The IRS recently released proposed clawback regulations on the treatment of gifts that are complete at the time of transfer but are potentially included in the donor's gross estate at death.1 Such gifts will likely get the exemption in effect on the donor's death and not the exemption on the date of the original transfer.

Under the 2017 Tax Cuts and Jobs Act (TCJA), the current gift and estate tax exemption is $12.06 million in 2022 but is due to sunset after December 31, 2025. Starting in 2026, the gift and estate tax exemption will revert to the pre-TCJA level of $5 million, adjusted annually for inflation. This temporary doubling of the exemption brought a unique estate planning opportunity by allowing clients to make large gifts prior to 2026 and secure the much higher exemption.

As an added benefit, the IRS released final regulations in 2019 that allowed a decedent to calculate estate tax credits in the year of the gift or the exemption available at death. This essentially allows individuals to make full use of the $12.06 million of gift exemption currently, without negative tax consequences if the individual's death occurs after 2025.

However, certain gifts may be complete at the time of the transfer but may be included in the donor's estate if the donor retains rights or control in the gifted property. Such inclusion is provided for in sections 2035, 2036, 2037, 2038, and 2042 of the Internal Revenue Code. These types of gifts, while complete and that may use the donor's increased lifetime gift exemption at the time of the gift, do not qualify for the preferential treatment provided for in the 2019 final regulations.

There is also an 18-month rule, which precludes the preferential 2019 final regulation treatment for those transfers described above—except for the transfer, relinquishment, or elimination of an interest, power, or property, effectuated within 18 months of the donor's death, by the donor alone or by any other person. Subject to limited exceptions, these transfers receive the estate tax exemption in the year of death and not the year of the gift.

The proposed regulations give several examples of how these rules may apply. One example is the donor giving a promissory note in the amount of $9 million to a donee:

  • If the note remains unpaid at the donor's death, then the assets that are to be used to satisfy the note are part of the donor's gross estate. The credit used in determining the donor's estate tax is based on the exemption in the year of death and not the year of the transfer.
  • It is also important to note that the result is the same if the donor or a person empowered to act on donor's behalf had paid the note within the 18 months prior to the date of donor's death. So timing is important.

Another example confirms much of what was already known when a donor dies during a GRAT term. Arguably some or all of the GRAT assets are included in the donor's estate because of the retained annuity interest and the exemption amount as of the donor's death applies, not the exemption on the date of the initial transfer.

Finally, clients should always be aware of estate inclusion caused by section 2036. Many estate planning techniques balance the donor's desire to make a completed gift while retaining control over the gift property. However, the proposed regulations make it clear that if section 2036 applies, the transferred property receive the exemption amount as of the donor's death applies, not the exemption on the date of the initial transfer.

There are exceptions to the treatment provided for in the new proposed clawback regulations:

  • First, transfers where the value of the taxable portion of the transfer did not exceed 5 percent of the total transfer are ignored under the new proposed clawback regulations and such transfer receives the preferential treatment under the 2019 regulations.2 For example, this de minimis rule likely applies to grantor retained annuity trusts (GRATs) or other lifetime transfer where the taxable portion of the gift is 5 percent or less of the amount transfer and the donor does not survive the term. Suppose, for example, a client creates a $10 million GRAT with a taxable portion of $500,000 or less, this transfer would qualify under the de minimis rule.
  • Second, the preferential treatment under the 2019 regulations continues to apply to transfers, relinquishments, or eliminations that occur within 18 months of the date of the donor's death effectuated by the termination of the durational period described in the original instrument of transfer by either the mere passage of time or the death of any person.