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The IRS has issued proposed regulations (REG-118913-21) amending estate tax regulations on the basic exclusion amount (BEA) used in computing federal estate and gift taxes. The proposed regulations would affect estates of decedents dying after 2017 and before the BEA decreases (presumably in 2026).

The Tax Cuts and Jobs Act of 2017 (TCJA) increased the BEA from $5m, adjusted for inflation after 2011, to $10m for decedents dying and gifts made in calendar years 2018–2025; under the current law, the BEA will revert to $5m, adjusted for inflation, on January 1, 2026.

Background

In addition to amending IRC Section 2010(c)(3) to increase the BEA from $5m to $10m for decedents dying and gifts made after December 31, 2017 and before January 1, 2026, the TCJA added new IRC Section 2001(g)(2). This provision authorizes the Treasury Secretary to issue regulations addressing the tax consequences for an estate whose decedent makes gifts between $5m and $10m during calendars years 2018–2025, when the BEA is $10m, but dies after 2025, when the BEA decreases to $5m.

In late 2019, the IRS and Treasury issued final regulations (TD 9884; see Tax Alert 2019-2111) under IRC Section 2010 to address situations described in IRC Section 2001(g)(2). The final regulations adopted a "special rule" that allows the estate to compute its estate tax credit using the higher of (1) the BEA applicable on the decedent's date of death, or (2) the BEA applicable to gifts made during the decedent's life (IRC Section 2001(b)). The purpose of the rule is to ensure the donor's estate is not taxed on completed gifts on which no gift tax was imposed due to the increased BEA.

The Preamble to the TD 9884 noted that "further consideration would be given to the issue of whether gifts that are not true inter vivos transfers, but rather are includible in the gross estate, should be excepted from the special rule." The new proposed regulations reflect that effort.

Proposed regulations

The Preamble to the proposed regulations explains that the "special rule" currently does not distinguish between completed gifts that are treated as (1) adjusted taxable gifts for estate tax purposes and not included in the donor's gross estate and (2) testamentary transfers for estate tax purposes and included in the donor's gross estate. The IRC, however, distinguishes between these two types of transfers. IRC Section 2001(b) excludes from "adjusted taxable gifts" any gifts that are includible in the gross estate. Similarly, IRC Section 2701(e)(6) and Treas. Reg. Section 25.2701-5 remove from adjustable taxable gifts any transfers includible in the gross estate that had already been subject to the IRC Section 2701 special valuation rules. The Preamble notes that the proposed regulations "generally would deny the benefit of the special rule to includible gifts" by maintaining the IRC's distinction between completed gifts treated as adjusted taxable gifts and those treated as testamentary transfers. In either case, the IRC "ensures that the gift is treated consistently with respect to credits allowable in the year in which the gift was made."

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, applying the same rate schedule used for gift tax purposes:

1. Determine a tentative tax on the sum of the taxable estate and the adjusted taxable gifts (IRC Section 2002(b)(1))
2. Determine a hypothetical gift tax on all post-1976 taxable gifts (IRC Section 2001(b)(2) and (g))
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 applicable exclusion amount 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))

The Preamble notes that the exclusion from adjusted taxable gifts of transfers includible in the gross estate does not affect Step 2, and gift tax is payable on all post-1976 taxable gifts, regardless of whether they are included in the gross estate. Because both "the hypothetical gift tax and the credit amounts are computed using the gift tax rates in effect at the date of death, when computing estate tax, a credit is provided for all credits provided on includible gifts in the year the gifts were made." This includes credit amounts attributable to the $10m BEA.

In response to a public comment received on proposed regulations that preceded TD 9844 (see Tax Alert 2018-2476), these new proposed regulations would provide an exception to the special rule for includible gifts. The commenter had asked whether a special rule should apply to taxable gifts made during the increased BEA period if the gifts are "essentially testamentary and thus included in the gross estate rather than in adjusted taxable gifts."

The Preamble explains that the special rule is designed to ensure that bona fide inter vivos property transfers are consistently treated as gifts for purposes of gift and estate tax. The Preamble points to a subset of includible gifts — gifts made during the increased BEA period that are essentially testamentary but are deductible for gift tax purposes due to the charitable or marital deduction — to which the special rule does not apply. Inconsistent gift or estate tax treatment will not occur with these gifts because no credits allocable to the gifts would be attributable to the BEA when computing gift tax payable under IRC Section 2001(b)(2). With no BEA applicable to the deductible gifts, the increase or decrease of the BEA is of no consequence.

Given that the IRC treats certain transfers as testamentary transfers, rather than adjusted taxable gifts, it "would be inappropriate," the drafters thought, to apply the special rule to includible gifts, particularly if the transferor retained some right to the transferred property. "To prevent this inappropriate result," the Preamble explains, the proposed regulations provide an exception to the special rule.

Specifically, new proposed Treas. Reg. Section 20.2010-1(c)(3) would provide an exception to the special rule for transfers that are includible in the gross estate or treated as includible in the gross estate for IRC Section 2001(b) purposes, including:

1. Transfers subject to a life estate or other powers or interests described in IRC Sections 2035–2038 and 2042, regardless of whether the transfer was deductible under IRC Sections 2522 or 2523
2. Transfers made by an enforceable promise to pay, to the extent the promise remains unsatisfied at date of death
3. Transfers that were subject to IRC Sections 2701 (regarding special valuation rules of certain transfers of interests in partnerships and corporations) and 2702 (regarding the transfer of income interests in a trust)
4. Transfers that would have been included in 1, 2 or 3 but for the elimination of that transfer from the gross estate within 18 months of the death of the transferor

Applicability date

When published in final form, the regulations will apply to estates of decedents dying on or after April 27, 2022, the date the proposed regulations were published in the Federal Register. If the BEA decreases before final regulations are issued, the exception to the special rule contained in the proposed regulations will apply to estates of decedents dying on or after April 27, 2022.

Implications

The proposed regulations will have somewhat limited application for more straightforward "bonus" gift exemption planning (e.g., $12.06m gift of cash, stock etc. with no retained interests). In other words, the proposed regulations should not negatively affect a completed gift that does not involve any kind of retained interest.

If, however, a donor has made higher-exemption gifts of assets that may have some potential estate tax exposure, for example, interests in family limited partnerships or a limited liability company under IRC Section 2036, the proposed regulations could present a risk of the estate's only getting the benefit of a lower BEA at death.

So-called "Defective Preferred Partnerships," which are designed to intentionally trigger a deemed gift under IRC Section 2701 while retaining a lifetime cashflow in the form of a preferred equity stream, will not work under the proposed regulations. Under the proposed regulations, the donor's estate would only be entitled to the lower BEA applicable at the donor's death (assuming a death after the "sunset" at the end of 2025, or if the BEA is reduced early by legislative change).

Longer-term taxable Grantor Retained Annuity Trusts (GRATs) may fail to meet the special rule. For example, if a donor attempts to create a non-zeroed-out GRAT in order to trigger a taxable gift to absorb the higher gift tax exemption amount, and the donor does not survive the GRAT annuity term, the donor's estate would only be entitled to the lower BEA applicable at the donor's death (assuming a death after the "sunset" at the end of 2025, or if the BEA is reduced early by legislative change).

The gift of an enforceable promissory note by a donor who dies before the note is paid off would result in the note's being included in the donor's estate and the estate's only being entitled to the lower BEA applicable at the donor's death.

Gifts that (1) a donor makes to a Grantor Retained Income Trust to trigger a deemed gift that will absorb the donor's higher gift-tax exemption and (2) terminate within 18 months of the donor's death, will be included in the donor's estate — and the estate will only be entitled to the lower BEA applicable at the donor's death. This also would appear to be the case with Qualified Personal Residence Trusts, although not explicitly mentioned in the proposed regulations.

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Published by NTD's Tax Knowledge Services Group, Washington, D.C.; Maureen P. Sanelli, legal editor