By Andrew Bechel, Esq.
The IRS recently published proposed regulations that provide certain exceptions to the anti-clawback regulations released in 2019. As the estate and gift tax exemption was only temporarily raised to $10 million, adjusted for inflation, per person in 2017, there was some concern that individuals utilizing their full estate and gift tax exemption while the exemption was temporarily increased, but dying after the exemption is reduced on January 1, 2026, could have the gifted assets clawed back into their taxable estates. The 2019 regulations provided assurances that assets would not, in fact, be clawed back upon death, thereby applying the estate and gift tax exemption that was available at the time a gift was made, rather than the amount available at the time of death.
However, with the exemption amount exceptionally high, many individuals wanted to lock in these large exemptions but were not comfortable giving up full control of what may be the bulk of their assets. Many of these individuals used planning techniques that may result in the gifted assets being pulled back into their taxable estates upon death. Because the 2019 regulations did not differentiate between 1) gifts that are completed gifts for gift and estate taxes and are excluded from a transferor’s taxable estate, and 2) gifts that are completed for gift tax purposes but are included in the transferor’s taxable estate, these individuals may have felt comfortable that even if the assets were pulled back into their taxable estates, the estate and gift tax exemption applicable at the time the gift was made would apply. However, the new proposed regulations make it clear that the IRS intends to apply the estate tax exemption applicable at the time of death, not the time a gift was made, to transfers that are pulled back into an individual’s taxable estate.
Background
In the past, when the exemptions were lower, most gifts were either outright gifts to friends and family or transfers to trusts intended to benefit future generations. The transferor in these transactions did not retain any significant beneficial interest in, or control, over the transferred assets. However, with the current high exemption, many families are in a position where the only way to lock in the high exemption is to gift most of, if not all of, their assets. These families will be subject to the estate tax when the exemption is reduced on January 1, 2026, meaning that there are significant advantages to locking in the higher exemption amounts now. As a result, many of these individuals and families utilized structures that qualified as completed gifts for gift tax purposes, but which also allowed the donor to benefit from or otherwise control the gifted assets.
Sections 2035 – 2038 and Section 2042 of the Internal Revenue Code provide that certain retained powers, such as the retained power to affect or alter the beneficial enjoyment of gifted assets, result in the gifted assets being pulled back into an individual’s taxable estate. Section 2036 has gained a lot of attention recently because the Tax Court and the IRS have been using this provision to pull gifted entity interests back into a transferor’s estate, if the transferor retained the power to determine when distributions from the gifted entity are made or can otherwise participate in decisions to liquidate the gifted entity. The new proposed regulations detail that, for individuals that die after April 27, 2022, if assets are pulled back into their taxable estate under the above described sections, the estate tax exemption at the time of death, not the time the gift was made, will apply to these transfers. Thus, for example, if an $11 million gift was made at a time when the exemption was $12 million, but the gift was pulled back into the transferor’s estate at a time when the exemption was $7 million, the $7 million exemption will apply and any assets in excess of $7 million will be subject to the estate tax.
What Types of Transactions Should Raise Concerns
As many gifting transactions have occurred in the years since the exemption was temporarily increased, the impact of this proposed regulation could be significant. That being said, there are certain transactions that have a significantly higher risk of being implicated by these proposed regulations. Anyone that engaged in any of the following transactions is at the highest risk under these proposed rules:
Gifts of Entity Interests . It is popular for families to place interests in partnerships and limited liability companies, particularly before gifting them. While there are numerous benefits to gifting entity interests, including ease of transferability and potential valuation discounts, there are also significant risks that the gifted assets are pulled back into the transferor’s estate if the transferor retained voting or management powers over the entity. As Estate of Powell v. Commissioner , 148 T.C. 392 (May 18, 2017) made clear, the retention of any powers that can theoretically affect the beneficial enjoyment of the transferred entity interests, including the mere ability to participate in a decision to liquidate the company, can result in the entire gifted interest being pulled back into the transferor’s estate. If the transferor dies after the estate tax exemption has been reduced, the estate tax exemption at the date of death will apply to the gifted assets, which may result in a significant estate tax.Grantor Retained Annuity Trusts (“GRATs”) . The rules concerning GRATs have long made it clear that, if the grantor dies during the annuity term, the assets of the GRAT are pulled back into the grantor’s taxable estate. However, the proposed regulations make it clear that, if the grantor dies before the term ends but after the estate tax exemption is reduced, the trust will be pulled back into the grantor’s estate and the estate tax exemption as of the date of death, not the date the GRAT was created, will apply. If a GRAT is already in existence, there is not a lot that can be done to address this issue. However, at least until January 1, 2026, when the exemption amount is reduced, it may be wise to avoid long-term GRATs to reduce the risk that the grantor will die before the annuity term ends.Section 2519 Deemed Gifts . Section 2519 of the Code provides that a transfer of all or a part of certain income interests, such as those in qualified terminable interest trusts (“QTIPs”), which are standard structures for marital deduction trusts, will result in a deemed gift of the entire underlying principal amount. Since even a partial gift of an income interest in a QTIP could result in a deemed gift of the entire principal of the trust, this technique is a viable option for surviving spouse’s to lock in the higher exemption amount. However, the regulations also provide that, if only a partial gift of the income interest is made, an amount of trust principal equal to the same proportion of the income interest that is retained will be included in the transferor’s taxable estate. Under the proposed regulations, the estate tax exemption as of the date of death will apply to the portion of the principal pulled back into the transferor’s taxable estate.Gifts with Retained Beneficial Interests . Many individuals were hesitant to give up the full benefit of such a significant portion of their wealth and searched for ways to continue benefitting from gifted assets while still utilizing their exemption. This resulted in more exotic, completed gift trust structures, where the transferor that was named a beneficiary, could be added on later as a beneficiary, or was eligible to receive assets under a power of appointment. These structures, if carefully drafted, should not implicate the newly proposed regulations. However, it is extremely important that a trust of this nature be administered for the benefit of all of the beneficiaries, not just the settlor, and that all trustee decisions are independently made by the trustee without any input from the settlor.Gifts of Promissory Notes . A technique that gained popularity the last few years was to have an individual gift a note payable, either outright to their descendants or in a trust. The note would remain outstanding until death, with the transferor’s estate responsible for the note. The proposed regulations make it clear that the note, at least to the extent it remains unsatisfied, is included in the transferor’s estate and the estate tax exemption amount as of the date of death is applicable, not the date the note was originally issued.
The above described techniques are merely some of the techniques that have been utilized in the last few years that could be implicated by these proposed regulations. Anyone that has made gifts utilizing the current high exemption amount should verify with their advisors that these proposed regulations will not impact their gifts.
How to Correct Potential Issues
While the proposed regulations have not yet been finalized and are subject to change, any potentially problematic transactions should be addressed immediately. Luckily, as the exemption amount is not currently scheduled to decrease until January 1, 2026, there is sufficient time to correct most of these issues. However, it is important that any issues are addressed quickly because the proposed regulations provide that many efforts to correct these issues will be ineffective if completed within eighteen months before the transferor’s death. As this eighteen month period is only significant if it continues past January 1, 2026, all potential issues should be corrected by the end of June of 2024, if not sooner.
The proper method to correct each potential problem will be fact dependent, but any problematic powers should be eliminated as quickly as possible. After these powers are eliminated, the proper administrative formalities for each trust/entity at issue must be closely followed. Deviations from these formalities increases the risk that transferred assets are brought back into the transferor’s taxable estate. If the documents are all in order, but formalities have not been properly followed, the most important action to do now is to ensure that all formalities are strictly followed going forward. You should consult with counsel concerning whether any remedial actions are necessary for any past actions.
The proposed regulations make it clear that the IRS knows that many aggressive structures were employed to take advantage of the temporarily increased exemption, and will likely be challenging many of these transactions. Luckily, there is still time to correct any issues before the exemption is decreased, which is ultimately when the true impact of these proposed regulations will be felt. If you have any concerns about these proposed regulations, you should reach out to your tax advisors and should closely follow any developments that may occur as these regulations are finalized.
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