquired the common interests, thereby securing the use of the gift exemption (and permitting the allocation of GST tax exemption to the gift). The preferred partnership interest would be included in the taxpayer’s estate but the exemption, it was thought, would be preserved. The proposed regs target these type of transactions and endeavor to exclude them from the anti-clawback rule.
Transfers Targeted by the Proposed Regs
There are several types of transfers that generally won’t benefit from the anti-clawback rule so that the lower exclusion available at death, not the higher exclusion that had been believed to have been used and secured on the date of a lifetime transfer, will be available. These appear to include:
- Gifts that are includible in the taxpayer’s gross estate under Internal Revenue Code Sections 2035, 2036, 2037, 2038 or 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.
- Transfers like a GRIT, in which where property is pulled back into gross estate under, for example, Section 2036. If the taxable portion was 5% or less, the taxpayer will still be able to take advantage of the general anti-clawback rule to the extent of the gift (but not the whole amount transferred).
- Certain transfers to grantor-retained annuity trusts (GRATs) and qualified personal residence trusts under Section 2702 if either technique used the bonus temporary exclusion amount.
- The relinquishment or elimination of an interest in any one of the targeted transactions within 18-months of the decedent’s death.
Two Exceptions
The proposed regs provide for two exceptions to the targeted transactions under the proposed regs, so the higher exclusion that existed at the date of the initial transfer will continue to apply, instead of a lower exclusion that may exist at the date of death.
- The relinquishment or elimination of an interest in any one of the targeted transactions more than 18 months prior to the decedent’s death. What if your client sells the asset involved for full and adequate consideration within the 18-month period? It would appear that the anti-clawback benefit wouldn’t apply to this transaction 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 isn’t more than 5% of the total transfer. So, for example, a taxpayer can use a small amount of excess exemption if a GRAT is created that’s been structured to be close to a zero-value gift (so-called “zeroed out” GRAT). 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. Thus, if a GRAT to which $20 million was given and the value of the current gift on that funding was $1.2 million, the proposed regs will ensnare the transfer if the taxpayer dies during the GRAT term. Although this isn’t analogous to the “artificial” gifts the proposed regs were to address, it’s nonetheless caught by them.
Evaluate Planning Options
The proposed regs provide complex and nuanced “anti-abuse” rules. Practitioners should evaluate planning that’s been completed to determine if the proposed regs might result in an adverse result. If that’s possible, practitioners should evaluate options to unwind or improve that planning.
