By: Judson M. Stein
For those of sufficient wealth to be concerned about federal estate taxes, lifetime gift giving can be an effective strategy. Although the estate tax is imposed on the aggregate of the taxable estate and lifetime taxable gifts, gifting removes the appreciation and cash flow of the property gifted from the amount subject to estate taxation. Additionally, there are certain exclusions in determining which gifts are subject to the gift and estate tax system (e.g., generally, annual exclusion gifts of $15,000 or less, per recipient, are excluded, as are gifts involving the direct payment of tuition and of medical expenses); and, sophisticated techniques may allow for significant valuation reductions for gifts.
Prior to the 2017 enactment of the Tax Cuts and Jobs Act (“TCJA”), the amount that each person could cumulatively pass by lifetime taxable gifts, and at death, without federal gift or estate taxation was $5,000,000, inflation adjusted from 2010 (as such, the inflation-adjusted “unified” gift and estate tax exemption amount for 2017 was $5,490,000). The TCJA dramatically increased the exemption amount to $10,000,000, inflation adjusted from 2010 (as such, the inflation-adjusted exemption amount for 2019 is $11,400,000 and the inflation-adjusted exemption amount for 2020 will be $11,580,000). However, the enhanced exemption amounts under the TCJA are temporary and are scheduled to expire at the end of 2025. Consequently, from and after January 1, 2026, the exemption amounts will return to $5,000,000, inflation adjusted from 2010. Cumulative amounts gifted and left at death in excess of the exemption amounts are taxed at a 40% rate.
Taxpayers are seemingly motivated to take advantage of these enhanced TCJA exemptions before expiration (political winds could, of course lead to an extension of the enhanced exemption, or to an earlier demise). This can be done either by making lifetime gifts during this temporary period of enhanced gift tax exemption or by dying during this period of enhanced estate tax exemption. Most clients tend to prefer the former to the latter.
As the estate tax is imposed on the aggregate of lifetime taxable gifts and taxable estate, Congress was concerned that an unwarranted increased estate tax could be imposed if a person makes large gifts during the TJCA temporary period of enhanced gift tax exemption, but dies after the expiration of the enhanced exemption. For example, absent a special rule, if one makes taxable gifts of $11,000,000 before 2026 when the exemption amount fully shelters the taxable gifts, and dies after 2026 with $0 (I know that this is unrealistic, but it will make the point), the amount subject to estate taxation would be $11,000,000; but, the exemption amount would only be $5,000,000, inflation adjusted from 2010. Presuming that the inflation adjusted exemption amount at the time of death is $6,800,000, the estate tax would equal $1,680,000. In effect, this imposes an estate tax on the previously untaxed gift – otherwise known as a “clawback”.
However, at the direction of the TCJA, the IRS has recently issued Treasury Regulations to avoid the clawback. These regulations, generally allow estates to compute the federal estate tax using the higher of the exemption amount applied to a decedent’s lifetime gifts or the exemption amount applicable on the date of death.
The new regulations provide examples. One example posits a person who had made taxable gifts of $9,000,000, all of which were sheltered from gift tax (including by the TCJA’s enhanced exemption amount), but dies at a time when the exemption amount is reduced to $6,800,000 (inflation adjusted). The example concludes that the exemption amount for determining estate taxation is the higher of the two; namely, $9,000,000. Another example posits the same facts, except that the taxable gifts were $4,000,000. Here, because the exemption amount that applied to lifetime gifts ($4,000,000) is less than the exemption amount applicable at the person’s death ($6,800,000), the applicable exemption amount for determining estate taxation is $6,800,000 (the date of death exemption amount, inflation adjusted).
In the first example, it is apparent that the gift giver benefitted from the temporarily enhanced exemption as his estate got to use the higher exemption amount that had been available, and utilized, at the time of the gifts. However, in the second example, the gift giver got no advantage from the higher exemption amount that had been available at the time of his gifts because he didn’t utilize the enhanced portion of the exemption. As such, the otherwise applicable date of death exemption applies. For him (and his estate) it is as if there was never an enhanced exemption.
Of course, gift giving may be motivated by many different reasons. However, if gift giving is motivated principally by a desire to take advantage of the temporarily enhanced gift tax exemption provided by the TCJA, the gifts need to be quite large in amount – at least in amounts cumulatively more that the anticipated post 2025 date of death estate tax exemption amount. Presumably, gifts of less than, say $6,500,000, may not be strategically advantageous if motivated by the current enhanced gift tax exemption. In order to benefit from the temporarily enhanced exemption amount, gift giving should be at, or near, the full enhanced exemption amount (e.g. currently $11,400,000). So, what is our take away? It seems to be that the enhanced exemption amount offered by the TCJA offers little planning allure for clients unless they are sufficiently wealthy to be able to consider gift giving on such a high level (or are willing to die before 2026).