On November 23, 2018, the IRS published proposed regulations addressing the effect of the Tax Cuts and Jobs Act (TCJA) on the computation of federal gift and estate taxes. The proposed regulations resolve an inconsistent tax outcome, albeit for a limited segment of taxpayers. The proposed regulations prevent clawback of gifts made prior to the expiration of the TCJA.
Computation of federal gift and estate tax revolves around a concept called the exclusion amount. The exclusion amount is the maximum amount that a person can transfer during life as a gift and at death before paying gift or estate tax. The exclusion amount unifies the gift and estate tax to ensure someone cannot avoid estate tax by giving away all their assets during life.
The exclusion amount has been on a steady upward path, increasing from $134,000 in 1978 to $11,180,000 in 2018. The TCJA is responsible for a significant portion of that increase by adding $5,000,000 to the exclusion amount at the start of 2018. However, as the TCJA giveth, the TCJA taketh away. On January 1, 2026, when certain portions of the TCJA expire, the exclusion amount reverts back to $5,000,000 with upward adjustments for inflation that occurred between 2018 and 2026.
Looking ahead to the 2026 reversion, members of the estate planning community discovered a potential problem, often referred to as clawback. If someone makes a gift between now and 2026, the amount of the gift is greater than the exclusion amount in 2026 after the reversion, and that person dies in 2026 or later, then that person’s estate will pay estate tax on a gift that was previously protected by the higher exclusion amount. In other words, the previous gift gets clawed back into the estate and the benefit of the higher exclusion amount from the TCJA gets completely reversed.
As an example, assume the exclusion amount in 2018 is $10,000,000 and a person gives a gift in 2018 in the amount of $9,000,000. The $10,000,000 exclusion amount would shelter the entire $9,000,000 gift from gift tax. Suppose that person then dies in 2026 after the exclusion amount reverts back to $5,000,000. If that person has a taxable estate worth $4,000,000 then the estate tax computation required by the Internal Revenue Code generates an estate tax of $3,200,000. This result occurs because the estate tax computation would add the $4,000,000 taxable estate to $4,000,000 of the 2018 gift previously sheltered by the higher exclusion amount allowed before 2026. The estate tax computation would then apply the 40% estate tax rate to the resulting $8,000,000. Thus the amount that escaped gift tax under the TCJA is subject to estate tax post-TCJA, rendering meaningless the increased exclusion amount given by the TCJA.
The IRS’s proposed regulations avoid this outcome by modifying the estate tax computation. The proposed regulations create a special rule that applies if the total of the basic exclusion amount allowable when gifts were made exceeds the exclusion amount allowable at death. When triggered, the special rule uses the higher of the two exclusion amounts when calculating any estate tax due.
Returning to the prior example, the special rule created by the proposed regulations would apply an exclusion amount of $9,000,000 and generate an estate tax of $1,600,000, rather than an estate tax of $3,200,000. Thus the benefit of the higher exclusion amount pursuant to the TCJA remains intact.
In all, the proposed regulations ensure that the estate tax benefit intended by the TCJA through higher exclusion amounts continues after the TCJA expires. The proposed regulations also provide certainty to estate planners advising clients whether making gifts between now and 2025 makes good tax sense.
If you have any questions about how the TCJA impacts you and your estate plan, please contact your attorney at Carlile Patchen & Murphy LLP or any member of the Family Wealth & Estate Planning Group