“The Proposed Regulations confirm what numerous planers thought to be the case as it relates to enforceable promises to make gifts and the treatment of assets held in a GRAT or similar trust. The Proposed Regulations also reaffirm the Treasury’s position on ‘clawback’ and the use of the increased exclusion amount, but also present new traps for the unwary that require appropriate planning on Toni Tiger’s part to prevent inclusion.”

Alan Gassman and Brandon Ketron provide members with timely and important commentary on the proposed clawback regulations. Members who wish to learn more should register for their LISI Webinar “Planning for New IRS Proposed Clawback Regulation - What the Sophisticated Advisor Needs to Know and Do Right Now!” that airs on Friday, May 6th @ 3pm.

Alan S. Gassman, J.D., LL.M. is a partner at the Clearwater, Florida law firm of Gassman, Crotty & Denicolo, P.A. He is a frequent LISI commentator. Mr. Gassman practices in the areas of Estate Tax and Trust Planning, Taxation, Physician Representation, and Corporate and Business Law, and was accepted to the Estate Planners Hall of Fame of the National Association of Estate Planning Councils in 2021. He a member of the Board of Advisors for the Notre Dame Tax and Estate Planning Institute which will be in South Bend Indiana this year on November 9th to 11th 2022, or virtual if necessary. His e-mail address is alan@gassmanpa.com.

Brandon Ketron, CPA, J.D., LL.M. is a partner at the law firm of Gassman, Crotty & Denicolo, P.A., in Clearwater, Florida and practices in the areas of Estate Planning, Tax and Corporate and Business Law. Brandon is a frequent contributor to LISI and presents webinars on various topics for both clients and practitioners. Brandon attended Stetson University College of Law where he graduated cum laude, and received his LL.M. in Taxation from the University of Florida. He received his undergraduate degree at Roanoke College where he graduated cum laude with a degree in Business Administration and a concentration in both Accounting and Finance. Brandon is also a licensed CPA in the states of Florida and Virginia. His email address is brandon@gassmanpa.com.

Here is their commentary:

EXECUTIVE SUMMARY:

The world of estate tax planning is rarely straightforward, clear, or simple.

While planners may be able to assist in the difficulties that taxpayers face by way of planning strategies, financial projections and illustrations, aggressive IRS responses to various planning strategies in court cases,  Treasury Regulation pronouncements and Proposed Regulations can result in unpredictability, and keep estate tax planners on their toes every day.

Planners and taxpayers were under the assumption that gifts made while the exemption was higher than upon the date of death would enable the estate of the donor to use the higher exemption amount that was in existence at the time of each gift, rather than the lower exemption amount that would apply after January 1, 2026 (or earlier, if the exemption amount is reduced sooner) as to all categories of transfers, but we could only dream that it be so simple. 

For example, Toni Tiger has a $12,060,000 estate tax exemption and may make an $8,000,000 cash gift, reducing his exemption to $4,060,000. If the exemption would be $13,000,000 in 2026 by reason of inflation adjustments and is subsequently reduced to $6,500,000, does this individual have to pay estate tax on $1,500,000? The answer for most will be no under Regulations finalized in 2019. 

However, if instead of making a complete traditional gift, Toni instead gifts a promissory note payable by him to his significant other, Kitten Clawback, of the same value, and the assets of his estate will be used to satisfy the note, his estate would be unable to benefit from the increased exclusion amount available at the time of the transfer, and instead would only have the availability of the exclusion applicable on the date of death resulting in estate tax being imposed on the $1,500,000 excess under the new Proposed Regulations.

FACTS:

In 2017, the Tax Cuts and Jobs Act (TCJA) was passed and provided that the exemption amount would be temporarily doubled to $10,000,000 with adjustments for inflation, but go back to $5,000,000 plus inflation adjustments in 2026.  The TCJA also provided the Treasury Department (which includes the IRS) with the power to establish regulations to prevent abuse for situations where a gift was made but the taxpayer retained the beneficial use of or control over transferred property as of the death of the taxpayer after the exemption reduction occurs.

In the wake of the passage of the TCJA, there was a lack of clarity for situations where the estate tax exemption amount that applied at the time of a decedent’s death was lower than the exclusion amount that applied when the transfer was made (by reason of a reduction in the exemption).

The TCJA raised concerns from planners and taxpayers an estate tax could apply to gifts otherwise exempt from gift tax by the temporarily increased exemption amount; the IRS’s response was final regulations released in 2019 to craft a “Special Rule” that allows an estate to calculate its estate tax credit using the higher of the exclusion applicable as of the date of the gift or the exemption amount applicable upon death.

Also included in the 2019 Regulations was clarification that the taxpayer would need to  “use it or lose it” by making gifts exceeding the historical exemption amount in order to take advantage of the temporary increased exclusion amount.  For example, if a taxpayer made a gift of $5,000,000 today when the exemption amount is $12,060,000, and the exemption amount is reduced to $7,060,000 in 2026, the taxpayer would only have $2,000,000 of exclusion remaining.  However, if the taxpayer made a gift of $12,060,000 using all of the increased exclusion amount, then there would be no “clawback” of the exemption previously used if the taxpayer died after 2026 when the exemption amount is reduced to only $7,000,000.

The question of how to treat gifts that are complete at the time of transfer, but still includible in the gross estate of the decedent upon death has not been determined, and has loomed over taxpayers and estate planners since the promulgation of the “Special Rule”. The Proposed Regulations issued on Tuesday, April 26 make clear that transfers where the donor continues to have title, possession, or other retained rights in the transferred property during life that will be treated as still owned by the donor upon death, which occur under §§2035, 2036, 2037, 2038, and 2042 of the Internal Revenue Code, do not qualify for the Special Rule.

For situations like these, the amount includible in the gross estate would only be given the benefit of the exemption amount available on the date of death. The Proposed Regulations provide for exceptions to the Special Rule, and also exceptions to the exception in certain situations.

It is noteworthy that Proposed Regulations are not binding upon taxpayers, but are generally binding upon the IRS until they become final, at which time they become binding upon both taxpayers and the IRS.  Proposed Regulations are issued to the public, given a brief period of time to make comments; thereafter, the IRS and Treasury Department review public comments and issue Final Regulations, which are usually a bit more taxpayer friendly than the Proposed Regulations that they replace, but not always.

The exception to the Special Rule applies to gifts that are includible in the gross estate pursuant to §§2035, 2036, 2037, 2038, or 2042 of the Code, unsatisfied enforceable promises, gifts subject to the special valuation rules of §2701 (related to valuation of intra-family transfers of equity interests in an entity where the senior generation retains certain preferred rights) and §2702 (related to GRATs and QPRTs), and the relinquishment or elimination of an interest in any one of the aforementioned situations that occurs within eighteen (18) months of the date of the decedent’s death. If a transfer falls under one of these categories, the Special Rule will not apply. But, of course, there are exceptions to the exception.

The Proposed Regulations further provide that the Special Rule will still apply to allow the exemption amount that was higher when a gift was made, where the assets gifted are includible in the donor’s gross estate, to apply in two types of situations:

(1)    transfers where the value of the taxable portion of the transfer did not exceed five percent of the total transfer, and

(2)    transfers where the retained interests were relinquished or terminated by the termination of a durational period described in the original instrument of transfer by either (a) the death of any person, or (b) the passage of time.

COMMENT:

While 2026 is still more than three years away, it is not unreasonable to think that the exemption could be reduced as early as 2023 if the House of Representatives stays in Democratic hands and the Senate swings by three or four seats further into Democratic control. Since the Biden Tax Plan that was published in March does not make mention of reduction of the exemption amount, one should not worry, yet.

As mentioned above, the Special Rule prevents the “clawback” for the use of the higher estate/gift tax exemption amount available on the date of the complete transfer when determining the amount of credit available as of the date of the taxpayer’s death, even if the applicable estate/gift tax exemption is lower as of the date of the taxpayer’s death. This is good news for taxpayers, but the Proposed Regulations provide exceptions to the applicability of the Special Rule.

The IRS continues to issue Proposed Regulations, including rules and examples, that are complicated; however, the specific circumstances where a taxable gift may be considered to have occurred are fairly well defined and contained.

Thankfully, the Proposed Regulation demonstrate well how the Special Rule and various exceptions apply; two examples loosely based on examples in the Proposed Regulations are discussed below:

1.      Example One: Taxpayer’s Gift of Note or Other Obligation.

Assume that a taxpayer with a net worth of $12,000,000 gives an $11,000,000 note to his or her children  and files a gift tax return showing use of $11,000,000 of his or her $12,060,000 estate tax exemption. The promissory note is to be satisfied with assets of the taxpayer’s gross estate.

Assume that the exemption goes up to $13,000,000 through 2025, and then is cut to $6,500,000 on January 1, 2026.

                  The taxpayer dies on January 1, 2027.

The taxpayer may at that time have a net worth of $1,000,000, but he or she still has $12,000,000 of assets and has not made any payment on the $11,000,000  promissory note, and therefore the $11,000,000 note is includible in the taxpayer’s gross estate. 

The limitation to the Special Rule applies and the taxpayer can only receive the benefit of the smaller exclusion amount that is applicable on the date of death, which is $6,500,000, and therefore would pay estate tax on $5,500,000 of assets ($12,000,000 - $6,500,000 = $5,500,000).

This limitation on the Special Rule would also apply if the taxpayer, or a third party empowered to act on the taxpayer’s behalf, paid the note within 18 months of the taxpayer’s death.

Many planners’ interpretation of the rule was confirmed in this example, which is that the use of a note, or an enforceable promise to pay, will not be effective in using the temporarily increased exclusion amount, if the regulations are made permanent.  The increased exclusion amount may be used only if payment actually occurs on the note, and such payment must occur 18 months prior to the taxpayer’s death.

2.      Example Two: Death of the Grantor Before the Grantor Retained Annuity Trust Term Ends

The Internal Revenue Code explicitly permits the use of what is called a Grantor Retained Annuity Trust (“GRAT”), whereby assets or ownership interests in investment or business entities can be placed under a trust that pays the Grantor a certain percentage of the day one value of the trust assets each year for a term of years.

What remains in the trust after the term of years is not subject to federal estate tax.

An example would be that a Grantor would place $2,000,000 of assets into a GRAT that would pay the Grantor 21.34% of the day one value of the trust assets ($426,800) each year for five years.

Under this scenario, the Grantor will be not be considered to have made a gift to establish the GRAT (also known as a “Zero’d out” GRAT), and any assets held under the GRAT after the fifth year and satisfaction of the annuity payments would not be subject to federal estate tax on the death of the Grantor.

As many planners were already aware of, if the Grantor of a GRAT dies before the end of the GRAT term, some or all of the GRAT assets will be included in the Grantor’s estate due to the retained annuity interest.  The new Proposed Regulations confirm that the applicable exclusion amount as of the date of the Grantor’s death would apply and, unfortunately, not the increased exclusion amount that was available at the time of the transfer to the GRAT.

The Proposed Regulations highlight the importance of proper planning in addition to properly explaining how taxpayers can take advantage of the increased estate tax exemption.  While it is clear that cash gifts, whether outright or in trust, will benefit from the increased exclusion, taxpayers should exercise caution when making gifts of an interest in a Limited Liability Company or other entity.  If the taxpayer’s ownership interest includes the ability to determine when a distribution can be made from the entity, or when the entity can be liquidated, then the entire value of the entity can be brought back into the gross estate of the taxpayer upon their death under Section 2036(a)(2).

As a result of the entity being included in the gross estate under Section 2036, the exception to the Special Rule would apply and the taxpayer would not have the benefit of the likely higher exclusion applicable to the date of the transfer, but only the benefit of the exclusion amount as of the date of their death.

For example, the taxpayer owns a LLC valued at $20,000,000 and makes a completed gift of 40% of the entity to a trust for the benefit of the taxpayer’s descendants in 2022 when the estate tax exemption amount is $12,060,000.  Ignoring any applicable discounts that may apply to the transfer, the taxpayer files a gift tax return reporting the use of $8,000,000 of her exemption amount.       

The taxpayer dies in 2027 when the exemption amount is $7,000,000.   

The taxpayer as a result of her 60% retained ownership in the entity can control when a distribution can be made from the entity and therefore the entire value of the entity is included in the gross estate even though 40% of the entity was previously transferred.  On top of the inclusion, the taxpayer will only receive the benefit of the applicable exemption amount of $7,000,000 as of the date of her death and will not get the benefit of using a portion of the increased exemption amount at the time the transfer was made. 

Taxpayers need to plan accordingly to prevent 2036(a) inclusion, and this is therefore even more important than before, given the new Proposed Regulations.  One effective way to prevent inclusion under 2036(a) is to create a special class of voting interest in the entity to control when a distribution, liquidation, or amendment to the governing documents can be made and transferring such interest more than three years prior to the taxpayers death to an irrevocable trust outside of the taxpayer’s estate with an independent trustee. 

Conclusion

The Proposed Regulations confirm what numerous planers thought to be the case as it relates to enforceable promises to make gifts and the treatment of assets held in a GRAT or similar trust.  The Proposed Regulations also reaffirm the Treasury’s position on “clawback” and the use of the increased exclusion amount, but also present new traps for the unwary that require appropriate planning on Toni Tiger’s part to prevent inclusion.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Alan Gassman

Brandon Ketron

CITE AS: 

LISI Estate Planning Newsletter #2958 (April 29, 2022) at http://www.leimbergservices.com. Copyright 2022 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited - Without Express Permission. This newsletter is designed to provide accurate and authoritative information regarding the subject matter covered. It is provided with the understanding that LISI is not engaged in rendering legal, accounting, or other professional advice or services. If such advice is required, the services of a competent professional should be sought. Statements of fact or opinion are the responsibility of the authors and do not represent an opinion on the part of the officers or staff of LISI