On November 26, 2019, the Internal Revenue Service (IRS) issued regulations which confirm that if an individual makes a gift utilizing the increased existing gift and estate tax exemption, that individual will not be penalized if the exemption is reduced in the future. Until these regulations were issued, there was fear that there could be “clawback” of the protection afforded by the increased exemption if that exemption were reduced.
For gifts made and estates of decedents dying before January 1, 2018, the estate and gift tax exemption was $5 million, indexed for inflation after 2011. For gifts made and decedents dying after December 31, 2017 and before January 1, 2026, the exemption has been increased to $10 million, also indexed for inflation. The exemption is $11.58 million for 2020. Prior to the IRS’s release of the new regulations, there was speculation that an individual who made a gift using the increased exemption and who dies after 2025 would lose the protection afforded by the increased exemption. The new regulations eliminate this concern.
The result of the new regulations can be illustrated by an example. Assume that an individual makes a taxable gift this year in the amount of $8 million. No gift tax is due as a result of that gift, because the gift is less than this year’s $11.58 million exemption. Assume that the individual dies after 2025 with an estate of $2 million, and that the exemption as of date of death is $6.5 million. In computing estate tax due as a result of the individual’s death, tax is payable on $2 million. The estate is not penalized because the individual made use of the exemption that no longer exists. The exemption is not lost or clawed back.
The IRS regulations also address the situation when a deceased spouse’s exemption is transferred to a surviving spouse. The estate tax law permits the gift and estate tax exemption which is not used by a predeceasing spouse to be transferred to that individual’s surviving spouse. A deceased spouse’s exemption transferred to a surviving spouse is referred to as the deceased spouse’s unused exclusion (DSUE). The transfer of DSUE is effected through the filing of a federal estate tax return on behalf of the deceased spouse’s estate. There must be an affirmative election on a timely filed estate tax return, whether or not a return is otherwise required.
The new IRS regulations make it clear that if one spouse dies prior to 2026 and if the deceased spouse’s increased exemption is transferred to the surviving spouse as DSUE, the DSUE transferred to the surviving spouse will not be reduced if the amount of the gift and estate tax exemption decreases in the future. The new IRS regulations treat DSUE more favorably than the ordinary rule governing any reduction in gift or estate tax exemption. If gift and estate tax exemption is reduced in 2026, the ability to use increased exemption not possessed by virtue of a transfer of DSUE will not exist. Ordinary exemption must be used while it remains in effect. Additionally, a surviving spouse receiving DSUE is not permitted to make gifts using his or her own increased exemption before using DSUE to cover the gifts. A surviving spouse must consume all DSUE before using his or her own increased exemption.
Now that the IRS has formally issued regulations that eliminate the possibility of “clawback,” persons who could be affected by the possible reduction of the estate tax exemption in 2026 may wish to make gifts or adopt other strategies utilizing the increased exemption. Before making gifts of appreciated assets, the loss of the step up in income tax basis at death should be considered. The possibility of transferring increased exemption as DSUE should also be borne in mind. Members of the firm’s estate planning department would be pleased to assist individuals who might wish to engage in this type of planning.