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The IRS has issued proposed regulations (REG-106706-18) addressing the effect that recent legislative changes have on the basic exclusion amount used in computing federal estate and gift taxes. These regulations will affect donors of gifts made after 2017 and estates of decedents who died after 2017. The IRS invites public comments and has scheduled a public hearing for March 13, 2019.

Background

To compute liability for federal gift tax or federal estate tax, the Internal Revenue Code applies a unified rate schedule to the taxpayer's cumulative taxable gifts and taxable estate and arrives at a net tentative tax, which is then reduced by a credit based on the applicable exclusion amount (AEA). The AEA is the sum of: (1) the basic exclusion amount (BEA) under Section 2010(c)(3); (2) the deceased spousal unused exclusion (DSUE) amount under Section 2010(c)(4), if any; and (3) in some cases, a restored exclusion amount under Notice 2017-15. Before the Tax Cuts and Jobs Act (TCJA) became effective on January 1, 2018, the BEA under Section 2010(c)(3) was $5 million, indexed for inflation after 2011. The TCJA doubled the BEA to $10 million for estates of decedents dying from January 1, 2018 through December 31, 2025; the BEA reverts back to $5 million effective January 1, 2026.

The new proposed regulations address this temporary change in the BEA, focusing in particular on two questions raised by commenters:

1. If a taxpayer exhausted his BEA and paid gift tax on a pre-2018 gift and then either makes an additional gift or dies during the increased BEA period, will the increased BEA be absorbed by the pre-2018 gift on which gift tax was paid, thereby denying the taxpayer the full benefit of the increased BEA during the increased BEA period?
2. If a taxpayer made a gift of between $5 million and $10 million during the increased BEA period that was fully sheltered from gift tax, but makes a gift or dies after the increased BEA period ends, will the gift made during the increased BEA period have the effect of increasing the gift or estate tax on the later transfer?

Computing federal gift tax

Federal gift tax, imposed under Section 2051, is determined in a seven-step computation under Sections 2502 and 2505 using the rate schedule set out in Section 2001(c) that is in effect for the calendar year in which the gifts were made. The seven steps are:

1. Determine a tentative tax on the sum of all taxable gifts made in the current year or in prior periods. (Section 2502(a)(1))
2. Determine a tentative tax on the sum of all taxable gifts made in all prior periods. (Section 2502(a)(2))
3. Determine the net tentative gift tax on the current-year gifts by subtracting the tentative tax determined in Step 2 from the tentative tax determined in Step 1. (Section 2502(a))
4. Determine a credit equal to the applicable credit amount within the meaning of Section 2010(c). (Section 2502(a)(1))
5. Determine the sum of all of the amounts allowable as a credit to offset the gift tax on gifts the donor made in all preceding calendar periods. (Section 2505(a)(2))
6. Subtract the total credit allowable for prior periods determined in Step 5 from the credit for the current period determined in Step 4. (Section 2505(a))
7. Subtract the credit amount determined in Step 6 from the net tentative gift tax determined in Step 3. (Section 2505(a))

Computing federal estate tax

Section 2001(a) imposes a federal estate tax on the transfer of a decedent's taxable estate at death, calculated in a five-step computation under Sections 2001 and 2010 using the same rate schedule that is used for gift tax purposes. The five steps are:

1. Determine a tentative tax on the sum of the taxable estate and the adjusted taxable gifts (i.e., all taxable gifts made after 1976 other than those included in the gross estate). (Section 2002(b)(1))
2. Determine a hypothetical gift tax (i.e., gift tax reduced, but not below zero, by credit amounts allowable in the gift years; referred to as "the gift tax payable") on all post-1976 taxable gifts. (Section 2001(b)(2) and (g)) Under Section 2502(c), the credit amount allowable for each gift year is the tentative tax on the AEA for that year, but may not exceed the tentative tax on gifts made during that year. The AEA equals the sum of: (1) the BEA in effect for the year in which the gift was made; (2) any DSUE amount as of the date of the gift as computed under Reg. Section 25.2502-2; and (3) any restored exclusion amount as of the gift date as computed under Notice 2017-15.
3. Determine the net tentative estate tax by subtracting the gift tax payable determined in Step 2 from the tentative tax determined in Step 1. (Section 2001(b))
4. Determine a credit amount (which may not exceed the net tentative estate tax) equal to the tentative tax on the AEA in effect on the date of death. (Section 2010(a) and (c))
5. Subtract the credit amount determined in Step 4 from the net tentative estate tax determined in Step 3. (Section 2010(a))

TCJA amendments

The TCJA modified Section 2010(c)(3) by increasing the BEA from $5 million to $10 million, adjusted for inflation, for decedents dying and gifts made from January 1, 2018 through December 31, 2025 (referred to as the "increased BEA period"). Further, the TCJA modified Section 1(f)(3) to base the determination of annual cost-of-living adjustments, including those for estate and gift tax purposes, on the Chained Consumer Price Index for All Urban Consumers for all tax years beginning after December 31, 2017. As noted in the Preamble to the proposed regulations, the tax reform law also directed Treasury to prescribe regulations necessary or appropriate to carry out Section 1001 "with respect to any difference between the BEA applicable at the time of the decedent's death and the BEA applicable with respect to any gifts made by the decedent."

Concerns raised by changes in BEA

The Preamble to the regulations sets out four example situations illustrating issues that could arise as a result of the temporary increase in the BEA, and concludes that the fourth situation is the only one that could be problematic.

Situation 1: Whether for gift tax purposes, the temporarily increased BEA is reduced by pre-2018 gifts on which gift tax was paid — For donors who made both pre-2018 gifts that exceeded the $5 million BEA, incurring gift tax liability, and other gifts during the increased BEA period, does the gift tax computation apply the increased BEA ($10 million) to the pre-2018 gifts? If so, the concern is that the BEA otherwise available to shelter gifts made during the increased BEA period would be reduced and credit would effectively be allocated to a gift on which gift tax had already been paid.

The Preamble points out that, in Step 3 of the gift tax determination, the tentative tax on all gifts from prior periods must be subtracted from the tentative tax on the donor's cumulative gifts, including the pre-2018 gifts on which gift tax was paid. "In this way, the full amount of the gift tax liability on the pre-2018 gifts is removed from the current year gift tax computation," the IRS explains, "regardless of whether that liability was sheltered from gift tax by the BEA and/or was satisfied by a gift tax payment."

Further, the IRS notes, Steps 4, 5, and 6 require that "the BEA for the current year be reduced by the BEA allowable in prior periods against the gifts that were made by the donor in those prior periods." Because the increased BEA was not available before 2018, when the gifts were made, the $10 million BEA is not reduced by a prior gift on which gift tax was paid.

Situation 2: Whether for estate tax purposes, the temporarily increased BEA is reduced by pre-2018 gifts on which gift tax was paid — For donors who made pre-2018 gifts that exceeded the $5 million BEA, incurring gift tax liability, and died during the increased BEA period, does the estate tax computation apply the increased ($10 million) BEA to the pre-2018 gifts? If so, the concern is that the BEA otherwise available against the estate tax during the increased BEA period would be reduced and credit would effectively be allocated to a gift on which gift tax was paid.

The Preamble notes that, under Step 3 of the estate tax determination, the hypothetical gift tax on the decedent's pot-1976 taxable gifts, including the pre-2018 gifts, must be subtracted from the tentative tax on the sum of the taxable estate and adjusted taxable gifts. As a result, the full amount of the gift tax liability on the pre-2018 gifts is removed from the estate tax computation. Next, Step 4 of the estate tax determination requires a credit on the amount of BEA for the year of death to be subtracted from the net tentative estate tax. The IRS explains that "the only time that the increased BEA enters into the computation of the estate tax is when the credit on the amount of BEA allowable in the year of the decedent's death is netted against the tentative estate tax, which in turn already has been reduced by the hypothetical gift tax on the full amount of all post-1976 taxable gifts (whether or not gift tax was paid). Thus, the increased BEA is not reduced by the portion of any prior gift on which gift tax was paid, and the full amount of the increased BEA is available to compute the credit against the estate tax."

Situation 3: Whether the gift tax on a gift made after the increased BEA period (January 1, 2026 or later) is inflated by a theoretical gift tax on a gift made during the increased BEA period that was sheltered from gift tax when the gift was made — For donors who make gifts during the increased BEA period that are sheltered from gift tax by the $10 million BEA, as well as post-2025 gifts, does the gift tax determination on the post-2025 gift treat the gifts made during the increased BEA period as gifts not sheltered from gift tax by the credit on the BEA?

The IRS notes that, as in Situation 1, Step 3 of the gift tax determination requires the tentative tax on gifts from prior periods to be subtracted from the tentative tax on the donor's cumulative gifts. As a result, "the full amount of the gift tax liability on the gifts from the increased BEA period is removed from the computation, regardless of whether that liability was sheltered from gift tax by the BEA or was satisfied by a gift tax payment." Steps 4-6 require the credit based on the BEA for the current year to be reduced by the corresponding credits allowable in prior periods. "Even if the sum of the credits allowable for prior periods exceeds the credit based on the BEA in the current (post-2025) year," the Preamble explains, "the tax on the current gift cannot exceed the tentative tax on that gift and thus will not be improperly inflated. The gift tax determination anticipates and avoids this situation, but no credit will be available against the tentative tax on the post-2025 gift."

Situation 4: Whether, for estate tax purposes, a gift made during the increased BEA period that was sheltered from gift tax by the $10 million BEA inflates a post-2025 estate tax liability — For donors who (1) make gifts during the increased BEA period that are sheltered from gift tax by the $10 million BEA and (2) die after 2025, does the estate tax computation treat the gifts made during the increased BEA period as post-1976 taxable gifts not sheltered from gift tax by the credit on the BEA, considering that the post-2024 estate tax computation is based on the BEA in effect on the date of death rather than on the date the gift was made? In Situation 4, the IRS notes, "the statutory requirements for the computation of the estate tax, in effect, retroactively eliminate the benefit of the increased BEA that was available for gifts made during the increased BEA period."

Interplay between Steps 2 and 4 of the estate tax determination, and the differing amounts of BEA taken into account in Steps 2 and 4, can be problematic under Situation 4, the Preamble explains:

Step 2 determines the credit against gift taxes payable on all post-1976 taxable gifts, whether or not included in the gross estate, using the BEA amounts allowable on the dates of the gifts but determined using date of death tax rates. Step 3 subtracts gift tax payable from the tentative tax on the sum of the taxable estate and the adjusted taxable gifts. The result is the net tentative estate tax. Step 4 determines a credit based on the BEA as in effect on the date of the decedent's death. Step 5 then reduces the net tentative estate tax by the credit determined in Step 4. If the credit amount applied at Step 5 is less than that allowable for the decedent's post-1976 taxable gifts at Step 2, the effect is to increase the estate tax by the difference between those two credit amounts. In this circumstance, the statutory requirements have the effect of imposing an estate tax on gifts made during the increased BEA period that were sheltered from gift tax by the increased BEA in effect when the gifts were made.

Proposed regulations

To implement the TCJA's temporary changes to the BEA, the IRS will amend Reg. Section 20.2010-1 to (1) provide that, for decedents dying or gifts made from January 1, 2018 through December 31, 2025, the increased BEA is $10 million and (2) provide a special rule for when the portion of the credit as of the decedent's date of death that is based on the BEA is less than the sum of the credit amounts attributable to the BEA allowable in computing gift tax payable within the meaning of Section 2001(b)(2). The special rule would base the portion of the credit against the net tentative estate tax attributable to the BEA upon the greater of the two credit amounts.

The IRS and Treasury believe "the most administrable solution would be to adjust the amount of the credit in Step 4 of the estate tax determination required to be applied against the net tentative estate tax," the Preamble states.

Step 4 of the estate tax determination would be changed to "require the determination of a credit equal to the tentative tax on the AEA as in effect on the date of the decedent's death, where the BEA included in that AEA is the larger of (i) the BEA as in effect on the date of the decedent's death under [Section] 2010(c)(3), or (ii) the total amount of the BEA allowable in determining Step 2 of the estate tax computation (that is, the gift tax payable)." The Preamble asserts that the new proposed regulations "ensure that a decedent's estate is not inappropriately taxed with respect to gifts made during the increased BEA period."

Implications

The problem resolved by the proposed regulations is the same problem many practitioners feared with the 2001 Tax Act that increased the BEA from $1 million to $3.5 million only to have the Act sunset and return the BEA from $3.5 million back to $1 million. The estate tax calculation does not take into effect changes in the BAE that may take place during the life of a taxpayer, whereas the calculation of gift tax does take such changes into consideration by effectively giving the taxpayer credit for the tax on prior taxable gifts regardless of whether the tax was actually paid due to fluctuations in the BEA. The estate tax calculation does not do so and a change in the calculation is needed in order to ensure that taxpayers who take advantage of the fluctuating BEA during their lifetime are not subject to estate tax because the BEA at the time of the taxpayer's death is lower than the BEA that existed during the taxpayer's life (and used by the taxpayer during his or her lifetime). Whereas the 2001 tax act did not contemplate this mismatch, the TCJA did so contemplate and directed Treasury and the IRS to draft regulations that would ensure the inequity did not occur.

The proposed regulations provide a very simple solution to the differences in the way the gift and estate tax are determined by making the BAE the amount that is the greater of the BEA at death of the taxpayer or the BEA used during the taxpayer's lifetime. While this fix applies during the period of the TCJA, query whether it will apply after the TCJA expires. The regulations should remain in effect after the TCJA sunsets but there is always the chance that future congressional actions could change the result produced by the regulations.

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