The Proposed Clawback Regulations: No Need to Panic Yet, but Knowledge is Key

Tax, trusts and estates updates from around the country

The anti-clawback mechanism of the estate tax applicable exclusion amount has elicited anxiety in estate planners since its enactment.  Throughout this time, there has been persistent doubt about the effect of a reduction of the basic exclusion amount on taxable gifts between the date of gift(s) and the date of death.  While 2012 legislation locked in the basic exclusion amount at a base of $5,000,000, indexed for inflation, the TCJA of 2017 again raised this specter of reduction in the exclusion by doubling this pre-inflation base to $10,000,000, with a scheduled sunset by one-half on January 1, 2026.

We thought we had received clarity in 2020, when final Treasury Regulations were published creating a mechanism under IRC 2010(g)(2) and Treas. Reg. 20.2010-1(c) to avoid a clawback.  This Regulation, simply put, bases the estate tax applicable credit amount on the greater of (1) the applicable exclusion available at death, or (2) the applicable exclusion actually used as credit against gift tax on lifetime taxable gifts. 

This seemed to give comfort to those seeking to make gifts in 2020 and 2021, especially as threats of premature reduction of the basic exclusion loomed.  The problem, as most practitioners and taxpayers faced, is that the only real way to use the exclusion before they lose it is to use all of it.  In other words, a gift which does not exceed the portion of the exclusion which might go away in 2026 or sooner is useless.  Why?  Because the formula considers the greater of the exclusion used, or available.  If the exclusion used does not exceed the exclusion available at death, you end up no better off than if you had made no gift. 

However, this threat and reality shifted the purpose of lifetime gifts. 

A New Gifting Purpose

Traditionally, gifts were designed to remove future income and appreciation in the value of gifted assets from the estate tax base.  While the base value of the gifted property was removed from the gross estate, it was not removed from the estate tax base, since the estate tax base is the sum of adjusted taxable gifts (valued at date of gift) and the taxable estate (valued at date of death).  This meant there was an economic incentive to avoid having gifted assets be pulled back into the gross estate through retained economic benefit or control under IRC Sections 2035-2038.  In other words, lifetime gifting had the effect of “freezing” the value of the gifted assets under the estate tax calculation so long as there were no problematic retained interests.  

But the anti-clawback formula, which considered the greater of exclusion used, or exclusion available, de-emphasized this value freezing purpose in favor of lifetime “use” of the portion of the exclusion which could be lost.  Given this shift, practitioners realized the potential of locking in the use of exclusion through gifts that would be included in the gross estate.  This type of gift took advantage of a loophole, whereby a gift subject to a donor’s retained economic benefit or control under IRC Sections 2035-2038 was nonetheless still considered a completed gift for federal gift tax purposes.  A completed gift uses applicable exclusion amount, and thus should qualify under the “use” test of the anti-clawback formula. 

The preamble and comments to the 2020 Regulations, however, contained a foreboding omen.  Could a gift which is complete, but which is more in the nature of a “testamentary” transfer (due to the donor’s lifetime retention of economic benefit or control, which abandons the “freezing” of value as a goal) really be treated as a valid use of gift tax applicable exclusion?  Or, would such a gift be deemed “abusive” if you look at the substance over the form at the time of death?  The 2020 Regulations did not resolve this question, but instead kicked the can for future comment.  Such future comment has now been proposed. 

New Proposed Clawback Regulations

New Treasury Regulations proposed on April 27, 2022 would carve out a set of special circumstances whereby the portion of basic exclusion used for certain types of lifetime gifts may be clawed back, thus circumventing the hoped-for outcome under the anti-clawback mechanism.  While this is not intended to be a complete discussion of the Proposed Regulations, the clawback mechanism appears to target two general categories of transactions:

·         Gifts which are included in the donor’s gross estate under IRC Sections 2035-2038, or 2042.

·         Gifts in the form of a “donative promise” by a donor, whereby the donor enters into a written obligation to make a gift at a future date (by promissory note or otherwise) which uses gift tax basic exclusion but is unfulfilled at the donor’s death. 

Note that, in either case, the gifted assets would have been included in the gross estate anyway, and would lose the value freeze.  The question is how much estate tax applicable credit can be applied to the increase in estate taxes attributable to the loss of the freeze.  Will the credit include the applicable exclusion actually “used” for the lifetime gifts, or will it only base the credit on the applicable exclusion available at death? 

To answer this question, we must distinguish between the basic exclusion amount which every individual receives (currently $12,060,000) and a deceased spousal unused exclusion amount (DSUE), which is only available to a taxpayer whose most recently-deceased spouse’s estate made a portability election.  The lifetime use of the DSUE is not affected by the Proposed Regulations – only the use of the basic exclusion amount.  Thus, if you use the DSUE for one of these “abusive” lifetime gifts, there is no clawback. 

There are some exceptions of note.

The Exceptions

There is a safe harbor for these potentially abusive gifts, whereby a decedent’s estate may be able to avoid the clawback of basic exclusion applied to such lifetime gifts.  The two general exceptions are:

·         Where the taxable portion of the initial gift was 5% or less than the value of the total transfer.

·         Where the right or power creating inclusion in the gross estate was relinquished more than 18 months prior to death. 

The 5% rule may be seen, for example, in certain retained annuity or unitrust types of transfers such as GRATs, CRTs, and CLTs.  In such cases, the discounted present value of either the income interest or remainder interest could be treated as a taxable gift, but the goal is often to reduce (or even eliminate) the taxable gift value through such discount.  Given that these transfers often are not designed to use a significant portion of the basic exclusion amount anyway, the effect of the safe harbor may be minimal. 

However, things get confusing when you consider the 18-month lookback on the relinquishment of retained benefit or control.  Many of you are familiar with the 3-year lookback under IRC Section 2035, and it can be difficult to distinguish the two at first glance.  To do so, you must distinguish their purposes.  The 18-month lookback only applies to the question of whether basic exclusion amount which applied to the initial gift (which was subject to retained but relinquished interests) can be used in calculating the estate tax applicable credit amount.  The 3-year lookback has a completely different purpose – determining whether a gift subject to a relinquished, retained interest is included in the gross estate. 

In either case, relinquishment of a retained interest often has a gift tax cost.  This value is easy to determine when the relinquished interest is a mandatory income interest.  However, the value proposition is more challenging when the interest is a controlling interest, or a discretionary economic interest in the income and/or principal of the trust.  This gift tax cost will have the effect of undoing some, or all, of the hoped-for value freezing that could have been achieved with a gift that lacked retained benefit or control. 

I also want to emphasize that, in either case, there is a bona fide sale exception for the relinquishment of retained interest or control whereby the lookback will not apply if the decedent’s estate can successfully establish the presence of a bona fide sale for adequate consideration in money or money’s worth.  I will not dive into the lengthy analysis which goes into this test, but there is one area where the Proposed Regulations are not clear – whether a full or partial payment of a donative promise within 18 months of death would satisfy the bona fide sale/indebtedness exception. 

Targeted Transfers

The examples in the Proposed Regulations seem to target two specific types of transfers, the effects of which have been divisive in the world of estate planning thought leadership: 

·         A grantor retained income trust (GRIT), for which the income interest retained by the grantor was assigned a zero value under IRC Section 2702.

·         A donative promise (as introduced above), whereby a donor gifted a legally-enforceable promissory note to a donee consisting of a promise to fulfill the gift in the future, but claimed basic exclusion for the “gift” of the note.

I have seen a number of articles both proposing, and cautioning against, these types of transactions ever since the first round of anti-clawback Treasury Regulations came out.  I have no doubt that practitioners who proposed these transactions may feel like Icarus, and will thus have comments on the Proposed Regulations.  I say this not to cast judgment, but to emphasize that there is always a risk to innovation in the world of transfer tax planning.  Sometimes, you fly too close to the sun. 

But, once again, the treatment of the donative promise leaves more questions than answers.  Since this is a debt, and not an asset, there is no inclusion in the gross estate under IRC Sections 2035-2038.  However, the loss of the use of the basic exclusion for the donative promise must be weighed against the availability of a deduction against the gross estate for the outstanding balance of the note at death under IRC Section 2053.  In many cases, this deduction would also be subject to a “bona fide” indebtedness test for adequate consideration, which would usually not be satisfied in the case of a donative promise. This deduction would have been lost regardless of the proposed clawback mechanism.  

Transfers Incidentally Affected

There are some types of transfers which may not be fully testamentary in nature, but nonetheless are affected by the Proposed clawback Regulations.  These include family limited partnerships, long-term GRATs, and generational split-dollar plans.  Recent Tax Court cases have highlighted the pitfalls of the estate tax valuation of family limited partnerships and generational split-dollar, namely the risks of gross estate inclusion under IRC Sections 2036 and/or 2038.  Long-term GRATs leverage a seemingly-guaranteed increase in the 7520 rate over the next several years, but could be problematic due to the use of a term which is also seemingly-guaranteed to exceed the life expectancy of the grantor (which results in gross estate inclusion under IRC Section 2036).  Comments to the Proposed Regulations note that the IRS does not want to get into facts-and-circumstances arguments about whether lifetime transfers are testamentary, which is the genesis of the proposed safe harbors in the 5% taxable gift test and the 18-month lookback. 

Conclusion

I usually wrap up with action items, but I want to remind you that these Regulations are merely proposed – they are now open to public comment but are by no means final.  The final Regulations may change some (or even all) of the outcomes in this article, and could even be scrapped indefinitely (like we saw with the Proposed IRC Section 2704 Regulations in 2017).  Nonetheless, I think it is important to stay aware of what happens next.  If and when we have amended Regulations and public comments, I will publish a follow-up.