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The IRS has issued final regulations (TD 9884) addressing the effect that changes made by the Tax Cuts and Jobs Act (TCJA) have on the basic exclusion amount used in computing federal estate and gift taxes. The final regulations will affect donors of gifts made after 2017 and the estates of decedents dying after 2025.

Although the IRS received written comments on the proposed regulations (REG-106706-18; see Tax Alert 2018-2476) published in November 2018, no public hearing was held. The final regulations adopt some of the changes recommended by commenters but deviate little from the proposed regulations.

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 IRC Section 2010(c)(3); (2) the deceased spousal unused exclusion (DSUE) amount under IRC Section 2010(c)(4), if any; and (3) in some cases, a restored exclusion amount under Notice 2017-15.

The TCJA amended IRC Section 2010(c)(3) by doubling the BEA for estate tax from $5 million to $10 million, adjusted for inflation, for decedents dying and gifts made during calendar years 2018–2025.

Federal gift tax, imposed under IRC Section 2501, is determined in a seven-step computation under IRC Sections 2502 and 2505 using the rate schedule set out in IRC 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. (IRC Section 2502(a)(1))
2. Determine a tentative tax on the sum of all taxable gifts made in all prior periods. (IRC 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. (IRC Section 2502(a))
4. Determine a credit equal to the applicable credit amount under IRC Section 2010(c). (IRC 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. (IRC 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. (IRC Section 2505(a))
7. Subtract the credit amount determined in Step 6 from the net tentative gift tax determined in Step 3. (IRC Section 2505(a))

Federal estate tax on the transfer of a decedent's taxable estate at death is calculated in a five-step computation under IRC Sections 2001 and 2010, using the same rate schedule that is used for gift tax purposes:

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). (IRC 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. (IRC Section 2001(b)(2) and (g))
   
   Under IRC 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 Treas. 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. (IRC 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. (IRC Section 2010(a) and (c))
5. Subtract the credit amount determined in Step 4 from the net tentative estate tax determined in Step 3. (IRC Section 2010(a))

Before the TCJA was enacted, the BEA was $5 million, indexed for inflation after 2011. The TCJA doubled the BEA to $10 million for estates of decedents dying in calendar years 2018 through 2025 (increased BEA period), but the BEA reverts to $5 million effective January 1, 2026.

Proposed regulations

To address concerns over what the tax consequences would be if a taxpayer were to gift between $5 million and $10 million during calendar years 2018–2025, and died in 2026 or later, when the BEA was only $5 million, the proposed regulations provided a special rule that would allow the estate to compute its estate tax credit using the higher of (1) the BEA applicable to gifts made during the decedent's life, or (2) the BEA applicable on the date of the decedent's death. The final regulations adopt the special rule from the proposed regulations so that a decedent's estate is not inappropriately taxed on gifts that were sheltered from gift tax by the increased ($10 million) BEA when the gifts were made.

Final regulations

Although most of the comments the IRS received expressed support for the special rule "to avoid an unfair situation that otherwise could effectively vitiate the statutory increase in the BEA" from 2008–2025, the IRS made some changes in the final regulations in response to comments received. A summary follows of the significant comments and the IRS's response to them in the final regulations.

Inflation adjustments

Comment: Clarify how the annual inflation adjustments to the BEA apply under the special rule.

Response: Examples of how the inflation adjustments worked were not included in the proposed regulations to simplify the illustration of the special rule. As the IRS and Treasury agree that examples would be appropriate, examples provided in the final regulations "reflect hypothetical inflation-adjusted BEA amounts." The Preamble notes that the increased BEA as adjusted for inflation is a use-it-or-lose-it benefit that is available to a decedent who lives beyond the increased BEA period if the decedent "used" the benefit by making gifts during the increased BEA period. (See Example 2 of Treas. Reg. Section 20.2010-1(c)(2)(i).)

Comment: Confirm that a decedent dying after 2025 would not benefit under the special rule from post-2025 inflation adjustments to the BEA to the extent the decedent made gifts large enough to cause the total BEA allowable in the computation of gift tax payable to exceed the date-of-death BEA as adjusted for inflation.

Response: Example 1 of Treas. Reg. Section 20.2010-1(c)(2)(i) in the final regulations provides this confirmation. To compute estate tax, the Preamble notes, the BEA is first applied against the decedent's gifts as taxable gifts were made; to the extent any BEA remains at the time of death, that remainder applies against the decedent's estate. Therefore, a decedent who made gifts in a large enough amount to cause the total BEA allowable in the gift tax computation to equal or exceed the date-of-death BEA, no BEA would remain available to be applied to reduce the estate tax. The IRS notes that the special rule does not change (1) the five-step estate tax computation or (2) that the credit remaining after computing gift tax payable may be applied against the estate tax.

DSUE

Comment: Confirm that a DSUE amount elected during the increased BEA period will not be reduced, even if the BEA amount decreases after 2025.

Response: Treas. Reg. Sections 20.2010-1(d)(4) and 20.2010-2(c)(1) confirm that reference to "BEA" means the BEA in effect at the time that the deceased spouse dies, as opposed to the BEA in effect when the surviving spouse dies. "A DSUE election made on the deceased spouse's estate tax return allows the surviving spouse to take into account the deceased spouse's DSUE amount as part of the surviving spouse's AEA," the Preamble explains. Ultimately, the sunset of the $10 million BEA, or any other decrease in the $10 million BEA, will not affect the existing DSUE rules or the existing regulations governing DSUE. Examples 3 and 4 of Treas. Reg. Section 20.2010-1(c)(2)(iii) and (iv) address this point.

BEA computations

Comment: Clarify how to calculate the credit amount solely attributable to the BEA in computing gift tax payable if the AEA consists of amounts other than the BEA.

Response: The final regulations provide guidance for determining the extent to which a credit allowable in computing gift tax payable is based solely on the BEA. Specifically, the regulations specify that:

1. The credit may not exceed the amount necessary to reduce the gift tax for the period to zero
2. Any DSUE amount available to the decedent for the calendar period is deemed applied to the decedent's gifts before any of the decedent's BEA is applied to the gifts
3. In a calendar period in which the AEA allowable for gifts made during the period includes both DSUE and BEA, the allowable BEA may not exceed the amount necessary to reduce the tentative gift tax to zero after applying the DSUE amount
4. In a calendar period in which the AEA allowable for gifts made during the period includes both DSUE and BEA, the portion of the credit based solely on the BEA for the period equals the BEA allocable to those gifts divided by the AEA allocable to those gifts

Generation-skipping transfer (GST) tax

Comment. Confirm that (1) donors may make late allocations during the increased BEA period of the increase in GST exemption to inter vivos trusts created before 2018, and (2) allocations of the increased GST exemption made during the increased BEA period will not be reduced as a result of the sunsetting of the increased BEA.

Response: The Preamble notes that an increase in the BEA correspondingly increases the GST tax exemption, because it is defined by reference to the BEA. The IRS also states, however, that these comments and the effect that the increased BEA has on the GST tax is beyond the scope of the regulations.

Anti-abuse rule

Comment: Consider adding an anti-abuse provision to prevent the special rules from applying to transfers subject to a retained life estate or other retained powers or interests.

Response: While acknowledging that adding an anti-abuse provision would be within the scope of the regulatory authority under IRC Section 2001(g)(2), the IRS believes that "such an anti-abuse provision would benefit from prior notice and comment." Therefore, the final regulations reserve this issue to allow discussion of it later.

Regulatory authority

Comment: The special rule would exceed the scope of congressionally granted authority because the rule is not limited to the treatment of transfers during calendar years 2018–2025.

Response: The IRS characterizes this assertion as inconsistent with both IRC Section 2001(g) — addressing the effect of changes in tax rates and exclusion amounts in the computation of the estate tax — and IRC Section 2001(g)(2) — addressing circumstances that can occur only after December 31. 2025, when the BEA increase sunsets and drops to $5 million. "The impact of the sunset of the increased BEA as of January 1, 2026, was precisely the situation Congress wished to have addressed when it made the explicit grant of regulatory authority under [IRC Section] 2001(g)(2) and, further, the purpose of that grant was to authorize a regulatory rule to ensure that there will be no imposition of estate tax on inter vivos gifts that were sheltered from gift tax by the increased BEA in effect when the gifts were made," the Preamble states.

Concluding that "the special rule is well within the scope of the regulatory authority and accurately reflects the purpose of that authority," the Preamble points out that a decrease in exclusion amount under current law cannot occur until 2026 or later, the period to which IRC Section 2001(g)(2) applies.

Alternate approach

Comment: The special rule would eliminate the benefit of some post-2025 inflation adjustments, so an alternative rule should be used instead. Under this alternative rule, gift tax payable to be applied after 2025 would be computed based on a $5 million BEA, as if the BEA had never increased to $10 million.

Response: The special rule does not eliminate the benefit of the post-2025 inflation adjustments or change that the credit based on the BEA may apply just once, the Preamble states. The IRS declined to adopt the proposed alternative rule, concluding that (1) it runs contrary to the plain language of IRC Section 2001(g)(2)(B); (2) it is inconsistent with how the credit in the unified gift and estate tax regime is treated — applied first against gift tax as gifts are made and later against the estate tax if any credit remains at death; and (3) computation of the estate tax is designed to impose a 40% tax on the taxable estate of a decedent who has fully exhausted the available credit by making gifts during life, regardless of whether the increased BEA sheltered those gifts from tax.

Applicability date

The final regulations generally apply to estates of decedents who die on or after November 26, 2019. Paragraph (e)(3) of the regulations — pertaining to the BEA — applies to estates of decedents dying after December 31, 2017 and before November 26, 2019.

Implications

The problem resolved by the proposed regulations is the same one that many practitioners feared when the 2001 Tax Act increased the BEA from $1 million to $3.5 million, only to sunset and return the BEA from $3.5 million to $1 million. The estate tax calculation does not take into account 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. A change in the estate tax calculation is needed so that taxpayers who take advantage of the fluctuating BEA during their lifetimes are not subject to estate tax simply 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). Unlike the 2001 Tax Act, the TCJA contemplated this mismatch and directed Treasury and the IRS to draft regulations that would prevent the inequity from occurring.

The final 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.

The final regulations address for the first time how the DSUE amount played into the estate tax calculation set forth in the proposed regulations and retained in the final regulations. The final regulations make clear: (1) the DSUE amount is never lost even if the BEA for the taxpayer is reduced, and (2) the DSUE amount is applied before the surviving spouse's BEA amount is applied (consistent with the ordering rules in existing Treas. Reg. Section 20.2010-3(b)). The final regulations add two examples to those contained in the proposed regulations to demonstrate the interplay of the DSUE amount and the BEA.

The final regulations also make clear that Treasury and the IRS believe that these regulations will survive the sunset of the TCJA. Treasury and the IRS explain that the whole reason IRC Section 2001(g) (instructing the Secretary of the Treasury to proscribe regulations to mitigate adverse tax consequences regarding fluctuations in the BEA) was added to the IRC was to address an issue that would only occur after the TCJA sunset. Therefore, Treasury and the IRS conclude that the final regulations will be given effect after the TCJA's sunset.

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