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The world of estate tax planning can be complicated and confusing.

While planners can navigate the situations that taxpayers face by way of planning strategies, financial projections and illustrations, the IRS’s assault on various planning strategies in court cases, Treasury Regulation pronouncements and Proposed Regulations can result in unpredictability, and make the day-to-day life of estate tax planners interesting, to say the least.

Many had assumed 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, in lieu of 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 this will apparently not be the case.

This is where it can get complicated.

For example, Polly Purebred has a $12,060,000 estate tax exemption and may make an $8,000,000 cash gift, reducing her 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.

What if instead of making a complete traditional gift, Polly instead gifts a promissory note payable by her to her significant other, Underdog, of the same value, and the assets of her estate will be used to satisfy the note? In this scenario, her estate would not be able to take advantage of 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.

While 2026 is still more than three years away, it is possible that the House of Representatives could stay in Democratic hands and the Senate could swing by three or four seats further into Democratic control, in which event, it is conceivable that the exemption would be reduced as early as 2023, although the Biden Tax Plan that was published on March 28, 2022 does not make mention of reduction of the exemption amount.

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By way of background, the Tax Cuts and Jobs Act (TCJA) was passed in 2017 and provided that the exemption amount would be temporarily doubled to $10,000,000 plus inflation adjustments, but revert back to $5,000,000 plus inflation adjustments in 2026. Further, the TCJA provided the Treasury Department (which oversees the IRS) with authority to issue regulations to prevent abuse for situations where a gift was made but the taxpayer retained the beneficial use of or control over the transferred property as of the taxpayer’s date of death after the exemption reduction occurs.

Following the enactment of the TCJA, uncertainty remained regarding situations where the estate tax exemption amount that applied at the time of a decedent’s death would be lower than the exclusion amount that applied when the transfer was made by reason of a reduction in the exemption. To address concerns that an estate tax could apply to gifts otherwise exempt from gift tax by the temporarily increased exemption amount, final regulations released by the IRS in 2019 crafted 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.

The 2019 Regulations also clarified that in order to take advantage of the temporary increased exclusion amount, the taxpayer would need “use it or lose it” by making gifts exceeding the historical exemption 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 $7,000,000 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 because of the “Special Rule”.

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, which is given a period of time to make comments. The IRS and Treasury Department then review the comments and issue Final Regulations, which are usually a bit more taxpayer friendly than the Proposed Regulations that they replace, but not always.

Since the establishment of the Special Rule, 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. 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. In these situations, the amount includible in the gross estate would only be given the benefit of the exemption amount available on the date of death. These are referred to as the exceptions to the Special Rule, and of course to make it even more complicated the Proposed Regulations have two exceptions to the exception to the Special Rule.

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, as mentioned above, 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 to apply in two types of situations where the assets gifted are includible in the donor’s gross estate:

(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.

While the rules provided under the Proposed Regulations are complicated, the specific circumstances where a taxable gift may be considered to have occurred are fairly well defined and contained.

Thankfully, the Proposed Regulation provided a few examples to demonstrate how the Special Rule and various exceptions apply. We have provided some of these examples below:

1. Example One: Note or Other Obligation of Taxpayer Given as a Gift.

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.

This example confirms what many planners thought to be true, 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. In order to use the increased exclusion amount payment must actually occur on the note, and such payment must occur 18 months prior to the taxpayer’s death.

2. Example Two: When the Grantor of Grantor Retained Annuity Trust Dies Before the End of the GRAT Term.

The Internal Revenue Code explicitly permits the use of what is called the 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 know, if the Grantor of a GRAT dies before the end of the GRAT term, some or all of the GRAT assets are 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 not the increased exclusion amount that was available at the time of the transfer to the GRAT.

The Proposed Regulations again confirm that the Treasury will not “claw back” the use of the increased exclusion amount for completed gifts made by the taxpayer, but also illustrate the importance of proper planning. 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 retains the ability to determine when a distribution can be made from the entity, or when the entity can be liquidated the entire value of the entity can be brought back into the gross estate of the taxpayer on 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 only have the benefit of the applicable exclusion amount as of their date of death, and not when the transfer is made.

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 retained ownership or voting rights 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.

Appropriate planning to prevent 2036(a) inclusion 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.

In conclusion the Proposed Regulations confirm what many 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 to prevent inclusion.

Source: Forbes

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